Summary

The OFT has just issued the findings of it’s investigation into barriers to entry, expansion and exit in retail banking which was launched in May earlier this year. The report has identified a number of areas which may potentially cause difficulty for firms wishing to enter the market, especially small firms. If firms face significant difficulties in entering and competing in the market then it is said incumbent firms will not be exposed to the challenge of competition and will have little incentive to reduce costs, innovate and price competitively. Equally, barriers to exiting the market mean inefficient firms will be insulated and new entrants will be deterred from trying to compete with or replace them.

Regulatory Requirements and Processes

Obtaining authorisation

There were concerns expressed to the OFT that firms were having difficulty obtaining authorisation from the FSA to operate in this market. Firms have reported that the actual process involved in obtaining authorisation is difficult and there is uncertainty surrounding the approach taken.

The report notes that the FSA has recently revised its authorisation procedure with the intention of making it more transparent and to provide greater certainty for applicants. The OFT will continue to monitor this area to gauge the effect of this revision.

Changes to Capital Requirements

The findings of the investigation suggest that new entrants and smaller firms face proportionally higher capital requirements than incumbent firms. This has increased their cost of capital and limited their ability to use the capital for expansion. The Basel III rules which will commence with a transition period in 2013 will further increase the level of capital required and place restrictions on the risk level of assets making up this capital.

The investigation has revealed that many small firms are concerned that this will impact on them significantly, however, it is also reasoned that the reforms will have the greatest impact on large banks as they remove from the list of permitted capital certain financial instruments commonly used by them. The OFT suggests that prudential regulators should consider and monitor the impact of these reforms on competition in the market.

No evidence was received by the OFT to suggest that compliance with consumer protection regulation or money laundering regulation is creating a barrier to entry.

Access to IT systems, payment schemes, information and finance

The IT platform and systems which a new retail bank needs to set up come at a significant initial cost, much of which will be sunk and unrecoverable if the firm subsequently has to exit the market. This can be a strong deterrent to market entry. Further, if entrants are unable to attract enough customers to recover these significant initial costs then they will find it difficult to sustain their business.

Although there have been reports of entrants encountering difficulties when trying to access payment schemes or gain merchant services, there was little evidence presented to the OFT to suggest that this has caused a widespread barrier to entry. Access to important payment schemes such as CHAPS and BACS by new entrants appears to be achievable.

The OFT also considered restrictions on access to customer risk profiles. The report found that customer risk information is less readily available in relation to personal customers and small/medium enterprises (SME’s), which are likely targets for a new entrant to the market. This, it is said, has the effect of making it difficult for firms to research and competitively price their products. However, the report also says a number of private sector initiatives are currently working on remedying this by gathering further information on SME risk profiles.  

A lack of interbank finance following the financial crisis is also noted by the OFT as a barrier to expansion within the market as firms are having difficulty finding viable alternative funding.

Achieving scale in the market

The OFT identified that a major problem faced by new entrants to the retail banking market is the struggle to attract new customers and achieve the kind of scale necessary for a sustainable business.

A particular problem reported is the reluctance of both personal and business account holders to switch from their current financial provider, even if a new entrant is offering a more suitable product and despite poor performance by an incumbent bank.

Noting that in the last few years the number of customers switching bank has remained very low, the report goes on to say that current accounts act as a gateway for firms to offer other financial products such as loan facilities. Without this initial business the new bank’s customer base will be extremely limited.

The investigation has shown that brand loyalty and the availability of a local branch play a significant role in determining which bank a consumer chooses. There is a wide reluctance across the UK to consider non UK banking providers, or those who do not offer a local branch such as “online only” banks. These trends, it is said, will act as barriers to expansion for new firms, limiting their ability to grow a customer base and compete effectively. It is noted that even the hugely powerful brands Tesco and Virgin have not had as great an impact on the market as they may have hoped for when they launched their own banks earlier this year. This is suggestive that the reluctance of consumers to switch their banking provider is a much greater barrier than the other issues considered.

Barriers to exit

Due to the interdependent nature of retail banking the failure of any large firm will impact systematically on the rest of the market (as was seen in the recent financial crisis), and to guard against the total collapse of the market the Government has put in place mechanisms to protect consumers in the event of a bank failing. Unfortunately, the report goes on to say, these protections may have the effect of ‘rescuing’ the failing bank at taxpayers expense, which effectively prevents a bank like Northern Rock from exiting the market. Accordingly, competition may be considerably weakened if inefficient firms are not allowed to exit the market and are insulated from insolvency risks by way of Government intervention and regulation. This, it is said, will affect both those smaller firms wishing to enter the market and compete, and the incumbent firms who are trying to rival other existing large firms.

The OFT notes two regulations which may have such an adverse effect; the Special Resolution Regime (SRR) and the Financial Services Compensation Scheme (FSCS). Both were set up to prevent a bank harming consumers following a disorderly exit from the market, but according to the report may actually be harming those consumers by preventing failing institutions from recognising problems earlier and forcing them to carry out damage control. Instead, it is suggested that the banks are able to carry on in hope of improvement, in the knowledge that there is regulation in place to bail out their customers in the event they fail.

Despite these concerns the investigation has not uncovered any evidence to suggest that these regulations are in fact acting as barriers to exit. The OFT expects that, whilst not specifically mentioned in the regulation, market competition would be considered when applying them.

Conclusions and proposals

This investigation was not the first to look in to the problems in retail banking regulation. It follows earlier reports which identified the existence of a moral hazard within the sector, centred around an inherent conflict between regulation and competition.

An issues paper published by the Independent Commission on Banking in September 2010 examined the flaws in the market and their role in the recent financial crisis. The paper noted the competition risks posed by the giving of financial support to the banking sector and posed the question “Can the financial system be reformed to contain the impact of the failure of a significant institution?”

The Commission plans to publish a more detailed analysis of the reform options in spring 2011, though suggested options included the total separation of retail banking from investment banking, and the application of “narrow” banking involving the removal of Government protection for anything but retail deposits. It could be suggested that the Commission will be publishing its conclusions a little late given that Chancellor George Osborne announced the Government’s plans for reform in the finance sector in his Mansion House speech back in June this year1.

With radical reform pending it remains to be seen to what extent the Government will act on the findings of these reports, and whether the new regulatory framework will be any more effective at preventing these market barriers than the last.