MLex Comment: UK banking policy could spell trouble for the Treasury

Author: Sebastian Chrispin
26 Nov 09 | 09:00 GMT+1

IN BRIEF
The UK Treasury announced that Royal Bank of Scotland and Lloyds Banking Group must each make a series of divestments in return for further capital injections from the government in the name of increasing competition. The government hopes this will increase competition on the banking market, but putting strict conditions on the potential purchasers of those assets may not achieve that goal.

The UK Treasury announced that Royal Bank of Scotland (RBS) and Lloyds Banking Group (Lloyds) must each make a series of divestments in return for further capital injections from the government in the name of increasing competition. The government hopes this will increase competition on the banking market, but putting strict conditions on the potential purchasers of those assets may not achieve that goal.

Such requirements are common following the grant of state aid, and have been made in consultation with the European Commission. But the government went a step further by demanding that these assets should only be sold to “small or new players in the market,” meaning those who will not command more than 15 percent of the banking market following the deal. The Treasury claimed this would “increase diversity and competition in the UK banking market.”

But the UK banking sector is heavily dominated by the ‘big four’ of Barclays, HSBC, Lloyds TSB and RBS. Commentators have questioned whether there are enough bidders who meet these criteria to guarantee the Treasury gets a fair price.

Even once a successful bidder is selected, whether this policy will really increase competition in the banking industry remains to be seen. Recent deals show that institutions of this size have struggled to survive independently, let alone challenge the industry’s heavyweights, and seem to chart the demise of the high street building society. TSB was bought out by Lloyds, Abbey by Santander, and Standard Life Bank is in the process of being acquired by Barclays.

If the new owners have to make an exit, the UK government could be faced with the unfortunate choice of buying these assets back or reneging on its earlier policy and selling them to one of the big players.

In either scenario, the government would not have realised its hopes of increasing banking competition.

A further hypothetical possibility is that banks who would have been interested in buying the assets but are barred by the Treasury’s market share restrictions, could appeal the policy in the European courts.

There is a technical legal argument that by placing such restrictions on who can make a bid, the Treasury has misapplied state-aid rules. An excluded potential bidder could, in theory, appeal the decision for failing to apply state-aid rules properly.

Both Santander and HSBC have publicly acknowledged an interest in entering the bidding for various assets, and could feasibly launch a challenge. But neither bank may have the appetite to engage in costly and time-consuming litigation.

- UK policy -

On 3 November, the Treasury stated that the government would furnish the two banks with a capital injection just shy of 40 billion pounds. In return, both Lloyds and RBS must agree to various commitments, chiefly to sell assets that, according to the Treasury, amount to 10 percent of the UK retail banking market.

The commission has approved the measures claiming that the policy will help a small or new player enter the banking market and will “remove the distortions of competition.”

But despite getting the green light from Brussels (see here), the Treasury has left itself open to questions about how it seriously expects to boost banking competition by tacking on conditions to state-aid policy.

- Possible failure -

The media has been rife with rumours regarding who could, or would, put in a successful bid for the assets.

The UK’s top four banks are ruled out as they control well above the Treasury’s 15 percent threshold; Spain’s Santander is similarly ineligible for retail assets. Meanwhile some other large international banks in receipt of state support are forbidden from making any further acquisitions for the time being.

The media spotlight has also focused on retailers including Tesco Finance and Virgin Money. While both have expressed an interest in opening a branch-based bank, there are doubts as to whether such bidders would seriously consider buying the RBS or Lloyds assets under current conditions.

In addition, private equity has been cited as a source of possible finance, but such bidders would be looking from the asset for an exit within only a few years. As such they cannot be relied on to improve long-term competition in the banking sector.

The Treasury has given RBS and Lloyds until 2013 to find a buyer. Although it is difficult at this stage to predict who that buyer will be – and the banking landscape will doubtless look totally different by then – the UK banking industry remains attractive to investors, and few doubt that bidders can be found.

But the restrictions placed on who can enter the race may render the sale more tricky. The smaller number of potential bidders could adversely affect the ultimate sale price or, more importantly, may not result in increased competition in the banking industry.

- Competition concerns -

The leading UK banks have a long-established control of the UK banking sector. In a 2001 review by the UK’s Office of Fair Trading into a proposed banking merger, which has been widely quoted since, the top four UK banks controlled around 70 percent of the current account and 80 percent of small- and medium-sized business (SME) banking market.

A report into the UK banking industry, published in 2000, also identified limited competition in the sector.

With a brake on any purchaser controlling more than 15 percent of the banking market, any new entrant would be dwarfed by the big four and may struggle to draw customers away from the main UK banks, which have established strong brand identities and ongoing customer relations.

While it is possible for small competitors to operate alongside an oligopoly, and sometimes pose a serious challenge to the main players, conditions within the banking industry may render this more difficult.

Chief among those is that costs of increased regulatory requirements being placed on banks may have to be passed on to consumers, who will pay higher charges for basic banking services. Small industry players may struggle to spread these costs as thinly as their larger competitors, and so may be unable to offer competitive rates.

While the commission has long pushed for an integrated pan-European banking market, the need to divest at a time of uncertainty inspired by the financial crisis may dissuade foreign institutions from entering the British market. Such forced sales may equally push some banks back behind their national barriers – by making them sell their foreign assets first – and decrease the likelihood of international institutions bringing competition to foreign markets.

Furthermore, the assets on sale are roughly the same size as two small UK banks or building societies – according to the commission, the Lloyds assets alone account for 4.6% of the current-account market – which will probably be based on the Northern Rock model. The idea is that the banks will have 100 percent ‘coverage,’ i.e. it will only lend out what it receives from depositors.

The problem, as Northern Rock discovered, is that this is hard to maintain if the bank is to remain competitive. In order to carry on lending, the banks would require a constant flow of new depositors and rely on a massive upstream flow of funds. Once its lending growth outstripped its deposit base, the Newcastle-based mortgage lender turned to capital markets in order to borrow money, to its misfortune.

If a buyer finds itself in a similar situation, and has to sell the assets sooner than expected, the government may have to find yet another bidder, and possibly resort to one of the top four banks that it is trying to avoid.

Moreover, its attempt to boost banking competition with cumbersome state-aid policy will have failed.

Banks that have received state aid are also banned from undercutting competitors who did not, and rolling out products or offering services that make use of their state support. For example, in return for a capital injection from the German government, Commerzbank is not allowed to do business (which includes deposit-taking) under more favourable price conditions than its top three competitors in markets, or products where it has a market share above five percent. Such restrictions not only inhibit competition, but also mean that consumers suffer.

It appears that even if the Treasury manages to get its problematic policy off the ground, it may not see the increased competition that it craves.