Review of barriers to entry, expansion and exit in retail banking

November 2010

OFT1282

© Crown copyright 2010

This publication (excluding the OFT logo) may be reproduced free of charge in any format or medium provided that it is reproduced accurately and not used in a misleading context. The material must be acknowledged as crown copyright and the title of the publication specified.

CONTENTS

Chapter/Annexe Page

1 Executive summary 4

2 Introduction 15

3 Overview of the retail banking sector 25

4 Overview of barriers to entry, expansion and exit 59

5 Regulatory requirements 67

6 Essential inputs 104

7 Barriers to expansion 124

8 Barriers to exit 162

9 Conclusion 174

A Parties consulted or who submitted evidence 181

B Consumer omnibus survey 184

C SMEs UK-wide survey 199

D SMEs Scotland-wide survey 222

E List of banks as compiled by the FSA on 30 September 2010 230

1 EXECUTIVE SUMMARY

1.1 The retail banking sector, supplying services to households and small and medium-sized businesses, is at the core of the UK's financial system and the wider economy. It provides essential services, including the means to make payments, deposit funds and access credit. In doing so, it supports the economy and society as a whole, forming a critical part of the investment chain, linking savers with borrowers, and helping people and businesses manage financial risks. The efficiency of the retail banking sector is therefore an important contributor to economic growth and productivity in the UK.

1.2 Retail banking has seen a number of long-term trends, such as growing consolidation and technological change. From summer 2007 onwards, the sector has been affected by the financial crisis. Some well-known brands have exited retail banking through consolidation or failure, or – perhaps temporarily – by choosing not to offer products in certain markets, leaving consumers with more limited choices of provider.

1.3 More recently there has been entry of new firms, and the expected entry of others, into retail banking in the UK. The divestment of banking assets by State-aided banks may also create opportunities for other firms to achieve a large-scale presence in the sector without having to incrementally build up their customer base from scratch.

1.4 Barriers to entry, expansion and exit, which can be a natural feature of the market or be created, or exacerbated, by the behaviour of incumbent firms, are critical to these developments. If firms face significant difficulties in entering and competing in the market, incumbent firms will not face the threat of new firms challenging them for business and will have little incentive to reduce costs, innovate and price competitively to retain and attract customers. Similarly, if there are barriers to exit, these may prevent inefficient incumbent firms from being replaced by more efficient entrants and thus dampen incentives for market entry.

1.5 The financial crisis has also been the catalyst for far-reaching reviews and proposals for regulatory change across the world. In the UK, the

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Government has set up the Independent Commission on Banking (ICB) to examine issues around the promotion of stability and competition in banking for the benefit of consumers and businesses.1 The institutional regulatory framework for banking is also being reviewed and globally there have been moves to revise capital and liquidity requirements that banks must meet.

1.6 The changing market and the regulatory and other changes being considered set the context for this review. As was set out at its launch in May 2010, the purpose of this review is to gain a better understanding of barriers to entry, expansion and exit in personal and SME banking markets, and to understand better the long term competitiveness of the retail banking sector. It is designed to examine the existence, and extent, of any barriers to entry, expansion or exit in retail banking – both to help the OFT in its future work and to provide evidence and analysis to inform the wider public debate and the work of other authorities and bodies such as the ICB.

1.7 The review builds upon the OFT's previous work in this area, such as the 2008 market study on personal current accounts (PCAs), and that of others, such as the Competition Commission's (CC) 2002 investigation into SME banking.

1.8 As part of this review, the OFT has received evidence from, and discussed the issues with, over fifty different parties. These parties include banks, building societies, recent and prospective entrants, industry bodies and consumer groups. The OFT has also worked with external partners in seeking primary evidence on consumer behaviour, as well as analysing public source material and market research data.

1.9 The OFT has examined four aspects of personal and SME banking where there may be potential barriers:

• regulatory requirements and processes

1 These, and other studies, are referenced and referred to elsewhere in the review.

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• access to essential inputs, such as IT systems, payment schemes, information and finance needed to offer retail banking products

• the ability of new entrants to attract customers and achieve scale, and

• issues around exiting the market.

1.10 In summary, the OFT has found that new entrants face significant challenges in attracting customers and expanding their market shares in retail banking. While we have heard some concerns around the operation of regulatory processes, most firms are able to achieve the necessary regulatory authorisations to accept deposits and extend credit. They are also able to gain access to the necessary infrastructure to offer retail banking products, although for the smallest SMEs there is limited information available which may make it more difficult for new entrants to offer them banking products and, for certain types of firms, a lack of non-retail funding may limit their ability to grow. However, we have found that new entrants face significant challenges in attracting personal and SME customers through a combination of low levels of switching, high levels of brand loyalty and consumers' preference for providers with a branch network.2 These challenges pose the greatest barriers and can have the effect of deterring firms from entering the market in the first place if they do not believe they will be able to attract sufficient numbers of customers to recover start-up costs, grow market share and maintain a successful presence in the market.

2 The extent of these challenges may differ across parts of the UK, for example attracting sufficient numbers of customers may be easier in urban areas compared to rural areas, and there may also be differences between England, Scotland, Wales and Northern Ireland. The impact of any barriers will also differ across firms and across different retail banking product markets.

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Regulatory requirements and processes

1.11 To offer retail banking products, a firm typically needs to be authorised by the appropriate regulatory authority. The OFT has considered issues around the following regulatory requirements and processes:

• obtaining authorisation from the FSA to be able to accept deposits and offer mortgages

• obtaining a consumer credit licence from the OFT to offer credit to customers, and

• ongoing regulatory requirements faced by firms to offer retail banking services, such as capital and liquidity requirements, money laundering regulations and consumer protection regulations.

1.12 Based on discussions with relevant parties and its own analysis, the OFT considers that firms do not face significant barriers to entry arising from regulatory requirements that must be met in obtaining authorisation to accept deposits or offer mortgages. However, the OFT has been informed that firms have faced difficulties and uncertainties arising from the process involved in obtaining authorisation and this has had the effect of delaying entry and making it harder to raise capital. The FSA has recently revised its authorisation procedures to increase transparency and introduce a more 'modular' or staged approach to give greater certainty. While it is too early to conclude whether these changes have lowered regulatory barriers, the OFT welcomes these steps, as well as any further initiatives to improve transparency and information provision. These changes may also merit monitoring.

1.13 The OFT has not received any evidence to suggest that the process for obtaining a consumer credit licence constitutes a significant barrier to entry for the vast majority of applicants

1.14 It has been suggested that new entrants (and smaller firms) have faced proportionally higher capital requirements than incumbents that have imposed a higher cost of capital and limited their ability to use this capital for expansion. Significant changes to capital requirements will be

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introduced over the next few years. It appears that new capital requirements, along with liquidity standards, could have the potential to exacerbate differences between incumbents and new entrants, for example, by imposing higher fixed costs of compliance. However, some parties have argued that other proposed changes may also reduce any discrepancies, such as removing certain financial instruments most commonly used by large banks from the list of permitted capital. As the new requirements take effect, it may be appropriate for the prudential regulators to consider and monitor the impact on competition of these changes.

1.15 The OFT has not received any evidence to suggest that compliance with consumer protection regulations, money laundering regulations or other regulatory requirements constitute barriers that prevent firms entering and competing in the retail banking sector.

Access to IT systems, payment schemes, information and finance

1.16 In order to be able to effectively provide retail banking services, firms need to have in place or have access to:

• IT systems that can deliver retail banking services to customers

• payment schemes that allow an individual firm to connect to industry-wide networks to send and receive payments

• essential information to give firms the ability to determine potential customers' risk profiles accurately, and

• sources of funds to finance expansion to allow firms to grow in response to consumer demand.

1.17 While firms have a number of options for establishing IT systems, all of these involve a substantial cost for a new entrant, much of which is likely to be sunk and not recoverable in the event of market exit. IT system costs account for up to two-thirds of all start-up costs, though the figure may be much lower for those firms only offering a limited number of products. While there is no standard minimum scale required

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to recover these costs (as entrants' business models and consequently their IT requirements differ), if entrants are unable to attract sufficient numbers of customers to recover these costs they will find it difficult to compete sustainably in the market.

1.18 While in some instances new entrants with unconventional business models have experienced difficulties in initially accessing industry-wide payment schemes such as the Clearing House Automated Payment System (CHAPS) and the Bankers' Automated Clearing System (Bacs), the OFT has not received evidence to suggest that there are significant or widespread barriers to achieving access to these systems.

1.19 There is a wealth of information on personal and SME customers' risk profiles available from a number of commercial sources to assist firms in accurately pricing their products. Access to this information does not appear to be restricted. However, less information is readily available on the smallest SMEs. This can have the effect of making it harder for new retail banking providers to be able to offer products, such as lending, to these SMEs due to a lack of reliable information on their risk profile. SMEs themselves appear willing to provide much information and there are a number of private sector initiatives which, in time, may help remedy this information gap.

1.20 Following the financial crisis, firms which had previously relied on interbank finance to fund operations have seen this funding source dry up. In the absence of viable alternative funding sources, this has constrained their ability to expand or, in some cases, maintain existing operations. The lack of interbank finance is, in the short-term, acting as a barrier to expansion for these types of firms.

Ability of new entrants to attract customers and achieve scale

1.21 Having entered the retail banking sector, the biggest challenge that firms face is attracting customers. If customers are reluctant to move their account to new firms, this will make it difficult for new entrants to

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attract business and achieve the necessary scale required to recover fixed costs.3 Under this heading, the OFT has explored the following potential barriers that may, individually or cumulatively, make it difficult for firms to attract sufficient number of customers to compete successfully:

• levels of switching across retail banking in general, and in particular in relation to current accounts

• the role of branding, and

• the role of the branch network.

1.22 Overall, switching rates for both PCAs and business current accounts (BCAs) remain low, making it difficult for new entrants to attract customers. These low levels of switching can create a further barrier to expansion in other retail banking product markets (such as saving and credit products) because PCAs and BCAs often act as 'gateway' products for the sale of other retail banking products. This may mean that, in certain retail banking product markets, firms which do not offer PCAs and BCAs will find their potential customer base limited.

1.23 Following its 2008 PCA market study, the OFT announced a number of initiatives to improve the functioning of the market, including initiatives around the switching process. The OFT will continue to monitor the PCA market to ensure that consumers are not put off switching by fears that things may go wrong. The OFT continues to monitor behavioural undertakings given by banks in the SME banking market following the 2002 CC SME banking report4 which include undertakings relating to the switching process. This is an area that may warrant further consideration

3 Many of these fixed costs may also be sunk.

4 See The supply of banking services by clearing banks to small and medium-sized enterprises: A report on the supply of banking services by clearing banks to small and medium-sized enterprises within the UK, Competition Commission 2002, www.competition-commission.org.uk/rep_pub/reports/2002/462banks.htm#full.

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by Government if SMEs continue to be dissuaded from switching due to a lack of confidence in the process.

1.24 We have found that brand remains important in retail banking. Our research has shown consumers to be wary of switching to an unfamiliar banking brand. Across the UK there is a wider reluctance to consider non-UK retail banking providers following the financial crisis. Brand loyalty may also be more pronounced in Scotland and Northern Ireland for certain products. While a new entrant can build brand awareness and, to some extent, may benefit from not being associated with the financial crisis, for many customers there remains a strong degree of brand loyalty to existing incumbents which may act as a barrier to expansion.

1.25 Our research also suggests that both personal and SME customers value the ability to engage with their retail banking provider in person through visits to a local branch. While there are some players in the sector who choose to rely on the internet, intermediaries and/or telephone as their main distribution channels, the evidence suggests that these channels largely remain complementary distribution channels for products such as PCAs and BCAs rather than substitutes. Given the gateway role of PCAs and BCAs, the lack of a branch may act as a limit on the ability of new entrants to grow their customer base and impose a competitive constraint on incumbents in other retail banking markets.

1.26 Taking these issues of switching, branding and branch network together, customer inertia remains a key barrier for potential entrants and smaller firms to attract customers and achieve sufficient scale to be able to recover costs, many of which are sunk.

1.27 We note that forthcoming divestments of the banking assets of Lloyds Banking Group and Northern Rock have the potential to create the opportunities for new entrants or smaller existing players to purchase these assets (and their associated customer base) and achieve accelerated growth without the need for incremental, organic growth.

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Barriers to exit

1.28 Unlike other sectors, the failure of a firm in the banking sector can have wider systemic consequences. The risk of a contagion effect, caused by the failure of a significant bank, has led Governments and financial regulators to put in place mechanisms to ensure the orderly exit of banks from the sector.

1.29 The absence of, or inappropriate, mechanisms can create moral hazard problems, whereby banks, expecting they will be rescued if things go wrong, will lack incentives not to carry out riskier activities. Competition may be weakened if inefficient incumbents are not allowed to exit the market, reducing the incentives, or ability, of more efficient firms to engage in intense rivalry.

1.30 Currently, international bodies and domestic regulators are proposing principles for better regulation and prudential supervision, and for the development of a policy framework aiming at reducing the moral hazard risks posed by systemically important financial institutions. These proposals could also reduce any competitive distortions entailed by moral hazard. Wider questions about trade-offs between financial stability and competition policy are beyond the scope of this review and are currently being considered by the ICB.

1.31 As part of this review, the OFT has considered whether regulations aimed at preventing disorderly exit from the banking sector may adversely impact upon competition. The two main regulations are:

• the Special Resolution Regime (SRR), and

• the Financial Services Compensation Scheme (FSCS).

1.32 The SRR was established by the Banking Act 2009 and provides a permanent statutory regime for dealing with failing banks through the deployment of stabilisation options, a bank insolvency procedure and a bank administration procedure. Its core objectives are to maintain the stability and resilience of the UK financial system, protect confidence in the banking sector, and protect depositors and public funds.

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1.33 The FSCS was set up in December 2001, with the coming into force of the Financial Services and Markets Act 2000 (FSMA 2000). In the event of a bank being unable, or likely to be unable, to pay claims against it, the FSCS allows for compensation to be claimed mainly by individuals and small business, up to a pre-determined limit.

1.34 The OFT has not received any evidence to suggest the SRR or FSCS are acting as a barrier to exit, preventing firms from leaving the market. While neither of these regulatory frameworks explicitly recognises competition goals, having been designed with financial stability in mind, competition issues can be considered during the operation of the SRR and we would encourage this to happen.

1.35 The OFT, or the European Commission,5 is able to evaluate the sale of any bank assets through the merger regime and also the impact on competition ex post through its enforcement powers.

Conclusion

1.36 Barriers to entry, expansion and exit differ in size and intensity according to the particular retail banking product market and the choice of business model. Whilst new firms have entered the sector recently, and more are expected to do so, significant challenges remain around attracting customers and being able rapidly to acquire market share. In particular, consumer inertia remains a key barrier. Other challenges include the limited availability of information on certain types of SMEs and, in the case of certain firms, the lack of non-retail funding which may constrain the ability of these firms to expand their market share and impose competitive constraint on incumbents.

1.37 The OFT expects that this review will be relevant in the following ways:

5 In the case, of the OFT, it can evaluate the sale when there is a 'relevant merger situation' as defined in Part 3 of the Enterprise Act 2002. If relevant thresholds are exceeded, the European Commission can examine the merger under the EC Merger Regulation (Council Regulation 139/2004/EC).

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• to the ICB, which will be making recommendations by September 2011 on structural and related non-structural measures to promote stability and competition in banking for the benefit of consumers and businesses.

• to the FSA (and any other successor bodies with responsibilities for prudential regulation), with respect to the design and operation of banking regulation and authorisation processes

• to HM Treasury and the Department for Business, Innovation and Skills (BIS), especially in the areas of improving the provision of information on SMEs

• to the devolved governments in Scotland, Wales and Northern Ireland, with respect to ongoing work on personal and SME banking.

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2 INTRODUCTION

2.1 The retail banking sector has experienced a great deal of change in recent years. As a result of the financial crisis, the sector has seen the consolidation of a number of well-known brands and the viability of certain business models threatened. However, there is also an opportunity for new firms to enter retail banking product markets to supply products to personal and SME customers, as evidenced by the number of firms expressing an interest in entering. It is therefore timely to review barriers to entry, expansion and exit in retail banking to identify whether there are features of the sector which could prevent new firms entering the market and exercising a competitive constraint on incumbents.

2.2 This chapter looks briefly at the mission of the OFT in relation to markets and its powers to conduct reviews such as this. It sets out the key factors that have motivated this review and locates it within a broader context. It also discusses our approach to the review and provides a brief description of its structure.

OFT mission and powers

2.3 The mission of the OFT is to make markets work well for consumers. When markets work well, more efficient businesses thrive by providing what consumers want, better and more cost-effectively than their competitors. Businesses that do not offer products that meet consumer needs or do not offer value for money will either need to improve their product offering or risk being forced to exit the market. Through this process, competition will drive efficiency and innovation, thereby increasing productivity and economic growth.

2.4 The OFT has a number of tools to meet its objectives. Under section 5 of the Enterprise Act 2002 (EA02) the OFT may obtain, compile and keep under review information relating to the carrying out of its functions. The OFT may use its functions under section 5 EA02 to carry

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out research into specific or narrow market-related issues. It is under this power that this current review has been carried out.6 This review is focused on developing an evidence base on barriers to entry, expansion and exit in retail banking.

Context of this review

2.5 The banking sector has seen considerable change over the past 25 years. Technological change has included the growing use of telephone and internet based banking. Changes in organisational and business models have included, in the UK, the demutualisation of some building societies and the rise of so-called 'monoline' providers offering only a single banking product, such as credit cards. Structurally, the sector saw the consolidation of a number of players in the early 2000s such as the merger of Halifax with Bank of Scotland, Royal Bank of Scotland with NatWest and Woolwich with Barclays.

2.6 The global financial crisis has had a particularly significant impact on the structure and nature of the sector since 2007. In the UK, this impact has included:

• the failure, closure or nationalisation of banks and building societies, for example the taking of Northern Rock into temporary public ownership

• the provision of financial support by the Government, most notably the recapitalisation of Lloyds Banking Group (LBG) and the Royal Bank of Scotland Group (RBS Group), and

• further significant consolidation in parts of the banking sector, including the acquisition by Lloyds TSB of Halifax Bank of Scotland

6 Examples of similar work by the OFT include the stock-take of infrastructure control and ownership and the high-cost credit review.

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(HBOS)7 and acquisitions by Santander and Nationwide of a number of banks and building societies respectively.

2.7 The effects of the financial crisis are expected to continue for a number of years. Further changes to retail banking in the UK are expected to include:

• the divestment of selected assets of LBG as a result of conditions placed on the firms by the European Commission in relation to the State aid that they have received 8

• the future sale of Government shareholdings in Northern Rock, RBS Group and LBG, and

• significant regulatory reforms, including changes to capital and liquidity standards that banks are required to meet and possible changes to the structure of regulation.9

2.8 The crisis has also triggered wide-ranging questions about the nature and structure of the banking sector. In the UK, the ICB and others (see

7 On 31 October 2008, the OFT published its report to the Secretary of State for Business, Enterprise and Regulatory Reform on the anticipated acquisition by Lloyds TSB Group plc (Lloyds) of HBOS plc (HBOS) (see www.oft.gov.uk/OFTwork/mergers/decisions/2008/LloydsTSB). The report concluded that the anticipated merger between Lloyds TSB and HBOS was expected to result in a substantial lessening of competition in three areas: PCAs, SME banking and mortgages. However, the Secretary of State considered that the public interest of ensuring the stability of the UK financial system outweighed competition concerns raised by the OFT and decided not to refer the case to the Competition Commission.

8 See www.lloydsbankinggroup.com/media1/faqs/FAQs.asp for a summary of the expected divestments. As part of its EC State aid conditions, RBS Group has already divested around 300 branches to Santander, see www.bankingtimes.co.uk/2010/08/04/santander-to-acquire-318-branches-from-rbs/.

9 See A new approach to financial regulation: judgement, focus and stability, www.hm-treasury.gov.uk/d/consult_financial_regulation_condoc.pdf.

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below) will be reporting on ways to promote stability and competition in banking for the benefit of consumers and businesses.10

2.9 Alongside the impact of the financial crisis, the retail banking sector continues to be characterised by technological development. This includes the development of alternative distribution channels (such as the rise of mobile banking services and applications) and improved tools for consumers to access information and manage their accounts. Such developments may have the overall effect of altering the way in which providers compete in the market, leading providers to focus on different aspects of their product offering.

2.10 It is therefore timely to review barriers to entry, expansion and exit in retail banking to identify whether there are features of the sector which will prevent new firms entering the market and exercising a competitive constraint on incumbents.

Barriers to entry, expansion and exit

2.11 Barriers to entry, expansion and exit are important determinants of competition in markets. The threat of losing business can spur innovation, provide strong incentives to keep costs and prices down and meet customers' requirements for quality of service and range of products. However, this relies on there being a dynamic market, with incumbents facing the threat of losing market share to new entrants (and other existing participants), which may ultimately lead them to being forced out of the market if they do not meet customer needs. The absence of insurmountable barriers to entry, expansion and exit are critical to this.

2.12 The OFT and others have considered barriers to entry and expansion11 in aspects of retail banking previously in:

10 See the ICB Issues Paper call for evidence, http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pdf.

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• the Cruickshank report on banking covering payment systems, personal banking and Small and Medium sized Enterprise (SME) banking in 2000 (the Cruickshank report)12

• the Competition Commission (CC) investigation of SME banking in 2002 (the CC SME banking report)13

• the OFT market study of Payment Systems in 2003 and the work of the Payment Systems Task Force in 200714

• the CC investigation of Personal Current Account (PCA) banking in Northern Ireland in 2007 (the CC NI banking report)15

• the OFT review in 2007 of the SME undertakings arising from the CC’s SME report in 2002 (the OFT SME banking review),16 and

11 The issue of barriers to exit in retail banking has not been formally considered previously.

12 Competition in UK Banking: A Report to the Chancellor of the Exchequer, Don Cruickshank, March 2000.

13 The supply of banking services by clearing banks to small and medium-sized enterprises: A report on the supply of banking services by clearing banks to small and medium-sized enterprises within the UK, Competition Commission 2002, www.competition-commission.org.uk/rep_pub/reports/2002/462banks.htm#full.

14 UK Payment Systems, an OFT market study of clearing systems and review of plastic card networks, OFT 2007 (OFT658) www.oft.gov.uk/shared_oft/reports/financial_products/oft658.pdf and Final report of the Payment Systems Task Force February 2007 (OFT901), www.oft.gov.uk/shared_oft/reports/financial_products/oft901.pdf.

15 Northern Ireland personal banking, Competition Commission 2007, www.competition-commission.org.uk/rep_pub/reports/2007/527banking.htm.

16 SME Banking: Review of the undertakings given by banks following the 2002 Competition Commission report, OFT 2007 (OFT937) www.oft.gov.uk/OFTwork/financial-and-professional/SME-banking/.

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• the OFT market study of PCAs in the UK in 2008 (the OFT PCA market study).17

2.13 In addition, the Future of Banking Commission has considered issues that relate to barriers to entry, expansion and exit in retail banking.18

2.14 Collectively, these studies have identified a number of features of the retail banking sector that may lead to significant barriers to entry, expansion and exit including:19

• establishing a branch network

• ease of transferring products and accounts

• developing a successful brand

• high sunk costs

• acquiring new customers

• access to information regarding customers' credit risk

• access to payment networks, and

• regulation.

2.15 This current review builds on the findings of the above reports and seeks to understand the extent to which barriers to entry, expansion and exit still persist or have changed due to the structural evolution of the market

17 Personal Current Accounts in the UK, OFT 2008 (OFT1005), www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdf.

18 The Future of Banking Commission report, http://commission.bnbb.org/banking/sites/all/themes/whichfobtheme/pdf/commission_report.pdf.

19 Chapter 4 of this review goes through these barriers in more detail.

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and other longer-term developments, as well as the events of the recent financial crisis.

Purpose of this review

2.16 The review will assist the OFT and others in understanding better barriers to entry, expansion and exit in both personal and SME banking markets, and in understanding the long term competitiveness of the retail banking sector.

2.17 As stated at its launch in May 2010,20 the review is intended to help the OFT and others in:

• assessing and informing options for change in the regulatory framework for retail banking

• assessing any relevant mergers that may arise in the banking sector, including any arising from divestments under European Commission (EC) State aid requirements

• understanding the choices facing the Government over the sale of banking assets, between the impact on competition and other public policy goals, such as maximising value

• contributing to relevant reviews or other work undertaken by the Government or other bodies such as those by the ICB, Treasury Select Committee and Scottish Government, and

• determining future Government and OFT work priorities in retail banking.

2.18 Since the announcement of this review, the Government has established the ICB. The ICB's terms of reference state that it will 'consider the structure of the UK banking sector, and look at structural and non-structural measures to reform the banking system and promote

20 See www.oft.gov.uk/news-and-updates/press/2010/55-10.

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competition'.21 The OFT has liaised closely with the ICB during this review22 and believes that this review is likely to be of relevance to the ICB's ongoing work.23

2.19 In July 2010, the Treasury Select Committee announced an inquiry into competition and choice in the retail banking market. In its inquiry announcement, the Committee noted that it may 'examine the key barriers to entry inhibiting increased competition — including regulation'.24 This review is likely to be of relevance to the Committee's inquiry.

2.20 The Scottish Government's Financial Services Advisory Board (FiSAB) 25 has recently established a banking sub-group that will report to Ministers as part of its consideration in responding to the ICB. In addition, the Scottish Government carries out surveys of SMEs' access to finance. While the focus of this review is whether there are barriers to entry, expansion and exit in the UK, the OFT has also explored whether there are specific barriers in England, Scotland, Wales and Northern Ireland. The findings of this review will provide context for some of the answers and may contribute to policy initiatives in this area.

21 See www.hm-treasury.gov.uk/d/banking_commission_terms_of_reference.pdf.

22 The OFT's liaison with the ICB has been carefully carried out to ensure it was within the scope of applicable legal restrictions on disclosure.

23 In September 2010, the ICB published its Issues Paper, http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pdf.

24 See www.parliament.uk/business/committees/committees-a-z/commons-select/treasury-committee/news/treasury-committee-launches-inquiry-into-competition-and-choice-in-the-banking-sector/

25 See www.scotland.gov.uk/News/Releases/2007/09/03143408.

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Approach

2.21 The main elements of the OFT's approach to gathering evidence for the review26 have included:

• a general call for evidence when the review was launched in May 201027

• questionnaires sent to a wide range of banks, building societies and new and potential entrants in July 201028

• discussions with retail banking providers, consumer groups and industry bodies

• commissioning an omnibus survey of 1,000 adults to learn more about consumer behaviour with respect to personal banking products (see Annexe B for the results)

• working with the Forum of Private Business to survey SMEs across the UK to learn more about their experiences of SME banking providers (see Annexe C for the results)

• working with the Federation of Small Businesses Scotland to survey SMEs in Scotland to learn more about their experiences of SME banking providers (see Annexe D for the results) and

• discussions with the Bank of England, FSA, HMT and BIS.

2.22 In addition to evidence submitted to it, the OFT has reviewed and analysed public source material and market research data.

26 Annexe A provides a list of all parties who submitted evidence or were consulted.

27 This can be found at: www.oft.gov.uk/shared_oft/personal-current-accounts/OFT1233.pdf.

28 These can be found at www.oft.gov.uk/OFTwork/markets-work/othermarketswork/review-barriers/.

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Structure of the review

2.23 The remainder of this review is structured as follows:

• Chapter 3 describes the retail banking sector, setting out the product markets we are focusing on, providing a description of the types of market participants and discussing the nature of competition

• Chapter 4 provides an overview of the theory of barriers to entry, expansion and exit in retail banking and the findings of previous investigations

• Chapter 5 considers whether the regulatory framework around offering retail banking products acts as a barrier to entry or expansion

• Chapter 6 examines whether there exist any barriers to accessing inputs necessary to offer retail banking products

• Chapter 7 explores whether there are barriers providers face when seeking to attract customers and expand their market share

• Chapter 8 looks at the regulatory provisions around exiting the retail banking market, in particular the operation of the SRR and FSCS, and

• Chapter 9 sets out the review's conclusions.

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3 OVERVIEW OF THE RETAIL BANKING SECTOR

3.1 The retail banking sector in the UK contains a number of related products with a diversity of business models in operation. Potential entrants can choose to enter the sector through a number of routes. In some cases, providers have chosen to supply only a limited set of products, often aimed at a particular customer segment, whilst in other cases, providers have sought to offer a complete suite of retail banking products for personal and SME customers. Despite this diversity, the major incumbents continue to enjoy the largest market shares across many of the different product markets.

3.2 This chapter provides an overview of the retail banking sector. It examines the different models of banking on offer, sets out some structural indicators for certain retail banking product markets and discusses how providers compete in each of these markets.

Retail banking

3.3 Retail banking is the provision of deposit-taking, payment and lending services to individual personal customers and SMEs.29

3.4 For convenience, the OFT has categorised retail banking services into three broad areas.

• Core banking services: personal and business current accounts, overdrafts and savings products traditionally associated with banks. To offer these services, a provider will typically need authorisation from the FSA to accept deposits.30

29 We use the same definition of SMEs as used in the CC SME banking report, that is, firms having turnover of up to £25 million. We are aware that within this turnover bracket there are a large range of different types of SMEs including micro-enterprises. Where appropriate, our review makes this distinction.

30 Details of the licensing process are set out in Chapter 5.

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• Secondary banking services: unsecured and secured loans to personal and SME customers. These are not just offered by what are commonly referred to as 'banks'. Some of these services require a consumer credit licence from the OFT or authorisation from FSA.

• Peripheral banking services: such as insurance, pensions, wealth management, hedging, letters of credit and legal services. Some of these services, such as the provision of pensions and insurance products, will have specific regulation and authorisation requirements, though there is no requirement to be authorised to accept deposits to offer them, and these services are not typically considered as retail banking services.

Figure 3.1: The retail banking space

3.5 Our review is focused mainly on, what we describe as, core and secondary banking services. This is based not only on stakeholder responses indicating the most commonly offered retail banking products, but also on where the OFT perceives there to be the greatest barriers to entry, expansion and exit.

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Retail banking business models

3.6 It is not necessary for a retail banking provider to supply both core and secondary banking services to personal and SME customers. Indeed, many providers have entered retail banking and concentrated on only a sub-set of services (for example, specialist credit card issuers or specialist mortgage providers).

3.7 Firms supplying retail banking products use a number of different business models. It is not possible to list all the different business model variants in retail banking. However, Table 3.1 below summarises the key models in operation.

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Table 3.1: Business models in retail banking

Business model Description

Retail bank Predominately accepts deposits and uses these funds to make loans. It deals with individual customers and firms.

Universal bank Not only offers retail services but is also involved (perhaps through another division) in wholesale and investment activities.

Building society A type of mutual institution whose principal purpose is to make loans secured on residential property, though it can also offer other financial services. Unlike banks, building societies cannot raise more than 50 per cent of funds from wholesale markets.31

Private banking provider

Focuses on high value private individuals investing sizable assets.32

Non-traditional financial institution offering banking products

Enters into an agreement with an established retail banking provider to provide banking services, for example, through a joint venture or a white label arrangement.

Monoline provider Focuses on a single product or product line.

Credit union Financial co-operatives owned and controlled by their members offering banking products.

Peer-to-peer facilitator Firms acting as facilitators for matching lenders to borrowers.

3.8 The choice of distribution channel varies between business models. Channels include the use of a branch network, the internet, telephone, post and intermediaries and other third parties. Some business models will lend themselves better to using online distribution channels (for example, peer-to-peer lending); others may be more suitable for

31 See www.bsa.org.uk/difference_bank_bs.htm for further details.

32 It should not be confused with a private bank, which is simply a non-incorporated banking institution.

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distribution through intermediaries (for example, monoline providers of mortgages); while others may require a physical presence (for example, credit unions).

Routes into retail banking

3.9 As Figure 3.2 below shows, entry into retail banking, through the creation of a new brand offering a number of products (such as the recent example of Metro Bank), is not necessarily the only entry route.

Figure 3.2: Entering the retail banking space

3.10 Some firms have entered retail banking by only offering a limited range of products to personal and SME customers (for example, monoline providers of credit cards such as Capital One). From this position it is possible to move towards offering a much wider portfolio of products (as is expected in the case of Virgin Money and Tesco Bank), or to expand from just offering products to individuals to catering for SME as well.

3.11 Other methods of entry into retail banking that have been used include:

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• entry through direct acquisition of existing banking assets,33 for example Grupo Santander acquiring Abbey

• entry through a regulatory passport,34 for example the entry of ING Direct, and

• entry through a joint venture, for example the Post Office working with Bank of Ireland.

3.12 As is discussed in subsequent chapters, barriers to entry, expansion or exit may differ between core and secondary banking sectors and by the method of entry or expansion.

Exit from retail banking

3.13 As in other sectors, providers can exit retail banking through a number of routes, including:

• exiting a particular product line, for example First Direct temporarily withdrawing from offering mortgages in 200835

• merger, to form part of a larger group, for example Santander acquiring Alliance & Leicester in 2008, and

• business failure, for example Kaupthing in 2008.

3.14 Exiting through failure is more complicated in retail banking than in other sectors due to specific regulations around exit and how customers' deposits with banks should be treated.36 The Special Resolution Regime

33 Acquisition can be used as a method of expansion as well as entry.

34 See Chapter 5 for details on how a non-UK bank can offer retail banking products to UK customers.

35 See http://news.bbc.co.uk/1/hi/business/7325692.stm.

36 It should be noted that these specific regulations only apply to institutions authorised to take deposits. Other financial institutions that fail will be treated under normal insolvency laws.

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(SRR), which governs how a deposit taking institution should be wound up in the event of failure, and the Financial Services Compensation Scheme (FSCS), which covers how depositors' money is protected, are both discussed in more detail in Chapter 8.

Personal banking products

3.15 The key personal banking product markets that we examine for the presence of barriers are PCAs (including overdrafts), saving accounts, investment products, mortgages, other types of secured loans, credit cards and other types of unsecured loans. In the following sections, we describe several structural indicators relating to the supply of these products. In addition to setting out market share data, we briefly consider the nature of competition in each of these products.

3.16 The structure of supply of many of these products has changed significantly in recent years, not only due to the emergence of new entrants with unconventional business models, but also due to consolidation in the market, in particular as a result of the financial crisis. As subsequent chapters discuss, the nature of competition and the structure of the market may influence the existence, and strength, of barriers to entry, expansion and exit.

Personal current accounts

3.17 A PCA can be defined as an account for individual consumers, which provides the facility to hold deposits, receive and make payments using cheques, debit cards, Direct Debits and Standing Orders, to use ATMs and to make regular payments. Additionally, PCAs often have overdraft facilities.37

37 An arranged overdraft facility occurs when the PCA provider has agreed in advance that a customer has a right to draw on their account to create an overdraft up to an agreed level if they wish to do so. An unarranged overdraft facility occurs when the PCA provider extends credit to a customer when their PCA balance exceeds a pre-arranged limit or if no such limit has been agreed.

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3.18 According to recent estimates, there are nearly 71 million PCAs in the UK.38 It is estimated that around 93 per cent of the adult population holds a PCA.39 Total revenue from PCAs is estimated to be around £9 billion a year. 40

3.19 PCAs are predominantly provided by retail and universal banks, although some building societies also offer them. More recently, a number of credit unions have begun to offer PCAs and there are expectations that firms from other sectors will also start to offer PCAs. To offer a PCA, a provider needs authorisation from the FSA to accept deposits or it must enter into a relationship with a provider who has such authorisation.

3.20 In its analysis of market shares, the OFT's 2008 PCA market study identified two main categories of provider in the UK: the four 'established banks' (Barclays, HSBC, RBS Group and Lloyds TSB) and 'challenger banks' (HBOS, Abbey and Nationwide). These challenger banks were regarded as having the potential to exert a competitive constraint on the four established banks. The shares of the market accounted for by these 'established' and 'challenger' banks are shown in Figure 3.3 below.

38 Datmonitor Banking on change: UK current accounts 2010, page12. This figure includes dormant accounts and multiple account holding - Datamonitor reports that over 30 per cent of consumers hold more than one PCA.

39 Datamonitor, What Consumers Want: Current Accounts and Savings in the UK 2010 .

40 Datamonitor, Banking on change: UK current accounts 2010, page 49.

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Figure 3.3: Established bank and challenger bank PCA market shares 1999-2010, by number of customers41

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Mar

ket

shar

e (%

)

Four established banks Challenger banks

Source: Mintel, Current Account/Current, Packaged and Premium Accounts, Finance Intelligence, 1999 – 2010. Base varies between years.

3.21 As Figure 3.3 illustrates, the challenger banks increased their market share, albeit slowly, between 1999 and 2007. However, following the financial crisis, the market has become more concentrated due to consolidation and the collective market share of challenger banks has declined. The two largest challenger banks identified in the 2008 PCA market study (HBOS and Abbey) have now become part of larger banking groups (LBG and Santander respectively) and there have been a number of further consolidations.42

41 Note, market share data was unavailable for 2001, 2004 and 2008. The observations in Figure 3.3 have been constructed as mid-points of the two adjacent years.

42 Over the period in question there were mergers of, among others, Santander with Bradford & Bingley and Alliance & Leicester, Co-operative Bank with Britannia Building Society and Nationwide Building Society with Portman Building Society.

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3.22 As shown in Table 3.2 below, as of March 2010, the largest PCA providers were the same 'four established banks' as before the financial crisis. However, it should be noted that these market shares are likely to change in the coming years due to the recent divestments by RBS Group43 and further divestments by LBG44 and the sale of Northern Rock.45

43 As part of the EC State aid framework, RBS Group was required to divest certain banking assets. It recently announced the sale of Royal Bank of Scotland branded branches in England and Wales and NatWest branded branches in Scotland to Santander. In total around 300 branches are being acquired by Santander affecting 1.8 customers. The sale process is expected to take between 12 and 18 months. See http://natwestbranchinformation.com/?DCMP=ILC-PersHPDivestTxt and www.rbs.com/customers/our-services/sale-of-branches.ashx for further details.

44 As part of the EC State aid framework, LBG expects to reduce its market share of personal current accounts by 4.6 per cent and also reduce its mortgage assets by up to 19 per cent. As part of this process around 600 branches will be sold off, including all Lloyds TSB Scotland branches, additional Lloyds TSB branches in England and Wales, all Cheltenham & Gloucester (C&G) branches, all C&G savings and certain C&G mortgages, the Intelligent Finance business and the TSB brand. Further details can be found at: www.lloydsbankinggroup.com/media1/faqs/FAQs.asp.

45 The Government shareholding in Northern Rock is currently managed by UK Financial Investments Ltd. Its objectives are to maximise sustainable value for UK taxpayers (taking account of risk), maintain financial stability and promote competition. See www.ukfi.co.uk/images/dynamicImages/UKFI_FD_180110.pdf. It is expected that the UKFI will manage the sell off of the Government's shareholding in Northern Rock in due course.

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Table 3.2: PCA market shares pre- and post-financial crisis, by number of customers

PCA provider June 2007 market share (%)

March 2010 market share (%)

Lloyds TSB 19 Halifax Bank of Scotland 14

30

RBS Group 17 16 HSBC (including First Direct) 14 14 Barclays 15 13 Abbey 6 Alliance & Leicester 3

12

Nationwide Building Society 5 7 Co-operative Bank Data unavailable 3 National Australia Group Europe (Clydesdale Bank & Yorkshire Bank)

3 2

Others 4 3

Source: OFT calculations based on Mintel Credit and debit cards, Finance Intelligence, July 2010 and Mintel Current Accounts, Finance Intelligence, June 2007. Number of consumers surveyed: 2007, n =1,824, 2010, n = 1,848.

3.23 The Herfindahl-Hirschman Index (HHI),46 a measure commonly used to assess the level of concentration in a market, rose in the UK from 1,410 in 2007 (as quoted in the PCA market study) to 1,736 in 2010, indicating that the PCA market is concentrated and has become more so since 2007.47 As was noted in the OFT Lloyds-HBOS merger report, PCA market shares differ in Scotland and the HHI is also likely to have changed between 2007 and 2010 in Scotland.48

46 The HHI is the sum of the squares of each provider's market share.

47 The recent joint OFT/CC merger guidelines note that a market with a HHI measure exceeding 2,000 can be characterised as 'highly concentrated'. See Merger Assessment Guidelines (OFT1254) www.oft.gov.uk/shared_oft/mergers/642749/OFT1254.pdf.

48 See OFT, Anticipated acquisition by Lloyds TSB plc of HBOS plc, page 31. The HHI is also likely to differ in Northern Ireland given its different market structure (see CC NI banking report).

Lloyds Banking Group

Santander

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3.24 The PCA market study found that competition to provide PCAs took place along price49 and quality of service dimensions. The level of competitive pressure on the various price elements of PCA varies. With the prevalence of the 'free-if-in-credit' model,50 core transaction charges have mostly been competed to zero. Challenger banks often competed on credit interest rates,51 although in the current low interest rate environment it will be harder for PCA providers to compete on credit interest rates. There was less competition on other elements of the PCA, in particular unarranged overdraft charges. Competition did not focus on these charges, despite accounting for around 30 per cent of PCA revenue in 2006.

Data are not available on market shares by different parts of the UK for retail banking product markets.

49 Price in the PCA market refers to a number of types of charges and fees including core transaction charges, credit interest rate, arranged and unarranged overdraft fees, monthly fees and other ancillary charges. Core transaction charges can be levied when carrying out transactions such as writing cheques or accessing an ATM. The credit interest rate is the interest rate paid on credit balances. Arranged overdraft charges are applicable when a customer accesses a pre-arranged overdraft facility with an agreed limit. Unarranged overdraft charges are incurred as a result of consumers requesting or instructing their bank to make payments for which there are insufficient funds available in their PCA. Ancillary charges include charges or fees for transactions carried out abroad, issuing replacement statements, making payments overseas, bankers' drafts and other special money transfers and arrangement fees.

50 The 'free-if-in-credit' model imposes no charges on consumers for day to day money transmission services, or for access via ATMS, branches, telephone or internet providing the account remains in credit. See Chapter 7 for more discussion on the role of this in the PCA market.

51 Net credit interest is the difference between what a consumer could earn in credit interest from their PCA and what they could earn using an account that pays a higher interest rate or a savings account. It is, in effect, the opportunity cost of holding credit in a current account with a low credit interest rate. Again, in a low interest rate environment, the revenue earned from this source is likely to have declined.

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3.25 Following its market study, the OFT has worked with PCA providers to introduce greater transparency around charge levels. A number of providers have also reduced their unarranged overdraft charge levels.52

3.26 Competition on quality of service in the PCA market centres on the customer service experience. This includes 'getting the basics right' (such as mistake-free transactions, a reliable internet site, low or no waiting times in branches and for telephone banking) and ensuring that, if a problem does occur, it is speedily resolved. Research quoted in the market study noted that the main reason why consumers switch providers is the 'push' factor of bad service.

3.27 It is worth noting that the level of service or quality is not easily observable by most consumers prior to switching and is usually something a consumer only experiences once they have switched bank. A number of consumer satisfaction surveys are now published and the Financial Ombudsman Service (FOS) and the FSA also publish data on the number of complaints made by customers to each PCA provider and the number upheld.53 Greater information on the number of complaints and the proportion that are upheld in consumers' favour will assist consumers in comparing how PCA providers treat their customers.

3.28 As well as offering PCAs, providers also offer basic bank accounts. A basic bank account is similar to a PCA except that it does not have an overdraft facility and may have limited functionality in other respects. At

52 See Personal Current Accounts in the UK: a follow up report, October 2009 (OFT1123) for a list of initiatives agreed www.oft.gov.uk/shared_oft/personal-current-accounts/OFT1123.pdf and www.oft.gov.uk/shared_oft/reports/financial_products/OFT1275.pdf for an update on the latest charge levels.

53 These can be found at www.ombudsman-complaints-data.org.uk/ and www.fsa.gov.uk/pages/Library/Other_publications/commentary/index.shtml respectively.

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the end of 2009 there were nearly 8 million basic bank accounts accessible through the Post Office, ATMs and branches.54

3.29 Increasingly, many providers also offer packaged accounts. With a packaged account, a customer typically pays a monthly fee or regular fixed charge, and in return receives bundled benefits (such as free travel insurance), receives preferential terms on other aspects of the account (and sometimes other products) and may be exempt from certain charges such as unarranged overdraft charges. Recent research indicates that around 18 per cent of PCA-holders hold a fee-charging packaged/premium account.55 The FSA recently noted that packaged accounts may not represent good value for money for all consumers and firms should make clear to consumers that they need not purchase a packaged account.56

Saving accounts and investment products

3.30 In addition to holding PCAs, many consumers also hold saving accounts and investment products with deposit-taking institutions. Unlike PCAs, saving accounts and investment products cannot be used to make payments and do not typically come with ATM facilities.

3.31 Saving accounts differ by whether or not they offer instant access, how often interest is paid, whether there are temporary bonus rates, withdrawal conditions and so on. Cash ISAs are a special type of savings account that offer tax-free savings, but with a limit on how much can be saved each year. Firms can also offer fixed rate savings bonds for a fixed term but with no access to the cash during the fixed period. It is estimated that over 65 per cent of adults hold savings

54 BBA: www.bba.org.uk/statistics/article/basic-bank-accounts-quarter-4-2009/basic-bank-accounts/.

55 Mintel, Current, packaged and premium accounts, June 2010.

56 FSA Financial Risk Outlook 2010, www.fsa.gov.uk/pubs/plan/financial_risk_outlook_2010.pdf.

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accounts.57 The value of these saving accounts is estimated at £1,111 billion.58 As the most popular saving vehicle, the focus of this review is on saving accounts.

3.32 Investment products also pay a return on a principal,59 but this is often not guaranteed and the level of return will depend on a range of factors such as how the stock market performs. Further, unlike saving accounts, some products offer no guarantee that the investor will receive back their initial investment. Examples of investment products include stocks and shares ISAs, tracker funds, managed funds, unit trusts and open-ended investment companies (OEIC), investment bonds and share-dealing.

3.33 To offer savings accounts and accept money for investments, firms need authorisation from the FSA to accept deposits or need to enter into a relationship with a firm that is already authorised. It is not just the established retail and universal banks who offer saving products. Traditionally, building societies have played a large role in the saving markets. As shown below in Table 3.3, the Post Office (through a joint venture with Bank of Ireland), National Savings & Investments and other types of institutions such as credit unions are also established players in the market. In addition, online and direct providers have made an impact on the market, reflecting the ability of these providers to utilise non-branch distribution channels to attract customers.

57 Datamonitor, What Consumers Want: Current Accounts and Savings in the UK, 2010.

58 Mintel (based on Bank of England data), Deposit and Savings Accounts, Finance Intelligence, April 2010.

59 That is, the initial amount of funds deposited in the saving account or investment product.

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Table 3.3: Saving accounts market shares pre- and post-financial crisis, by number of customers60

Market share (%) in savings market Savings account provider

Oct 2006 Feb 2010

HBOS 16 Lloyds TSB 13

21

Abbey 7 Alliance & Leicester 4 Bradford & Bingley 1

12

Nationwide 9 9 RBSG 10 10 HSBC 8 8 Barclays 9 10 Co-op 2 Britannia 1

4

NS&I Data unavailable 6 Northern Rock 1 2 ING Direct 2 Data unavailable NABG (Clydesdale Bank & Yorkshire Bank) 1 Data unavailable Post Office 3 2 Other bank 2 8 Other building societies 6 5 Others 7 2

Source: OFT calculations based on Mintel Deposit and Savings Accounts, Finance Intelligence, January 2007 and April 2010. Note due to rounding, numbers may not add up to 100. Number of consumers surveyed: 2006 n = unknown and 2010 n = 865.

3.34 As has been the case for PCAs, there has been consolidation in the saving accounts market following the financial crisis. However, the saving accounts market is characterised by lower levels of concentration compared to the PCA market. The HHI figure for saving accounts rose from 889 in October 2006 to 1,083 in February 2010 with the top five providers accounting for more than 60 per cent of the market.

60 The number of accounts held by each provider does not take into consideration multiple accounts held by consumers.

LBG

Santander

CFS

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3.35 Providers compete on a number of dimensions in the saving market. The key factor is the rate of interest offered, including how and when it is paid. Providers can rapidly build up their brand profile by offering high rates of return and achieving 'best buy' status. Other dimensions of competition include, but are not limited to; distribution channels, conditions around withdrawal of funds, quality of service and security of the provider.

3.36 Investment products are also offered by a wide variety of providers. Market share data is not available for different investment products. Intermediaries play a key role in the distribution of investment products making it easier for firms without a branch network to compete in this market. It is estimated that in 2008, 85 per cent of unit trust / open ended investment companies' gross retail sales took place through intermediaries.61

3.37 Competition between investment product providers focuses on a range of features. As returns are not certain, and to an extent depend on external factors, firms often compete on the basis of past performance62 or offer to guarantee investment principals. They also compete on commission rates. The choice of investment product and provider will largely be driven by individual consumers' risk appetite and expected returns, but may also include quality of service dimensions, such as how complaints are dealt with.

Mortgages and secured loans

3.38 A secured loan is a form of loan that is backed by an asset belonging to the borrower. The assets will be forfeited to the lender in the event of the borrower defaulting on loan repayments. The most common form of secured lending in the UK is a residential mortgage where the loan is secured on a home. Other forms of secured lending include car loans.

61 Mintel, Collective Investments, Finance Intelligence, August 2009.

62 Although past performance is not necessarily an accurate indicator of future performance.

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3.39 Residential mortgage providers require authorisation from the FSA.63 This authorisation is different from that to accept deposits. To offer other types of secured lending, a credit licence is required from the OFT.

3.40 Providers can sell mortgages directly and/or through intermediaries. It was estimated that intermediaries accounted for 55 per cent of mortgage sales in 2008-09, though evidence suggests that following the financial crisis this proportion is expected to fall.64

3.41 Traditionally, residential and buy-to-let mortgages have been supplied by banks and building societies with a business model based on taking in deposits and using these to finance mortgage lending. In recent years, other business models have emerged in the mortgage market. In particular, a number of providers either supplemented or substituted deposit-taking with funds obtained from the inter-bank lending market, or other types of wholesale funding, and issuing mortgage backed securities. This allowed providers with only small deposit bases, or in some cases no deposit bases, to enter the market. Some of these providers focused on specific mortgage products such as buy-to-let mortgages.

3.42 One of the most significant effects of the financial crisis was the collapse of the wholesale funding markets, severely restricting the availability of wholesale funds and significantly increasing their cost. Combined with increased risk aversion by lenders, triggered by rising levels of mortgage defaults and other elements of the financial crisis, gross mortgage lending has significantly declined in the last two years. As Figure 3.4 illustrates, gross mortgage lending65 in the UK has sharply fallen from a peak of £363 billion in 2007 to £143 billion in 2009.

63 The FSA authorisation regime does not cover commercial mortgages or second-charge mortgages. See Chapter 5 for more details.

64 Source: Mintel, Mortgages Finance Intelligence, March 2010.

65 Gross lending gives the total value of loans secured on dwellings that are newly advanced by institutions in the period.

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Figure 3.4: Gross mortgage lending in the UK, 2001 - 2009

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

2001 2002 2003 2004 2005 2006 2007 2008 2009

Gro

ss m

ortg

age

lend

ing,

£m

Source: CML

3.43 However, whilst gross mortgage lending has declined, according to the Council of Mortgage Lenders, there remains a large customer base of 11.4 million mortgages in the UK with loans outstanding worth over £1.2 trillion in August 2010. At the end of June 2010, there were 1.26 million buy-to-let mortgages outstanding worth a total of £149 billion.66

3.44 Table 3.4 below sets out market shares in the mortgage market in 2009 using a measure of new mortgage business (gross lending) and the existing stock of mortgages held by consumers (outstanding balance).

66 CML, www.cml.org.uk/cml/statistics.

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Table 3.4: Total mortgage market shares, gross lending and outstanding balances, 2009

Mortgage provider Gross lending, market share (%)

Outstanding balance, market share (%)

Lloyds Banking Group 24 28 Santander 18 13 Nationwide Building Society 8 10 Royal Bank of Scotland Group 13 7 HSBC 11 5 Barclays/Woolwich 10 7 Others 15 29

Source: Mintel Mortgages, Finance Intelligence, March 2010. Note figures may not sum to 100 per cent due to rounding.

3.45 As can be seen, market shares differ by gross lending and outstanding balances. The five largest providers account for over 75 per cent of gross new lending. The other category includes other banks and building societies and specialist mortgage providers.

3.46 The differences between gross lending and outstanding balance market shares may be explained by lower levels of lending made by specialist mortgages providers following the financial crisis. In January 2007, these providers accounted for 17 per cent of gross lending,67 reflecting their ability to source mortgages using wholesale finance. Following the financial crisis, such finance has become much scarcer, and by July 2010, the share of specialist lenders of gross mortgage lending fell to five per cent.68 However, since many of the mortgages made by these specialist providers prior to the financial crisis remain outstanding, the outstanding balance market share continues to reflect previous levels of lending.

67 Bank of England, monetary and financial statistics (LPMAUAT and LPMVTUZ series).

68 Ibid.

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3.47 Competition in the mortgage market centres on interest rates offered, the arrangement fee, other ancillary fees associated with purchasing a property and the terms and conditions of the loan. There has also been competition on loan-to-value ratios, though this has declined following the financial crisis. Quality of service issues may also be important to consumers, such as how they will be treated if they fall into arrears.

3.48 One recent development has been the rise of bundled offers where attractively priced mortgages (or those with higher loan-to-value ratios) are sold in conjunction with other retail banking products such as PCAs. These bundled offers are not typically sold through intermediaries.

3.49 Trends in the residential mortgage market are replicated across other forms of secured lending. Overall, gross advances in secured lending fell from £39 billion in 2007 to £26.5 billion in 2008.69 A large part of this difference was accounted for by the fall in gross advances for secured personal loans, which fell from £7.4 billion in 2007 to £1.3 billion in 2008.

3.50 Table 3.5 below sets out market shares in secured lending in 2007. Comparable data are not available for post-financial crisis market shares. It may be the case that the ability of specialist secured lending providers to extend credit will also have been reduced, reducing their market shares.

69 Mintel, Secured Lending Products, Finance Intelligence, January 2009. The fall in secured lending amounts may also reflect reduced demand.

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Table 3.5: Total gross secured lending market shares, by value, 2007

Secured lending provider Market share (%)

Lloyds Banking Group 27 Barclays 11 Santander (Abbey only) 8 Northern Rock 8 Nationwide Building Society 7 Royal Bank of Scotland Group 7 HSBC 4 Others 28

Source: Mintel, Secured Lending Products, Finance Intelligence, January 2009. Number of consumers surveyed not given.

Credit cards and other forms of unsecured loans

3.51 Unsecured lending refers to loans that are made in the absence of collateral. If the borrower defaults, the lender does not have an asset as a security to fall back upon. Lenders generally provide unsecured loans for relatively small purchases for example computers, holidays or an unexpected expense such as a medical bill. The most common form of unsecured lending is through credit cards.70 In 2009 there were over 58 million credit cards in issue in the UK compared to around 66 million in 2008.71 More recently, peer-to-peer lending facilitators have entered the market. They provide a 'matching' service online for borrowers and lenders.

3.52 The total value of gross advances on unsecured loans in 2009 was estimated to be £24 billion.72 As was the case for secured loans, this

70 Credit cards can be defined as pay-later payment cards that allow cardholders to make point-of-sale transactions and withdraw cash up to a pre-arranged limit.

71 Mintel, Credit and Debit Cards, Finance Intelligence, July 2010. It should be noted that many customers hold multiple credit cards (some of which may be dormant) with different providers.

72 Source: Mintel, Unsecured Personal Loans, Finance Intelligence, December 2009.

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figure represents a decline on previous years (the equivalent figure in 2008 was £38 billion) reflecting the impact of the financial crisis and subsequent economic downturn. The value of purchase transactions made on credit cards in the UK was £97.2 billion in 2009 compared to £102 billion in 2007.73

3.53 Unsecured lending providers range from the major banks to small scale specialist and non-specialist lenders. Additionally, in some cases, firms choose to provide 'white label' credit cards that are distributed through other firms such as retailers.

3.54 Distribution channels for unsecured lending vary by business model. The branch network is the most common distribution channel for arranging loans (36 per cent of customers went directly to their current account provider to arrange loans in 2009).74 Many providers also arrange personal loans online or via the telephone. A similar picture emerges for credit cards, with research indicating that 48 per cent of customers applied for a new credit card in a bank branch compared to 22 per cent online.75 Table 3.6 and Table 3.7 below set out market shares in the unsecured personal loan and credit card markets respectively.

73 Mintel, Credit and Debit Cards, Finance Intelligence, July 2010.

74 Mintel, Unsecured Personal Loans, Finance Intelligence, December 2009.

75 Mintel, Credit and Debit Cards, Finance Intelligence, July 2010.

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Table 3.6: Unsecured personal loan market shares, by number of customers, 2009

Unsecured lending provider Personal loan Sept 2009, market share (%)

Lloyds Banking Group 25 Barclays 13 Santander 10 Royal Bank of Scotland Group 9 HSBC 7 Nationwide Building Society 4 Northern Rock 3 Co-op 1 Other high street bank 2 Other building society 0.5 Direct / specialist loan company 7 Retailer 7 Internet only / direct bank 3 Credit card issuer 0.5 Other 11

Source: OFT calculations based on Mintel Unsecured Personal Loans, Finance Intelligence, December 2009. Note: figures may sum to more than 100 due to multiple holdings. Number of consumers surveyed: n = 279.

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Table 3.7: Credit card market shares, by number of customers, 2010

Credit card provider Percentage of consumers who hold at least one credit card with this

provider April 2010, (%)

Lloyds Banking Group 29 Barclays 23 Royal Bank of Scotland Group 19 HSBC 13 MBNA 8 Marks & Spencer 7 Santander 6 Nationwide Building Society 5 American Express 5 Tesco 5 Capital One 4 Credit card from another retailer/supermarket 3 Sainsbury 2 Credit card from any other provider 10

Source: OFT calculations based on Mintel Credit and debit cards, Finance Intelligence, July 2010. Note, figures sum to more than 100 per cent due to multiple holdings. Number of consumers surveyed: n = 1,937.

3.55 The top five providers account for over 60 per cent of unsecured personal loans.76 The markets for both credit cards and unsecured personal loans contain significant players outside of traditional banks, such as monoline unsecured loan providers. As in the secured loan market, these monoline providers have, in the absence of retail deposits, relied on wholesale funding to finance their operations.

3.56 Competition in the unsecured lending market takes place across a number of dimensions including interest rates and charges, available credit, distribution channels and repayment periods. In the credit card

76 The equivalent figure cannot be calculated for credit cards due to multiple holding.

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market there is also competition on interest-free periods, rewards, annual fees and ancillary charges.

SME banking products

3.57 Of the estimated 4.8 million private enterprises in the UK, the overwhelming majority (over 95 per cent) are classified as SMEs. The aggregate turnover of SMEs is estimated at £1,500 billion (2008).77

3.58 SMEs require banking facilities in order to carry out day-to-day business operations such as invoicing, paying costs and maintaining cashflow. As the OFT's focus in SME banking is on core and secondary banking services, the key products that we will examine for the presence of barriers are business current accounts (BCAs), savings/deposit accounts, term loans and unsecured lending, and secured lending products such as commercial mortgages, factoring and invoice discounting and asset financing. These are defined below, with market structure and the nature of competition discussed where data are available.

3.59 The SME sector is not homogenous. It contains a range of businesses, differing by size and sector. Due to this diversity, SME retail banking services are often more bespoke than personal banking services. It should also be noted that in some cases, typically in the case of the smallest SMEs (micro-enterprises), businesses may choose to use personal banking products rather than SME specific banking products.78 The use of personal banking for business purposes will not typically be reported in data on SME banking.

77 Department for Business, Innovation & Skills, http://stats.bis.gov.uk/ed/sme/Stats%20Press%20release%202008%20edition%20-%20corrected%20version%20July%202010.pdf.

78 The CC SME banking report estimated that up to 20 per cent of SMEs used PCAs, although these were likely to be the smallest SMEs, see page 15.

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Business current accounts

3.60 Business Current Accounts (BCAs) are the equivalent of PCAs for business customers. As with PCAs, the main function is to make and receive payments (what are termed 'money transmission services'). Many BCAs also have overdraft facilities that can provide SMEs with short-term liquidity which are repayable on demand. Other features that can be offered with BCAs include debit cards and business advice. In its SME banking report, the CC found that BCAs were also used for short-term deposits and concluded that BCAs were part of a product market for liquidity management services. Service charges are generally levied for the use of BCAs.

3.61 To offer a BCA, a provider requires authorisation from the FSA to accept deposits. This is the same authorisation as for personal customers. BCAs are typically offered by retail and universal banks although, as the CC SME banking report noted, some building societies also offer BCAs.79

3.62 In 2007 there were 3.6 million BCAs, of which 2.9 million were in credit. Just under one million BCAs had overdraft facilities and in 2007 there were 0.72 million overdrafts extended worth, on average, £12,054.80 The number of accounts without overdraft facilities was reported to have risen 31 per cent between 2000 and 2007.81

3.63 Historically, the supply of these products has been dominated by the four established banks. The OFT SME banking review considered the evolution of market shares (measured by the number of account holders) for SME liquidity management services (including BCAs) and noted that between 1999 and 2005 the HHI figure declined from 2,190 to 1,926. However, despite this decline the four established banks still held a

79 See CC SME banking report page 17.

80 Mintel Small Business Banking, Finance Intelligence, October 2008

81 Ibid.

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collective market share of 85 per cent in 2005 (compared to 92 per cent in 1999).82

3.64 The latest available data (2008) on liquidity management services suggests that the four established banks continue to have the largest market shares, accounting for nearly 80 per cent of the market.

Table 3.8: SME liquidity management services market shares, by number of accounts, 2008

Provider 2008, market share (%)

Royal Bank of Scotland Group 23 Lloyds TSB 19 Barclays 18 HSBC 18 Alliance & Leicester 6 HBOS 4 Clydesdale 3 Co-operative Bank 2 Abbey 1 Others 6

Source: Mintel Small Business Banking, Finance Intelligence, October 2008. Base not given.

3.65 More recent data following the financial crisis is not available, though it is likely that the market will have become more concentrated due to consolidation in retail banking, in particular the merger of Lloyds with HBOS and Santander with Alliance & Leicester.

3.66 As set out by the CC in its SME banking report, providers compete in the BCA market on the basis of price and quality of service.83 In the case of pricing, the bespoke nature of some elements of liquidity management

82 See OFT SME banking review, page 28.

83 See page 26 of the CC SME banking report. The CC took price to include 'interest forgone', that is interest not received, because accounts do not pay interest, or do so at a rate significantly below the value of funds to the provider.

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services means there is likely to be price differentiation between SME customer types and some fees and charges may be negotiated. Service fees are typically charged on BCAs.

3.67 As set out in the CC SME banking report, providers compete in a number of quality of service areas. These include:

• Relationship managers: SMEs are typically assigned a relationship manager to look after their accounts with their provider. The quality of this relationship and the specialist knowledge that managers have will be important determinants of SME satisfaction.

• Branch network: the proximity of a branch to an SME's business operations is an important consideration for those SMEs that deal with substantial cash and cheque transactions.84

• Errors and disputes: the incidence of errors and disputes may be an important determinant for SMEs choosing a provider, as may be the way in which complaints and disputes are dealt with by the provider.

3.68 Other quality of service parameters may include online banking services, cheque clearing times and the level of security on deposits.

Saving/deposit accounts

3.69 SMEs can have a number of different deposit products. These will differ by minimum and maximum amounts allowed to be deposited and limits on the amount and method of withdrawal. These accounts are not designed to handle day to day transactions but are like saving vehicles and are normally free of service charges. To offer saving/deposit accounts, a provider requires authorisation from the FSA.

84 In its 2007 SME banking review, the OFT found 44 per cent of SMEs received payment through cheques and 66 per cent made payment through this method.

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3.70 It is estimated that there were around 1.59 million SME saving/deposit accounts in 2007. Including deposits held in BCAs, a total of £54 billion was held by SMEs in business bank accounts.85 Data are not available on SME deposit account provider market shares.

Term loans and unsecured lending

3.71 Term loans are a form of unsecured lending to SMEs. Unlike overdrafts, term loans are not repayable on demand, but rather have an agreed repayment schedule. A term loan is capable of being drawn down, repaid and redrawn at the SME's discretion. Term loans are therefore more flexible, in some respects, than overdrafts and are granted over a fixed term with a rate of interest agreed (either a fixed or variable rate) with the SME.

3.72 Term loans can be offered by any institution with a consumer credit licence such as retail and universal banks and monoline providers. A recent development in the SME unsecured lending market has been the entry of peer-to-peer lending facilitators who match borrowers to lenders.86 This has created an additional, albeit small, source of lending for SMEs.

3.73 In 2007, 0.57 million term loans were taken out by SMEs. The total outstanding lending amount was around £42 billion.87 Figure 3.5 below charts trends in the size of the stock of term loans between 2000 and 2007.

85 Mintel Small Business Banking, Finance Intelligence, October 2008. As has been reported elsewhere, recently firms (both SMEs and larger firms) have been saving more. For example, see www.economist.com/economics/by-invitation/questions/why_are_firms_saving_so_much.

86 Previously peer-to-peer facilitators have only been operating in the personal retail banking space. For more details of the regulatory framework for such facilitators is given in Chapter 5.

87 Mintel Small Business Banking, Finance Intelligence, October 2008.

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Figure 3.5: Term loan lending (outstanding balances) in the UK, 2000 - 2007

0

5

10

15

20

25

30

35

40

45

2000 2001 2002 2003 2004 2005 2006 2007

Term

loan

s (a

mou

nt o

utst

andi

ng) £

bill

ion

Source: Mintel Small Business Banking, Finance Intelligence, October 2008

3.74 Figure 3.6 below shows that new lending to SMEs has declined following the financial crisis in 2007. This decline could be due a number of factors, including reduced demand for loans by SMEs and a reluctance of firms to lend to SMEs. It also may be a reflection of monoline lenders curtailing their lending due to difficulties faced in sourcing finance.

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Figure 3.6: New Term loan lending in the UK, post-financial crisis

0

100

200

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400

500

600

700

800

900

1,000

Oct

-08

Nov

-08

Dec

-08

Jan-

09

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-09

Apr

-09

May

-09

Jun-

09

Jul-0

9

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-09

Sep

-09

Oct

-09

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-09

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-09

Jan-

10

Feb-

10

Mar

-10

Apr

-10

May

-10

Jun-

10

New

ter

m le

ndin

g £m

Source: BBA

3.75 Data are not available on SME unsecured lending provider market shares.

Secured lending

3.76 SMEs can obtain secured lending from providers. SMEs can use these lending sources as alternatives to overdrafts to assist with cashflow. There are a number of types of secured lending available to SMEs.

• Commercial mortgages: this is a mortgage provided to SMEs to purchase property for commercial purposes.

• Asset financing: this is form of funding that allows SMEs to obtain funding for the purchase of assets needed to run and grow their business. Asset finance can include finance leases, operating leases and hire purchase, where the SME leases the capital asset and ownership remains with the leasing company.

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• Factoring: these are services used by SMEs to improve cash flow. Factoring involves the factoring provider purchasing the sales invoices of the SME, at a discount, as they arise in the normal course of trading. In return the factoring provider processes the invoices, administers the SME's sales ledger and allows the SME to draw funds on the amount owed to it.

• Invoice discounting: this is an alternative way of drawing money against invoices for SMEs. The bank provides finance to the SME by purchasing its sales invoices but the SME maintains its sales ledger and collects the money from its debtors on behalf of the bank to whom the debts have been assigned.

3.77 There are a number of specialist SME financing companies in addition to retail and universal banks. These specialists may operate from dedicated business centres or through intermediaries. In some cases these specialists also have deposit licences allowing them to access a broader funding base. Secured lending (like term loans) is a bespoke activity and the terms of each loan will vary by lender and provider.

3.78 Data is not available on SME secured lending market size and provider market shares.

Summary

3.79 The retail banking sector is diverse in a number of respects. While there are common regulatory standards in different product markets, providers can, and do, choose to offer their products in a variety of ways, using different distribution channels, focusing on particular consumer segments and pursuing different growth strategies.

3.80 The financial crisis has had a major impact on retail banking in the UK. One very visible effect has been the consolidation of a number of well-known banking brands resulting in a greater concentration across the sector. The degree of concentration differs in each product market. In some cases, this trend towards greater concentration has been amplified

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by the closing of wholesale funding sources which has led to the withdrawal or curtailing of activities by certain types of providers.

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4 OVERVIEW OF BARRIERS TO ENTRY, EXPANSION AND EXIT

4.1 Barriers to entry and expansion can be defined as obstacles that increase the difficulty of a firm entering or expanding in a particular market. They arise when incumbents have an advantage over potential entrants that is not due to superior efficiency. Barriers to entry, expansion and exit can be a natural feature of the market or be created, or exacerbated, by the behaviour of incumbent firms.

4.2 Barriers to exit arise when there are obstacles to firms leaving a market. Incumbents may face such large losses associated with leaving a market that they find it more profitable to remain active in the market, even if this means continuing to make (smaller) losses. The regulatory framework may also make it harder for firms to quickly leave a market, or can specify how exit is to take place. Barriers to exit may exacerbate entry barriers for potential entrants who may be dissuaded from entering, if they think that they will not be able to easily exit and recover their investment if they are unable to successfully establish themselves.

4.3 When barriers to entry and expansion are high, incumbents' profits and position in the market cannot easily be threatened by challengers. This, in turn, will lead to incumbents' incentives for innovation and greater efficiencies being reduced with consumers facing higher prices, lower quality and a narrower range of products or services than they could otherwise benefit from. In all cases, what is important is not so much whether there are barriers to entry, expansion or exit, but rather whether potential entrants and existing firms are able to overcome them to be able to effectively compete in the market.

4.4 This chapter presents an overview of barriers to entry, expansion and exit in a general context as well as in the case of retail banking activities.

Barriers to entry and expansion

4.5 Barriers to entry create a negative effect on market discipline by preventing or delaying the entry of new firms into a market. As set out

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in the OFT's 'Assessment of Market Power' guideline, the existence of barriers to entry 'allow an [incumbent] undertaking to sustain supra-competitive profits in the long term, without being more efficient than its potential rivals'.88 As a result consumers may face higher prices, lower quality and a narrower range of products or services.

4.6 Barriers to expansion refer to obstacles that prevent or make it difficult for new entrants and smaller firms to increase their market shares, limiting the competitive pressure they can exert on larger rivals. From a dynamic perspective, barriers to expansion can adversely impact upon a potential entrant's decision to enter a market. If a potential entrant anticipates that it will face barriers in achieving the scale necessary to recoup sunk costs,89 or earn sufficient returns to satisfy investors, they may be dissuaded from entering the market.

Typology of barriers to entry and expansion

4.7 The OFT and the CC have recently published updated guidelines on the assessment of mergers, in which four broad categories of barriers to entry or expansion are identified:90

• absolute advantages for incumbents, which can include legal or technical advantages

• intrinsic or structural advantages

• economies of scale, and

88 Supra-competitive profits refer to those profits that are in excess of what would have been earned if the market was perfectly competitive. See www.oft.gov.uk/shared_oft/business_leaflets/ca98_guidelines/oft415.pdf.

89 Sunk costs refer to costs that once incurred cannot be recovered when exiting the market.

90 See the joint publication of the OFT and CC, Merger Assessment Guidelines (OFT1254) www.oft.gov.uk/shared_oft/mergers/642749/OFT1254.pdf.

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• strategic advantages.

4.8 The above categories overlap and it is not always the case that a market will contain barriers from all four categories. Within each category, the existence and significant of barriers can be affected, to differing degrees, by incumbent firms.

4.9 Absolute advantages for incumbents may stem from a variety of sources. Legal advantages may result from regulation and can make it substantially more difficult, expensive or time-consuming for new firms to enter the market. Although regulations are likely to also apply to incumbents, their impact may be felt differently by potential entrants. For example, if the initial and ongoing costs of compliance with regulation are significant, this may disproportionately affect new entrants. The cost of compliance may entail a significant fixed cost which the entrant cannot easily recover due to not having yet acquired sufficient scale, unlike incumbents. This may, in turn, deter entry if the initial cost of compliance is a sunk cost and unlikely to be recovered in the event of the firm leaving the market.

4.10 Technical advantages may result, for instance, from incumbents having preferential access to essential facilities or intellectual property rights, which make it difficult for new entrants to compete effectively. The terms and conditions of access to these facilities may themselves be affected by the behaviour of incumbents.

4.11 Intrinsic, or structural, advantages arise from the 'natural' conditions of a particular industry. They relate to the technology, production methods or other factors necessary to establish an effective presence in the market. Intrinsic or structural advantages can pose a barrier to entry or expansion when the costs for establishing these features are 'sunk'. Incumbents, who are established in the market, may have already recovered their sunk costs, and will be able to set prices accordingly. In contrast, a new entrant will need to recoup these costs and will have to set its prices to take this into account. As such, if they anticipate fierce rivalry after entry that will drive prices down, their expected revenues may not be

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large enough to compensate for entry costs incurred. Thus, they may choose not to enter the market.

4.12 Economies of scale occur when the average costs of producing a given product or service fall as the level of output rises. They may prevent small-scale entry in the market if there is a minimum efficient level of scale necessary to avoid being at a cost disadvantage compared to incumbents. The larger the costs of entry, the larger the scale entrants must expect to reach in order to find entry profitable.

4.13 Strategic advantages arise where incumbent firms have advantages over new entrants because of their established position in the market (sometimes known as 'first-mover advantages'). These advantages can flow, for example, from the experience and reputation which incumbents have built up, or from the loyalty developed by their customers and suppliers. Incumbent firms may sometimes behave strategically in responding to the threat of entry, for example by lowering prices or by investing in additional capacity or additional brands to deter entry.

4.14 In addition to these barriers, consumers' behaviour may affect barriers to entry and, or, expansion. For example, if there are high levels of consumer inertia (which may be exacerbated by absolute and strategic barriers) then new entrants and smaller firms may face further difficulties in attracting customers and reaching a minimum efficient level of scale.

4.15 Barriers to entry and expansion can change over time. What constitutes a barrier to entry at one point in time may not do so in the future. For example, there may be a technological innovation which greatly reduces sunk costs and thereby eliminates a barrier to entry. Similarly, some barriers may increase over time, for example when the number of brands is so large that entrants find it difficult to differentiate themselves, or when the market is already well served and new undertakings can only rely on attracting customers away from competitors rather than on market growth.

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Barriers to entry and expansion in the retail banking sector

4.16 Previous analyses conducted by the OFT and the CC have identified several characteristics of different retail banking sector product markets that may constitute barriers to entry and expansion.91 For example, the following potential barriers in the PCA market and in the provision of banking services to SMEs were identified.

• Establishing a branch network: despite the development of alternative means of carrying out banking transactions, a majority of customers, personal as well as SMEs, considered that having access to a branch was an important factor for choosing a bank. Investing in a significant branch network was found to be a structural barrier to entry for PCA and SME banking services providers.92

• Developing a successful brand: as deposit takers, providers need to gain customers' trust and to build a reputation for providing safe, high quality services. Building brand recognition and reputation was found to constitute an entry barrier in the PCA and SMEs banking services markets.93

• Acquiring new customers: the low propensity of customers to switch providers was identified as a barrier to entry and expansion, as it was considered that it prevented new entrants from building a customer base quickly in the PCA market as well as for the provision of banking services to SMEs.94

91 See CC, The supply of banking services by clearing banks to small and medium-sized enterprises (March 2002) and OFT, Market study on the provision of PCAs in the UK (2008).

92 See page 28 of the OFT PCA market study and page 37 of the CC SME banking report.

93 See pages 36-37 of the OFT PCA market study and pages 38 to 41 of the CC SME banking report.

94 See pages 31 to 32 of the OFT PCA market study and page 57 of the CC SME banking report.

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• Access to information regarding customers' credit risk: if entrants cannot get access to accurate information on risk profiles they will be unable to offer appropriate financial products and therefore find it difficult to build up their customer base. This issue was found not to be a barrier in the PCAs market, but was raised as a concern by the CC with regards to the financial information available on small SMEs.95

• Access to payment networks: as money transmission represents a core activity of the banking sector, access to payment networks is of crucial importance for a new entrant. Access to payment facilities was not identified as a barrier to entry neither in the PCA market nor in the provision of banking services to SMEs.96

• Regulation: a new entrant into the banking sector has to meet a number of regulatory requirements that could delay entry or make it more costly. The OFT and the CC concluded that obtaining regulatory authorisation did not represent a major barrier to entry.97

4.17 Subsequent chapters examine whether these barriers to entry and expansion persist across the retail banking sector, as well as exploring whether new barriers have emerged.

Barriers to exit

4.18 If significant barriers to exit exist in a market then this may have the effect of allowing inefficient firms to remain in the market. One consequence of this may be that more efficient undertakings, instead of

95 See page 37 of the OFT PCA market study and pages 55 to 56 of the CC SME banking report.

96 See page 35 of the OFT PCA market study and pages 60 to 61 of the CC SME banking report.

97 See pages 35 to 36 of the OFT PCA market study and page 59 of the CC SME banking report.

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undercutting inefficient rivals' prices, find it more profitable to engage in less aggressive rivalry, keeping prices higher.

4.19 Examples of barriers that may deter or prevent firms from exiting a market include large one-off costs payable upon exit such as redundancy pay. Sunk costs may also represent barriers to exit, if a firm finds it more attractive to remain in the market to try to recover these costs rather than exiting the market and incurring the write-off costs.

4.20 In the retail banking sector, regulation is also likely to play an important role in creating or affecting barriers to exit. Unlike other sectors, the failure of a firm in the banking sector can have wider systemic consequences. The risk of a contagion effect, caused by the failure of a significant bank, has led Governments and financial regulators to put in place mechanisms to ensure the orderly exit of banks from the sector, or to intervene to prevent exit and subsequent disruption to the rest of the sector. The absence, or inappropriateness, of regulation around the process of dealing with failing banks and their deposits may make it harder for inefficient incumbents to exit the market and may raise moral hazard issues. This is discussed in Chapter 8.

Summary

4.21 The existence of barriers to entry, expansion and exit and the extent to which they affect firms' expected profits have important consequences on a market's dynamism and its ability to work well for consumers. The lower the pressure of potential or actual competition, the lower the incumbents' incentives to keep prices down and to innovate.

4.22 As previous studies have highlighted, barriers to entry and expansion in the retail banking sector may arise from aspects of the regulatory framework and substantial initial capital investments that are sunk. These may be reinforced by customers' behaviour with regards to comparing and switching providers.

4.23 The existence of barriers to exit may entail further competition distortions. Exit barriers may weaken competition by reducing the

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incentives, or the ability, of new, more efficient firms to engage in aggressive rivalry. If inefficient incumbents cannot easily be forced out of the market, potential entrants, who are more efficient, may be dissuaded from entering. The absence of inappropriateness of regulation specific to banking may also heighten barriers to exit.

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5 REGULATORY REQUIREMENTS

5.1 Banking is a highly regulated industry. Most retail banking activities are covered by licensing regimes and firms must meet a range of requirements before they can begin taking deposits or offering credit. Once licensed, they must continue to meet these requirements and must adhere to certain financial and behavioural standards that are set out in industry guidance and enforced by regulators.

5.2 This chapter examines the entry requirements that must be fulfilled before a firm can begin taking deposits and those applying to firms wishing to offer unsecured or secured consumer credit. It then considers ongoing capital and liquidity requirements to which providers must adhere, and finally examines other areas of regulation that were raised as potential barriers to entry or expansion by respondents. For each of these up-front and ongoing requirements we discuss the extent to which they might be creating barriers to entry or expansion that negatively impact upon competition in retail banking. Regulations around the exit of firms from retail banking are covered in Chapter 8.

The regulatory framework

5.3 Retail banking providers98 are subject to a range of regulations that are specific to the activities they undertake, as well as requirements that are similar across financial services, such as consumer protection legislation and money laundering rules.

5.4 In the majority of cases, financial services regulation is the same (or similar) regardless of whether products are provided to personal customers or SMEs. We note where this is not the case. One notable exception is the regulation of consumer credit provision, where the

98 The term 'bank' is often used by regulators to refer to an organisation that is authorised to accept deposits, rather than in the more usual sense of an institution offering a range of financial products. This chapter refers to 'deposit takers' and 'retail banking providers' respectively to avoid confusion.

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regime is primarily concerned with the protection of individual consumers rather than the regulation of products. Therefore, while the regime does extend to products supplied to sole traders and certain small partnerships, it does not go further and cover those provided to other entities such as incorporated businesses.

5.5 The key objectives of retail banking regulation are:

• in the case of deposit takers, to maintain the stability of the banking system by ensuring that deposit-taking institutions hold certain minimum amounts and types of capital and liquidity, are properly funded, and are run by competent individuals; and to protect depositors by specifying standards of conduct to which providers must adhere

• in the case of lenders, to protect consumers by ensuring that credit providers are fit to engage in regulated activities, and are run by competent individuals, and that consumers are treated fairly and provided with sufficient information, and

• in the case of those retail banking providers which offer investment products, to protect consumers by ensuring that they are advised by competent individuals, and that they are treated fairly and provided with sufficient information.99

5.6 In order to carry out most retail banking activities, retail banking providers must obtain authorisation from the appropriate regulatory authority. A firm wishing to take deposits, for instance, must obtain authorisation (commonly referred to as a licence) from the FSA, while a firm offering forms of credit such as overdrafts and credit cards must first obtain a consumer credit licence from the OFT.

99 As the focus of this Review is on core and secondary banking services as categorised in Chapter 3, we do not consider regulation of investment providers further in this chapter.

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5.7 Once licensed, providers must comply with further requirements, set out in legislation or regulatory rules, and must have regard to relevant guidance. They must also adhere to certain financial and behavioural standards that are set out in regulatory guidance or industry codes. Some of these ongoing regulations are specific to the types of product offered, and some are more general (such as money laundering and consumer protection regulations). A provider that fails to observe relevant regulations may face sanctions such as the loss of its licence or the imposition of formal requirements.100 Some breaches may constitute criminal offences, or lead to enforcement action by regulators, or result in a consumer credit agreement being unenforceable.

5.8 Figure 5.1 summarises the licensing and other regulatory requirements for different types of product.

100 In the case of consumer credit providers, the OFT may impose formal requirements under the Consumer Credit Act 1974 (CCA74).

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Figure 5.1: Regulatory requirements by type of product offered

ProductsRegulator and

legislationType of licence

required

Current accounts

Savings accounts FSA:

Financial Services and Markets Act 2000

Residential Mortgages1

OFT: Consumer Credit Act 1974 (as amended)

Basic bank account

Credit cards

Unsecured loans

Ongoing regulation

• Capital and liquidity requirements

• Systems and controls requirements

• Requirements on suitability of management and controllers

• Conduct of business rules

• Anti-money laundering rules

• Compensation scheme requirements

“Banking licence”

(deposit taking authorisation)

Consumer credit licence

Home finance authorisation

Overdrafts

• Conduct of business rules

• Anti-money laundering rules

• Standards required of licensed firms set out in guidance documents covering e.g. irresponsible lending and debt collection

• Risk-based monitoring by OFT of compliance with standards

• Anti-money laundering rules

FSA: FSMA 2000

Secured loans

Providers of residential mortgages may be subject to different types of regulatory regimes depending on the type of mortgage and the type of borrower – see paragraph 5.43 and footnote 118 below.

5.9 In certain cases firms may offer financial products without being authorised.101 For example:

• appointed representatives such as the Post Office (for the Bank of Ireland) and the AA (for the Co-operative Bank) do not require a banking licence or home finance authorisation as they do not carry out core banking or lending functions themselves

• intermediaries such as peer-to-peer lending facilitators who match depositors and borrowers do not require a banking licence, but are

101 General categories of exemption are listed below. There may also be some individual exemptions, assessed on a case-by-case basis.

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likely to need to be licensed under the CCA74, although the category or categories of licence required will depend on the nature and extent of the credit and ancillary credit activities undertaken.

• providers which are authorised under any of the European single market directives102 to operate in other European Economic Area (EEA) states may if they wish use a 'passport' from their home state regulator to enable them to operate a UK branch of the business without obtaining separate authorisation from the FSA,103 and

• firms offering credit only to limited companies or large partnerships, or wholly or predominantly for business purposes (and where the credit exceeds £25,000), do not need a consumer credit licence.

5.10 There are also categories of firms which, whilst requiring authorisation, may face less stringent requirements as their business models are considered lower risk. These groups include:

• providers of e-money104 which do not need to be authorised as banks but face a separate authorisation regime, and

• credit unions and friendly societies, which must be authorised by the FSA if they wish to carry out activities covered by FSMA 2000, but face less stringent requirements than other providers (and are generally exempt from consumer credit regulation).105

102 For example, the Banking Consolidation Directive (2000/12/EC) or the Markets in Financial Instruments Directive (2004/39/EC)

103 See paragraphs 5.36-38 below. Providers which have an EEA passport are also exempt from obtaining a consumer credit licence if they wish to carry out credit activities in the UK.

104 E-money is funds deposited by customers that will be used, for example, to pay for items via a prepayment card or mobile phone.

105 A credit union is a financial co-operative that is owned and controlled by its members. A friendly society is a mutual organisation with a common financial purpose. Due to lack of

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5.11 As well as the compulsory regulatory requirements set out above, firms may comply with self-regulatory regimes, such as the Lending Code (monitored and enforced by the Lending Standards Board), or the Finance and Leasing Association Lending Code. These codes are separate from, but complement, regulatory guidance such as the OFT's guidance on irresponsible lending. Subscribers to the codes should be familiar with, and have regard to all relevant guidance.

Potential barriers

5.12 Regulatory requirements may act as barriers to entry. In many cases it is entirely appropriate that they do so. For example, rules preventing firms which are inadequately capitalised, insufficiently liquid, or run by unfit individuals from becoming deposit takers, are essential for protecting depositors and maintaining confidence in the banking system. Similarly, rules on consumer credit are essential to safeguard the interests of borrowers and ensure that firms compete fairly.

5.13 Nonetheless, regulation must strike a balance between achieving these aims and ensuring that competent firms are not unduly hindered from entering and expanding in the market. Any regulations or regulatory processes that unnecessarily prevent or delay the entry of competent new operators to the market will represent increases in the size of barriers to entry, with consequent detrimental impacts on the price, quality and range of products available to consumers. For example, regulations based on existing business models may struggle to accommodate innovative potential market entrants and this may prevent or delay the entry of such firms to the market.

5.14 In most cases, regulations will affect all firms providing a particular retail banking product. It may be, however, that regulations impact more strongly on certain groups of firms. For example, a regulation imposing

concern expressed by respondents regarding the process and requirements for these organisations to obtain deposit taking authorisation, we do not discuss these issues further in this review.

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high fixed costs106 will have a more significant impact on smaller firms than larger ones.

Obtaining authorisation to accept deposits

5.15 Under FSMA 2000, a firm that wishes to accept deposits in the UK must be authorised by the FSA or be exempt We refer to this deposit taking authorisation by the commonly used term, a 'banking licence', throughout this review.107

UK firms: obtaining a banking licence

5.16 Firms can pursue a number of routes to obtaining a banking licence:

• applying for a new banking licence (a de novo application)

• seeking a variation of permission of an existing licence to enable the firm to engage in deposit taking activities, or

• applying for a change in ownership of a banking licence currently held by another firm, usually referred to as a 'change of control'.108

5.17 The FSA has recently made significant changes to its licence application process. For example:

106 Fixed costs are costs that do not vary with a firm's level of production.

107 Annexe E provides a list of banks as compiled by the FSA on 30 September 2010. This comprises: Banks incorporated in the United Kingdom; banks incorporated outside the EEA authorised to accept deposits through a branch in the UK; banks incorporated in the EEA entitled to accept deposits through a branch in the UK; and banks authorised in the EEA entitled to establish branches in the UK but not to accept deposits in the UK.

108 Change of control can be achieved by acquiring an existing bank or moving from a position of partial to full-ownership of a bank with an existing banking licence. This may for example include non-UK firms taking control of a UK bank, such as Grupo Santander buying Abbey and acquiring its licence, and UK non-banks acquiring banks, for example, Virgin Money's purchase of Church House Trust.

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• the FSA now actively encourages prospective applicants to engage in pre-application discussions, and it has a page on its website providing information to firms on how to apply for authorisation109

• as outlined in Figure 5.2 below, the application process is now typically carried out in stages with the possibility of issuing a minded to approve letter partway through the process, and

• all applicants have a dedicated FSA contact who is available to provide advice and regular updates.

109 www.fsa.gov.uk/pages/Doing/How/help/index.shtml

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Figure 5.2: Assessment of a banking licence application

1. Capital and liquidity requirements are covered below in paragraphs 5.62 to 5.79.

2. IT systems are covered in Chapter 6

3. If required, there may be iterations of stages 3A-3C before a decision is made, including the submission of missing information, discussion of information with FSA and redrafting and resubmission of documents based on feedback from FSA.

5.18 The FSA assesses each application against five threshold conditions. These are:

• the legal status of the applicant, which for a bank must be a body corporate or partnership

• the location of the applicant’s registered and head offices, which should be in the UK

Assessment Key

Assess applicant’s business plan

Assess governance arrangement

Assess systems and controls

Decisio 3

• Does the applicant have in place adequate systems (including IT systems ) and controls to meet the threshold conditions? 2

• Do the applicant’s board and management collectively have sufficient expertise to carry out the functions of a bank and comply with all relevant requirements?

• Is the plan based on realistic assumptions? • Does it comply fully with capital and liquidity requirements 1

Pr -application discussions

• None. The FSA encourages firms to contact it before submitting an application to discuss authorisation requirements and the obligations on authorised firms

Timeline De novo

applicationChange of ownership

0 0

Up to 12 Up to 3

Application submitted

1

2

3

4

3

3C

•Applications must be accompanied by supporting documents including a business plan, policies and procedures, governance arrangements, a risk assessment, and capital requirement

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• whether the applicant has close links with any person or company that might prevent the FSA from carrying out effective supervision of the applicant, if authorised

• whether the applicant has adequate resources (financial, human and physical), and

• the applicant’s suitability – this includes assessments of persons connected to the applicant, of whether the applicant will conduct business with integrity and in compliance with proper standards, and of whether it has competent and prudent management.

5.19 Respondents to our consultation, including recent and potential applicants, generally felt that these requirements were appropriate given the need to protect customers and prevent firms from becoming authorised if they were not fully competent to act as a deposit taker.

5.20 There are a number of potential benefits to the applicant from the staged process outlined in Figure 5.2. The applicant may benefit from a reduced timescale for gaining a licence and lower upfront costs of the application, as consideration of the application can commence while IT systems are being developed, premises selected and fitted out, and some staff recruitment and training undertaken. This will enable the applicant to submit an application earlier than might otherwise have been possible (although the FSA will need somewhat longer to assess an incomplete application than a complete one). The applicant may also benefit by finding it easier to secure funding for its application. Once the FSA has completed the majority of its assessment it may, on request, write a letter to the applicant stating that it is minded to grant a licence once the applicant has fulfilled any outstanding requirements, such as the purchase and testing of IT systems. This may make it easier for applicants to obtain the necessary funding for these systems.

5.21 As part of the authorisation process, the FSA carries out approved person checks on key staff, typically including the Chairman, the Chief Executive Officer (CEO), the Head of Risk, the Chief Financial Officer, the Head of Treasury, the official in charge of money laundering,

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executive directors and non-executive directors.110 These checks may entail face-to-face interviews. For deposit takers that are already authorised, there is an ongoing requirement for approved person checks to be carried out whenever personnel holding these roles change.

5.22 With respect to the length of time an application takes, in the case of de novo licence applications and variations of permission to become a bank, the FSA has a statutory obligation to make a decision within the earlier of six months of receiving a complete application or 12 months of receiving an incomplete application. In practice, most applications are incomplete when received as applicants do not usually put in place all the systems and controls required to obtain a licence before applying. If the FSA has been unable to reach a decision within a year to a grant a licence, for example because the firm has not raised the required capital or because development of IT systems is not complete, the firm may withdraw its application and re-apply to enable the assessment of its application to continue.111 The applicant does not automatically become authorised, or have a variation of permission granted, if the FSA exceeds the deadline.

5.23 In the case of a change of ownership, the statutory timescale is 60 working days following the receipt of a complete application. The FSA may, however, 'stop the clock' once for a maximum of 20 working days

110 While all key staff must be certified as approved persons, the FSA does not require all members of the firm’s management and board to possess banking qualifications or experience. All approved persons do, however, require relevant experience and skills in relation to their role. As part of its assessment of the firm’s governance, the FSA may require that boards contain qualified and experienced people and that they include non-executive directors who collectively have the ability and capacity to provide an effective challenge to the executives.

111 Statistics published by the FSA show that between April and September 2010, 99 per cent of applications for authorisation met these statutory timescales while 28 per cent were completed within three months. This includes re-submitted applications that were previously withdrawn. These figures include all applications for authorisation, not just applications for a banking licence. Figures from: www.fsa.gov.uk/Pages/About/Aims/Performance/standards/latest/authorisation/index.shtml.

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(30 days if the prospective controller is outside the EEA) if the information provided following the start of the statutory timetable is incomplete. In such cases, the FSA must, therefore, reach a decision within 90 days of receiving a completed application.

5.24 During the period January 2005 to December 2009, the FSA received 38 applications for a banking licence. Of these, 29 were authorised, nine withdrew and none were refused. If it proposes to refuse a licence application, the FSA will discuss this with the applicant, and applicants in this position generally choose to withdraw their application.

5.25 The FSA has indicated that it is currently considering six applications for the authorisation of new deposit takers, and two applications for a variation of permission to allow a firm to accept deposits.

Table 5.1: Applications for a banking licence

Year Authorised Withdrawn Refused Total

2005 2 1 0 3

2006 11 0 0 11

2007 9 0 0 9

2008 2 7 0 9

2009 5 1 0 6

Source: FSA data

5.26 While there is no clear trend in the number or success rate of licence applications over this period, the high number of withdrawals in 2008 is notable. The FSA has indicated that five of these seven withdrawals related to issues emanating from the global banking crisis, while two related to firms which immediately resubmitted their applications.

5.27 In addition to the 38 applications for a banking licence, between 2005 and 2009 there were six applications for a variation of permission that would allow the authorised firm to accept deposits. Only one of these applications was granted, while five were withdrawn. The reasons for these withdrawals included issues relating to the global banking crisis,

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serious firm-specific issues that emerged during the application process, and inadequately prepared applications.

5.28 The FSA fee for a de novo banking licence application is £25,000, while the fee for a variation of permission to become a bank is £12,500.112 For a change of ownership no application fee is charged. The level of these fees, if any, is comparatively small and we have not received evidence to suggest that the cost of applying for a banking licence has deterred entry.

5.29 In addition to these application fees, an applicant is likely to incur consultancy and legal fees during the course of its application, in order to ensure that its business plan is robust and that it complies with all legal and regulatory requirements. The applicant will also require sufficient funds to sustain the firm during the application process and any period between authorisation being granted and it becoming profitable. We have not received evidence to suggest that these costs are so significant as to constitute barriers to entry.

5.30 However, while the cost of obtaining a banking licence is not regarded as prohibitive, a number of potential entrants have indicated that the process for obtaining a banking licence can be unclear and uncertain. In particular, applicants with unconventional business models have argued that little guidance is available on how licensing requirements might be interpreted in their particular cases. Also, a number of parties have suggested that there is very little up-front information available on the FSA licensing process which makes it hard to make well-informed decisions about whether to apply and how to present an application.

5.31 One particular issue regarding the process that has been raised is that potential entrants have found themselves in a 'catch 22' situation. They are unable to obtain a banking licence without making capital investments (for example on IT systems) to meet licensing requirements, but have had difficulty in raising the capital required without some

112 If a firm re-applies for a licence it must pay the same fee as for its original application.

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assurance that this would lead to them becoming licensed. Even for those entrants that are able to overcome this 'catch 22' situation, because this capital expenditure must be made before a licence is granted, these investments have sat unused for a considerable period while other aspects of the authorisation process are completed.

5.32 Concerns have also been raised over the overall length of the processes, the different statutory timescales to reach decisions (as set out in paragraphs 5.22-5.23 above). One specific concern raised in relation to this was that the FSA lacked the appropriate technical expertise to scrutinise new entrants' ICT arrangements, which could also lead to delays in the process. A further concern was raised over the FSA's ability to 'stop the clock' during the process, for example when examining the credentials of potential approved persons.

5.33 A small number of respondents indicated that the uncertainty, length of time of and cost of the application process had proved insurmountable and that they had decided not to apply for a licence. Others had proceeded with an application but had experienced delays in the application process, or had revised their business plans in order to reduce the time taken to gain a licence (as distinct from changing the business plan in order to meet licensing requirements).113 Overall, therefore, it appears that certain aspect of the process may have acted as barriers to entry and that this may have led to a detrimental impact on the price, quality and range of products available to customers.

5.34 It is too early to tell whether the changes introduced recently introduced by the FSA and outlined in paragraph 5.17 with Figure 5.2 above have reduced the extent to which current and future applicants will face the barriers outlined above. However, we consider the changes to be

113 We understand that a number of these concerns relate to licence applications that were in progress during 2008 and 2009, when banking regulation was undergoing significant reform in response to the financial crisis and before the FSA introduced formal pre-application discussions. In at least one case, the FSA changed its licensing requirements while an application was in progress, requiring the applicant to make unanticipated changes to its business model.

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positive and to have the potential to address many of the concerns raised by respondents. For example, the regulator's willingness to issue a letter in appropriate circumstances stating that it is minded to grant a licence if certain conditions are fulfilled is likely to make it easier for an applicant to persuade investors to provide the funding that would enable it to fulfil these conditions. The impact of these changes would merit monitoring.

5.35 It is also possible that further measures could be introduced to improve the transparency and ease of use of the information that is available to applicants. For example, we understand that it is sometimes difficult to locate and comprehend those parts of the FSA Handbook that explain the requirements and procedures for authorisation. Additionally, while the 'Helping You Apply' section of the FSA's website contains much useful information for potential applicants, we understand that it does not list all the requirements of which applicants should be aware. Other relevant information may be found elsewhere on the website, such as in speeches given by FSA directors, although this may not be readily apparent.

Overseas banks: the passport scheme

5.36 Under European Union (EU) single market rules,114 an authorised deposit taker in the EEA does not need to be authorised by the FSA but can accept deposits through branches in the UK if it has been issued a 'passport' under the Banking Directive from its home state regulator and the FSA.115

5.37 A deposit taker authorised in an EEA state that wishes to operate in the UK via a branch must first notify its home state regulator that it wishes to set up a branch in the UK. The home state regulator has up to three

114 The passport scheme was introduced via the Second Banking Directive in 1989, implemented in 1993.

115 These need not be physical branches but may be electronic or telephone based.

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months to notify the FSA. The FSA then has a further two months from the date of receipt of this notification to prepare to supervise the firm’s UK operations or, if there are concerns, to contact the home state regulator. A firm that already has a banking passport that wishes to carry out activities that are not incorporated in the Banking Directive can apply for a 'top-up' of its passport.

5.38 Based on information provided by the home state regulator to the FSA in relation to an EEA bank wishing to operate in the UK, the FSA will decide on the appropriate level of requirements to place on the firm, for example in relation to the proportion of capital that it must invest in liquid assets, This potentially limits the extent to which the provider is able to make loans and operate its business.

5.39 Banks incorporated in a country outside the EEA may open a deposit taking branch in the UK subject to authorisation by the FSA.116 On receiving an application for authorisation by a non-EEA bank, the FSA carries out an assessment, against internationally accepted standards, of the supervisory work carried out by the regulator in the home country. If the FSA finds that the home country regulator complies wholly, or in substantial part, with these standards, it then considers whether the applicant bank meets its own threshold conditions for authorisation. These conditions include the adequacy of financial resources (including liquidity adequacy), management and systems and controls. In making this assessment the FSA will not, as a general rule, seek to duplicate work done by the home country regulator.

5.40 The FSA has the power to grant waivers to international (EEA and non-EEA) retail banking providers, removing the obligation for a provider's UK operation to comply with liquidity requirements on a standalone basis, as long as these requirements are met for the provider’s international

116 Overseas banks, including those in the EEA, can alternatively set up a UK-incorporated subsidiary which will be subject to UK requirements in full.

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operations as a whole. If such a waiver is not granted, an international firm’s UK operations may not be able to operate successfully in the UK because it cannot meet these requirements without support from its international parent.

5.41 We understand that providers based in certain countries are required to gain permission from their home regulator before commencing operations or expanding their business in the UK. In some cases it may be time consuming to gain this permission, potentially increasing the size of barriers to entry or expansion in the UK for such banks.117

5.42 While these issues might, in principle, pose difficulties for overseas-authorised banks operating in the UK, they were not raised as a significant concern by such banks or by other respondents. We do not consider that there is currently evidence to suggest that these issues represent barriers to entry or expansion for overseas banks wishing to operate in the UK. Generally we would expect the procedures for authorisation of overseas banks to reduce barriers to entry to the UK market, relative to obtaining separate UK authorisation, and a considerable number of EEA and non-EEA banks operate branches in the UK. While none has reached the scale of leading domestic providers, some (such as ING Direct) have been successful in attracting large numbers of customers.

Obtaining a licence to offer credit

5.43 Retail banking providers can offer two types of credit to personal and SME customers: unsecured credit (including loans and overdrafts) and credit which is secured against property or other assets. Lending activity – both the provision of credit and related activities such as advising customers about credit or introducing customers to other lenders – is covered by two different regulatory regimes. Unsecured lending activity, and certain types of secured lending activity, are covered by the CCA74 and are regulated by the OFT in conjunction with Local Authority Trading

117 Although similar barriers may apply to opening additional branches in other countries.

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Standards Services. Other types of secured lending activity such as the majority of residential mortgages, termed 'home finance' activities, are covered by FSMA 2000 and are regulated by the FSA.118

Obtaining a consumer credit licence

5.44 Under the CCA74, the OFT is responsible for licensing consumer credit businesses and the monitoring of licensees, and can take enforcement action against most firms that offer goods or services on credit or hire, or which lend money to consumers.119 This includes both unsecured and certain secured loans, overdrafts and the granting of credit in respect of credit cards. Firms that provide information or advice to customers about credit, or that deal with customers once they have taken out a loan (such as debt collection agencies), also generally require a licence.

5.45 To obtain a consumer credit licence firms are required to submit an application form to the OFT. 120 For high risk applications, such as certain debt counselling and debt collection activities, supporting documents are also required. 121 An application for a licence will be refused by the OFT if it is not satisfied that the trader is fit to hold one, and the licence can subsequently be revoked or varied if new issues relevant to fitness come to light after a licence has been granted. In addition, in accordance with

118 Home finance activities do not include second charge mortgages (a mortgage taken out on a house that already has another mortgage attached to it) or buy-to-let mortgages. Many second charge mortgages are specifically exempt from the CCA74. Where they are not, providers of such mortgages must obtain a consumer credit licence from the OFT and are subject to regulation under the CCA74 (although this differs in a number of important respects from the regime applicable to unsecured lending).

119 The CCA74 was amended in 2006 and most of the amendments relating to the reform of the consumer credit licensing regime came into force in April 2008.

120 Application forms and guidance, including on high risk credit activities and credit competence assessments, are provided in the consumer credit licensing section of the OFT's website.

121 In 2009, there were 6,027 successful applications which were considered to be low risk and 3,016 which were considered to be high risk.

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the CCA74, the OFT can issue a licence subject to formal requirements or impose requirements on an existing licence when it is dissatisfied with any matter connected with the licensable activities. The OFT regards this as a proportionate means of regulating conduct where a firm is not considered unfit to hold a licence.

5.46 At present, an application for a consumer credit licence costs £330 for a sole trader and £820 for all other firms unless the applicant satisfies certain criteria, making them exempt from the paying a fee.122 The level of fees increased in 2008. Once licensed, a firm does not have to pay a further fee – whether for a renewal licence or a 'maintenance' charge – for a further five years. The application fee was not raised as a concern by respondents to our call for evidence in this review and is unlikely to represent a barrier to entry for retail banks.123

5.47 Between January 2005 and December 2009, the OFT completed 68,615 applications for new credit licences.124 Of these applications, 65,431 (95 per cent) were granted, 2,977 withdrew and 207 were refused. A large proportion of these applicants were firms for whom providing credit is

122 If a firm is not FSA authorised it will be required to pay an additional £150. This additional payment goes to the Financial Ombudsman Service (FOS).

123 Nonetheless the OFT is aware that for some firms a fee of £820 may represent a significant cost and has conducted a public consultation on its fee structure, including whether or not there was a case to move towards a differential pricing model: OFT, Review of Consumer Credit Licensing Fees, December 2009. For the time being, however, it has decided not to implement further differential pricing. This decision took account of responses to the consultation and issues such as the uncertainty surrounding the external regulatory landscape going forward.

124 This figure includes a significant number of new applicants who offer credit but also includes, for example, licensees who are merely changing their legal status and firms which only provide ancillary services such as debt collecting or providing advice on credit and debt. The OFT has a target of dealing with 90 per cent of completed standard online applications within 25 working days and 75 per cent of completed high risk applications within 90 working days. In 2009, the OFT met its target for high risk applications but did not meet the target for standard applications, dealing with 82 per cent within 25 working days. In the first half of 2010 the OFT exceeded its targets for both high risk and standard applications.

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only a small part of their business, for example furniture or car sales firms offering their customers the ability to pay for the goods over a period of time.

Table 5.2: Applications for a consumer credit licence

Year Licence granted Withdrawn125 Refused Total

2005 15,677 504 44 16,225

2006 14,602 529 28 15,159

2007 14,725 644 66 15,435

2008 11,384 777 54 12,215

2009 9,043 523 15 9,581

Source: OFT data

5.48 The number of applications for a consumer credit licences is substantial, although there has been a noticeable decrease in recent years. Among other factors, this is likely to reflect the tougher market conditions facing firms, a lack of appetite for risk in lending and an increase in write-off rates.126 Further, there is some evidence of individual small businesses operating in retail sectors being replaced by larger chains. In addition, businesses may be reconsidering whether they engage in licensable activities, especially in high risk activities, given the increased rigours introduced by the amendments to the CCA74 made in 2006. The increase in the cost of a licence application is also relevant.

5.49 Once a firm has obtained a credit licence, it must comply with all relevant legislative requirements, as set out in the CCA74 and related regulations. It must also adhere to relevant OFT guidance, for example

125 The figures include firms that have withdrawn their application voluntarily and firms which have not responded to a request for further information or a fee payment.

126 Bank of England Trends in lending, September 2010. www.bankofengland.co.uk/publications/other/monetary/TrendsSeptember10.pdf.

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on irresponsible lending and debt collection.127 The OFT operates a risk-based system for monitoring licensees' compliance and continued fitness to engage in credit activities, and may take action against any licensee that is not meeting the required minimum standards of behaviour.

5.50 Respondents to our consultation generally believed that the process and requirements for obtaining a consumer credit licence were not onerous and did not constitute a significant barrier to entry.

5.51 The Association of British Credit Unions (ABCUL), however, has indicated that the costs entailed in obtaining a consumer credit licence for advisory purposes have presented a substantial barrier to credit unions, as they are subject to the same requirements as commercial entities despite operating on a not-for-profit or non commercial basis.128 Nonetheless, we consider it important that credit unions which offer advice to their members are competent to do so and do not pose a threat to consumer well-being.

5.52 Some firms, including those with unconventional business models such as peer-to-peer lending platforms, have argued that the need to establish the precise nature of the business model before the appropriate licence can be issued may cause some delay in entering the market. It is important that all firms, including those with unconventional business models, comply with the appropriate regulatory and licensing requirements. The requirement to hold an appropriate licence applies both to those businesses that operate platforms which facilitate peer-to-peer lending, and anyone carrying on a consumer credit business who provides credit via such a platform.

127 A list of relevant guidance can be found on the OFT website.

128 Credit unions do not require a consumer credit licence for their core business if they are offering loans at APRs of less than 26.9 per cent but those credit unions which engage in advisory activities, such as debt counselling, must apply for a credit licence although they are exempt from paying a fee provided they are registered as a credit union.

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5.53 Based on the lack of concern raised by most respondents and the relatively cheap, short process involved, we consider it unlikely that the consumer credit licensing process carried out by the OFT acts as a significant barrier to entry for the majority of potential new providers and can be overcome in nearly all cases, save of course for those who are not fit or competent to operate in the sector.

Obtaining home finance authorisation

5.54 Certain credit activities, notably lending money to homeowners to finance the purchase of a property, are classed as home finance activities. Firms wishing to offer home finance activities must obtain authorisation from the FSA, which regulates these activities using powers under FSMA 2000.

5.55 A firm may apply to the FSA for a banking licence and home finance authorisation at the same time. If a firm already has a banking licence, it must obtain a variation of permission to enable it to carry out home finance activities. The timescales are identical to that for a banking licence. For a de novo application the cost is £5,000 while for a variation in permission (for example, if a firm already holds a banking licence and wishes to provide mortgages) the cost is £2,500.

5.56 The criteria and assessment process for obtaining authorisation for home finance activities are very similar to those described in the section on obtaining a banking licence above and many of the same observations apply.

5.57 In October 2009, the FSA published a Discussion Paper considering changes to the regulatory regime around mortgages. This document, known as the 'Mortgage Market Review', covered prudential regulation reform and conduct of business reform. Additional policy proposals will be consulted on separately.129

129 These documents, together with further information on the Mortgage Market Review, can be found at www.fsa.gov.uk/pages/About/What/mmr/index.shtml.

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5.58 One respondent commented that certain changes proposed by the FSA as part of its review were likely to reduce opportunities for new entrants by, for example, banning certain products and changing the way in which providers that do not take deposits are regulated. It may be appropriate to monitor the changes in order to check that competent firms are not being prevented from entering the market.

5.59 Another respondent considered that the process for gaining separate FSA approval to offer home finance was onerous, and that the long timescales and large amounts of documentation involved may act as a barrier to entry to the mortgage market deterring entry. However, other respondents did not raise this as a significant area of concern, suggesting that this is not a widespread issue. Furthermore, this process is likely to benefit from the improved procedures put in place by the FSA, which are outlined in paragraph 5.17 with Figure 5.2 above.

Proposed changes to credit licensing responsibility

5.60 The Government has said that it intends to consult on transferring credit licensing responsibilities from the OFT to a new Consumer Protection and Markets Authority (CPMA). It has also proposed that the CPMA would take over some of the activities currently undertaken by the FSA in relation to some other retail financial services.130

5.61 A number of respondents welcomed this prospect, believing that removing the current split of responsibility for credit licensing between the OFT and FSA had the potential to reduce the costs of entry, for example by offering a single licensing process and consistent regulatory approach to conduct matters for all retail banking activities. However, we are aware that some businesses currently regulated by the OFT under the CCA74 have raised concerns that potentially having to meet

130 These and other proposed changes to financial regulation are set out in the Treasury consultation document: A new approach to financial regulation: judgement, focus and stability 26 July 2010, available at www.hm-treasury.gov.uk/d/consult_financial_regulation_condoc.pdf. Prudential regulation will be the responsibility of the Bank of England.

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new capital requirements that do not exist under the CCA74 regime, for example in relation to mortgage lending, may lead to an increase in potential cost and may, therefore, increase barriers to market entry.

Capital and liquidity requirements

5.62 To enter the market and meet ongoing regulatory requirements, firms must comply with regulations related to capital and liquidity requirements.131 Rules on capital and liquidity are designed to protect savers and investors from the risk of failure or bankruptcy of financial institutions (in this case, deposit takers). It is essential that deposit takers hold a certain amount of capital, in a sufficiently liquid form, in order to ensure that depositors are able to access their funds when required.132 Capital adequacy rules set out the amount and type of capital a deposit taker must hold, which is based on risk. Liquidity requirements specify the amount of assets that must be held in a form, such as short term deposits, that can quickly be converted to cash to refund depositors.133 The requirements are calculated in relation to the size of a deposit taker’s liabilities.

5.63 Prudent deposit takers will, as part of their internal risk management processes, determine the level of capital that they need to hold in order to continue trading under a wide range of scenarios, including situations of financial stress. Given the systemic risk that a bank failure poses to the wider economy, however, the FSA imposes minimum capital standards (based on international guidelines) and also has rules on liquidity – activities collectively termed 'prudential regulation'. Deposit

131 There are also ongoing requirements around anti-money laundering and consumer protection. These are discussed in a separate section below.

132 We focus on the requirements facing deposit takers in this review. However capital requirements also apply to insurers, broker-dealers and mortgage lenders.

133 Note that this is not the same as market liquidity, which relates to the volume of trading of an asset in the market and the ease with which the asset can be bought or sold without affecting its price.

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takers must meet the minimum requirements set by the FSA but many will choose, based on their particular policies and internal modelling, to exceed these standards.

Current requirements

5.64 The Bank for International Settlements, based in Basel, has issued guidelines regarding the minimum level of capital each deposit taker should have to hold - the Basel Accords. The EU has made these requirements mandatory for Member States under the Capital Requirements Directive (CRD).134

5.65 The types of capital that can be used to meet the requirements are categorised into two tiers. Tier 1 capital comprises mainly shareholders' equity, 135 while Tier 2 comprises most other forms of capital.136

5.66 Under the CRD, levels of capital required for different types of risk are calculated as set out in Table 5.3 below. Total capital requirements incorporate amounts relating to three types of risk, which are assessed separately and using different methods.

134 Basel I was agreed in 1988 and became law in G10 countries in 1992. Basel II was published in 2004. In the EU the Capital Requirements Directive (comprising Directive 2006/48/EC and Directive 2006/49/EC), based on Basel II rules on capital measurement and standards, came into force on 1 January 2007 and all deposit takers had to implement Basel II no later than 1 January 2008. On 12 September 2010 'Basel III' was announced. This will be implemented in the EU under CRD4.

135 Shareholders’ equity is equal in value to the difference between a firm’s assets and its liabilities. It represents the amount the company 'owes' to its shareholders, including their initial investment and any subsequent retained earnings. Some types of preferred stock (an instrument with characteristics of both debt and equity) may also be used to satisfy Tier 1 capital requirements.

136 Under Basel I banks were required to hold Tier 1 capital of at least four per cent of 'risk-weighted assets' and total capital of at least eight per cent of risk-weighted assets. The capital requirements established under the original Basel Accord remain in place but have been extended to cover not only credit risk but market risk (an addition to Basel I) and operational risk (Basel II).

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Table 5.3: Capital assessments under Basel II

Risk Methodologies for calculation

Credit: the risk of loss if another party fails to perform its obligations or fails to perform them in a timely fashion

One of either:

1. Standardised approach under which certain risk weightings are determined by external credit ratings assigned to the borrower

2. Foundation Internal Ratings based approach under which risk weighting for each exposure or type of exposure is based on the lender's estimate of the probability of default, while the regulator provides set values for loss given default, exposure at default and maturity of exposure

3. Advanced Internal Ratings based approach under which risk weighting is based on the lender's estimate of the probability of default, loss given default, exposure at default and maturity of exposure.

Operational: the risk of loss resulting from inadequate or failed internal processes, people and systems

One of either:

1. Standardised approach under which a bank's business lines' capital requirements are calculated as a percentage of gross income for that business line

2. Basic indicator approach under which a bank must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. The fixed percentage is typically 15 per cent of annual gross income

3. Advanced measurement approach under which banks are allowed to develop their own empirical model to quantify required capital for operational risk.

Market: the risk that arises from fluctuations in asset values or income

One of either:

1. Standardised approach

2. Value-at-risk approach based on the internal models of particular banks.

5.67 Under the CRD, the regulator has discretion to adjust the regulatory capital requirement of an individual firm. In connection with this, the FSA has published Individual Capital Guidance (ICG) which typically

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requires deposit takers to hold capital higher than the minimum requirement under the CRD. This is usually expressed as a percentage of the minimum total capital requirement plus a buffer expressed as a monetary amount.

5.68 On a like-for-like basis, the internal ratings based approaches are likely to lead to lower regulatory capital requirements than the standardised approach. This may lead to certain types of banks facing more onerous capital requirements (as a proportion) than others. If capital requirements have a greater impact on some groups of banks than on others, these banks will find it harder to make profits equal to or greater than their cost of capital, and will be less able to attract investment. This, in turn, will pose a significant barrier to entry preventing banks from expanding their market share that they may not be able to easily overcome.

5.69 Concerns along these lines have been expressed to us, with some respondents arguing that the current capital (and liquidity)137 requirements discriminate against new entrants and smaller deposit takers. In particular:

• a number of smaller or newer deposit takers have noted that they face much higher capital requirements than incumbents who can bear the higher risk management and compliance costs associated with the individual 'advanced' approaches. Regulatory requirements therefore favour firms able to bear a certain level of fixed costs and this may put newer and smaller firms at a competitive disadvantage

• one respondent commented that the FSA had imposed particularly stringent capital and liquidity requirements on deposit takers that were growing rapidly, and

• building societies have highlighted that they are unable to issue equity-style capital which creates a greater reliance on retail deposits.

137 See below for a discussion of liquidity requirements.

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5.70 Two firms with the same asset bases may face substantially different capital costs depending on whether they use the individual or standardised approaches to assessing their regulatory capital requirements. Higher risk-weightings applied to the same assets under the standardised approach translate into higher capital requirements and thus higher costs of holding capital for firms that use the standardised approach, compared with those using individualised approaches. The greater tier 1 capital requirements facing firms using the standardised approach have a considerable impact on profitability due to the relatively high costs of tier 1 capital. Banks with lower profits will have less capital to reinvest in the business and are likely to find it harder to attract investment.

5.71 In addition to capital requirements, the FSA has established rules under which banks must undertake an assessment of their liquidity needs (under various scenarios) and submit this to the regulator under the Individual Liquidity Adequacy Assessment (ILAA) process. The FSA will then provide banks with Individual Liquidity Guidance (ILG). Certain qualitative requirements (relating for example to measuring standards) have already been implemented while quantitative requirements (such as the proportion of investments that must be in specified classes of liquid asset) will be phased in as economic conditions improve. While some respondents noted that current liquidity requirements represented a cost to business, none believed that they posed significant barriers to entry or expansion.

Proposed changes to capital and liquidity requirements

5.72 Following the financial crisis of 2007 to 2009, there has been international agreement to review the capital and liquidity requirements placed on banks, a process which has been labelled 'Basel III'.

5.73 On 12 September 2010, capital reforms, together with the introduction of a global liquidity standard, were announced and will be presented for ratification to the heads of Government of the G20 group of nations at

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their summit in November.138 A new EU law, 'CRD4', will require Member States to adopt the standards set out in the Basel III package. The new requirements are due to come into effect at the beginning of 2013 and will be phased in over six years.

5.74 CRD4 will increase the regulatory minimum equity requirement from two per cent to 4.5 per cent of risk-weighted assets. Banks must hold a further 2.5 per cent of equity in addition to this minimum requirement as a buffer against future shocks, bringing the total common equity requirements to seven per cent of risk-weighted assets.139

5.75 A number of respondents indicated that the capital and liquidity standards set out in the Basel III package were likely to lead to an increase in the cost of capital for all affected providers when adopted by EU Member States, or to a reduction in their returns, and argued that this might, in turn, deter prospective entrants.140

5.76 Certain aspects of the new standards have the potential to exacerbate their impact on newer or smaller banks. For example, firms that gain a larger proportion of their funding from established savings accounts are likely to face lower liquidity requirements, placing new firms that do not yet have a stable deposit base at a disadvantage.

5.77 Respondents also noted that authorised firms were likely to face a considerable increase in compliance costs as a result of the new, more stringent regulations, that these costs are to an extent fixed, and that they are therefore likely to have a disproportionate impact on smaller or

138 Press release 35/2010 of the Basel Committee on Banking Supervision.

139 The overall Tier 1 capital requirement (which may include a limited range of non equity instruments in addition to equity) will increase from four per cent to six per cent over the same period, while minimum total capital will remain at eight per cent. These figures exclude the equity buffer against future shocks.

140 We note that current FSA capital requirements are higher than those that will be required under CRD4, which may limit the further costs of raising capital.

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newer providers. The changes do, therefore have the potential to increase the size of existing barriers to entry or expansion.

5.78 However, in contrast, other respondents considered it likely that the forthcoming changes may level the playing field between smaller and larger banks by:

• introducing a 'too big to fail' levy for larger, more systemically important banks, to be incurred in addition to the standard requirements, and

• removing certain financial instruments most commonly used by large banks from the list of permitted capital.

5.79 As CRD4 takes effect, it may be appropriate for the prudential regulators to consider and monitor, to the extent possible, the impact of the changes on competition.

Other regulations

5.80 A number of other regulations apply to licensed banks and/or lenders. In this section we consider a number of regulations that were raised as potential barriers to entry or expansion by respondents.141

Anti-money laundering

5.81 The Money Laundering Regulations 2007142 require financial institutions to put in place checks, controls and procedures in order to anticipate and prevent money laundering or terrorist financing. The regulations adopt a risk-based approach under which firms implement the requirements in

141 Certain other regulations are covered elsewhere in this document: the Payment Services Regulations (PSR) are considered in Chapter 6, while the Financial Services Compensation Scheme (FSCS) is considered in Chapter 8.

142 SI 2007/2157 available at www.legislation.gov.uk/uksi/2007/2157/pdfs/uksi_20072157_en.pdf.

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relation to the level of risk they have identified. Retail financial firms authorised by the FSA, such as banks, fall under the FSA’s supervisory umbrella for anti-money laundering purposes whereas non-FSA authorised firms will be supervised by HM Revenue & Customs (HMRC) if they act as a money service provider,143 or by the OFT if they do not.

5.82 Key elements of money laundering controls for all financial institutions are customer due diligence measures known as the Know Your Customer (KYC) and Know Your Business (KYB) procedures for personal and business customers. KYC/KYB is a procedure for verifying the identity of the customer, and any beneficial owner of the customer, using documents or information from an independent source. The extent of the KYC measures adopted must be assessed on a risk-sensitive basis.

5.83 A further key requirement is for financial institutions to carry out ongoing monitoring of their business relationships with customers with a view to identifying any suspicious transactions, and keeping KYC records up-to-date. Again, procedures must be established on a risk-sensitive basis.

5.84 Larger financial institutions generally considered the money laundering regulations to be necessary and in the interests of the financial services industry. These firms did not consider that the regulations were likely to constitute a significant barrier to entry or expansion, but noted that they might be more onerous in respect of SME customers than personal customers.

5.85 Certain smaller financial institutions, however, considered the money laundering regulations to be a barrier to entry. Potential switchers between different current accounts might be deterred by the identification requirements related to anti-money laundering, for example if they had difficulty producing the relevant documents or in reaching a branch to present them. This issue may be particularly pronounced for

143 Money service providers include companies offering person to person money remittances and firms providing foreign exchange services with onward transfer.

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retail banking providers that do not have a physical branch network and instead offer internet or phone-based products. While such providers may use a range of techniques to carry out customer due diligence, such as requesting that the customer post copies of the necessary identification documents to them, it may be difficult or time-consuming for a customer to fulfil these requirements.

5.86 Although the regulations require that firms carry out enhanced due diligence measures when business is not face to face due to the higher risk of such transactions, they also provide for firms to rely, in certain circumstances, on the KYC/KYB procedures used by third parties. This is likely to mitigate the potential difficulties faced by non branch-based providers to some extent.

5.87 The majority of respondents who commented on money laundering regulations believed that they were necessary. The above issues were raised by a small number of respondents, none of whom indicated that this legislation was among the most significant barriers to entry that they faced. Further, we have been informed that providers often take a conservative approach in requesting documents and that there is scope for them to accept a wider range of documents to satisfy anti-money laundering regulations. Nonetheless, any factor that increases the reluctance of customers to switch accounts may have a detrimental effect on competition, as discussed in Chapter 7.

Consumer protection legislation

5.88 Licensed consumer credit providers are subject to provisions of the CCA74 which specify, for example, how firms must set out credit agreements and what information customers must be given. In addition, firms are subject to more general consumer protection legislation including the Consumer Protection from Unfair Trading Regulations and the Unfair Terms in Consumer Contract Regulations. These Regulations and other consumer protection legislation are not sector specific and have not been considered in this review.

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5.89 Several respondents noted that the consequences for firms that failed to comply with the requirements of the CCA74 were potentially severe. For example, credit agreements may not be enforceable.144 Respondents also indicated that consumers were increasingly making use of claims management firms who sought to establish that their clients' credit agreements are not valid. However, it is of note that the level of activity by claims management companies has reduced following the publication of OFT guidance and enforcement action being taken by the OFT and the Ministry of Justice Claims Management Regulator.

5.90 While a number of respondents raised the requirements of CCA74 as an area that might in principle have an impact on potential entrants, none provided evidence that the requirements impact disproportionately on particular types of credit provider. Those firms most likely to be affected by the issues mentioned above, such as recent overseas entrants, did not indicate that credit legislation posed a major barrier to entry or expansion. Overall, we do not consider that these requirements are likely to act as a barrier to entry.

Conduct of business rules

5.91 The FSA's conduct of business rules cover a range of areas relating to the conduct of authorised firms, including:

• advising on and selling certain products

• a requirement for prompt, efficient and fair service

• account switching

144 The Consumer Credit (EU Directive) Regulations 2010, which transpose the Consumer Credit Directive 2008/48/EC into UK law, will become mandatory from 1 February 2011. The Directive requires sanctions for breach of rules to be effective, proportionate and dissuasive, and the UK Government has taken the view when implementing the Directive that unenforceability remains an appropriate sanction in some cases and is an important protection for consumers.

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• communications with customers, including the form of financial promotions

• the type of information to be communicated to customers

• cancellation rights, and

• conduct of business provisions in the Payment Services Regulations

5.92 Certain individual products have their own specific rules. For example, rules around how mortgages should be provided are contained in the Mortgage Conduct of Business sourcebook, rules for the conduct of banking services are contained in the Banking Conduct of Business sourcebook, and rules covering payment services are contained in the Payment Services Regulations.

5.93 One respondent commented that compliance with the FSA's conduct of business rules represented a cost to business, although it was difficult to quantify this cost. No other respondents to our call for evidence indicated that these requirements posed a significant barrier to entry or expansion.

5.94 Overall, no evidence has been provided that the FSA's conduct of business rules represents a barrier to entry or expansion, or that they impact disproportionately on smaller or larger financial institutions.

Wider regulatory environment

5.95 A few respondents were concerned that regulation not specific to the financial services sector could act as a barrier to entry and/or expansion in retail banking. Areas of concern included:

• the effect of the merger regime

• the regulatory risk of Government intervention, for example the focus on the banking sector by a number of organisations, including the OFT, and

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• the existing tax regime (and potential changes to it).145

5.96 While the merger regime may pose a barrier to expansion for larger retail banking providers, this would be of concern only if the effect of the regime were to reduce the level of competition in the market. The aim of the UK merger regime (in retail banking, as in any other industry) is to prevent harmful effects on competition arising from a merger, and we do not therefore consider it further in this review.

5.97 Respondents indicating that the regulatory risk of Government intervention might in principle increase barriers to entry or expansion did not provide specific examples of interventions that they considered unnecessary or disproportionate, or evidence on the effects that intervention might have had on the size of these barriers. While any regulatory uncertainty has the potential to deter market entry, we are not aware of any specific areas in which Government intervention has posed a significant problem.

5.98 Similarly, respondents mentioning the tax regime as a potential issue did not provide information on their concerns, or evidence as to the effect or potential effect of the regime. While the tax regime may impact differently on smaller or larger firms in general, we are not aware of any existing or potential provisions that might increase barriers to entry or expansion for smaller or newer retail banking providers specifically.146

Summary

5.99 Firms wishing to offer most retail banking products are subject to a range of regulations, many of which are specific to the activities they

145 One respondent also commented that changes to specific accounting rules had the potential to create barriers to entry in certain product markets.

146 On 21 October 2010, the Government announced the introduction of a bank levy on global balance sheets and has set out legislation to this effect (www.hm-treasury.gov.uk/press_55_10.htm). This appears to affect the largest banks only and we do not therefore consider that it is likely to increase barriers to entry or to achieving scale.

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undertake. Before commencing operations firms must obtain authorisation from the appropriate regulatory authority (FSA or OFT), unless they are covered by an exemption, and prove they satisfy the necessary criteria. Once they commence operations, retail banking providers must continue to meet relevant standards, such as capital and liquidity requirements, conduct of business standards, and anti-money laundering rules. Adherence to these standards is monitored by the regulator. Providers may also choose to meet certain higher voluntary standards.

5.100 Respondents raised a number of concerns relating to the process for gaining a banking licence, indicating that little up front information is available on the licensing process, that uncertainty surrounding the process may make it difficult for prospective entrants to raise the capital required, and that the timescale for obtaining a licence may be lengthy and uncertain. It appears that these problems may collectively in the past have posed a significant barrier to entry. The FSA has recently introduced changes which we consider have the potential to address many of these concerns, though it is to early conclude whether they have lowered barriers. The impact of these changes would merit monitoring and there may be other steps that can be taken to improve the level of information available for potential entrants.

5.101 The OFT has not received any evidence to suggest that the process for obtaining a consumer credit licence constitutes a significant barrier to entry for the vast majority of applicants. Concerns expressed around the home finance authorisation process may be addressed through changes introduced by the FSA, as mentioned above.

5.102 Capital and liquidity requirements emerged as an area of concern among a number of respondents. At present, these requirements, which are designed to protect depositors and improve the overall stability of the financial system, may have a differential impact on smaller and larger firms due to the different methodologies such firms may use to calculate their required capital holdings. Capital and liquidity requirements are currently undergoing significant change as a result of the Basel III process and associated changes to EU law. It appears that new capital

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requirements, along with liquidity standards, could have the potential to exacerbate differences between incumbents and new entrants, for example, by imposing higher fixed costs of compliance. However, some parties have argued that other proposed changes may also reduce any discrepancies, such as removing certain financial instruments most commonly used by large banks from the list of permitted capital. As the new requirements take effect, it may be appropriate for the prudential regulators to consider and monitor the impact on competition of these changes.

5.103 Other regulatory requirements did not emerge as widespread concerns, although some smaller financial institutions did consider that money laundering regulations and the rules applying to consumer credit providers might increase barriers to entry.

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6 ESSENTIAL INPUTS

6.1 In order to offer retail banking products, providers need to have in place appropriate infrastructure to process transactions and comply with risk management processes, to allow their customers access to industry-wide payment schemes, to be able to accurately determine potential customers' risk profiles and to have access to finance to fund operations.

6.2 The building blocks of a retail banking provider's IT infrastructure are the hardware, software and staff that support and facilitate banking. Collectively these building blocks allow a provider to perform essential services in relation to account management such as calculating interest, processing payments and identifying, measuring and managing risks.

6.3 Similarly, providers of most retail banking products need to be able to connect to external payment systems. In the UK, these include clearing schemes (such as Bacs and CHAPS) and plastic card networks (such as Visa and MasterCard). If a provider cannot offer access to such schemes to their customers, their ability to compete successfully will be constrained.

6.4 In addition to access to banking infrastructure, retail banking providers typically need access to customers' financial and credit information to allow them to accurately identify and appraise the risk associated with selling retail banking products such as credit cards or mortgages. Any difficulties in accessing accurate relevant information may create impediments to opening and managing new accounts.

6.5 Retail banking providers seeking to grow in the market must be able to find viable sources of funding to finance their expansion. If they are hindered from doing so, they may not be able to expand operations, preventing them from exerting competitive pressure on incumbents.

6.6 We collectively refer to the above as 'essential inputs'. If new entrants are prevented from accessing these essential inputs they will be unable to compete effectively with incumbents and the likelihood of them being

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successful will be limited. This chapter considers each of the components in turn.

IT systems

Description and functions

6.7 The provision of retail banking products requires the setting up and maintaining of complex computer, information and communication systems (collectively referred to as 'IT systems'). These systems are at the heart of a provider's infrastructure and are crucial to the safety and resilience of the organisation, and the financial system as a whole.

6.8 The functions that these systems need to perform will vary by retail banking product. For example, for a core banking service such as PCAs, a provider needs to build an IT system capable of opening and closing accounts, gathering and holding customers' information, processing payments, calculating interest (due to and from customers), evaluating credit risk and delivering information (through statements or other means). The IT system must also be able to implement the necessary processes to identify, measure, manage and control risks (such as liquidity risk, credit risk and operational risk), not only to ensure business solvency but also to comply with regulatory obligations such as capital and liquidity requirements. In contrast, a monoline provider of credit cards will need a less complex IT infrastructure capable of storing and protecting cardholders' data and encrypting flows on transmitted information (for example, payment transactions), in compliance with the payment card industry security standards.

6.9 Despite these differences, there are common functionalities across IT systems used in retail banking. Regardless of product, a retail banking provider's IT system is likely to comprise of:

• central database servers which centralise all relevant data on customers and operations

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• application servers that each branch or other distribution channel can access

• network infrastructure linking all branches/agencies and ATMs, and allowing for internet banking

• infrastructure to provide security for data stored and transferred, and

• applications implementing complex functions in relation to information and risk management systems.

6.10 As individual providers' IT systems need to communicate with other providers', and industry-wide, systems, there are standardised rules and applications for interconnection. For instance, the content and format of information provided to credit reporting agencies is standardised to facilitate the flow and access to consistent data necessary for assessing customers' credit risk.

6.11 The ability to connect to industry systems rests with an individual provider's IT system. The robustness of these individual systems is critical for the resilience of the larger retail banking sector. For this reason, to obtain authorisation to accept deposits, providers must demonstrate that their systems meet threshold conditions set out by the FSA.147 The applicant's overall system must be sufficiently tested to demonstrate its resilience.

6.12 Moreover, additional regulations, such as the Single Customer View required by the Financial Services Compensation Scheme and KYC or KYB resulting from the Money Laundering Regulations 2007 (described in Chapter 5), impose further requirements on banks' systems and the way in which they manage and report customers' information.

147 For more details, see the FSA Handbook at http://fsahandbook.info/FSA/html/handbook/.

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The availability of IT systems

6.13 If firms considering entering retail banking believe they will face difficulties in establishing an appropriate IT system or that the cost of doing so is very high (and not easily recoverable148), then they may be deterred from entering. This section considers the availability of IT systems for new entrants and their cost.

6.14 A new entrant has a number of options when it comes to establishing its own IT systems:

• developing an IT system in-house

• adapting the IT system of the exiting provider (if entry is through acquisition)

• purchasing an IT system from a third-party supplier, and

• outsourcing the IT operations to a third-party.

6.15 Each of the options listed presents trade-offs.149 The in-house building option increases the ability to design and control a bespoke system, albeit at substantial cost. In contrast, a fully outsourced solution may not allow for a complete customisation of the system, but may be less complex and less costly to implement.

6.16 From our discussions with stakeholders, our understanding is that recent entrants and potential entrants have chosen to source large parts of their IT infrastructure from third-party suppliers. While there are some limitations around buying a third-party system (for example, software

148 New entrants may also find the cost prohibitive at the time of purchase if they cannot raise sufficient funds to finance the investment.

149 See Deloitte (2008), When legacy is not enough -- Understanding the high stakes game of replacing a bank’s core system. Available at www.deloitte.com/assets/Dcom-Canada/Local%20Assets/Documents/ca_en_consulting_whenlegacyisnotenough_Jun08.pdf

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licence restrictions and general risks associated with outsourcing), there is a clear preference for such an IT solution as it is quicker and cheaper than building an in-house system. We have been informed that there are around 10 IT suppliers, with more likely to enter the market.

6.17 Trends in outsourcing IT systems are likely to continue with new entrants likely to replace traditional back office IT departments, which require a high initial investment, with outsourced IT operations that can expand as the entrant expands. The use of Software as a Service150 and cloud computing151 offer scalability, and ease of updating and upgrading, and allows entrants to pay for what they use. These possibilities can significantly reduce up-front costs, as new entrants can 'rent' the services that they require, avoiding large capital expenditures.

6.18 Further, as has been noted by a number of respondents, new entrants may have an advantage over incumbents when it comes to IT systems, as they start from a blank slate and do not face challenges due to legacy systems inherited from the past and from other organisations they have merged with, as older institutions may. Entrants' ability to develop a single, efficient platform may potentially provide them with operational cost advantages over incumbents who face legacy systems, and who sometimes have to run several, incompatible applications. Endowed with a single, up-to-date system, a new entrant may benefit from having a lower minimum efficient scale and lower variable costs than incumbents.

6.19 With respect to the cost of establishing IT systems, we have been informed that this represents a substantial part of the total cost of launching a bank, regardless of the option chosen. We have been told

150 Software as a Service is a software distribution model in which applications are hosted by a vendor or service provider and made available to customers over a network, typically the Internet. With SaaS, a provider licenses an application to customers through a subscription in a 'pay-as-you-go' model (source: www.searchcloudcomputing.com).

151 Cloud computing is a form of network-based computing, whereby resources, software, and information are hosted and centralised on remote servers and are provided to a network of computers and other devices on demand.

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that IT costs could represent as much as two-thirds of the total start-up costs necessary to start a bank's operations.

6.20 The actual cost of establishing an IT system varies substantially according to the business model of the bank. Figures provided by respondents range from tens to hundreds of million pounds, depending on the number and complexity of products offered, the size of the branch network, the size of the customer base, and the extent to which the bank relies on in-house or outsourced solutions. If a provider is able to convert the fixed cost of establishing an IT system into a variable cost that alters with the number of customers it attracts, then the initial cost of the system is greatly reduced.152

6.21 High start-up costs, combined with uncertainty as to the authorisation process, may deter a new player from entering the retail banking sector, particularly if it considers that the costs involved in building up the IT infrastructure are sunk. Whichever IT system option is chosen, we have been informed that the system and its associated software will require customisation by specialist staff or third-party providers to adapt the system to a particular provider's requirements. A large portion of their costs are therefore likely to be sunk, as each IT system will have been calibrated for a particular bank's needs, increasing its specificity and reducing its value to others. For instance, the Dunfermline Building Society invested £31m in developing a new IT system, but was forced to write off £9.5m in development costs, for a product that its purchaser, Nationwide, was not seeking to deploy in its own branches.153

152 We know of at least one case where this has been put into practice: see www.sourcingfocus.com/index.php/site/newsitem/2746/.

153 House of Commons – Scottish Affairs Committee, Dunfermline Building Society - Fifth Report of Session 2008–09. Available at www.publications.parliament.uk/pa/cm200809/cmselect/cmscotaf/548/548.pdf

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6.22 We have not received evidence to suggest that firms have faced difficulties in securing the funds to finance capital expenditure necessary to establish an IT system, beyond those outlined in Chapter 5 relating to the authorisation process.

6.23 To summarise, we have not received evidence to suggest that new and potential entrants face difficulties in acquiring IT systems. Technological innovations in the IT industry are leading to the development of new solutions for financial services providers to choose from and we believe that this trend will continue. We have also not received evidence to suggest that the cost of establishing IT systems is in and of itself deterring entry.

6.24 However, relatively high start-up costs to establish IT systems may deter entry if firms believe they will be unable to recover these sunk costs (or are unable to convert them to variable costs). This will be the case if they believe they will face difficulties in attracting customers to reach sufficient scale to recover these costs. Thus, relatively high start-up costs combined with difficulties in attracting customers may pose a significant barrier to entering for new entrants. Challenges around attracting customers are discussed in more detail in Chapter 7.

Payment schemes

Description, function and regulation

6.25 A payment system is a process allowing monetary transfers between two retail banking product account holders without using cash. It is defined by a set of common rules and standards used by retail banking providers and other financial institutions to communicate credit or debit orders to each other. This standardisation of messages allows for a common infrastructure to forward a message received from the originator of the transmission to the beneficiary and for the clearance and settlement of the transmission by the appropriate clearing and settlement mechanism.

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6.26 Payment systems generate network effects, in that the value to a participant of accessing a payment system is positively related to the number of other users who join the system. For instance, the value to a customer of being able to initiate an automated payment is positively related to the number of participants able to receive such a payment. Network effects however may also reduce the competitive pressure an individual payment system faces from alternative ones. Indeed, once a payment system is established, it may be difficult for a rival network to attain a scale sufficient to function effectively.

6.27 In the UK, the main schemes providing payment systems are:

• Bankers' Automated Clearing Services (Bacs), a membership based industry body, dealing with direct debits, direct credits and standing orders154

• Clearing House Automated Payment Scheme (CHAPS) Sterling and CHAPS Euro, real-time gross settlement systems (RTGS), offering a same-day payments mechanism for high value sterling or euro payment requirements

• Faster Payments Service (FPS), the most recent payments service introduced in the UK allowing for phone, internet, and standing order payments to move within a few hours

• Cheque and Credit Clearing Company (C&CCC) and Belfast Bankers' Clearing Company Limited (BBCCL), which manage respectively the clearing of cheques in Great Britain and Northern Ireland

154 A Direct Debit is a pre-authorised debit on the payer's account initiated by the payee (for instance utility bills may often be paid by Direct Debit authorised by the customer). A Direct Credit is a credit made on a customer’s account initiated directly by the payer (for instance most salaries are paid by direct credit). A Standing Order is an instruction given by a customer to its bank to transfer a specific amount to the account of a specific creditor.

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• LINK ATM Scheme, the UK cash machines network, members of which are card issuers and ATM operators who want to offer their customers nationwide access to cash, and

• plastic card payment networks, such as Visa, MasterCard and American Express, which provide services to allow electronic transactions for purchases and cash withdrawals.

6.28 In the UK, clearing schemes are not generally independent of the institutions that use them on behalf of their final customers. Moreover, the infrastructure provider that processes many payments, VocaLink, is also owned by the same group of institutions that run payment systems.

6.29 Payment systems in the UK are subject to the Payment Services Regulations 2009155 (PSRs 2009) that implement the Payment Services Directive156 into national legislation. These regulations require payment service providers to be authorised or registered by the FSA and to comply with certain rules about the provision of payment services.157 In addition, they aim to support competition among payment service providers, by stipulating that rules governing access to payment systems should be objective, proportionate and non-discriminatory, subject to certain exemptions.

6.30 Under Part 8 of the PSRs 2009, the OFT has the power to take action to enforce a prohibition on restrictive rules on access to payment services not designated under the Financial Markets and Insolvency (Settlement Finality) Regulations 1999, such as the UK ATM network (LINK) and

155 SI 2009/209 (see www.legislation.gov.uk/uksi/2009/209/contents/made) and The Payment Services (Amendment) Regulations 2009 SI 2009/2475 (see www.legislation.gov.uk/uksi/2009/2475/contents/made)

156 Directive 2007/674/EC on payment services in the internal market.

157 The PSRs set out requirements for the conduct of business by payment service providers, concerning information to be provided to payment service users, and specific rules on the respective rights and obligations of payment service users and providers.

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Visa and MasterCard credit and debit card systems.158 In addition the OFT can investigate relevant potential competition issues around these (and other) systems under the Competition Act 1998/Articles 101 and 102 of the Treaty on the Functioning of the European Union (TFEU) or consider them under its EA02 powers.

Access to payment schemes

6.31 In our analysis and discussions with stakeholders, we have examined the ability of new entrants and smaller players to access payment systems.159 We consider whether firms are prevented from accessing these schemes and if the costs are prohibitive.

6.32 A retail banking provider can access an automated payment scheme (Bacs, CHAPS, FPS) directly, as a member of the scheme, or indirectly, via an agency agreement with a member of the scheme. The choice between these two options depends on the necessity of access to the scheme, the relative cost of these options and the eligibility criteria.

6.33 The objectives of the criteria that must be met to become a member of a payment system are to ensure the safety of the system. Membership criteria ensure that joining members meet the necessary liquidity obligations required by the authorities and are of sufficient credit-worthiness to ensure that they minimise their risk of default. In summary the criteria are that members must:

158 Part 8 of the PSRs 2009 does not apply to proprietary three party payment systems such as American Express.

159 The OFT and others have published extensively on the topic of payment systems, for example, the OFT report on the UK payment systems (March 2003), available at www.oft.gov.uk/shared_oft/reports/financial_products/oft658.pdf, and the Payment Systems Task Force reports listed in the final report published in February 2007 available at www.oft.gov.uk/shared_oft/reports/financial_products/oft901.pdf.

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• hold a settlement account at the Bank of England

• be a bank, a building society, or a participant designated by the Bank of England or the FSA

• demonstrate the ability to comply with technical and operational requirements to access the payment infrastructure and clearing services, and

• have credit ratings above certain thresholds.

6.34 Payment systems which are considered systemically important have to comply with the Bank of England's objectives to guarantee the stability of financial systems.160 Scheme members share the scheme's administration costs in proportion with their usage, such that larger members cover a greater part of the costs.

6.35 Membership criteria for plastic card networks such as MasterCard and Visa require a member to be a payment service provider (as defined in the Payment Services Directive) and authorised and supervised as appropriate. Any payment service provider needs to meet risk management requirements, as well as being capable of complying with operating regulations as defined by the card scheme.

6.36 We have been informed that new entrants and smaller players typically enter into agency agreements with existing member banks to access automated payment systems such as Bacs, CHAPS and FPS. The main reason for this is that they do not process sufficient numbers of payment transmissions to find it profitable to apply for membership of the schemes. Indirect access to payment systems is subject to the criteria set out by the clearing bank serving as agent. These relate to

160 The Bank of England has adopted 14 Principles, consisting of the 10 internationally-recognised Core Principles for Systemically Important Payment Systems and four additional Principles, against which it will evaluate payment systems (www.bankofengland.co.uk/financialstability/role/risk_reduction/payment_systems_oversight/principles_oversight.htm).

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connectivity, their credit policy, rules and procedures laid down by the schemes and criteria set by regulators.

6.37 While not every member of the payment schemes provides for agency arrangements to indirect members, there appear to be enough to allow an indirect member to compare competing offers. It is possible for indirect members to switch providers, albeit after incurring certain costs.

6.38 Some respondents reported that they encountered difficulties in the past in finding a clearing member willing to act as their agent. The Payment Service Regulations 2009 have clarified the authorisation and prudential regime for payment service providers that are not banks, building societies or e-money issuers (already authorised or certificated by the FSA), referred to as Payment Institutions (PIs), as well as the rules governing access to payment systems. These regulations have the potential to remove any ambiguity surrounding the regulatory regime to which a payment service provider is subjected to, and may remove some of the difficulties faced by firms with unconventional business models being accepted as an indirect member of a scheme by one of its members.

6.39 The cost of accessing payment schemes is also important for new entrants. We have been informed that the cost of an agency agreement is bespoke and varies primarily with the volume of transactions (there are limited fixed costs) and with different types of transactions individually priced. Member banks (who offer agency agreements) indicated that larger volumes of transactions allow for discounts, reflecting scale economies. We have not received evidence from institutions holding agency agreements suggesting that the cost of these agreements is prohibitive and hindering access to payment schemes, although the cost is reported to be higher for new services, such as Faster Payments, compared to older schemes.

6.40 We have not received any evidence suggesting that there are difficulties in meeting the criteria to issue plastic cards.

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6.41 Overall, direct and indirect access to payment networks does not appear to raise insurmountable barriers to entry or expansion.

Access to customer information

6.42 Accurate information about a customer's financial situation is a crucial component enabling providers to offer retail banking products, such as credit, to customers effectively.161 In the absence of accurate information about potential customers' risk profiles, providers may be forced to use less reliable information, resulting in credit being over- or under-provided. One consequence of this might be providers ceasing to offer certain products for customers for whom they cannot accurately calculate risk. Thus, a lack of accurate information can potentially become a barrier to entry in certain product markets or consumer segments.

6.43 The types of information required by providers to access potential customers' creditworthiness will differ between products. In the PCA market study, the OFT found that banks needed both financial and non-financial information on their potential customers' history to determine whether to offer them an account and whether to grant them overdraft facilities. The OFT concluded that there was no particularly complex or expensive process involved in acquiring information regarding the credit risk posed by potential customers.162

6.44 As regards to SME banking services, the CC acknowledged that financial information about larger SMEs was available from credit reference agencies or from company accounts for corporate SMEs. The CC however underlined that such information was not as readily available for smaller SMEs that did not file accounts. As this information was only available to the SMEs' current banking service providers, the CC

161 As well as having access to accurate data, providers need to have the relevant skilled staff to interpret it.

162 A similar conclusion was reached by the Competition Commission report on Northern Ireland.

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concluded that new entrants were at a disadvantage in competing, as they could not 'market their services in a targeted way to individual customers or therefore build up market share quickly'.163

6.45 In response to our call for evidence and questionnaires, several providers have suggested that they face certain barriers to acquiring information about customers which makes it difficult to retain or attract certain customers. Some pointed out that incumbents, with which customers already hold their main PCA or BCA, will hold data on income and expenditure, as well as wider product holdings, giving them the ability to more accurately target and price products. Further, this allows incumbents to check quickly customers' creditworthiness without the need for detailed applications and verification, giving them a competitive advantage in attracting those customers who do not want to go through a lengthy application process.

6.46 However, it should be noted that information on existing customers' income flows and spending patterns is commercially sensitive and the wider availability of such information to all retail banking providers would undermine banking relationships. What is important is that accurate information on potential customers' creditworthiness is available to all providers to avoid these customers being offered inappropriate products and enable providers to price correctly.

6.47 Information on creditworthiness of personal and SME customers is available from credit rating agencies which any provider, including new entrants, can easily access. For example, in the PCA market study, the OFT indicated that both new entrants and established suppliers could obtain credit scorings from credit reference agencies such as Experian and Equifax. Respondents to our call for evidence and questionnaires indicated that they rely heavily on these agencies to get credit risk information for making their decisions. Access to these agencies' services was not considered to be difficult. In the case of SME banking, similar services are available. Respondents indicated that a commercial

163 See the CC SME banking report, page 56.

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version of Experian's Credit Account Information Sharing (CAIS) database164 of credit agreements, equivalent to the consumer CAIS database, is now available.

6.48 Information is also available from Companies House, although several respondents indicated that some information is often outdated and does not allow them to assess current credit risks properly.

6.49 Some respondents noted, echoing findings by the CC, that the level of information available on SMEs depends on their size. For example, for SMEs with turnover under £1 million a year, financial information can be scarce, whereas for large SMEs, commercial provision of such information is extensive and has developed significantly over the last five years. Further, these smaller SMEs often use personal banking services rather than dedicated business services, which means there will not be a track record of information available on their business banking profile when they come to seek business banking services.

6.50 It is worth noting, that as part of the CC's SME banking report, recommendations were made (and implemented) that SMEs are entitled, up to twice a year, to request free of charge, an up to date credit history of the last 12 months with their existing bank. 165 This can be sent to as many UK suppliers of banking services as they nominate. It is unclear how often businesses make these requests, or whether this measure has helped to reduce information asymmetries.

6.51 We have also been informed of a number of private sector initiatives to increase the availability of information for retail banking providers on SMEs. For example, initiatives such as CreditPal166 allow for SMEs to

164 See www.experian.co.uk/www/pages/why_experian/our_information_source/our_information_source_consumer_information.html.

165 See CC SME banking report, page 140 and Behavioural Undertakings.

166 See www.creditpal-online.com/home/.

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upload information for submission to retail banking providers. Such schemes have the potential to allow the smallest SMEs to make available the relevant information to providers to allow them to offer them business banking services.

6.52 Indeed, there are indications that SME customers' willingness to supply information themselves is high, allowing new entrants access to important sources of information about potential customers which they can use to accurately understand customer's financial behaviour and predict credit risk. Data from a survey conducted by the Forum of Private Business/Future Route, summarised in Table 6.1 below, indicates only one per cent of SMEs are not willing to provide this information to banks. More than half of surveyed SMEs already provide their financial information to banks.

Table 6.1: To whom would SMEs be prepared to provide their accounts' information?

Already do Definitely Reluctantly Never

Banks 58% 24% 17% 1% Invoice discounters or other financiers

18% 20% 35% 27%

Utilities companies 3% 4% 27% 66% Credit reference agencies 10% 21% 40% 29% Credit insurers 13% 19% 34% 34%

Source: OFT analysis of FPB/Future Route data. Base unknown.

6.53 Based on evidence received, it appears to be the case that retail banking providers can access the necessary information to offer banking products effectively. There is less information readily available on the smallest SMEs, which may make it more difficult for firms to offer these SMEs products if they cannot accurately assess their credit risk. There appear to be some mechanisms to overcome this information gap, but these are still at the early stages.

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Financing expansion

6.54 If new entrants and existing smaller firms in retail banking are unable to secure funding to finance expansion this may hamper their ability to respond to increased consumer demand and finance innovation. This barrier may, in turn, reduce their ability to impose a competitive constraint on larger incumbents.

6.55 In general, providers of retail banking services have five main sources of funds to finance expansion:

• retail deposits, which come from customers' savings

• interbank loans where banks lend money to each other

• issuing equity which can involve direct or public selling of new shares to investors

• retained earnings, which involve a share of profits that is not distributed to shareholders as dividends, and

• debt securities such as covered bonds, which include loans with basic terms and maturity date, which can be bought or sold to third parties.

6.56 Not all of these sources are available to all types of retail banking providers and demand for them differs according to the provider's growth strategy. For example, not all retail banking providers in the UK are authorised to accept deposits and cannot access this funding source.

6.57 The relative attractiveness of different sources of funds varies over time, depending on changes in investor confidence and credit ratings, on the costs of running a retail deposit business, on changes to consumers' propensity to save and also on regulatory requirements.

6.58 Since the financial crisis, the availability of wholesale funding such as interbank loans has been severely reduced so that currently there is renewed emphasis on retail deposits. Many respondents reported that, in

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the short-term, they are seeking to maximise the proportion of their funding that comes from customer deposits.

6.59 This drying up of wholesale funding has had the effect of reducing the availability of finance for those providers whose business models depended on it, such as monoline providers of residential and commercial mortgages. If firms' access to different funding sources is restricted or curtailed, this may act as a barrier to expansion.

6.60 While some of these providers may be able to switch to using retained earnings or issuing equity, this may not be a viable option for many.167 Similarly, the option of applying for and obtaining a banking licence to attract retail deposits may not be viable in the short-term and there is no guarantee they will be able to raise sufficient deposits. Taken together, these factors have led to a reduction in such providers' ability to finance new business, and in some cases, have led to their exit from the market.

6.61 We have also heard concerns that, as a result of Government support, some incumbents have received higher credit ratings than would otherwise have been justified in the absence of such support. This in turn, it is argued, led to these incumbents being able to access cheaper funds, allowing them to maintain or enhance existing levels of lending. The difference in the cost of borrowing between smaller providers and new entrants compared to incumbents was therefore even greater than it would be in normal market conditions.168

6.62 In both cases, these appear to be short-term developments related to the financial crisis. It might be expected that as wholesale markets recover the significance of these barriers to expansion will decline. We also understand that any credit rating uplift granted to large incumbents has

167 We have also been informed that smaller institutions lack the expertise and are potentially unable to bear the costs of creating a covered bond vehicle, even if the market were open.

168 One would expect that smaller institutions and new entrants will typically face a higher cost of capital compared to incumbents as they do not have a track record and scale.

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been, or is in the process of being, phased out, which should mean that their cost of capital is a more accurate reflection of their financial position.169

Summary

6.63 IT systems are the backbone of retail banking activities and are essential to the safety and resilience of financial systems. There are a number of options available to new entrants to meet their IT system needs and we have not received any evidence to suggest that the cost of such systems, in and of itself, is deterring entry. However, the sunk costs associated with establishing IT systems may deter entry if entrants then face difficulties in attracting sufficient numbers of customers to recover this outlay.

6.64 Access to industry-wide payment schemes has been under scrutiny for the last decade and there have been significant changes during that time. Firms can access payment schemes either by becoming a full member of the scheme or through an agency agreement with a scheme member. While in some instances new entrants with unconventional business models have experienced difficulties in initially accessing industry-wide payment schemes, the OFT has not received evidence to suggest that there are significant or widespread barriers to achieving access to these systems.

6.65 Access to accurate information to assess customers' creditworthiness is essential for providers to be able to accurately identify and manage business risks and offer customers products. Providers can access information on personal and SME customers from a range of third-party sources, as well as their own records. New entrants or smaller providers do not appear to face any impediments in accessing this information. However, in the case of the smallest SMEs, there appears to be less information available to providers. This can have the effect of making it

169 See for example Phasing Out Extraordinary Support Assumptions from UK Bank Ratings, March 2010, available at www.moodys.com .

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harder for new retail banking providers to be able to offer products, such as lending, to these SMEs due to a lack of reliable information on their risk profile. SMEs themselves appear willing to provide much information and there are a number of private sector initiatives which, in time, may remedy this information gap.

6.66 Financing expansion has become more challenging after the financial crisis, which caused interbank funding to dry up, affecting the viability of certain business models. We have also heard suggestions that due to Government support, incumbents have received higher credit ratings, leading to lower borrowing costs than new entrants and smaller firms. In both cases, these appear to be short-term developments related to the financial crisis. It might be expected that as wholesale markets recover the significance of these barriers will decline.

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7 BARRIERS TO EXPANSION

7.1 Attracting new customers and growing market share is crucial for the long term viability and success of entrants in retail banking. This relies upon providers being able to offer value-for-money products with the features that they want. Equally, customers must have the confidence and ability to switch between rival providers. In a sector such as retail banking, where there are well established incumbents which already have a large established customer base, high brand recognition and an extensive branch network, new entrants may face significant difficulties in attracting customers.

7.2 This chapter considers features of retail banking markets that can create difficulties for new entrants and smaller providers in attracting customers. Previous research has suggested the presence of barriers to expansion for such firms. For example, the Cruickshank Report found that new entrants had made little impact on retail banking.170 The CC also found that it was difficult for new entrants to build market share quickly in the provision of accounts in Northern Ireland171 and similar findings were made in the OFT's PCA market study.172 If providers face difficulties in building up a customer base they will struggle to recover the sunk costs of entry, which in turn may dissuade them from entering in the first place.

7.3 The chapter begins by examining whether personal and SME customers have the confidence and ability to switch between providers in different retail banking product markets and whether there are any barriers to them doing so. It explores the consequences that low levels of switching may have on the ability of firms to attract customers. The chapter then

170 Cruickshank, Competition in UK Banking: a report to the Chancellor of the Exchequer, March 2000.

171 See CC NI banking report, pages 72-75.

172 See OFT PCA market study, pages 28-37.

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examines the role played by brand and the branch network, and the extent to which they constitute potential barriers to expansion.

Switching in personal banking markets

7.4 The term 'switching' in retail banking refers to customers moving their banking relationship from their existing provider to a new one. Through the process of switching, consumers can reward those providers who offer the best value-for-money and products with the features they desire. Providers that do not offer products that offer value-for-money will either have to improve their offerings or face the risk of being forced out of the market due to lack of demand for their products.

7.5 If consumers face real or perceived difficulties in switching this may result in low levels of switching. New entrants will therefore find it more difficult to attract customers away from incumbents, even if they offer better value-for-money. If potential entrants do not believe they can attract sufficient numbers of customers to recover their sunk costs, they may be deterred from entering in the first place.

7.6 Rates of switching differ across core and secondary personal retail banking markets. From the available data in personal retail banking markets, we note that the annual rate of switching in the PCA market was 9.2 per cent in 2009173 compared to around six per cent in 2006.174 The OFT's recent response to a super-complaint on cash ISAs found that around 12 per cent of consumers in 2010 had switched cash ISA

173 EC Consumer Market Scoreboard, 3rd Edition, p.131.

174 See OFT PCA market study, page 85.

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provider in the last year.175 This compares to a rate of 24 per cent of residential mortgage customers switching provider in 2010.176

7.7 While the above switching rates appear low (for example when compared to other sectors177), the low rates are of themselves not necessarily a problem. Switching rates can remain low when a market becomes more competitive if consumers are offered better deals from their existing providers to deter them switching. However, when low switching levels are due to consumers being uncertain whether they will be better off by switching provider, or fearful of the switching process itself, this is very likely to reduce the competitiveness of the market and create a barrier to firms being able to attract customers.

7.8 As part of our analysis, we commissioned a consumer omnibus survey (OFT consumer survey) to explore attitudes towards switching in retail banking.178 Figure 7.1 below reports the proportion of consumers who have thought about switching their retail banking provider for various personal banking products over the last year.

175 See Cash ISAs: Response to super-complaint by Consumer Focus, June 2010 (OFT1246), page 42.

176 Source: Datamonitor, Unlocking the Secrets of the UK Banking Customer: Insight From the Retail Banking Survey, September 2010. The higher level of switching for mortgages may reflect mortgage-products coming to the end of their fixed interest rate term, which creates a stimulus to consider other providers.

177 The EC reports that 32.7 per cent of consumers switched electricity service provider in 2009, Consumer Market Scoreboard, 3rd Edition, page.131.

178 As well as research presented here on switching, Consumer Focus has also recently published the results of a survey in the PCA market. See http://consumerfocus.org.uk/g/4mf.

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Figure 7.1: Proportion of consumers considering switching retail banking provider in the last 12 months, July 2010

10%13% 14%

89%86% 85%

1% 1% 1%0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

PCAs Savings / Investments Loan products

Yes No Not sure

Source: OFT consumer survey, July 2010. The above figure excludes respondents who reported that they did not hold either a PCA, saving/investment or loan product. Base: PCAs n=932, Savings/Investment n=792, Loan products n=234

7.9 Across each of the personal banking product areas, the majority of respondents indicated that they had not considered switching their retail banking provider. The main reason given for this was that customers were satisfied with their existing provider's product, quality of services and charges/interest rates (ranging from over 80 per cent for PCAs to 65 per cent and 50 per cent for savings/investments and loan products respectively). Only one per cent of respondents indicated they had not considered switching due to experiencing problems in doing so in the past (same across all product categories). The above results did not differ significantly between different countries in the UK.

7.10 Our consumer omnibus also asked whether consumers were more likely to switch their retail banking provider now compared to three years ago (which was approximately the start of the global financial crisis – though

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respondents were not made aware of this in the survey question, see Annexe A).

Figure 7.2: Proportion of consumers who are more or less likely to switch retail banking provider as compared to three years ago, July 2010

11%14%

11%

41% 42% 42%

47%44%

46%

1% 1% 1%0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

PCA Savings or Investment Loan

I am more likely to switch now I am less likely to switch nowMy attitude is unchanged Don't know

Source: OFT consumer survey, July 2010. Base: PCAs n=932, Savings/Investment n=792, Loan products n=234

7.11 The results in Figure 7.2 indicate that the majority of consumers have either not changed their attitude towards switching (over 40 per cent in all banking product areas) or are less likely to switch (also over 40 per cent in all banking product areas). It may be the case that the financial crisis has led to consumers seeking security with their existing provider rather than taking a risk (real or perceived) with an unfamiliar provider.179

179 Issues around brand strength and impact are discussed later in this chapter.

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These results did not differ significantly across different countries in the UK.

7.12 Taken together, these data suggest that personal consumers are unlikely to consider switching and their propensity to do so may have actually declined since the financial crisis. This potentially creates a barrier for new entrants and smaller firms which, as a result, may find it more difficult to attract customers.

7.13 The free-if-in-credit (FIIC) model180 for PCAs, which accounts for around 75 per cent of the market,181 may also have an impact on switching rates. Respondents to our consultation noted that the widespread use of FIIC contributed to consumers' perceptions that all PCAs were the same, increasing inertia.

7.14 These respondents further suggested that a new entrant seeking to offer a PCA charging for individual components or charging a flat monthly fee was likely to find it hard to attract customers used to not being charged directly for holding a PCA,182 even if the overall package offered better value-for-money. This is because consumers continue to focus on the most visible elements of a PCA when choosing a provider.183 Consumers may be overly optimistic when choosing a provider, believing that they will not incur one-off charges such as unarranged overdraft charges. This

180 The free-if-in-credit model imposes no charges on consumers for day-to-day money transmission services, or for access via ATMs, branches, telephone and internet. Charges will still apply for services such as the use of overdraft, overseas transactions and so on.

181 Both Mintel research and the PCA market study found that the FIIC represent 75 per cent of the PCA market. Current, Packaged and Premium Accounts, Finance Intelligence, June 2010, page 39 and PCA market study, page 15.

182 Even if PCA customers never use an overdraft facility or incur ancillary charges, they will 'pay' in terms of interest forgone.

183 For example, research by Mintel suggests that only 12 per cent of consumers considered overdraft charges as an important factor in choosing their PCA provider, Current, Packaged and Premium Accounts, Finance Intelligence, June 2010, Figure 73.

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may lead to them choosing a FIIC PCA over one that has monthly charges.

7.15 Respondents also argued that the FIIC model prevented firms entering the market by undercutting incumbents as had been the case in other financial services, such as general insurance.

7.16 As is discussed in paragraph 7.24 below, the OFT has worked with the major PCA providers to improve transparency around the costs of PCAs. As consumers become more aware of the costs associated with different PCAs and competition extends across all aspects of the PCA, there should be greater scope for providers to differentiate their offerings and attract customers to non-FIIC PCAs.

The role of the PCA as a gateway product

7.17 The findings on switching in the PCA market set out above are particularly important because, as set out in the OFT's PCA market study, the PCA is a 'gateway' product184 - that is an avenue through which consumers access, and firms sell, other financial products. If firms face barriers in attracting customers in the PCA market due to low rates of switching, these same barriers may also prevent them from attracting customers in savings and investment, secured lending and unsecured lending product markets.

7.18 As Table 7.1 below reports, a large proportion of personal consumers hold other retail banking products with their PCA provider, suggesting that the PCA continues to remain an important gateway product in retail banking.185 The data are also consistent with the views of parties that

184 See OFT PCA market study, page 13.

185 It should be noted that these PCA customers may also hold additional retail banking products with other providers. For example, they may hold multiple savings accounts with a number of providers, only one of which is their PCA provider. It is also possible that in some cases the 'other' provider is the gateway to the customer switching their PCA.

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we have spoken to and received evidence from, who argued that the PCA remains a gateway product.

Table 7.1: Current account cross-selling conversion rates, by product type, Sept 2009

Retail banking product Proportion of PCA customers who hold this

product with their PCA provider (%)

Savings account 88%

Credit card 53%

Cash ISA 42%

Unsecured personal loan 42%

Mortgage 27%

Source: Mintel, Current, Packaged and Premium Accounts, Finance Intelligence, June 2010. Base varies according to the number of people who own each product (and is not provided); the overall base is 1,829 PCA holders.

7.19 There are several explanations of why cross-selling rates are high. In the PCA market study it was noted that cross-selling arises due to the regular contact PCA customers have with their provider and the level of customer specific information held by PCA providers. For example, a customer applying for a PCA may be encouraged to take additional products based on the information gathered during the application process. However, in some retail banking product markets, namely mortgages, the role of the PCA as a gateway may not be as strong. This may reflect consumers' greater propensity to shop around for mortgages (as seen in the switching rate).

7.20 Table 7.2 shows that the largest PCA providers retain large market shares in other retail banking product markets, though not consistently.

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Table 7.2: Market shares of main banking groups across retail banking

Main PCA (March 2010)

Gross mortgage lending (2009)

Unsecured personal

loan (2009)

Saving account (2010)

Credit cards (April 2010)

Lloyds Banking Group

30% 24% 25% 21% 29%

RBS Group 16% 13% 9% 10% 19%

HSBC 14% 11% 7% 8% 13%

Barclays 13% 10% 13% 10% 23%

Santander 12% 18% 10% 12% 6%

Nationwide 7% 8% 4% 9% 5%

Source: various Mintel reports – see Chapter 3 for individual references. Note the data reflect multiple holdings. Base: PCAs n=1,848, Unsecured personal loans n = 279, saving accounts n =865 and credit cards n = 1,937 (base for mortgage shares not available).

7.21 The incidence of consumers holding a PCA and another retail banking product with the same provider is likely to increase if providers require customers to hold these products together to qualify for the best deals. For example, providers may only offer the best mortgage deals or saving rates to consumers that also move their main PCA to them or vice versa. The effect on switching levels of such behaviour is ambiguous. It may lead to increased levels of switching of products such as PCAs, for which switching is low, as customers move to get the best deals on, say, mortgages. Equally, it may lead to lower levels of switching for products which previously had high rates of switching as consumers become reluctant to move because they do not wish to hold multiple products with one provider.

7.22 On the basis of the above evidence, discussions with relevant parties and submissions received, it appears that the PCA continues to act as a gateway product for other retail banking products. Given the low rates of switching between PCA products and apparent lack of willingness to switch expressed by consumers, this creates a potential challenge for

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new entrants and smaller firms to attract customers in the PCA market and in other retail banking product markets more generally.

OFT initiatives in the PCA market

7.23 As part of its work on PCAs, the OFT has agreed with industry the implementation of a number of initiatives around switching in the PCA market. In October 2009, the following initiatives were agreed with Bacs, the payments processor, to improve the process of switching bank accounts and to increase consumers' confidence in the switching process:

• steps to reduce problems that arise from transferring Direct Debits

• measures to reduce the impact on customers of any problems with transferring Direct Debits, and

• a new consumer guide and information on switching between PCAs that is available from Bacs' website.186

7.24 These initiatives are designed to help facilitate switching between PCA providers and raise consumer confidence in the process.187 By doing so, they will help to reduce fears around switching and make consumers more confident to switch to providers who offer value-for-money. This in turn will lower barriers to expansion faced by new entrants and smaller firms.

7.25 While it is too early to evaluate fully the impact of these switching initiatives, the preliminary indications suggest the process is improving

186 See www.bacs.co.uk/bacs/consumers/accountswitching/pages/accountswitching.aspx.

187 We are aware of recent calls to introduce number portability for PCAs to improve consumers' ability to switch. See, for example, Consumer Focus' recent report on switching (www.consumerfocus.org.uk/assets/1/files/2010/10/Stick-or-twist-for-web.pdf) The OFT, in the past, concluded that, at the time, this was not an effective means of encouraging switching.

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and the number of consumers experiencing problems has declined.188 A survey by Bacs found that the proportion of PCA switchers experiencing problems declined from 32 per cent in 2007 to eight per cent in 2010 and satisfaction with the process rose from 78 per cent in 2007 to 85 per cent in 2010.

7.26 In addition to these steps, the OFT has also worked with major PCA providers in Great Britain to voluntarily agree to implement a number of initiatives that will make the costs of PCAs more transparent. These will allow consumers to evaluate providers' charging propositions more effectively to decide which offers the best value-for-money. These include proving customers with:

• enhanced monthly information

• an annual summary of the cost of their PCA

• information on average credit and average debit balances, and

• illustrative scenarios showing unarranged overdraft costs.

7.27 By the end of June 2010, a number of providers had published illustrative charging scenarios on their websites. Links to the charging scenarios of the major providers in Great Britain can be found on the OFT's Consumer Direct website.189 The major PCA providers in Great Britain have all confirmed that they will implement the remaining transparency initiatives by or around the end of 2011.

188 Further details can be found in Personal current accounts in the UK: Progress update, (OFT1275) www.oft.gov.uk/shared_oft/reports/financial_products/OFT1275.pdf.

189 See www.consumerdirect.gov.uk/before_you_buy/money_and_credit/Currentaccounts/thinkaboutcharges

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7.28 These initiatives on switching and transparency190 are intended to address some of the elements of consumer inertia that create potential barriers to expansion.

Switching in SME banking markets

7.29 The OFT SME banking review set out annualised switching rate figures ranging from two per cent to five per cent for SME banking services between 2004 and 2006.191 More recent data based on survey research by the Federation of Small Businesses in May 2010 showed that over 85 per cent of SMEs had been with their main banking provider for more than three years, and up to 40 per cent have been with their main bank for 10 years or more.192

7.30 As part of our analysis, we worked with the Forum of Private Business to survey SMEs to explore their attitudes to, and experiences of, switching (the OFT/FPB UK-wide SME survey). We also worked with the Federation of Small Businesses Scotland to survey SMEs in Scotland (OFT/FSB Scottish SME survey).

7.31 The results of these surveys can be found in Annexes C and D, respectively. The OFT/FPB UK-wide SME survey found that the main motivations for moving principal banking provider were a poor relationship with the old provider, better service at the new provider and that the old provider refused to provider a particular service such as a loan.

7.32 As noted above, low rates of switching in and of themselves may not be problematic. What is important is that SMEs feel confident in switching

190 Further details on switching and transparency initiatives can be found in the above update report and Personal current accounts in the UK: a follow up report, (OFT1123) www.oft.gov.uk/shared_oft/personal-current-accounts/OFT1123.pdf.

191 See OFT SME banking review, page 33.

192 FSB, Voice of Small Business, Panel Survey, May 2010.

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and are not prevented from doing so. If SMEs face difficulties in switching, then this will create a barrier to expansion for new entrants and providers.

7.33 Table 7.3 suggests that, the main reason for the low levels of switching is SMEs believing the process to be too complicated or too much hassle. Real or perceived problems with the switching process can have the effect of deterring SMEs from considering moving their BCA, even if they can get better value-for-money elsewhere.

Table 7.3: Main motivations for not switching principal banking provider, September 2010

Per cent of responses giving this reason

Too complicated/too much hassle to switch 32.7%

Still considering not decided yet 32.0%

Too much disruption to payments during the switching process

29.3%

Did not think it would make any difference 24.5%

Did not find any better deals elsewhere 19.7%

Good relationship with current bank/no need to change 19.7%

May find it difficult to open an account elsewhere 12.2%

Would take too long/cost too much to switch 11.6%

Not got around to it to switching 8.8%

Current bank offers better prices/charges/fees 5.4%

Location of current account is convenient 5.4%

Current bank revised their services/rates/resolved their problems

2.0%

Source: OFT/FPB UK-wide survey. Base: 308 responses.

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7.34 Similar issues were also found in a recent survey of SMEs by the Scottish Government.193 A large majority of the firms (77 per cent) had not considered changing their bank and of those who did consider changing bank and had decided against doing so, 21 per cent reported that it was 'too much hassle'.

7.35 For those who did switch, Figure 7.3 reports that, while on average, 21 per cent of SMEs across the UK were able to switch within a week, for nearly a third of switching SMEs, the process took over a month. In Scotland, only five per cent of SMEs reported the switching process taking less than a week and 40 per cent reported it taking longer than one month.194

193 SME Access to Finance – Update Survey 2009 Business, Enterprise and Energy AU February 2010, page 8.

194 Figures adjusted to exclude SMEs who kept their existing account.

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Figure 7.3: Time taken to switch principal SME banking provider, September 2010

21%

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Source: OFT/FPB UK-wide survey (figures adjusted to exclude SMEs who kept their existing account). Base: 127 SMEs nationwide - figures adjusted to exclude SMEs who kept their existing account.

7.36 Problems encountered during the switching process mentioned in the OFT/FPB UK-wide and OFT/FSB Scottish SME surveys included the time required to action switching, the length of time to set up internet banking, issues around Direct Debits and Standing Orders being mis-directed, and the 'old' provider not closing the old account in a timely manner. Awareness of these problems may reduce SMEs' propensity to switch, even if they feel they can get a better offer elsewhere.

7.37 The results from the OFT/FPB UK-wide survey indicated that the monetary cost of switching varied. Over 40 per cent of SMEs did not incur any monetary costs from switching, but 14 per cent said that they

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incurred costs in excess of £1,000.195 Higher switching costs are likely to deter SMEs from switching, especially if they exceed the expected benefit from moving account. As shown in Table 7.3, over 10 per cent of SMEs reported that they had not switched due to the cost and time involved.

7.38 Another potential deterrent to the switching could lie in the amount of information requested by providers from SMEs looking to switch. The OFT/FPB UK-wide survey found that the level of information required by different providers differed, but common information requests included historic accounts, cash flow forecasts, building valuations, business plans, proof of identification, debtor and creditor ledgers, and personal details of directors and key personnel. Much of this information is kept as a matter of course for business and so does not pose an additional challenge to switching provider.

7.39 For those that did switch principal banking, as Figure 7.4 below reports, the majority of SMEs nationwide found the process either 'easy' or 'very easy'. The equivalent figures from the OFT/FSB Scottish SME survey for were similar (42 per cent and 30 per cent said it was 'very easy' or 'easy' to switch respectively).

195 21 per cent of SMEs in the OFT/FPB UK-wide survey reported they did not know how much it had cost to switch.

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Figure 7.4: Reported ease of switching principal banking provider, September 2010

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Very Easy Easy Difficult Very difficult Do not recall

Source: OFT/FPB UK-wide survey (figures adjusted to exclude SMEs who kept their existing account). Base: 140 SMEs nationwide

7.40 The evidence gathered suggests that switching rates for BCAs remain low for SMEs. Given that some of the main reasons for not switching centre on perceived complications and a fear of disruption (though, as Figure 7.4 shows, this is not always the case), this may mean that the rate of switching is lower than it otherwise would be making it harder for new entrants to attract SME customers. In paragraph 7.47 below we discuss initiatives in the SME banking market to improve levels of switching.

Levels of multi-banking

7.41 It has been suggested to us by parties that the low rates of switching between principal SME providers may not necessarily lead to significant barriers to expansion for new entrants and smaller firms due to the prevalence of multi-banking by SMEs. Multi-banking refers to holding banking relationships with several providers. If multi-banking is prevalent amongst SMEs, this may mean that new entrants can still acquire

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customers, at least partially, without the customers having to switch completely from their principal banking provider.

7.42 The OFT SME banking review found that, in 2006, 12 per cent of businesses held a business account with another provider in addition to their main BCA.196 Figure 7.5, based on responses to the OFT/FPB UK-wide survey, shows the percentage of SMEs who held additional banking products with providers other than their principal banking provider.

Figure 7.5: SME banking products held with other providers alongside the principal SME banking provider, September 2010

0%

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Source: OFT/FPB UK-wide survey. Base: 123 SMEs nationwide

7.43 As can be seen, a large proportion of SMEs nationwide hold at least one banking product with providers other than their principal banking provider. This is especially the case for holding more than one BCA or

196 See OFT SME banking review, page 38.

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having a saving account with another provider.197 We have not received any evidence to suggest that incumbent providers place conditions around having multiple banking relationships (except when it involves having an overdraft).

7.44 However, as indicated by respondents, the incidence of multi-banking varies. Respondents indicated that multi-banking may be less prevalent for the smallest SMEs (micro-enterprises) as they are concerned about the inconvenience and risks involved in managing several accounts in different banks. This is supported by research that indicates that more than half of SMEs using only one banking provider do so for the reason that it is simpler administratively and easier to keep track of finances.198 The OFT/FPB UK-wide survey lends some support to this – 56 per cent of SMEs nationwide said it was too much hassle having products with multiple banks.199

7.45 Differing levels of multi-banking between SMEs may also be a reflection of the nature of the products held in multi-banking relationships. Products such as asset finance and commercial mortgages are not typically used by micro-enterprises and so they are less likely to be involved in multi-banking.

7.46 Whilst it may be the case that for larger SMEs and for certain product categories, multi-banking is a viable option, it seems that for the smallest SMEs (micro-enterprises) the incidence of multi-banking is far less and, in many cases, not viable. This means that new entrants may face greater barriers in attracting the smallest SMEs.

197 The lower levels of cross-holding of other SME banking products may also reflect lower levels of holding of these products, as well as lower levels of multi-banking.

198 Mintel, Small Business Banking, Finance Intelligence, October 2008.

199 Based on 86 SME responses to Q.27.

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Initiatives in the SME banking market

7.47 Following the completion in 2002 of the CC's investigation into SME banking, two sets of undertakings were agreed:

• behavioural undertakings agreed by nine clearing bank groups in the UK, aimed at increasing price transparency, reducing switching costs and limiting the bundling of current accounts with other banking services

• transitional undertakings on the four main clearing banks in England and Wales, broadly requiring them to offer all SME customers either interest on credit balances at a specified rate (2.5 per cent below the Bank of England base rate or higher), or free core money transmission services (such as direct debit payments and cash transfers).

7.48 In 2007 the OFT reviewed these undertakings.200 It found that the transitional undertakings had been successful and that the four main banks had complied with the requirements placed on them. The undertakings had ensured that all customers were offered tariffs either paying interest or offering free banking, and changed SMEs' expectations of what constitutes competitive pricing by a bank.

7.49 In its consideration of the behavioural undertakings, the OFT noted that there remained some concerns in the market, namely:

• while there had been an apparent increase in SMEs' willingness to consider switching, there did not appear to have been a significant increase in actual switching activity since 2002

• SME customers appeared not always to be aware of their banking costs and did not always find it easy to compare rival offers from alternative providers, and

200 See OFT SME banking review.

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• there also appeared to be a lack of confidence in the effectiveness of the switching process among some SMEs, with little awareness of the safeguards on switching set out in the behavioural undertakings.

7.50 The OFT considered that the behavioural undertakings would continue to facilitate the development of competition in the market. For these reasons, it concluded that the behavioural undertakings should remain in place. There was evidence, at the time, that these undertakings were having a positive effect in improving SMEs' access to information on accounts, and making it easier to switch bank. Following the OFT's recommendations, the CC removed the price controls on the four largest business banks in England and Wales but retained the behavioural undertakings.

7.51 The OFT continues to monitor compliance with the behavioural undertakings relating to price transparency, bundling and switching. Given that recent evidence gathered for the purpose of this review suggests that rates of switching remain low and are potentially creating a barrier to expansion for new entrants and smaller firms, this is an area that may warrant further consideration by the Government201 if SMEs continue to be dissuaded from switching due to a lack of confidence in the process.

The branch network

7.52 Personal and SME customers visit their local bank branch for a variety of reasons. These include engaging in money transmission activities (taking out and paying in money), managing their accounts, taking out new products, seeking advice and meeting with their bank manager, raising a complaint and so on. Increasingly, however, many providers allow customers to carry out these activities online or over the telephone

201 For example as part of its work around business finance, see www.bis.gov.uk/businessfinance.

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7.53 The branch network was identified as a potential barrier to entry and expansion in the PCA market study and also in the CC SME banking review.202 Through our analysis and discussions with stakeholders, we have identified the following issues around the branch network that could potentially constitute barriers to expansion and entry:

• the need for providers to offer customers the option to visit a branch or have access to branch facilities, and

• the need for providers to have an extensive branch network to have a significant impact on the market.

7.54 We consider these issues in turn.

The need for providers to have branch facilities

7.55 As part of our consumer omnibus survey we asked about personal consumers' willingness to consider a retail banking provider that did not have a branch network. As can be seen from Figure 7.6 below, consumers expressed a strong preference against retail banking providers that do not have any branches. One possible reason for this might be the reassurance that a provider having a physical branch gives to consumers. Consumers will know where to go to discuss their banking product and be able to withdraw money in person.

202 See CC SME banking report, pages 53-63.

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Figure 7.6: Willingness to consider using a retail banking provider that has no branches and only operates an internet and telephone service, July 2010

23%29%

77%71% 68%

7% 6% 3%

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PCAs Savings/Investments Loan products

Yes No Not sure

Source: OFT consumer survey. Base: PCAs n=932, Savings/Investment n=792, Loan products n=234

7.56 However, it is worth noting that the proportion of consumers who would consider a loan provider that does not have a branch is nearly twice that for PCAs. This is further discussed in paragraph 7.64.

7.57 In addition to the importance personal consumers attach to having a branch presence, the location of the branch is regarded as important. Figure 7.7 below shows that a large proportion of personal consumers place importance on where their retail banking provider has its branches. This is most important for PCAs, reflecting that this is the product consumers are likely to have the most interaction with their provider on a regular basis. In contrast, over 50 per cent of loan product holders said branch location was not important to them.

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Figure 7.7: Is it important that your retail banking provider has branches near…

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Where youlive

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work

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notimportant to

you

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PCAs Savings/Investments Loan products

Source: OFT consumer survey. Base: PCAs n=932, Savings/Investment n=792, Loan products n=234

7.58 From data provided by incumbents, the average number of personal customers visiting any bank or building society branch across in the UK in a given month was around 9,900 (urban and rural areas are approximately 10,000 and 3,200 respectively).

7.59 In the case of SMEs, being able to visit a provider's branch is also regarded as important. The OFT SME banking review found that the majority of businesses (79 per cent) still conducted some or all of their banking business in person via a branch.203 The survey also showed that most SMEs considered it important to be close to their branch. Of those surveyed, 56 per cent of SMEs were located within 10 minutes' travelling time of the branch where their account was held with a further

203 See OFT SME banking review, page 71.

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28 per cent within 11 to 30 minutes. The visitation figures for SMEs, calculated from data provided by incumbents, were just over 1,000 per month (urban and rural areas are approximately 1,100 and 750 respectively).

7.60 As indicated in the CC SME banking report 'telephone or internet access can be used for transfer of funds and account enquiries, and the postal system is used for deposits or withdrawals by cheque for some business deposit accounts, but branches are still used far more widely for cheque as well as cash transactions, partly due to the extra and sometimes unpredictable delay in using the postal system'.204 The CC indicated that 'liquidity management services generally require access to relationship managers as well as to branches given the importance both to the clearing bank and SMEs of familiarity with the latter's businesses when judging requests for overdraft facilities. To that extent, such services cannot easily be met, if at all, by internet or telephone banking (the penetration of which in any event has to date been limited)'.205

7.61 In the OFT/FPB UK-wide survey, the location of providers' branch was the third most important reason for choosing a particular provider.206 In the OFT/FSB Scottish SME survey, the location of branch was given as less important – it was the sixth most popular reason for choosing any given provider.207

7.62 While it is the case that internet and mobile banking continue to grow strongly (BBA data reports that there were 38 million registered users of

204 See CC SME banking report, page 22.

205 For more on the explanation, CC SME banking report, page 23.

206 Based on 666 responses to Q.6. Though less than 10 per cent of responses for switching provider related to location of provider.

207 Based on 230 responses to Q.2.

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internet banking in 2008208), the use of these services remains limited.209 Research by Mintel found that only two per cent of adults had used their mobile phone to conduct a banking transaction and most of these have used it simply to check their account balance. It also indicated that the most popular tasks that people carry out when banking online are checking account balances and statements, rather than taking out new products – of the 4.5 billion online banking transactions in 2008, around 2.5 billion transactions relate to balance queries or information.210 In other cases, the internet is used to gather information and compare prices before visiting a branch to make the transaction.

7.63 It has also been suggested to us by respondents to our consultation that consumers may find it more difficult and cumbersome to purchase banking products online compared with in a branch. This is due to money laundering regulations211 which require potential customers to send copies of identity documents. Often this means that, before a transaction can be confirmed, a potential customer has to send copies of these documents to the provider and wait for them to be processed – something that can happen in a matter of minutes in a branch. This may deter potential customers.

7.64 However, as suggested by other respondents, the role of the branch may be less important for other core and secondary retail banking products such as saving accounts and secured and unsecured loans. For example, as noted in Chapter 3, in the case of mortgages, intermediaries play an important role. For saving and loan products, best buy tables may also

208 Mintel, Current, Packaged and Premium Accounts, Finance Intelligence, June 2010, Page 103.

209 Internet speeds and penetration rates are not uniform across the UK, which may also limit the role of the internet as a distribution channel in some areas.

210 Mintel, Current, Packaged and Premium Accounts, Finance Intelligence, June 2010, page 103.

211 See Chapter 5 for a full discussion of money laundering regulations.

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have an impact on the role of branches. They are increasingly providing financial information to consumers and businesses and may reduce dependency on branch staff for advice. As technology improves, it is likely that personal and SME consumers will have even greater ability to manage and conduct their retail banking relationships without having to visit a branch. 212

7.65 On balance, on the basis of the above evidence, personal and SME consumers appear to continue to value highly the ability to visit a local retail banking provider in person, especially in the case of PCAs and BCAs. Despite an increase in the use of alternative distribution channels, our evidence suggests that providers which do not have a branch will face constraints in the number of customers that they will be able to attract. As the PCA market study indicated,213 the internet and telephone currently largely remain complements to branch banking rather than substitutes.

7.66 It should be noted that we have not received any evidence to suggest that acquiring retail space to establish a branch or attracting appropriate staff for branches is a problem.214 We have heard that the choice of

212 Given that the variable costs of providing retail banking services online are lower than that of provision through the branch, one might expect incumbent providers to increasingly direct consumers online. For example, in the SME Banking Review, the OFT found that greater use of automated payments technology has encouraged banks to develop new tariffs offering cheaper rates for use of automated payments. Similarly, we have been informed that the introduction of a new generation of ATM machines with automatic deposit and account management facilities will potentially reduce the number of visits to branches, particularly for smaller cash transactions.

213 A similar conclusion was reached by the Competition Commission report into current accounts in Northern Ireland.

214 The issue of shared banking facilities was also raised as a potential means of encouraging providers to establish a presence in communities in which they would otherwise not establish a branch due to the poor prospect of recovering costs. From the evidence received, this was not a route either existing incumbents or potential entrants expressed interest in as they were reluctant to share space with rivals and dilute their own customer experience.

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location of a new branch is largely dictated by the potential customer base, with highly populated urban areas seen as more attractive than rural areas. The challenge remains attracting sufficient numbers of customers in a given locality to recover costs, not the establishing of a physical branch itself.

The need for providers to have extensive branch facilities

7.67 Given that it appears necessary for retail banking providers to have a branch to be able to successfully offer the full range of retail banking products, the question arises whether there is a minimum number of branches necessary to effectively compete in the market and attract and retain customers.

7.68 The number of branches that any given retail banking provider has varies considerably, from providers with only one branch or very few branches (for example local credit unions or building societies) to the large multi-national banking groups with an extensive branch network across the UK. The choice of the number of branches will largely depend on the providers' business model and expansion strategy.

7.69 As Table 7.4 below shows, the size of different providers' branch networks varies considerably. The distribution of branches will also differ, with some providers having more branches in particular areas of the UK. The providers with the largest branch networks also tend to be those with the largest market shares in core- and secondary-retail banking products, although the largest branch network used for retail banking is that of the Post Office.

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Table 7.4: UK branch networks of selected major retail banking providers and the Post Office

Provider 2005 2006 2007 2008 2009

Abbey 712 712 705 713

Alliance & Leicester 254 254 254 254

Bradford & Bingley 207 205 197 195

1,300

Barclays 2,029 2,014 1,733 1,724 1,700

Lloyds TSB 1,745 1,659 1,808 1,802

Lloyds TSB Scotland 185 185 185 185

HBOS 1,058 1,002 1,005 995

3000

HSBC 1,513 1,492 1,475 1,444 1,380

Northern Rock 57 56 56 56 NA

Nationwide NA NA NA NA 700

RBS Group 2,274 2,276 2,278 2,279 2,280

National Australia Group (Clydesdale Bank and Yorkshire Bank)

370 344 343 342 340

Bank of Ireland 44 44 44 44 NA

First Trust Bank 58 56 48 48 NA

Northern Bank 95 95 94 90 NA

Ulster Bank 91 91 92 92 NA

Non-converted building societies 2,148 2,105 2,016 NA NA

Post Office 14,609 14,376 14,219 13,567 NA

Source: BBA Annual Abstract of Statistics, 2009 and Mintel Current, Packaged and Premium Accounts, Finance Intelligence, June 2010.

7.70 We have heard a number of views from respondents about the importance of having a large branch network that covers all the UK. We received evidence suggesting that new entrants do not necessarily need a large branch network to establish a viable business, as they can start with a limited number of branches and grow organically by slowly adding

LBG

Santander

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more branches in response to consumer demand. Indeed, some providers questioned the viability of having a large UK-wide network, given the large costs associated with maintaining this.

7.71 We have also heard that some providers have chosen to limit their branches to certain (mainly urban) areas and rely on other distribution channels, such as intermediaries and the internet, to reach other potential customers. However, as noted in the previous section these alternative distribution channels still largely remain complements not substitutes for a branch network. One option currently available is for providers to use the Post Office network to give their customers branch access in areas where they do not have a branch.215

7.72 In contrast, we received evidence arguing that to achieve a significant presence in retail banking a large number of branches are required. Establishing a large branch network, with the associated customer base, is said to allow a provider to move into a position to be able to compete effectively against the major incumbents and exert a competitive constraint. As noted in Chapter 3, divestments of the banking assets of Lloyds Banking Group and Northern Rock are expected to give new entrants the potential opportunity to purchase these assets (and their associated customer base). This could help overcome difficulties in attracting customers.

7.73 Ultimately, it appears that the need to have an extensive branch network depends on the ambitions of the provider and their business model. For providers who seek to achieve a large-scale retail banking presence rapidly, an extensive branch network with associated customer base appears to be an essential prerequisite. Without such a network, they will be unable to effectively compete against the major incumbents. In

215 For further details of which retail banking providers currently offer access to banking services at the Post Office see www.postoffice.co.uk/portal/po/content1?catId=19400181&mediaId=19700174 (personal) and www.postoffice.co.uk/portal/po/content1?catId=94800755&mediaId=94900762 (business).

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contrast, for those providers who favour a more organic growth path or who choose to focus on a particular consumer segment, the lack of an extensive branch network in the short-term will not necessarily pose a barrier to expansion.

Retail banking brands

7.74 Branding plays an important role in the nature of competition in retail banking. Incumbents with strong and well known brands have built strong brand value over time, allowing them to attract and retain the largest share of customers. Reluctance on the part of consumers to consider new or unfamiliar retail banking brands may create a barrier to expansion for new entrants or smaller firms who do not command brand recognition. For example, evidence from the impact assessment of the Consumer Credit Directive in March 2009 by BIS indicated that barriers to offering credit across national borders included lack of familiarity with (and hence consumer confidence in) brand or reputation, alongside 'natural barriers'.216 Further, if the costs of establishing a recognised brand are prohibitive, and cannot be easily recovered, this will also act as a barrier to expansion.

7.75 As part of our personal consumer omnibus, we surveyed willingness to consider using an unfamiliar retail banking provider. As Figure 7.8 shows, consumers' willingness to consider a new or unfamiliar personal banking is low. While there may be some customers who are prepared to switch to unfamiliar names to get the best deals, the majority of customers seem unwilling to consider these types of providers.

216 For more on this, see: www.berr.gov.uk/files/file50893.pdf.

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Figure 7.8: Willingness to consider using a retail banking provider who has only started offering the product in the last six months, July 2010

8% 9%17%

81% 81%77%

11% 11%6%

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Source: OFT consumer survey, July 2010. Base: PCAs n=932, Savings/Investment n=792, Loan products n=234

7.76 The lack of trust in unknown brands may make consumers reluctant to switch to new entrants despite the financial benefits these brands may be offering. The highest proportion of consumers willing to consider an unfamiliar provider was found for loan product providers, which may reflect consumers being more comfortable borrowing money from unfamiliar names rather than depositing money with them.

7.77 Even if consumers are aware of a particular brand, they may still be reluctant to switch to it. As Figure 7.9 shows, even for well-known brands such as Tesco, Virgin, Sainsbury's and Asda, there remains a large gap between personal consumers' brand awareness and willingness to switch for retail banking services. While this is based on survey evidence, rather than actual behaviour, this suggests that even established banks with no track record in offering PCAs may find it difficult to attract customers.

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Figure 7.9: Brand awareness and willingness to switch, March 2010

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Source: OFT analysis of Mintel, Current, Packaged and Premium Accounts, Finance Intelligence, June 2010. Base = 1,848 PCA holders.

7.78 Branding also plays a role in the SME banking market, albeit perhaps not so strongly. The OFT/FPB UK-wide survey reports that 'strong reputation' was the fourth most popular reason for choosing their provider (11.1 per cent).217 However, reputation was not so important for SMEs in Scotland – less than five per cent of respondents gave this as the reason for choosing their principal banking provider.218

7.79 We have heard arguments from respondents that, especially after the financial crisis and subsequent raised awareness of the workings of consumer deposit guarantees,219 both personal and SME consumers may

217 Based on 666 responses to Q.6.Though it should be noted that strong reputation may not always be equivalent to strong brand awareness.

218 Based on 230 responses to Q.2.

219 See Chapter 8 for more details.

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exhibit an increased reluctance to use non-domestic retail banking providers. If this is the case, an overseas bank wishing to operate in the UK might find itself facing considerable barriers to expansion, even if it is authorised by the FSA and covered by the domestic deposit protection guarantees (or has an equivalent scheme in place in its home country). Similarly, we have also had put to us by respondents that personal consumers in Scotland and Northern Ireland are more loyal to what are perceived as their domestic brands and exhibit reluctance to switch to non-Scottish or non-Northern Irish brands.

7.80 If it is the case that personal and SME customers are reluctant to switch to unfamiliar brands, then the question arises whether new entrants are able to raise brand recognition to overcome this barrier. The cost of developing a brand can be considerable. The top 10 advertisers of PCAs and related services collectively spent over £62 million in 2009220 and the top fifteen advertisers of business banking services spent over £28 million in 2007-08.221

7.81 The use of advertising channels varies between personal and SME banking. In personal banking, providers engage in more high-profile advertising campaigns, while in SME banking they appear to use more highly-targeted promotion activities. For example, the spending distribution for PCAs in 2008 was heavily targeted on mass-media such as television (44 per cent) and press (25 per cent),222 whereas 72 per cent of business banking advertising spending was channelled through the press (such as business magazines and newspapers) with only 15 per cent spent on television advertising.223 Respondents also indicated

220 Mintel, Current, Packaged and Premium Accounts, Finance Intelligence, June 2010.

221 Mintel, Small Business Banking, Finance Intelligence, October 2008

222 Mintel, Current, Packaged and Premium Accounts, Finance Intelligence, June 2010, page 98

223 Mintel, Small Business Banking, Finance Intelligence, October 2008, page 86

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that the branch network can be used to advertise products, particularly to existing customers.

7.82 Notwithstanding the above advertising channels, we have been informed that there are a number of low-cost routes to raising brand awareness and attracting customers. These include:

• internet advertising, for example through sponsored links

• achieving high rankings on third-party 'best buy' tables

• media coverage, and

• word of mouth.

7.83 New entrants or smaller firms can generate awareness for their products by achieving high rankings on best-buy tables.224 This in turn will attract those customers who are prepared to switch to unfamiliar providers. However, such customers may also be more likely to be 'footloose' and move more quickly if they believe they can get better offers elsewhere. Further, the above low-cost routes, including best buy tables, are likely to lack the universality of a large scale television or print campaign and may only reach a particular customer segment.

7.84 A number of respondents claimed that the financial crisis has had an impact on retail banking brands. They argued that it had created an opportunity for both new and established brands from other sectors to enter retail banking to take advantage of dissatisfaction with incumbents. However, a particular risk identified for new entrants from other sectors was that if their experience in banking proved unsuccessful this might negatively impact upon their reputation in their original sector.

7.85 To summarise, in a sector such as retail banking, brand plays an important role in affecting consumers' choice of provider. The evidence

224 See for example www.telegraph.co.uk/finance/personalfinance/savings/7913775/Who-are-the-Bank-of-Baroda-Raphaels-Bank-and-Aldermore.html.

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indicates that consumers are reluctant to consider brands they do not know and this creates a potential barrier for new entrants to attract customers. The potential barrier posed by brand will have a stronger effect if entrants face constraints in acquiring sufficient funding to invest in the promotion of their brand, though there are low-cost alternatives to developing brand recognition.

Summary

7.86 Attracting new customers and retaining market share is crucial for the long term viability and success of new entrants to retail banking. If potential entrants are unable to attract sufficient numbers of customers to recover their sunk costs they will be deterred from entering. Equally, if new entrants and smaller firms face significant challenges in growing their market share, they will not be able to effectively exert competitive pressure on incumbents.

7.87 The evidence reviewed suggests that levels of switching between providers for PCAs and BCAs remain low, making it hard for new entrants and smaller firms to attract these customers. These low levels of switching can create a further barrier to expansion in other retail banking product markets (such as saving and credit products) since PCAs and BCAs, to differing degrees, act as 'gateway' products for the sale of other retail banking products. This may mean that, in certain retail banking product markets, firms who do not offer PCAs and BCAs will find their potential customer base limited.

7.88 As part of its work in the PCA market, the OFT secured agreement from industry to implement a number of initiatives to improve the switching process and transparency of costs. While it is too early to assess the effect of these initiatives,225 the initial evidence suggests that the switching process is improving, increasing consumer confidence and potentially making it easier for new entrants to attract personal customers. The OFT will continue to monitor the PCA market to ensure

225 In the case of the transparency initiatives, not all have yet been implemented.

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that consumers are not put off switching by fears that things may go wrong. The OFT also continues to monitor behavioural undertakings given by banks in the SME banking market following the 2002 CC SME banking report226 which include undertakings relating to the switching process. This is an area that may warrant further consideration by Government if SMEs continue to be dissuaded from switching due to a lack of confidence in the process.

7.89 As is the case in many other sectors, we have found that brand remains important in retail banking. Our research has shown consumers to be wary of switching to an unfamiliar banking brand. Across the UK there is a wider reluctance to consider non-UK retail banking providers following the financial crisis. Brand loyalty may also be more pronounced in Scotland and Northern Ireland for certain products. While a new entrant can build brand awareness and, to some extent, may benefit from not being associated with the financial crisis, for many customers there remains a strong degree of brand loyalty to existing incumbents which may act as a barrier to expansion.

7.90 Our research suggests that personal and SME consumers continue to place value on the ability to engage with their retail banking provider in person through visits to a local branch. Whilst internet and mobile banking are growing in importance they largely remain, especially for PCAs and BCAs, complements to, rather than substitutes for, branches.

7.91 While we have found providers need to have a branch to be able to offer the full range of retail banking products successfully, we have not found that it is necessary to have an extensive branch network covering the entire UK. The need to have an extensive branch network will be largely be related to a provider's choice of business model and decision whether

226 See The supply of banking services by clearing banks to small and medium-sized enterprises: A report on the supply of banking services by clearing banks to small and medium-sized enterprises within the UK, Competition Commission 2002, www.competition-commission.org.uk/rep_pub/reports/2002/462banks.htm#full.

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to pursue incremental, organic growth or a more accelerated growth path.

7.92 Taken together, these features of the retail banking sector constitute key barriers to expansion for new entrants and small firms. While they are not inherently insurmountable, they do pose a considerable challenge to developing a long-term successful presence in the retail banking sector and may further deter potential entrants from entering if they fear they will be unable to attract sufficient numbers of customers to recover start-up costs.

7.93 We note that forthcoming divestments of the banking assets of Lloyds Banking Group and Northern Rock have the potential to create the opportunities for new entrants or smaller existing players to purchase these assets (and their associated customer base) and achieve accelerated growth without the need for incremental, organic growth.

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8 BARRIERS TO EXIT

8.1 Unlike other sectors, the failure of a firm in the banking sector can have wider systemic consequences. The risk of a contagion effect, caused by the failure of a significant deposit-taking institution (a 'bank'), has led Governments and financial regulators to put in place mechanisms to ensure the orderly exit of banks from the sector.

8.2 Governments and authorities across the world have intervened in the normal processes of market exit of retail banks arising from failure through:

• regulating their activities, as described in part in Chapter 5, including the arrangements for changing ownership of banks through mergers and acquisitions

• providing financial support to banks to prevent their failure or make it less likely, and

• establishing regimes to deal with banks that fail – to put in place more controlled arrangements and deposit guarantees, for example, to mitigate or avoid some of the problems set out above.

8.3 The absence of, or inappropriate, mechanisms dealing with banks' exit can create moral hazard problems, whereby banks, expecting they will be rescued if things go wrong, will lack incentives not to carry out riskier activities. Competition may be weakened if inefficient incumbents are not allowed to exit the market, reducing the incentives, or ability, of more efficient firms to engage in intense rivalry.

8.4 Many of these issues are under consideration by other authorities or bodies, such as the ICB. This chapter therefore concentrates on:

• a brief description of the forms of support and other interventions by the UK authorities during the recent financial crisis

• an explanation of the two specific regulations in the UK – the Special Resolution Regime (SRR) and the Financial Services Compensation

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Scheme (FSCS) – that are intended to mitigate some of the risks to financial stability from the failure and exit of a bank, including some assessment of potential competition issues, and

• some other more recent developments in this field.

Interventions in the UK

8.5 In response to the exceptional turbulence in world financial markets, the UK Government set out a number of measures designed to restore financial stability and safeguard the UK economy. These measures were aimed at restoring confidence and encouraging inter-bank lending, through the provision of liquidity, the recapitalisation of the financial sector and the provision of state guarantees for new debt issuance.227 In particular, sector-wide schemes included.228

• the Credit Guarantee Scheme

• the Special Liquidity Scheme

• the Recapitalisation Programme

• the Asset Protection Scheme

• the Asset Backed Securities Guarantee, and

• the Asset Purchase Facility.

8.6 Through the above schemes and one-off interventions, the UK Government has taken direct action in respect to certain UK banks.229

227 European Commission, State Aid decision N 507/2008 – Financial Support Measures to the Banking Industry in the UK.

228 See www.hm-treasury.gov.uk/fin_finstability_actions.htm for further details.

229 As well as the examples of RBS Group and Lloyds Banking Group, the Government took direct action with respect to Alliance & Leicester, Bradford & Bingley, Dunfermline Building Society and certain Icelandic banks.

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For example, the Government acquired 84 per cent ownership of RBS Group through an overall recapitalisation of £45.5 billion. In October 2008, the Government acquired a 43 per cent shareholding in Lloyds Banking Group (LBG) through recapitalisation of £17 billion. In June 2009, LBG redeemed £4 billion of the Government's preference shares from this initial input, with the Government taking up its rights to retain £1.5 billion worth of ordinary shares leaving its holding at £14.5 billion. In December 2009, LBG launched a £13.5 billion right issue in which the Government took up its pro rata rights with an additional input of £5.85 billion, bringing the Government's total input to date to £20.4 billion (excluding income received from underwriting fees).

8.7 Government interventions aimed at restoring financial stability have, to a large extent, benefitted large financial institutions. The Bank of England has described this as 'a major public policy issue that entails a substantial implicit subsidy to the banking system, mostly centred on the largest banks'.230 One consequence of the implicit guarantee by Government to rescue banks that are 'too big to fail' may be the creation of a moral hazard in banking.

8.8 Respondents commented that perceived public protection and support may have detrimental effect on competition if such institutions decide to offer better rates than their rivals (who are not deemed too big to fail), knowing that they will rescued if they risk defaulting. Other respondents noted that if customers perceive large banks as 'safe havens', they will be more inclined to deposit funds in these institutions, even if they are not safer than other banks. Given the high levels of consumer inertia discussed in the previous chapter, this may make it even more difficult for new entrants to attract new customers.

8.9 Wider issues around moral hazard and potential trade-offs between competition and financial stability are beyond the scope of this review

230 Bank of England, Financial Stability Report, June 2010, Issue No.27, page 65.

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and they are currently being considered by the ICB.231 In the following section, we discuss the current regulatory framework around the exit and failure of a bank and its effect on barriers to exit.

The Special Resolution Regime (SRR)

8.10 Bank bail-outs and their costs have triggered regulatory reforms aiming at reinforcing bank supervision and improving the way a bank's failure is managed. In the UK, the Special Resolution Regime (SRR) was established by the Banking Act 2009 to provide a permanent statutory regime for dealing with failing deposit-taking institutions in the UK. This complemented the Financial Services Compensation Scheme (FSCS) (see below).

8.11 The limits of previous provisions designed to resolve a bank's failure were demonstrated with the Northern Rock crisis that unfolded in 2007, where authorities were unable to take control of the bank while it was still solvent.232 As it appeared impossible to find a private sector solution, Northern Rock's business continued to lose value and was eventually nationalised. A profound legislative revision of the UK's bank resolution regime followed, based on these experiences and conclusions drawn from the subsequent global financial crisis.

8.12 The SRR's core, high level objectives are to maintain the stability and resilience of the UK financial system, protect confidence in the banking sector, and protect depositors and public funds. It consists of three stabilisation options, a bank insolvency procedure and a bank administration procedure.

8.13 The three stabilisation options consist of:

231 See http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pdf.

232 See P. Brierley, 'The UK Special Resolution Regime for failing banks in an international context' Bank of England, Financial Stability Paper No. 5, July 2009.

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• the transfer of the failing bank or banking business to a private sector purchaser

• the transfer of the failing bank into a bridge bank (a new company owned by the Bank of England), and

• the transfer into temporary public ownership.

8.14 These options are currently exercised by the tripartite authorities (the Bank of England, FSA and HM Treasury) through stabilisation powers, which are the powers to transfer shares and other securities or transfer property rights and liabilities.

8.15 The authorities can trigger the SRR when a bank is in distress but before it becomes insolvent, thereby controlling contagion effects that may otherwise threaten the rest of the industry. The SRR also provides for the possibility of guaranteeing the continuity of essential banking functions, such as access to accounts, payment systems and credit facilities, and protects depositors to a larger extent than corporate insolvency law does.

8.16 The SRR has only been used on one occasion, to resolve the failure of the Dunfermline Building Society ('Dunfermline').233 In this case, the FSA triggered the SRR after having determined not only that Dunfermline was not meeting the threshold requirements to be authorised as a deposit taker, but also that there was no other option available which would have enabled the company to satisfy these conditions. The authorities decided to carry out a partial property transfer, by transferring the core parts of the building society (retail and wholesale deposits, branches, head office and originated residential mortgages) to Nationwide,234 while the social housing loans of Dunfermline's customers (and related

233 See www.bankofengland.co.uk/publications/news/2009/030.htm

234 Note that the OFT examined and cleared the merger (see www.oft.gov.uk/shared_oft/mergers_ea02/2009/Nationwide-Dunfermline.pdf).

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deposits) were transferred to a bridge bank owned and controlled by the Bank of England. Given that the SRR is still relatively untested it is difficult to draw any clear conclusions with respect to its impact on moral hazard and competition distortions.

8.17 One issue that some respondents mentioned was around the SRR process. In most cases, it is expected that the SRR process will need to be carried out rapidly and this may involve the takeover of a failing bank by another bank. The need for such a takeover to be undertaken rapidly is likely to favour large institutions that not only have the necessary understanding of the markets and assets involved but also have the funds to acquire these assets and capacity to absorb them. Further, a potential entrant to retail banking is unlikely to be invited or to be involved in this process. This strategy may be the most appropriate at the time of resolution but may nevertheless result in a detrimental increase in market concentration and an adverse effect on competition.

8.18 As the SRR allows for failing banks to be split up, separating solvent lines of business from insolvent ones, there should be more potential private sector purchasers for the 'good book'. A small purchaser may be able to absorb the 'good book' without needing the scale or scope necessary to absorb also the 'bad book'. The 'bad book' can then be disposed off over a longer time scale. The possibility of splitting out the different lines of business of a failing bank may help address the concern raised that only large institutions can take part in the SRR.

8.19 While it is the case that the SRR may not explicitly seek to promote competition, such concerns can be considered during its operation, and we would encourage this. Further, the OFT, and the European Commission, is able to evaluate the sale of any bank assets through the merger regime and also the impact on competition ex post through its enforcement powers.

The Financial Services Compensation Scheme (FSCS)

8.20 The existence of deposit insurance can reduce the risk of bank runs, as depositors gain certainty that some, or all, of their funds will be repaid in

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the event of a bank failing. In the UK, the FSCS guarantees depositors and small businesses can recover funds deposited in an authorised financial services firm. The FSCS was set up in December 2001, with the adoption of the Financial Services and Markets Act 2000 (FSMA 2000), mainly to assist private individuals and small businesses235 in recovering their deposits placed into a failed bank. Larger businesses are generally excluded, although there are some exceptions to this for deposit and insurance claims.

8.21 The FSCS covers deposits, insurance policies, insurance broking, investment business and home finance up to a limit of £50,000 per person and per authorised firm. Following European legislation, the FSCS limit for deposits will increase to the equivalent of €100,000 on 31 December 2010.236

8.22 The FSCS is funded through a levy on firms authorised by the FSA.237 The FSCS levy is split into five broad classes concerning deposits, life insurance and pensions, general insurance, investments and home finance. The total levy on all classes provides for an annual capacity of over £4 billion to the FSCS.

8.23 Stakeholders reported that they did not believe the FSCS itself posed any difficulties around exiting from retail banking.

235 A smaller company must meet two of the following criteria (as set out in section 247 of the Companies Act 1985 or section 382 of the Companies Act 2006 as applicable): turnover no greater than £6.5 million; balance sheet total not greater than £3.26 million; total number of employees not greater than 50.

236 See www.fscs.org.uk/news/2010/september/protection-for-depositors-will-rj8gw5k9/index.html.

237 See www.fscs.org.uk/industry/funding/ for further details.

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Recent developments

8.24 The recent financial crisis and the subsequent public interventions have given rise to profound reappraisals of the regulatory environment in which financial institutions operate.

8.25 One of the issues being addressed is the moral hazard risk posed by systemically important banks, as outlined above. In the UK, the FSA has published a discussion paper setting out policy options to deal with systemically important banks.238 At the international level, the Financial Stability Board (FSB) has proposed principles for the development of a policy framework aimed at reducing the moral hazard risks posed by systemically important financial institutions (SIFIs).239 The reforms proposed by the FSB to address moral hazard concerns raised by SIFIs fall into three categories: 240

• reducing the probability and impact of failure mainly through capital and liquidity requirements

• improving the capacity to resolve firms in crisis, by improving ex ante preparedness, contingency planning and cooperation between relevant authorities, and

238 Financial Services Authority, Turner review conference discussion paper – A regulatory response to the global banking crisis: systemically important banks and assessing the cumulative impact, DP 09/4, October 2009. Available at www.fsa.gov.uk/pubs/discussion/dp09_04.pdf

239 Financial Stability Board, Reducing the moral hazard posed by systemically important financial institutions -- Interim report to G20 leaders, June 2010. Available at www.financialstabilityboard.org/publications/r_100627b.pdf

240 Financial Stability Board, Overview of progress in the implementation of the G20 recommendations for strengthening financial stability – Report of the Financial Stability Board to G20 leaders, June 2010. (Available at www.financialstabilityboard.org/publications/r_100627c.pdf)

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• reducing interconnectedness and contagion risks by strengthening infrastructures and markets that link banks together.241

8.26 Reducing risk can be achieved by reducing the probability of failure and/or limiting the impact of failure, by strengthening prudential supervision and banks' capital and liquidity requirements, as discussed in Chapter 5.

8.27 Improving preparedness can be achieved by requiring banks and other systemically important firms to ex ante prepare plans in which they lay down the steps to be taken to recover from a crisis. In its discussion paper mentioned above, the FSA indicates that it is preparing guidance for systemically important firms to use in developing their 'Recovery and Resolution Plans' following the principles set out by the FSB. The Financial Services Act passed in April 2010 requires the FSA to make rules requiring certain firms to prepare such plans.

8.28 Recovery and Resolution Plans will build on existing capital and liquidity requirements by supplementing details about the actions to be taken in case of a future crisis. They should include a detailed description of the banks' different lines of businesses and subsidiaries, in order to delineate which parts are to be supported and which ones can be sold to third parties if failure occurs and the SRR is triggered.

8.29 The Future of Banking Commission indicated in its report that so-called 'living wills' were important to re-designing the architecture of the financial services industry.242 By publicly committing to a plan to be

241 This category of reforms refers to the willingness to address the lack of resiliency of interbank and money markets observed during the recent crisis. Many commentators have argued that the current, decentralised, organisation of interbank markets (over-the-counter derivative contracts, bilateral obligations, etc.) had dramatically increased systemic risks and contagion effects. This topic is outside the scope of the present review and we will not address it further.

242 The Future of Banking Commission, report published in June 2010, available at www.commission.bnbb.org/banking/sites/all/themes/whichfobtheme/pdf/commission_report.pdf

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followed in case of a crisis, banks would be encouraged to adapt their behaviour with regards to the way they managed risk and extended credit.

8.30 As regards the deposit insurance scheme, the Banking Act 2009 extended the powers of the HM Treasury to make provision by regulation to allow the FSCS to impose levies in advance of any default (pre-funding). This new funding arrangement has not been introduced yet and is expected to be the subject of future consultations. It may also allow contributions to the compensation scheme to be spread over a longer period of time, which reduces the burden on banks when failure actually occurs and financial stress is likely to be greater.243

8.31 The implementation of improved resolution regimes may, over time, change the expectations of systemically important firms' investors and creditors about the risk they bear in the event of failure. This could lead large institutions to be subject to greater market discipline and thus to be discouraged from taking excessive risks, which in turn will create a more level playing field upon which competition can take place, as the largest firms will not be able to rely on the Government rescuing them if their activities go wrong.

8.32 We also heard a concern around proposed changes to deposit insurance. If regulators were to introduce an exit levy that applied to firms leaving the sector in respect of liabilities incurred while they had authorised status, such a levy, it was argued, this could create a barrier to exit through the creation of an additional legacy cost. Such concerns will need to be addressed as part of any revision to deposit insurance.

243 See Emilio Avgouleas, Banking supervision and the special resolution regime of the Banking Act 2009: the unfinished reform, Capital Markets Law Journal (2009), vol. 4(2), pages. 201-235.

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Summary

8.33 Financial stability and the protection of depositors and public funds are the main rationale for regulations that seek to prevent the disorderly exit of systemically important financial institutions. The absence of, or inappropriate, mechanisms can result in moral hazard issues. Moral hazard issues may distort market discipline and firms' behaviour and thus affect the likelihood of entry or expansion in the retail banking sector.

8.34 Currently, international bodies and domestic regulators are proposing principles for better regulation and prudential supervision, and for the development of a policy framework aiming at reducing the moral hazard risks posed by systemically important financial institutions. Such plans have the potential to cause banks to internalise the systemic risk their activities can generate. As such, these proposals could also reduce the competitive distortions entailed by moral hazard. These wider questions about trade-offs between financial stability and competition policy are beyond the scope of this review and are currently being considered by the ICB.

8.35 The regulatory landscape has changed substantially in the past few years, both in the UK and at the international level. The UK has introduced a SRR that provides authorities with the tools necessary to deal with failing banks in a controlled manner. Depositor insurance has been amended to allow for a higher limit of compensation and a faster transfer to customers. These regulations have been designed with financial stability in mind and do not explicitly recognise competition goals. However, it is possible for the SRR to take account of the impact on competition when considering options for how they are used in particular circumstances. It would be beneficial to choose approaches that minimise any detrimental effects on competition where possible. In many cases, there may be no trade-off between ensuring financial stability and promoting competition.

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8.36 Further, the OFT, or the European Commission, is able to evaluate the sale of bank assets through the merger regime and also the impact on competition ex post through its enforcement powers.

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9 CONCLUSION

9.1 This review has considered the existence and extent of barriers to entry, expansion and exit are in retail banking in the UK. Building on existing studies, the OFT has received evidence from, and discussed the issues with, over fifty different parties, including banks, building societies, recent and prospective entrants, industry bodies and consumer groups. The OFT has also worked with external partners in seeking primary evidence on consumer behaviour, as well as analysing public source material and market research data.

9.2 The findings of this review will assist the OFT and others in understanding better barriers in personal and SME banking markets, and in understanding the long term competitiveness of the retail banking sector. The review is expected to contribute to the work of ongoing reviews into banking more generally, such as the work of the ICB.

9.3 Below we set out the key findings across our review's thematic areas of regulation, essential inputs, barriers to achieving scale and barriers to exit.

Key findings

Regulation

9.4 We have not received evidence to suggest that regulatory requirements relating to gaining authorisation to accept deposits and to offer mortgages and other consumer credit products act as a barrier to entry. We have been informed, however, that firms have faced difficulties and uncertainties around the regulatory process of obtaining authorisation to accept deposits. The FSA has recently revised its authorisation process to increase transparency and certainty. While it is too early to conclude whether or not these changes have lowered regulatory barriers, the OFT welcomes these, and any other steps to improve transparency and information provision. These changes may also merit monitoring.

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9.5 It has been suggested that new entrants (and smaller firms) have faced proportionally higher capital requirements than incumbents that have imposed a higher cost of capital and limited their ability to use this capital for expansion. Significant changes to capital requirements will be introduced over the next few years. It appears that new capital requirements, along with liquidity standards, could have the potential to exacerbate differences between incumbents and new entrants, for example, by imposing higher fixed costs of compliance. However, some parties have argued that other proposed changes may also reduce any discrepancies, such as removing certain financial instruments most commonly used by large banks from the list of permitted capital. As the new requirements take effect, it may be appropriate for the prudential regulators to consider and monitor the impact on competition of these changes.

9.6 The OFT has not received any evidence to suggest that other ongoing regulatory requirements in retail banking, such as the money laundering regulations and consumer protection regulations, are preventing firms from entering and competing in the sector.

Essential inputs

9.7 We have found that potential entrants have a number of options available to them to meet IT system requirements. Whilst the cost of establishing such systems can be significant, we have not heard that, in and of itself, it is deterring entry. However, if potential entrants believe they will face difficulties in achieving the necessary scale required to recover these costs (most of which will be sunk), then they will find it difficult to compete and may be deterred from entering in the first place.

9.8 Firms can choose to access most industry-wide payment schemes either directly (by becoming members) or indirectly (through agency agreements). The latter is more common with new entrants and smaller firms, and we have not received evidence to suggest that these firms are systematically discriminated against and cannot get access to the payment schemes. We have also not received evidence to suggest that the cost of agency agreements is regarded as prohibitive.

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9.9 We have received evidence demonstrating that retail banking providers can access accurate information on personal and SME customers from a range of third-party sources, as well as their own records. New entrants or smaller providers do not appear to face impediments in accessing this information. However, in the case of the smallest SMEs, there appears to be less information available to providers. SMEs themselves appear willing to provide much information and there are a number of private sector initiatives (such as CreditPal) which, in time, may remedy this information gap.

9.10 We have found that, as a result of the financial crisis, the viability of certain business models is threatened due to a lack of interbank funding. As the impact of the financial crisis dissipates and the interbank bank lending market re-opens, we might expect there to be greater access to finance, reducing the extent of this barrier.

Barriers to expansion and achieving scale

9.11 We have considered three issues that may individually, or cumulatively, act as barriers to new entrants and smaller firms being able to expand and achieve scale in the retail banking sector. These issues are levels of switching, the role of brands and the role of the branch network.

9.12 The evidence reviewed suggests that levels of switching between PCA and BCA providers remain low, making it hard for new entrants and smaller firms to attract customers. These low levels of switching can create a further barrier to expansion in other markets (such as saving and credit products) since PCAs and BCAs act as 'gateway' products for the sale of other retail banking products. This may mean that, in certain retail banking product markets, firms who do not offer PCAs and BCAs will find their potential customer base limited.

9.13 Following the OFT's 2008 PCA market study, a number of initiatives to improve the functioning of the market were announced, including initiatives around switching. The OFT will continue to monitor the PCA market to ensure that consumers are not put off switching by fears that things might go wrong. The OFT continues to monitor behavioural

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undertakings given by banks in the SME banking market following the 2002 CC SME banking report which include undertakings relating to the switching process. This is an area that may warrant further consideration by Government if SMEs continue to be dissuaded from switching due to a lack of confidence in the process.

9.14 We have found that brand remains important in retail banking. Our research has shown consumers to be wary of switching to an unfamiliar banking brand. Across the UK there is a wider reluctance to consider non-UK retail banking providers following the financial crisis. Brand loyalty may also be more pronounced in Scotland and Northern Ireland for certain products. While a new entrant can build brand awareness and, to some extent, may benefit from not being associated with the financial crisis, for many customers there remains a strong degree of brand loyalty to existing incumbents which may act as a barrier to expansion.

9.15 Our research also suggests that both personal and SME customers value the ability to engage with their retail banking provider in person through visits to a local branch. While there are some players in the sector who choose to rely on the internet, intermediaries and / or telephone as their main distribution channels, the evidence suggests that these channels largely remain complementary distribution channels for products such as PCAs and BCAs rather than substitutes. Given the gateway role of PCAs and BCAs, the lack of a branch may act as a limit on the ability of new entrants to grow their customer base and impose a competitive constraint on incumbents in other retail banking markets.

9.16 Taken together, these features of the retail banking sector constitute key barriers to expansion for new entrants and small firms, making it difficult to achieve scale. While they are not inherently insurmountable, they do pose a considerable challenge to maintaining a long-term successful presence in the retail banking sector and may further deter potential entrants from entering if they fear there will be unable to attract sufficient numbers of customers to recover costs.

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9.17 The forthcoming divestments of the banking assets of Lloyds Banking Group and Northern Rock have the potential to create the opportunities for new entrants or smaller existing players to purchase these assets (and their associated customer base) and achieve accelerated growth without the need for incremental, organic growth.

Barriers to exit

9.18 Unlike other sectors, the failure of a firm in the banking sector can have wider systemic consequences. The risk of a contagion effect, caused by the failure of a significant bank, has led Governments and financial regulators to put in place mechanisms to ensure the orderly exit of banks from the sector.

9.19 The absence of, or inappropriate, mechanisms can create moral hazard problems, whereby banks, expecting they will be rescued if things go wrong, will lack incentives not to carry out riskier activities. Competition may be weakened if inefficient incumbents are not allowed to exit the market, reducing the incentives, or ability, of more efficient firms to engage in intense rivalry.

9.20 Currently, international bodies and domestic regulators are proposing principles for better regulation and prudential supervision, and for the development of a policy framework aiming at reducing the moral hazard risks posed by systemically important financial institutions. These proposals could also reduce any competitive distortions entailed by moral hazard. Wider questions about trade-offs between financial stability and competition policy are beyond the scope of this review and are currently being considered by the ICB.

9.21 This review has examined whether the Special Resolution Regime (SRR) and the Financial Services Compensation Scheme (FSCS), which together seek to prevent disorderly exit from the banking sector, have an adverse impact on competition.

9.22 The OFT has not received any evidence to suggest the SRR or FSCS are acting as a barrier to exit, preventing firms from leaving the market.

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While neither of these regulatory frameworks explicitly recognises competition goals, having been designed with financial stability in mind, competition issues can be considered during the operation of the SRR and we would encourage this to happen.

9.23 The OFT, or the European Commission, is able to evaluate the sale of any bank assets through the merger regime and also the impact on competition ex post through its enforcement powers.

Conclusion

9.24 In a sector where there are low or no barriers to entry, expansion and exit, more efficient firms will be able gain market share at the expense of less efficient firms. This is good for consumer welfare and, by providing pressure to reduce costs, is good for UK productivity. Our review has found that whilst most firms are able to gain authorisation and establish operations to offer retail banking products, new entrants face significant challenges in attracting customers and expanding their market shares in retail banking. These barriers differ in size and intensity according to the particular product market and the choice of business model.

9.25 Whilst new firms have entered the sector, and more are expected to do so, we have found that there remain significant challenges around attracting customers and being able rapidly to acquire market share. In particular, consumer inertia remains a key barrier. Other challenges include the limited availability of information on certain types of SMEs and, in the case of certain firms, the lack of non-retail funding which may constrain the ability of these firms to expand their market share and impose competitive constraint on incumbents.

9.26 The OFT expects that this review will be relevant in the following ways:

• to the ICB, which will be making recommendations by September 2011 on structural and related non-structural measures to promote stability and competition in banking for the benefit of consumers and businesses.

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• to the FSA (and any other successor bodies with responsibilities for prudential regulation), with respect to the design and operation of banking regulation and authorisation processes

• to HM Treasury and the Department for Business, Innovation and Skills (BIS), especially in the areas of improving the provision of information on SMEs

• to the devolved governments in Scotland, Wales and Northern Ireland, with respect to ongoing work on personal and SME banking.

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A PARTIES CONSULTED OR WHO SUBMITTED EVIDENCE

Aldermore Bank plc

Association of British Credit Unions Limited

Bankecon

Bank of Baroda

Bank of Ireland (UK)

Barclays Bank plc

Belfast Bankers Clearing Company Limited

British Bankers' Association

British Venture Capital Association

Building Societies Association

Campaign for Community Banking Services

CardOneBanking

Citibank

Commercial First Mortgages Ltd

Consumer Council for Northern Ireland

Consumer Focus

Council of Mortgage Lenders

CreditPal

Cumberland Building Society

Cut Loose

Experian plc

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Federation of Small Businesses Scotland

Finance and Leasing Association

Financial Services Consumer Panel

Forum of Private Business

Funding Circle

Gatehouse Bank

GE Capital

Handelsbanken

Heritable Bank Plc

HSBC Bank plc

ING Direct

Information Technology Telecommunications & Electronics Association

Intermediary Mortgage Lenders Association

Lloyds Banking Group plc

Metro Bank plc

National Australia Banking Group

Nationwide Building Society

Northern Bank Ltd

Payments Council

Post Office

Principality Building Society

Progressive Building Society

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Project New Bank

Royal Bank of Scotland Group (including Ulster Bank)

Santander UK plc Group

Slough Mortgage Centre

Tesco Bank

Triodos Bank NV

UK Money Transmitters Association

Virgin Money

Vocalink

Which?

Zopa Ltd

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B CONSUMER OMNIBUS SURVEY

Introduction

B.1 In July 2010 the OFT placed a number of questions on a consumer omnibus survey to explore consumer attitudes to switching and new providers of retail banking services. The OFT was particularly interested in learning more about what consumers looked for in a retail banking provider and whether their attitudes had changed over the last three years (since the financial crisis).

Methodology

B.2 Twenty-six questions were placed on the GfK NOP telephone omnibus survey – Telebus. This telephone survey interviewed 1,000 adults aged 16 and over. The fieldwork was conducted over the weekend of 24-25 July 2010. The survey covered respondents throughout the UK.

B.3 Respondents were selected by random digit dialling. The sampling frame was all telephone directories in the UK. Given that the sample is controlled by quotas, the final demographic profile should be fairly representative of the target population. Post-survey the sample was weighted to ensure that it is representative in terms of the UK population based on age, sex, social class, number of adults in household, working status and region.

B.4 Note, not all columns sum to 100 per cent due to rounding.

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Questions and results

Q.1. Thinking about your main PCA (the one you use for most of your financial transactions), have you considered switching your PCA to a different provider in the last 12 months?

Base: All adults 16 + Responses Per cent of responses

Yes 90 9%

Not sure 7 1%

No 835 83%

Don’t have a PCA 69 7%

Total responses 1001 100%

Total unweighted number of respondents was 1001.

Q.2. Which of the following was most important in making you consider using a different PCA provider?

Base: All adults considering switching their PCA Responses Per cent of responses

Another provider offered a better product, quality of service or charges

28 31%

I was dissatisfied with my current provider’s product, quality of service or charges

22 24%

I experienced problems with the way my account was managed

13 15%

I do not feel my money was safe with my existing provider

3 4%

Other 23 26%

Don’t know - -

Total responses 90 100%

Total unweighted number of respondents was 88. Note small base size.

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Q.2a.You said another provider offered you a better product, service quality or charges, how did you first find out about the better product, service quality or charges?

Base: All those saying another provider offered a better product

Response Per cent of responses

Searching on the internet 12 44%

Friends or Family 6 20%

Saw another provider’s advertisement 5 18%

Independent advisor 2 6%

Other 3 12%

Don’t know - -

Total responses 28 100%

Total unweighted number of respondents was 27. Note small base size.

Q.3. Which one of the following is the most important reason why you did not consider switching PCA provider?

Base: All adults not considering switching PCA provider Response Per cent of responses

I am happy with my current provider’s product, quality of service, and charges

674 81%

My current provider is convenient 85 10%

I don’t trust the switching process 21 3%

Other providers do not offer better products, quality of service and charges

15 2%

I have experienced problems before in switching my account between providers

8 1%

Others 28 3%

Don’t know 3 <1%

Total responses 835 100%

Total unweighted number of respondents was 834

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Q.4. In the last 3 years, have you become more or less likely to switch your main PCA provider?

Base: All adults who have a PCA Response Per cent of responses

My attitude is unchanged 437 47%

I am less likely to switch now 383 41%

I am more likely to switch now 101 11%

Don’t know 10 1%

Total responses 932 100%

Total unweighted number of respondents was 929

Q.5. Is it important to you that your PCA provider has branches near...

Base: All adults who have a PCA Response Per cent of responses

Where you live 356 38%

Where you work 20 2%

Both where you live and work 216 23%

Either near where you live or near where you work (but you don’t mind which)

53 6%

Branch location is not important to you 281 30%

Don’t know 6 1%

Total responses 932 100%

Total unweighted number of respondents was 929

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Q.6. Would you consider using a PCA provider that has no branches and only operates an internet and telephone service?

Base: All adults who have a PCA Response Per cent of responses

Yes 144 15%

Not sure 68 7%

No 720 77%

Total responses 932 99%

Total unweighted number of respondents was 929

Q.7. If you decided to switch PCA provider, would you consider using a provider that had only started offering PCAs in the last 6 months?

Base: All adults who have a PCA Response Per cent of responses

Yes 76 8%

Not sure 102 11%

No 753 81%

Total responses 932 100%

Total unweighted number of respondents was 929

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Q.8. Think about the savings or investment account that you use for most of your savings or investment transactions, have you considered switching to a different provider in the last 12 months?

Base: All adults aged 16+ Response Per cent of responses

Yes 104 10%

Not sure 6 1%

No 681 68%

Don’t have a savings or investment account 209 21%

Total responses 1001 100%

Total unweighted number of respondents was 1001

Q.8a. Is your saving or investment account with the same provider as your main PCA (the account you were thinking about when answering the PCA questions)?

Base: All adults who have a PCA and a savings/investment account

Response Per cent of responses

Yes 436 57%

No 323 42%

Don’t know 3 <1%

Total responses 762 99%

Total unweighted number of respondents was 758

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Q.9. Which of the following was the most important in making you consider using a different savings or investment account provider?

Base: All adults who have considered switching their savings/investment account provider

Response Per cent of responses

Another provider offered me a better interest rate 45 43%

I was dissatisfied with my current provider’s interest rates

25 24%

I was dissatisfied with my current provider’s quality of service

9 9%

It was more convenient for me to have my savings or investments with another provider

6 5%

I experienced problems with the way my account was managed

5 5%

An introductory interest rate had expired 5 4%

I did not feel my money was safe with my existing provider

3 3%

Other 6 5%

Don’t know 1 1%

Total responses 104 99%

Total unweighted number of respondents was 108

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Q.9a. You said another provider offered a better interest rate, how did you first find out about the better interest rate?

Base: All adults who said another provider offered a better interest rate at Q9

Response Per cent of responses

Searching on the internet 17 39%

Saw another provider's advertisement 7 17%

Friends or family 6 14%

Independent advisor 3 8%

Other 11 23%

Don't know . .

Total responses 45 101%

Total unweighted number of respondents was 49. Note small base size.

Q.10.Which one of the following is the most important reason why you did not consider switching savings of investment provider?

Base: All adults not considering switching their savings/investment account provider

Response Per cent of responses

I am happy with my current provider’s interest rates 444 65%

It is convenient to have my savings or investments with my current provider

152 22%

Other providers do not offer better interest rates for my savings or investments

44 6%

I have experienced problems before in switching my savings or investment account between providers

6 1%

Others 30 4%

Don’t know 6 1%

Total responses 681 99%

Total unweighted number of respondents was 670

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Q.11. In the last 3 years, have you become more or less likely to switch your savings or investment account provider?

Base: All adults who have a savings/investment account

Response Per cent of responses

I am more likely to switch now 113 14%

I am less likely to switch now 329 42%

My attitude is unchanged 345 44%

Don’t know 5 1%

Total responses 792 100%

Total unweighted number of respondents was 785

Q.12. Is it important to you that your savings or investment account provider has branches near...

Base: All adults who have a savings/investment account Response Per cent of responses

Where you live 265 33%

Where you work 17 2%

Both where you live and work 160 20%

Either near where you live or near where you work (but you don’t mind which)

51 6%

Branch location is not important to you 297 38%

Don’t know 3 <1%

Total responses 792 99%

Total unweighted number of respondents was 785

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Q.13. Would you consider using a savings and investment provider that has no branches and only operates an internet and telephone service?

Base: All adults who have a savings/investment account

Response Per cent of responses

Yes 181 23%

Not sure 47 6%

No 563 71%

Total responses 792 100%

Total unweighted number of respondents was 785

Q.14.If you decided to switch savings and investment provider, would you consider using a provider that had only started offering savings and investment accounts in the last 6 months?

Base: All adults who have a savings/investment account

Response Per cent of responses

Yes 68 9%

Not sure 84 11%

No 641 81%

Total responses 792 101%

Total unweighted number of respondents was 785

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Q.15. Think about your largest loan (for example, a secured personal loan or an unsecured personal loan, but not a mortgage or credit cards), have you considered switching to a different provider in the last 12 months?

Base: All adults aged 16+ Response Per cent of responses

Yes 32 3%

Not sure 3 <1%

No 198 20%

Don't have a loan product 767 77%

Total responses 1001 100%

Total unweighted number of respondents was 1001

Q.15a. Is your loan with the same provider as your main PCA (the account you were thinking about when answering the PCA questions)?

Base: All adults with a PCA and a loan Response Per cent of responses

Yes 106 57%

No 82 43%

Don’t know . .

Total responses 188 100%

Total unweighted number of respondents was 185

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Q.16. Which of the following was the most important in making you consider using a different loan provider?

Base: All adults who have considered switching their loan provider

Response Per cent of responses

Another provider offered me a better interest rate or charges

16 50%

I was dissatisfied with my current provider’s interest rates or charges

10 31%

It was more convenient for me to have my loan with another provider

3 9%

I was dissatisfied with my current provider’s quality of service

2 7%

I experienced problems with the way my loan was managed

1 3%

Other . .

Don’t know . .

Total responses 32 100%

Total unweighted number of respondents was 31. Note small base size.

Q.16a. You said another provider offered a better interest rate, how did you first find out about the better interest rate?

Base: All adults who said another provider offered a better interest rate at Q16

Response Per cent of responses

Searching on the internet 8 48%

Friends or family 4 23%

Independent advisor 1 6%

Saw another provider's advertisement 1 6%

Other 3 18%

Total responses 16 101%

Total unweighted number of respondents was 16. Note small base size.

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Q.17.Which one of the following is the most important reason why you did not consider switching loan provider?

Base: All adults not considering switching loan provider Response Per cent of responses

I am happy with my current provider’s interest rates 100 50%

It is convenient to have my loan with my current provider

38 19%

The loan is over a fixed period of time 35 18%

Other providers do not offer better interest rates or charges

14 7%

I have experienced problems before in switching my loan between providers

2 1%

Others 7 4%

Don’t know 1 <1%

Total responses 198 99%

Total unweighted number of respondents was 193

Q.18. In the last 3 years, have you become more or less likely to switch your loan provider?

Base: All adults who have a loan Response Per cent of responses

My attitude is unchanged 107 46%

I am less likely to switch now 98 42%

I am more likely to switch now 25 11%

Don’t know 3 1%

Total responses 234 100%

Total unweighted number of respondents was 228

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Q.19. Is it important to you that your loan provider has branches near...

Base: All adults who have a loan Response Per cent of responses

Branch location is not important to you 121 52%

Where you live 53 23%

Both where you live and work 42 18%

Either near where you live or near where you work (but you don’t mind which)

10 4%

Where you work 6 2%

Don’t know 1 <1%

Total responses 234 99%

Total unweighted number of respondents was 228

Q.20. Would you consider using a loan provider that has no branches and only operates an internet and telephone service?

Base: All adults who have a loan Response Per cent of responses

Yes 68 29%

Not sure 8 3%

No 158 68%

Total responses 234 100%

Total unweighted number of respondents was 228

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Q.21.If you decided to switch loan provider, would you consider using a provider that had only started offering savings and investment accounts in the last 6 months?

Base: All adults who have a loan Response Per cent of responses

Yes 40 17%

Not sure 15 6%

No 179 77%

Total responses 234 100%

Total unweighted number of respondents was 228

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C SMES UK-WIDE SURVEY

Introduction

C.1 In August 2010, the OFT worked with the Forum of Private Business to survey SMEs nationwide to learn more about their experiences in the retail banking sector. The OFT was particularly interested in the decision process for choosing a banking provider, the ease of switching a provider and whether SMEs had experience of certain products being unilaterally withdrawn by providers.

Methodology

C.2 A total of 42 questions were placed on a website (www.fpb.org/images/surveys/oft_survey.htm) between August and September 2010 and a link sent out to Forum of Private Business members to encourage them to complete the survey (though access to the link was not restricted). The survey was available online for approximately two weeks.

C.3 A total of 314 SMEs nationwide completed the survey. The results are presented below. The numbers are rounded and unweighted. Answers to questions seeking information about individual companies have been omitted.

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Questions and results

Q.1. With which bank/building society do you hold your principal banking relationship with?

Responses

Per cent of responses

HSBC 57 19%

Lloyds (including Halifax, Bank of Scotland) 56 19%

Natwest 50 17%

Royal Bank of Scotland 38 13%

Barclays 36 12%

Santander (Alliance and Leicester, Abbey and Bradford and Bingley)

25 8%

Other bank/building society 14 5%

Clydesdale Bank 7 2%

Bank of Ireland 5 2%

Ulster Bank 3 1%

Allied Irish Bank (including Post Office brand) 3 1%

Yorkshire Bank 2 1%

Nationwide 2 1%

Total responses 298 100%

Q.2. What is the name of the other supplier? (Free text question.)

C.4 Other suppliers listed included Co-operative Bank, First Trust Bank, Northern Bank and Investec. Fourteen responses received.

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Q.3. What banking products and other services do you hold with them?

Responses Per cent of responses

Business current account

Overall 97.0% of all respondents held this product 288 30.1%

Credit/debit cards

Overall 58.9% of all respondents held this product 175 18.3%

Overdrafts

Overall 51.9% of all respondents held this product 154 16.1%

Savings/deposit account

Overall 46.5% of all respondents held this product 138 14.4%

Term loans

Overall 25.9% of all respondents held this product 77 8.1%

Money transmission services

Overall 14.8% of all respondents held this product 44 4.6%

Commercial mortgages

Overall 9.4% of all respondents held this product 28 2.9%

Factoring/invoice discounting services

Overall 6.1% of all respondents held this product 18 1.9%

Insurance

Overall 4.7% of all respondents held this product 14 1.5%

Asset financing

Overall 3.0% of all respondents held this product 9 <1%

Cash flow and credit control support

Overall <1% of all respondents held this product 1 <1%

Other key products

Overall 3.4% of all respondents held this product 10 1.0%

Total responses 956 100%

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As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to this criterion (n = 297 SMEs).

Q.4. What are the other key products? (Free text question.)

C.5 Other products mentioned included insurance, credit/debit card payment processing services, foreign currency accounts, accounts Software, legal and business training packages and settlement guarantees in securities. Three responses received.

Q.5. When choosing your current principal banking relationship provider what was the main criteria you used? (Free text question.)

C.6 Responses given included value-for-money at the time of opening, relationship with the bank manager, recommendations by others, and level of service. Two hundred and twenty-four responses received.

Q.6. Which of the following other criteria did you use to choose this provider?

Responses Per cent of responses

It offered the services you needed

Overall 44.9% of all respondents gave this reason

131 19.7%

Already had a personal account with them

Overall 35.3% of all respondents gave this reason

103 15.5%

Location was the closest to your business premises

Overall 27.4% of all respondents gave this reason

80 12.0%

It had a strong reputation

Overall 25.3% of all respondents gave this reason

74 11.1%

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Quality of relationship with manager

Overall 25.3% of all respondents gave this reason

74 11.1%

You held previous accounts with them/past experience

Overall 23.3% of all respondents gave this reason

68 10.2%

It offered the best prices

Overall 21.9% of all respondents gave this reason

64 9.6%

You were recommended to them by a business acquaintance

Overall 17.1% of all respondents gave this reason

50 7.5%

The bank has specialist experience

Overall 5.8% of all respondents gave this reason

17 2.6%

Do not know

Overall 1.7% of all respondents gave this reason

5 <1%

Total responses 666 100.0%

As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to this criterion (292 SMEs).

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Q.7. Have you always banked with the bank with which you currently have your principal banking relationship?

Responses

Per cent of responses

Yes, it has always been the principal bank 148 51%

Yes, we have always had relationship but it has not always been the principal banking provider

17 6%

No 125 43%

Total responses 290 100%

Q.8. When did you start banking with your current provider with whom you have your principal banking relationship?

Responses

Per cent of responses

Fewer than six months ago 6 5%

Between six months and one year 3 3%

Between one and two years ago 12 11%

Between two and three years ago 13 12%

Three years to a decade ago 44 39%

More than a decade ago 35 31%

Total responses 113 100%

Base: SMEs whose principal banking relationship has not always been with their current principal bank.

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Q.9. Which bank did you previously bank with?

Responses

Per cent of responses

Natwest 26 23%

Barclays 24 21%

Lloyds (including Halifax Bank of Scotland) 23 20%

HSBC 13 11%

Clydesdale Bank 8 7%

Royal Bank of Scotland 6 5%

Allied Irish Bank (including Post Office brand) 3 3%

Santander (Alliance and Leicester, Abbey and Bradford and Bi

3 3%

Yorkshire Bank 2 2%

Nationwide 1 1%

Bank of Ireland - -

Ulster Bank - -

Other bank/building society 5 4%

Total responses 114 100%

Base: SMEs whose principal banking relationship has not always been with their current principal bank.

Q.10. What is the other supplier(s)? (Free text question.)

C.7 One further response was received – First Trust Bank.

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Q.11. What was your motivations for switching principal provider?

Responses Per cent of responses

Poor relationship with old bank/their staff

Overall 36.6% of respondents gave this motivation

52 15.4%

Better service at new bank

Overall 31.0% of respondents gave this motivation

44 13.1%

Old bank refused to provide a service/product for example, a loan

Overall 26.8% of respondents gave this motivation

38 11.3%

Offered free banking

Overall 25.4% of respondents gave this motivation

36 10.7%

Old bank manager not accessible for example, lack of contact

Overall 21.8% of respondents gave this motivation

31 9.2%

New bank had lower prices

Overall 21.1% of respondents gave this motivation

30 8.9%

Old bank too rigid

Overall 16.9% of respondents gave this motivation

24 7.1%

Your business account was actively sought by another bank

Overall 12.0% of respondents gave this motivation

17 5.0%

Errors by old bank

Overall 10.6% of respondents gave this motivation

15 4.5%

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Responses Per cent of responses

Better location of new bank

Overall 7.0% of respondents gave this motivation

10 3.0%

Higher rates of interest on credit balances at new bank

Overall 5.6% of respondents gave this motivation

8 2.4%

Individual at old bank moved on

Overall 5.6% of respondents gave this motivation

8 2.4%

Changed ownership of new bank

Overall 2.8% of respondents gave this motivation

4 1.2%

Other

Overall 14.1% of respondents gave this motivation

20 5.9%

Total responses 337 100%

As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to this motivation (142 SMEs).

Base: SMEs whose principal banking relationship has not always been with their current principal bank.

Q.12. What is the other motivation for switching supplier? (Free text question.)

9.27 Other reasons given included the closure of a branch, change of relationship manager and concerns about the viability of the provider. Seventeen responses were received.

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Q.13. How many suppliers did you consider?

Responses Per cent of responses

One 45 31.5%

Two 68 47.6%

Three or more 22 15.4%

Do not know 8 5.6%

Total responses 143 100%

Results are presented by percentage of responses - only two SMEs gave more than one response.

Base: SMEs whose principal banking relationship has not always been with their current principal bank.

Q.14. How long did it take you to switch your account?

Responses

Per cent of responses

Less than a week 27 18.5%

Less than a month 52 35.6%

Between one and three months 29 19.9%

More than three months 9 6.2%

I have kept the old account 19 13.0%

Do not know 10 6.8%

Total responses 146 100.0%

Results are presented by percentage of responses - only four SMEs gave more than one response.

Base: SMEs whose principal banking relationship has not always been with their current principal bank.

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Q.15. What sort of information was required when moving provider? (Free text question.)

C.8 Answers included historic accounts, cash flow forecasts, building valuations, business plans, proof of identification, debtor and creditor ledgers, and personal details of directors and key personnel. Seventy-five responses were received.

Q.16. How easy was it to switch suppliers?

Responses Per cent of responses

Very Easy 44 31%

Easy 63 45%

Difficult 20 14%

Very difficult 5 4%

Do not recall 8 6%

Total responses 140 100%

Base: SMEs whose principal banking relationship has not always been with their current principal bank.

Q.17. Approximately what was the cost of switching?

Responses Per cent of responses

£0 60 43%

Under £100 9 6%

£100 to £500 16 11%

£500 to £1,000 6 4%

Over £1,000 19 14%

Do not know 30 21%

Total responses 140 100%

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Base: SMEs whose principal banking relationship has not always been with their current principal bank.

Q.18. What, if any, problems did you encounter? (Free text question.)

C.9 Problems encountered included the time required to action switching, the length of time to set up internet banking, issues around Direct Debits and Standings Orders being mis-directed, and the 'old' provider not closing the old account in a timely manner. Seventy-four responses were received.

Q.19. What was the motivation for not switching provider?

Responses Per cent of responses

Too complicated/too much hassle to switch

Overall 32.7% of respondents gave this motivation

48 15.6%

Still considering not decided yet

Overall 32.0% of respondents gave this motivation

47 15.3%

Did not think it would make any difference

Overall 24.5% of respondents gave this motivation

36 11.7%

Too much disruption to payments during the switching process

Overall 29.3% of respondents gave this motivation

43 14%

Did not find any better deals elsewhere

Overall 19.7% of respondents gave this motivation

29 9.4%

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Responses Per cent of responses

Good relationship with current bank/no need to change

Overall 19.7% of respondents gave this motivation

29 9.4%

May find it difficult to open an account elsewhere

Overall 12.2% of respondents gave this motivation

18 5.8%

Would take too long/cost too much to switch

Overall 11.6% of respondents gave this motivation

17 5.5%

Not got around to it to switching

Overall 8.8% of respondents gave this motivation

13 4.2%

Current bank offers better prices/charges/fees

Overall 5.4% of respondents gave this motivation

8 2.6%

Location of current account is convenient

Overall 5.4% of respondents gave this motivation

8 2.6%

Current bank revised their services/rates/resolved their problems

Overall 2.0% of respondents gave this motivation

3 1.0%

Other

Overall 6.1% of respondents gave this motivation

9 2.9%

Total responses 308 100.0%

As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to this motivation (147 SMEs).

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Base: SMEs whose principal banking relationship has always been with their current principal bank.

Q.20.What is the other reason? (Free text question.)

C.10 No other reasons were given.

Q.21. What other banks do you use alongside your principal bank?

Responses

Per cent of responses

No other banks

Overall 50.4% of respondents did not use other banks

126 43.0%

Lloyds (including Halifax Bank of Scotland)

Overall 12.0% of respondents also used this bank 30 10.2%

Santander (Alliance and Leicester, Abbey and Bradford and Bingley brands)

Overall 8.8% of respondents also used this bank

22 7.5%

Barclays

Overall 7.6% of respondents also used this bank 19 6.5%

NatWest

Overall 6.8% of respondents also used this bank 17 5.8%

HSBC

Overall 6.0% of respondents also used this bank 15 5.1%

Nationwide

Overall 2.8% of respondents also used this bank 7 2.4%

Royal Bank of Scotland

Overall 2.8% of respondents also used this bank 7 2.4%

Allied Irish Bank (including Post Office brand)

Overall 2.4% of respondents also used this bank 6 2.0%

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Responses

Per cent of responses

Clydesdale Bank

Overall 2.4% of respondents also used this bank 6 2.0%

Ulster Bank

Overall <1% of respondents also used this bank 2 <1%

Bank of Ireland

Overall <1% of respondents also used this bank 1 <1%

Yorkshire Bank

Overall <1% of respondents also used this bank 1 <1%

Other bank/building society

Overall 13.6% of respondents used these providers 34 11.6%

Total responses 293 100.0%

As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to this provider (n = 250 SMEs).

Q.22. What is the other bank/building society? (Free text question.)

9.28 Other banks and building societies mentioned included, Kent Reliance Building Society, Egg, Anglo Irish & Secure Trust Banks, Progressive Building Society, Safron Building Society, Paypal, Co-operative Bank, MBNA, Newbury Building society, GE Commercial Finance, Standard Life (Barclays) and CIC Banque (France). Twenty-three responses were received.

Q.23. What banking products and services do you hold with the other provider?

Responses Per cent of responses

Business current account

Overall 46.3% of respondents held this product 57 28.1%

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Responses Per cent of responses

Savings/deposit account

Overall 43.9% of respondents held this product 54 26.6%

Credit/debit cards

Overall 25.2% of respondents held this product 31 15.3%

Overdrafts

Overall 14.6% of respondents held this product 18 8.9%

Term loans

Overall 9.8% of respondents held this product 12 5.9%

Money transmission services

Overall 6.5% of respondents held this product 8 3.9%

Factoring / invoice discounting services

Overall 3.3% of respondents held this product 4 2.0%

Asset financing

Overall 3.3% of respondents held this product 4 2.0%

Commercial mortgages

Overall 1.6% of respondents held this product 2 1.0%

Insurance

Overall <1% of respondents held this product 1 <1%

Other key products

Overall 9.8% of respondents held this product 12 5.9%

Total responses 203 100.0%

As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to holding this product with another provider (n=123 SMEs).

Base: SMEs who use other banks alongside their principal bank.

Q.24. What is the other bank/building society? (Free text question.)

C.11 No responses received.

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Q.25. What are the main reasons for using multiple banks?

Responses Per cent of responses

You choose each banking product from the bank that offers you the best deal

Overall 37.7% of respondents gave this reason

46 29.1%

Spread of risk between a number of financial institutions

Overall 31.1% of respondents gave this reason

38 24.1%

Current provider refused to provide additional finance

Overall 19.7% of respondents gave this reason

24 15.2%

You previously had a principal relation with another bank and did not transfer across your additional products to your new principal relationship bank

Overall 13.1% of respondents gave this reason

16 10.1%

Your existing provider does not offer a full suite of business products

Overall 10.7% of respondents gave this reason

13 8.2%

Other

Overall 17.2% of respondents gave this reason 21 13.3%

Total responses 158 100%

As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to this reason (122 SMEs).

Base: SMEs who use other banks alongside their principal bank.

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Q.26. What is the other reason(s)? (Free text question.)

9.29 Other reasons given included the need to have a safety net in case of future problems with banking, the ability to use the Post Office network, the need to have multiple providers for multiple companies and a requirement to have international banking facilities. Twenty-one responses were received.

Q.27. What are the reasons for banking with one bank/building society?

Responses Per cent of responses

Too much hassle having products with multiple banks

Overall 55.8% of respondents gave this reason

48 49.5%

Never thought about it

Overall 22.1% of respondents gave this reason 19 19.6%

More likely to get additional finance if needed

Overall 14.0% of respondents gave this reason

12 12.4%

My existing provider insists on an exclusive banking relationship

Overall 5.8% of respondents gave this reason

5 5.2%

Other

Overall 15.1% of respondents gave this reason 13 13.4%

Total responses 97 100%

As SMEs were able to give multiple responses to this question, the second sets of statistics in italics refer to the percentage of all SMEs who answered yes to this reason (n=86 SMEs – small base).

Base: SMEs who do not use other banks alongside their principal bank.

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Q.28. What is the other reason for banking with one bank/building society? (Free text question.)

C.12 The main other reason given was difficulties in gaining access to overdraft facilities. Ten responses were received.

Q.29.Do you have any experience of banks unilaterally deciding to withdraw banking services or products to you?

Responses Per cent of responses

No 183 63%

Yes 94 33%

Do not know 12 4%

Total responses 289 100%

Q.30.What products / services were withdrawn? (Free text question.)

C.13 Products and services withdrawn included overdraft facilities (or reductions in limits), term loans, merchant acquirer services, deposit accounts as well as entire banking packages. Eight-four responses were received.

Q.31.What was the bank's justification?

Responses

Per cent of responses

No reason given 32 37.2%

Poor credit rating 12 14.0%

Branch closing down 2 2.3%

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Responses

Per cent of responses

Lack of demand 1 1.2%

Other reason 39 45.3%

Total responses 86 100.0%

Results are presented by percentage of responses - only one SME gave more than one response. Base: SMEs who have experience of banks unilaterally deciding to withdraw products or services. Note small base size.

Q.32.What is the other reason? (Free text question.)

9.30 Other reasons included a change in turnover, dissatisfaction with the business plan, the bank wishing to reduce exposure to firms in particular sectors and lack of available funds. Thirty-six responses were received.

Q.33.How satisfied are you with the banking services you currently enjoy?

Responses Per cent of responses

Very satisfied 30 10%

Satisfied 59 20%

Neutral 80 27%

Unsatisfied 55 19%

Very unsatisfied 68 23%

Do not know - -

Total responses 292 100%

Q.34.Why do you think that? (Free text question.)

C.14 Reasons given for satisfaction include confidence that the provider will assist the SME if things go wrong, a lack of problems encountered and flexibility.

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C.15 Reasons given for dissatisfaction include a lack of support and understanding of SMEs and particular sectors, the lack of ability of local branches to make decisions independent of head office approval, lack of flexibility, delays in service and high costs. Two hundred and thirty-one responses were received.

Q.35. Company name

Redacted.

Q.36. Is your business a…

Responses

Per cent of responses

Limited liability company 204 69%

Sole trader 55 19%

Partnership 26 9%

Other 9 3%

Total responses 294 100%

Q.37. Please state other type of business

9.31 No other categories given.

Q.38. How would you describe your business

Responses

Per cent of responses

Business services 52 18%

Manufacturing 46 16%

Retail or wholesale 38 13%

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Responses

Per cent of responses

Financial services 31 11%

Construction 27 9%

Personal services 8 3%

Transport, storage or communications 8 3%

Agriculture, fishing or forestry 5 2%

Hotels and restaurants 3 1%

Other 74 25%

Total responses 292 100%

Q.39. What is your annual turnover for the last account year?

Responses

Per cent of responses

Under £100,000 91 32%

£100,000 to £1,000,000 109 38%

£1,000,001 to £5,000,0000 71 25%

£5,000,001 to £25,000,000 12 4%

Over £25,000,000 5 2%

Total responses 288 100%

Q.40. Number of employees at the business?

Responses Per cent of responses

0 101 35%

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1 to 9 160 55%

10 to 49 22 8%

50 to 249 7 2%

Total responses 290 100%

Q.41. Postcode

Redacted

Q.42. Contact person

Redacted.

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D SMES SCOTLAND-WIDE SURVEY

Introduction

D.1 In August 2010, the OFT worked with the Federation of Small Businesses Scotland to survey SMEs in Scotland to learn more about their experiences of the retail banking sector. The OFT was particularly interested in the decision process for choosing a banking provider, the ease of switching a provider and whether SMEs had experience of certain products being unilaterally withdrawn by providers.

Methodology

D.2 Fifteen questions were placed on the OFT website during August 2010 and the Federation of Small Businesses Scotland sent an email to its members to encourage them to complete the survey. The survey was available online for two weeks and the link only told to FSB Scotland members who received the email. As the purpose of this survey was to explore specific issues in Scotland, it was a reduced version of the longer UK-wide survey.

D.3 The survey covered respondents from Scotland only. Respondents were asked to enter their business' post code to ensure this coverage. A total of 232 SMEs completed the survey. The results are presented below. The numbers are rounded.

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Questions and results

Q.1. What was your annual turnover for the last account year?

Responses Per cent of responses

Under £100,000 103 44%

£100,000 to £1,000,000 102 44%

£1,000,001 to £5,000,000 24 10%

£5,000,001 to £25,000,000 3 1%

Over £25,000,000 - -

Total responses 232 100%

Q.2. When choosing your current principal banking relationship provider which of the following criteria did you use to choose this provider?

Responses Per cent of responses

Already had a personal account with them 52 23%

It offered the best prices 44 19%

It offered the services you needed 35 15%

Recommended to you 27 12%

You held previous accounts with them / past experience

24 10%

Location – was the closest to your business premises

19 8%

Quality of relationship with manager 14 6%

It had a strong reputation 9 4%

The bank has specialist experience 2 1%

Do not know 4 2%

Total responses 230 100%

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Q.3. Have you always banked with the bank with which you currently have your principal banking relationship?

Responses Per cent of responses

Yes, it has always been the principal bank 121 52%

Yes, we have always had a relationship but it has not always been the principal banking provider

7 3%

No 104 45%

Total responses 232 100%

Q.4. If you have not always banked with your current principal banking provider, what were the reasons for moving your relationship to them? (Free text question.)

D.4 Of the range of answers that were provided, the two most common responses by far were around the cost of banking and service levels (52 responses). The next most common response was around banks withdrawing services including lending. One hundred and eight responses were received to this question.

Q.5. If you have moved your principal banking relationship, how long did it take you to switch your account?

Responses Per cent of responses

Less than a week 5 5%

Less than a month 47 43%

Between one and three months 25 23%

More than three months 12 11%

I have kept the old account 17 15%

Do not know 4 4%

Total responses 110 100%

Base: Scottish SMEs who have moved their principal banking relationship

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Q.6. What sort of information was required when moving provider? (Free text question.)

D.5 Of the diverse range of answers that were provided, the most common response was copies of the business' accounts (37 responses). The second most common response was direct debit and standing order information (17 responses). Other common responses included proof of identification, personal information and bank statements. Ninety-eight responses were received to this question.

Q.7. How easy was it to switch suppliers?

Responses Per cent of responses

Very easy 46 42%

Easy 33 30%

Difficult 17 15%

Very difficult 9 8%

Do not recall 5 5%

Total responses 110 100%

Base: Scottish SMEs who have moved their principal banking relationship

Q.8. What, if any, problems did you encounter? (Free text question.)

D.6 Of the diverse range of answers that were provided, the most common response related to problems around the transfer of direct debits and standing orders (18 responses). The second most common response was poor communication or poor cooperation between the two banks (17 responses). The next most common response was the length of time taken to switch. Fifty-seven responses were received to this question.

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Q.9. If you have always had your principal banking relationship with the same provider, what was the main motivation for not switching provider?

Responses Per cent of responses

Still considering – not decided yet 29 24%

Too complicated/too much hassle to switch 21 17%

Good relationship with current bank/no need to change

16 13%

Not got around to it to switching 10 8%

Did not think it would make any difference 9 7%

May find it difficult to open an account elsewhere 7 6%

Did not find any better deals elsewhere 6 5%

Current bank offers better prices/charges/fees 5 4%

Too much disruption to payments during the switching process

5 4%

Location of current account is convenient 5 4%

Would take too long/cost too much to switch 2 2%

Current bank revised their services/rates/resolved their problems

1 1%

Other 5 4%

Total responses 121 100%

Base: Scottish SMEs who have always had their principal banking relationship with the same provider.

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Q.10. Do you hold any products and services with a bank with whom you do not have a principal banking relationship?

Responses Per cent of responses

Do not hold products/services 134 58%

Do hold products/services 98 42%

Total responses 232 100%

Q.11. What is the main reason for using multiple banks?

Responses Per cent of responses

You choose each banking product from the bank that offers you the best deal

33 34%

Spread of risk between a number of financial institutions 19 20%

Current provider refused to provide additional finance 10 10%

You previously had a principal relation with another bank and did not transfer across your additional products to your new principal relationship bank

10 10%

Your existing provider does not offer a full suite of business products

6 6%

Other 19 20%

Total responses 96 100%

Base: Scottish SMEs who use other banks alongside their principal bank.

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Q.12. If you do not use multiple banks, what is the main reason for banking with one bank?

Responses Per cent of responses

Too much hassle having products with multiple banks 74 56%

Never thought about it 22 17%

More likely to get additional finance if needed 14 11%

My existing provider insists on an exclusive banking relationship

7 5%

Other 14 11%

Total responses 131 100%

Base: Scottish SMEs who do not use other banks alongside their principal bank.

Q.13: Do you have any experience of banks unilaterally deciding to withdraw banking services or products to you?

Responses Per cent of responses

No 142 62%

Yes 80 35%

Don't know 8 3%

Total responses 230 100%

Q.14: What products/services were withdrawn? (Free text question.)

D.7 Of the diverse range of answers that were provided, the most common response was the withdrawal of overdraft facilities (31 responses). Other common answers included the withdrawal of lending facilities, refusing to provide additional finance and the withdrawal of a local relationship manager. Seventy-two responses were received to this question.

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Q.15: What was the bank’s justification? (Free text question.)

D.8 Of the diverse range of answers that were provided, the most common response was that the bank gave no justification (18 responses). The next most common answer was that the bank was reducing its risk exposure or that the business posed too high a risk (13 responses). Other answers included the bank believing the business could not service the loan or overdraft, a reduction in the business’ revenue or profit, a review of account activity, poor projected figures or a poor business plan and finally the banking crisis and current climate. Seventy-two responses were received to this question.

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E LIST OF BANKS AS COMPILED BY THE FSA ON 30 SEPTEMBER 2010

E.1 This list of banks is intended to be used solely as a guide.244 The FSA does not warrant, nor accept any responsibility for the accuracy or completeness of the list or for any loss which may arise from reliance by any person on information in the list.

E.2 (Amendments to the List of Banks since 31 August 2010 can be found below)

Banks incorporated in the United Kingdom

Abbey National Treasury Services plc ABC International Bank plc Access Bank UK Limited, The Adam & Company plc Ahli United Bank (UK) plc Airdrie Savings Bank Aldermore Bank Plc Alliance & Leicester plc Alliance Trust Savings Ltd Allied Bank Philippines (UK) plc Allied Irish Bank (GB)/First Trust Bank - (AIB Group (UK) plc) Alpha Bank London Ltd AMC Bank Ltd Anglo-Romanian Bank Ltd Ansbacher & Co Ltd ANZ Bank (Europe) Ltd Arbuthnot Latham & Co, Ltd Banc of America Securities Ltd Bank Leumi (UK) plc

244 It can also be found online at www.fsa.gov.uk/pubs/list_banks/2010/sep10.pdf.

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Bank Mandiri (Europe) Ltd Bank of Beirut (UK) Ltd Bank of Ceylon (UK) Ltd Bank of China (UK) Limited Bank of London and The Middle East plc Bank of New York Mellon (International) Limited, The Bank of Philippine Islands (Europe), PLC Bank of Scotland plc Bank Saderat plc Bank Sepah International plc Barclays Bank plc Barclays Bank Trust Company Ltd British Arab Commercial Bank Ltd Broadcastle Bank Ltd Brown Shipley & Co. Ltd Butterfield Bank (UK) Ltd C Hoare & Co CAF Bank Ltd Capital One Bank (Europe) plc Cater Allen Ltd Charity Bank Ltd, The Church House Trust plc China Construction Bank (London) Limited CIBC World Markets plc CIT Bank Limited Citibank International plc Close Brothers Ltd Clydesdale Bank plc Consolidated Credits Bank Ltd Co-operative Bank plc, The Coutts & Company Credit Suisse International Credit Suisse (UK) Ltd Crown Agents Bank Ltd

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DB UK Bank Limited Dunbar Bank plc Duncan Lawrie Ltd EFG Private Bank Ltd Egg Banking plc European Islamic Investment Bank Plc Europe Arab Bank Plc FBN Bank (UK) Ltd FCE Bank plc FIBI Bank (UK) plc Gatehouse Bank plc Ghana International Bank plc Goldman Sachs International Bank Guaranty Trust Bank (UK) Limited Gulf International Bank (UK) Ltd Habib Allied International Bank plc Habibsons Bank Ltd Hampshire Trust plc Hardware Federation Finance Co Ltd, The Harrods Bank Ltd Havin Bank Ltd HFC Bank Ltd HSBC Bank plc HSBC Private Bank (UK) Ltd HSBC Trust Company (UK) Ltd ICBC (London) Ltd ICICI Bank UK Plc Intercontinental Bank (UK) plc Investec Bank PLC Islamic Bank of Britain plc

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J P Morgan Europe Ltd J P Morgan International Bank Ltd Jordan International Bank plc Julian Hodge Bank Ltd Kaupthing Singer & Friedlander Limited (In administration) Kexim Bank (UK) Ltd Kingdom Bank Ltd Kleinwort Benson Private Bank Ltd Kookmin Bank International Ltd Liverpool Victoria Banking Services Ltd Lloyds TSB Bank plc Lloyds TSB Private Banking Ltd Lloyds TSB Scotland plc Macquarie Bank International Limited Marks and Spencer Financial Services plc MBNA Europe Bank Ltd MediCapital Bank plc Melli Bank plc Methodist Chapel Aid Ltd Metro Bank PLC Mizuho International plc Morgan Stanley Bank International Ltd N M Rothschild & Sons Ltd National Bank of Egypt International Ltd National Bank of Kuwait (International) plc National Westminster Bank plc Nomura Bank International plc Northern Bank Ltd Northern Rock plc Northern Trust Global Services Limited Pensions Bank Limited

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Persia International Bank Ltd Philippine National Bank (Europe) plc Punjab National Bank (International) Ltd Quib (UK) Plc R Raphael & Sons plc Rathbone Investment Management Ltd Reliance Bank Ltd Royal Bank of Canada Europe Ltd Royal Bank of Scotland plc, The Sainsbury’s Bank plc Santander UK Plc Schroder & Co Ltd Scotiabank Europe plc Scottish Widows Bank plc Secure Trust Bank plc SG Hambros Bank Limited Smith & Williamson Investment Management Ltd Sonali Bank (UK) Ltd Southsea Mortgage & Investment Co Ltd Standard Bank Plc Standard Chartered Bank State Street Bank Europe Ltd Sumitomo Mitsui Banking Corporation Europe Ltd TD Bank Europe Ltd Tesco Personal Finance Plc Turkish Bank (UK) Ltd UBS Ltd Ulster Bank Ltd Union Bank UK plc United National Bank Ltd United Trust Bank Ltd

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Unity Trust Bank plc Vanquis Bank Ltd VTB Capital Plc Weatherbys Bank Ltd Wesleyan Bank Limited Westpac Europe Limited Whiteaway Laidlaw Bank Ltd

Zenith Bank (UK) Limited Banks incorporated outside the EEA authorised to accept deposits through a branch in the UK

ABSA Bank Ltd Arab Banking Corporation (B.S.C) Arab National Bank Australia & New Zealand Banking Group Ltd Banco do Brasil SA Bangkok Bank Public Company Ltd Bank Hapoalim BM Bank of America NA Bank of Baroda Bank of Ceylon Bank of China Limited Bank of East Asia Ltd Bank of India Bank of Montreal Bank of New York Mellon, The Bank of Nova Scotia, The Bank of Taiwan Bank of Tokyo Mitsubishi UFJ Limited Canadian Imperial Bank of Commerce

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Canara Bank Chang Hwa Commercial Bank Ltd Chiba Bank Ltd, The CIMB Bank Berhad Citibank NA Commonwealth Bank of Australia Credit Suisse DBS Bank Ltd Emirates NBD PJSC Export-Import Bank of India Fairbairn Private Bank (IOM) Limited First Commercial Bank FirstRand Bank Limited Gulf International Bank BSC Habib Bank AG Zurich Habib Bank Ltd Hongkong and Shanghai Banking Corporation Ltd, The HSBC Bank USA NA Hua Nan Commercial Bank Ltd Industrial Bank of Korea Israel Discount Bank Ltd JPMorgan Chase Bank N.A Korea Development Bank, The Korea Exchange Bank Macquarie Bank Ltd Malayan Banking Berhad Mashreqbank PSC

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Mega International Commercial Bank Co. Ltd Mitsubishi UFJ Trust and Banking Corporation Mizrahi Tefahot Bank Limited Mizuho Corporate Bank Ltd Nacional Financiera SNC National Australia Bank Ltd National Bank of Abu Dhabi National Bank of Canada Nedbank Ltd Norinchukin Bank, The Northern Trust Company, The Oversea-Chinese Banking Corporation Ltd Pt Bank Negara Indonesia (Persero) TBK Qatar National Bank SAQ

Rafidain Bank (Provisional Liquidator Appointed) RBC Dexia Investor Services Trust Riyad Bank Royal Bank Of Canada

Samba Financial Group Shanghai Commercial Bank Ltd Shinhan Bank State Bank of India State Street Bank and Trust Company Sumitomo Trust & Banking Co Ltd, The Syndicate Bank TC Ziraat Bankasi AS Toronto-Dominion Bank, The Turkiye Is Bankasi AS

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UBS AG Union Bancaire Privée, UBP SA United Overseas Bank Ltd Wells Fargo Bank, National Association Westpac Banking Corporation Woori Bank Banks incorporated in the EEA entitled to accept deposits through a branch in the UK

Akbank NV Allfunds Bank SA Allied Irish Bank plc Alpha Bank AE Anglo Irish Bank Corporation plc Banca IMI SpA Banca March SA Banca Monte dei Paschi di Siena SpA Banco Bilbao Vizcaya Argentaria SA Banco de Sabadell Banco Espírito Santo SA Banco Itau Europa SA Banco Popolare S.c Banco Santander, S.A. Banco Santander Totta SA Banif - Banco Internacional do Funchal SA Bank Insinger de Beaufort NV Bank J Safra (Gibraltar) Limited Bank of Cyprus Public Company Ltd Bank of Ireland, The Bank of New York Mellon SA/NV, The Bank of Scotland (Ireland) Ltd Banque AIG Banque Chaabi du Maroc

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Banque Transatlantique SA Bayerische Landesbank BLOM BANK France BNP Paribas BNP Paribas Securities Services Byblos Bank Europe SA Caixa Geral de Deopsitos SA Commerzbank AG Confederacion Espanola de Cajas de Ahorros Credit Agricole Corporate and Investment Bank SA Crédit Agricole SA Crédit Industriel et Commercial Danske Bank A/S Deutsche Bank AG Deutsche Hypothekenbank AG Deutsche Pfandbriefbank AG Deutsche Postbank AG Dexia Bank Belgium SA Dexia Credit Local SA DnB NOR Bank ASA Dresdner Bank AG DZ Bank AG, Deutsche Zentral-Genossenschaftsbank EAA Covered Bond Bank plc EFG Eurobank Ergasias SA Emporiki Bank of Greece SA Erste Group Bank AG Eurohypo AG Fortis Bank (Nederland) NV Fortis Bank S.A/N.V GE Corporate Finance Bank SAS Glitnir Banki hf

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HSH Nordbank AG Hypo Public Finance Bank ING Bank NV ING Direct NV Intesa Sanpaolo SpA Irish Nationwide Building Society Jyske Bank A/S KAS Bank N.V Kaupthing Bank HF KBC Bank NV Landesbank Baden-Württemberg Landesbank Berlin AG Landesbank Hessen-Thüringen Girozentrale Landsbanki Islands hf Lehman Brothers Bankhaus AG Marfin Popular Bank Public Company Ltd Merrill Lynch International Bank Limited National Bank of Greece Natixis Newedge Group Norddeutsche Landesbank Girozentrale Nordea Bank Finland plc Piraeus Bank SA Powszechna Kasa Oszczednosci Bank Polski SA Rabobank International (Coöperatieve Centrale Raiffeisen-Boerenleenbank Ba) Royal Bank of Scotland N.V., The

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Skandinaviska Enskilda Banken AB (PUBL) Société Générale State Street Bank GmbH Svenska Handelsbanken AB (PUBL) TD Waterhouse Bank NV Triodos Bank NV Ulster Bank Ireland Ltd Ukio Bankas AB UniCredit Bank AG UniCredit S.p.A Volkswagen Bank GmbH Westdeutsche ImmobilienBank AG Western Union International Bank GmbH WestLB AG Banks authorised in the EEA entitled to establish branches in the UK but not to accept deposits in the UK

Aareal Bank AG Banco Espirito Santo de Investimento SA Banque PSA Finance Calyon Financial Snc Carnegie Investment Bank AB Citigroup Global Markets Deutschland AG & Co. KGaA CNH Financial Services SAS Depfa Bank plc DVB Bank SE First Active plc

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Franfinance (Société Générale Vendor Finance) Handelsbanken Finans AB IKANO Bank SE IKB Deutsche Industriebank AG Joh. Berenberg, Gossler & Co. KG John Deere Bank SA M&B Capital Markets, Sociedad De Valores, S.A. MainFirst Bank AG Mediobanca Natixis Private Banking International NIBC Bank N.V. Skandinaviska Enskilda Banken S.A. Amendments to the List of Banks since 31 August 2010

Banks incorporated in the United Kingdom

E.3 Deletion: Dresdner Kleinwort Limited

E.4 Change of name: European Finance House to QIB (UK) Plc

Banks incorporated outside the EEA authorised to accept deposits through a branch in the UK

E.5 No changes

Banks incorporated in the EEA entitled to accept deposits through a branch in the UK

E.6 No changes

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Banks authorised in the EEA entitled to establish branches in the UK but not to accept deposits in the UK

E.7 No changes

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