The Financial Conduct Authority (“FCA”) has announced that in spring 2015 it intends to launch a market study into the effectiveness of competition in the UK investment and corporate banking services sector. The announcement coincided with the release of the FCA’s Feedback Statement in its Wholesale Sector Competition Review 2014-15 (the “Review”), which explains the rationale for its decision to launch a formal market study and its general thinking on the state of competition in various wholesale financial markets. The proposed investment and corporate banking services market study will be the FCA’s first wholesale market study.
What is a market study?
Market studies are general reviews of why particular markets may not be working well. Under new competition legislation in force since 1 April 2014, the Competition and Market Authority (“CMA”) or a sector regulator with relevant concurrent competition law powers must complete a market study within one year of formal launch. One of the possible outcomes of a market study is reference for a second-stage market investigation lasting 18 months (or 24 months if extended). Within six months of the launch of a market study, the CMA or relevant regulator is obliged to consult on whether or not it should make such a reference, where it proposes to refer or has received representations that it should refer, or must announce that it will not make a reference.
Market studies and second-stage market investigations are regulated by specific legislation separate from the mainstream competition law prohibitions and, unlike those prohibitions, they do not involve the penalisation of individual companies’ conduct. However, the frame of analysis may overlap with mainstream competition law and a market study/investigation may lead to competition law enforcement.
The FCA already conducts market studies into the state of competition under its regulatory powers. However, from 1 April 2015, the FCA will have full concurrent competition law powers, allowing it to make references to the CMA for phase-two market investigations.
The key issues for investment and corporate banking services
The Review began by noting that a high-level indicator of the effectiveness of competition in a given sector is the concentration level in the market. The FCA found that there was a “typically moderate” level of concentration in the markets in which investment banks are active, with the top 15 banks accounting for 81% of the market share in debt and equity capital markets. However, the FCA then went on to state that concentration is not a defining indicator of the effectiveness of competition in a given sector, and that there are three key concerns currently present in the investment (and corporate) banking services sector:
- Low levels of transparency – the quality and costs of investment and corporate banking services were found to be difficult to predict in advance and difficult to understand generally, even taking into account the commercial sophistication of corporate buyers.
- Bundling and cross-selling of services – although the FCA accepted that investment and corporate banking services benefit from economies of scope, where the main cost for the banks is their investment in the client relationship rather than the provision of an additional service, it was deemed to be very difficult for clients (especially SMEs) to assess whether they are getting value for money when presented with a bundled set of services. Furthermore, the bundling and cross-selling of services by the larger market players was deemed to act as a potential barrier to entry and expansion by smaller market players.
- Conflicts of interest – the FCA was critical of the banks’ potential lack of compliance with the regulatory requirement of “best execution”, which obliges investment and corporate banks to take all reasonable steps to obtain the best possible result when executing orders on behalf of retail and professional clients. The FCA found that banks are often incentivised to allocate equity and/or debt to their preferred clients, as opposed to entities that would most benefit the issuing client’s interests. Furthermore, due to the complicated bundling of the package of services offered to the client, the FCA found that there are real risks that the client is not even aware of this practice by the banks.
The reasons for a market study in this case
In its Review, the FCA states: “We currently undertake market studies when we have identified that there are potential competition issues in a market. We do not need to have found definitive evidence of such issues.” The FCA then outlines a number of reasons as to why it considers a market study into investment and corporate banking to be a priority. These include:
- Poor disclosure of the costs of the different components of a bundle, mixed with weak bargaining power or weak monitoring incentives of a client, acts to the detriment of the client. It may not only lead to a difference in quality of the services offered to clients depending on their size and bargaining power, but also to the locking-in of clients by banks who are able to impose high switching costs through their stronger negotiating capabilities.
- The FCA recognises that there nevertheless may be strong efficiency reasons for tying, bundling, and cross-selling of services by banks. A market study would allow them to explore further the actual effects on the market of these practices.
- The FCA has also identified competition issues in relation to asset management and related services and anticipates launching a further market study into those services at a later stage. It is delaying the launch of an asset management market study to allow implementation of new regulations which may influence market behaviour. The FCA believes that there are no comparable forthcoming regulations for investment/corporate banking services and that this is another reason to prioritise a review of those services. For instance, its states in the Review that it does not believe that anticipated changes to MiFID II concerning trade transparency requirements undermine the case for a market study.
- The very high potential scale of benefits from improvements in the operation of competition in the investment and corporate banking sector. In 2013, the revenues received from investment and corporate banking services provided to UK corporate clients alone totalled £10bn. A client overpaying for the banking services it buys, or receiving inadequate advice on e.g. the share price of an IPO, could also influence its other investment decisions in a way that will ultimately be passed on to retail consumers. The wider economy, especially the UK’s, is heavily affected by the cost and quality of services provided by investment and corporate banks.
What can we expect to happen?
The FCA will launch its market study in the spring by means of a market study notice accompanied by publication of its terms of reference. This will trigger the one-year market study period mentioned above.
Although some commentators have cast doubt on how easy it will be to change current practices through competition law measures, banks that operate in the investment and/or corporate banking sectors will unquestionably be paying close attention to the contents of the terms of reference for the imminent market study, which will come out at the very moment the FCA acquires new competition law powers. Despite the FCA’s statement that expected regulatory changes need not hold up this market study, some stakeholders may contend that, at least in part, the FCA’s concerns may be addressed by changes likely to be introduced in parallel by MiFID II.
It is also likely that banks operating in those sectors will be asked for extensive information and for their views concerning relevant practices. The FCA is already talking about further wholesale market studies (e.g. into asset management) and this announcement could well be the start of a comprehensive and lengthy period of intense scrutiny with potentially significant regulatory outcomes.
To read the FCA’s press announcement and the full Wholesale Sector Competition Review 2014-15, please click here.