Competition and choice in retail banking - Treasury Contents

Written evidence from nef (the new economics foundation)



1.1  Banking is unlike any other industry sector. It has unique properties that require an approach that goes beyond competition and choice to examine its broader social, economic and environmental impacts. We argue that effective reform needs to take as its starting point a re-statement of the function of banking, and while acknowledging that there is a strong case for reforms of the investment banking industry, we focus here on retail banking.

1.2  The most important privilege of the banking sector is the ability to create credit. This effectively hands complete control over the allocation of credit and significant control over the money supply, the means of exchange that underpins the economy, to private banks. Closely connected to this is the problem of moral hazard arising from the implicit and explicit government guarantees of banks' solvency.

1.3  These features of banking make it more analogous to public utilities, natural monopolies or merit goods1 such as health and education, than to ordinary free market industry sectors. The incoherence caused by the privatisation and deregulation of a public good creates inherent instability in the banking system.

1.4  Apart from these unusual features, the banking market does not approach anywhere near conditions of perfect competition. Therefore a laissez-faire deregulatory approach paradoxically leads to less competition and choice. Other observed market failures include:

—  the demise of relationship banking;

—  distorted incentives and short-termism;

—  patchy access to finance and poor customer service;

—  withdrawal of support from local economies, and;

—  increasing risks from increasing scale.

1.5  We argue that among the plethora of useful reform initiatives, the watchword for transforming banking for the better is "diversity"—of function, scale and location, and ownership.

1.6  We further argue that to truly get at the roots of systemic instability, the committee should consider convening a separate inquiry into the case for and against monetary reform.


The banking system is, by its very nature, not subject to the normal laws of market competition. Although competition and choice merit careful examination, the Committee is well advised to take a broad approach to reform. We believe it is necessary and desirable to start any review of banking with the question "What is the function of banking?" and we offer the following definition:2

"To facilitate the allocation and deployment of economic resources, both spatially and temporally, to ecological sustainable activities that maximise long-term financial and social returns under conditions of uncertainty"

We argue that a fundamental redesign of existing market structures is required for banking to fulfil this function.


3.1  Banking is unlike any other industry; this has been made abundantly clear in the current crisis. Banks enjoy certain privileges that normal commercial businesses do not have. The most important of these is the privilege of "credit creation", and closely connected is the problem of moral hazard arising from the implicit and explicit government guarantees of their solvency.

Credit Creation

3.2  In modern economies, through fractional reserve banking, banks play a key macro-economic role in the creation and allocation of virtually the entire money supply as credit. This is accepted by the Federal Reserve and the European Central Bank and by most monetary economists, although it does not feature in most general equilibrium models of the economy used by orthodox economists.3 Private-sector commercial banks can thus be seen to provide a key public utility function as the originators and allocators of the money supply.

Moral Hazard

3.3  This leads inevitably to the second privilege, that risks are effectively underwritten by the taxpayer. This happens in two ways: in order to prevent the sudden loss of confidence that can lead to a run on the banks they are provided with a highly valuable deposit guarantee scheme funded at taxpayers' expense. This is compounded by the problem of institutions that are too systemically important to fail. One estimate of the value of this implicit guarantee in the UK, in terms of allowing banks access to cheaper capital, is over £50 billion a year.4 This figure has swollen following the banking bailout, as these banks would have faced significantly higher funding costs without the government interventions, but the pre-crisis figure for 2007 was still £11 billion. Significantly, this value accrues almost entirely to the largest five banks.

An Incoherent System: Public Money, Private Banks

3.4  The government, via the Bank of England, has a monopoly on the creation of legal tender. The means of exchange that forms an essential building block of any modern economic system is therefore limited to a single currency that allows no legally enforceable competitors. There are alternatives to a monopoly fiat currency, but discussion of these is outside the scope of this paper. What is relevant to the reform of the banking system is that the provision of a reliable and stable currency to fulfil the function of a means of exchange is a public good. But the advent of electronic banking and the demise of notes and coins (which now make up less than 3% of the money supply) have resulted in money now mostly existing in electronic form as credit created by private banks. This could never have been envisaged by the architects of the 1844 Bank of England Act that banned the private creation of money by conferring a monopoly of issuance of notes and coins on the central bank.

3.5  The means of money creation and its allocation have significant economic, social and environmental impacts. The Bank of England's attempts to control retail price inflation does influence credit creation indirectly through interest rates and, more recently, quantitative easing, but essentially the quantity and allocation of money in the economy is determined by private banks.

3.6  Thus an inherent contradiction exists: a stable monetary system is a public good, money is backed by a state guarantee in the public interest and in this respect nationalised, but its creation and allocation is controlled by private banks motivated only by profit. It should hardly come as a surprise when private banks are bailed out by the taxpayer when the system crashes.

3.7  These features of banking make it more analogous to public utilities, natural monopolies or merit goods such as health and education, than to ordinary free market industry sectors. Retail banking underpins economic activity and has a related impact on social inclusion. Access to basic transactional banking services is increasingly important for full participation in the economy and for social justice. The cost of not having a current account and access to mainstream credit, borne by the most financially disadvantaged, can reach £1,000 per year.5 Forcing people into the arms of loan sharks and confining them to the cash economy provides fertile ground for criminal operations and tax evasion.

3.8  Although "public good" industries often incorporate market mechanisms and competition to great benefit, they are ultimately managed and regulated in the public interest and subject to democratic control. Broader economic, social and environmental goals take precedence over profit. We would argue for this reason alone that the structure of the banking market, the level of financial returns, the number of market participants and their scale and scope, are all appropriate and indeed essential subjects for regulation. There are further arguments for state intervention based on observed market failures which we examine next.


4.1  The banking sector displays fundamental flaws in approximating to anything close to conditions of perfect competition. Indeed, the nature of banking as outlined above is such that a laissez-faire approach will lead to less competition, not more, and even improving competition cannot of itself address all forms of market failure.

Deregulation destroys competition

4.2  Policy on banking regulation has been largely based upon assumptions, derived from neo-classical economics, of perfect competition and information that have no basis in reality. A rigorous and objective review of competition in the banking sector must start without making such deductive assumptions about how economies and markets work based upon hypothetical models of general equilibrium. It should take a more inductive approach based upon empirical evidence of what is actually happening in the sector.

4.3  Over the last three decades, regulators became exceedingly relaxed about competition in the banking sector, relying on the UK sector's international standing as proof of its competitiveness. Policy permitted an ever more homogeneous and top-heavy sector to develop. Consolidation, takeovers and aggressive acquisitions left the UK economy with fewer banking institutions and the competitiveness of UK banks in terms of their product offering to UK citizens and businesses was neglected. They have been, to a greater or lesser extent, doing the same things and offering customers the same products.

4.4  The sheer profitability of the financial sector makes it clear that the system is not competitive in the usual meaning of the term. Competition is meant to ensure that the lure of high profits will attract new entrants who will offer products at a cheaper price. The fact that this has not occurred suggests that there are major barriers to entry and that incumbent institutions are operating in an oligopolistic6 rather than in a competitive market. Over 85% of current accounts are now concentrated in the hands of the big five banks.7 This destruction of diversity has had profound effects:

The demise of relationship banking

4.5  These few big banks operate at an ever-more profitable distance from their customers, thanks to new, automated techniques such as credit scoring. "Relationship-banking" has gone in to decline, as employees with direct knowledge of borrowers have been shed in favour of centralised IT systems able to deliver more "efficient" computer ratings. However, homogeneity in approach to credit scoring leaves some sections of society underserved while decreasing system resilience as a small number of institutions chase the same group of customers and assess them in the same way.

Distorted incentives and short-termism

4.6  The recent problems in the system have been compounded by the way in which traders are remunerated on a very short-term basis, creating incentives to maximise short-term returns. Similarly, the financial "engineers" creating new products for the derivatives market are often paid immediately for the returns forecast over the whole term of the product. This creates potentially destructive incentives to develop products with a long "tail" of risk.

4.7  Institutions have converged on those activities that offer the highest returns, particularly over the short time horizons against which performance is generally judged in listed companies.8 There is little to be gained from accepting lower returns now to move into sustainable long-term sectors that may ultimately produce higher returns, if all your shareholders have left in the meantime for rivals posting better quarterly results.

Choice for whom? The lack of access to finance

4.8  As institutions stopped specialising, either geographically or by market sectors, less profitable activities - such as maintaining a branch network and providing financial services for low-income people9 - became ever more marginalised. The spatial and social dynamics of branch closure are important. Academic research shows that branch reductions have generally been greatest in more deprived and ethnically diverse areas, and lowest in more affluent ones.10 This means that where finance is available, it is often on exorbitant terms - a typical APR from the legal end of the home credit market, is 272%.11

4.9  According to the Campaign for Community Banking, the number of bank branches in the UK is now just 9,094 - 43% fewer than just 20 years ago.12 The UK has 197 bank branches per million inhabitants (including building societies). This compares with over 500 and 1,010 branches per million inhabitants respectively in Germany and Spain.13 Not only does Spain have more banks per head of population, they are also far better disbursed than they are in the UK. The UK has 162 banks14 compared with France's 450 banks15 and Germany's 2,000 banks.16 Both countries have a variety of banking forms, such as savings banks, co-operative banks, private banks, municipal banks and post banks that are firmly anchored in local communities. This helps explain the superior performance of these economies is providing access to finance.17

4.10  And, when we find a branch that is still open, there are fewer people to deal with any queries we have. Figures from the British Bankers Association (BBA) show that in the five years from 2003, Abbey reduced its staff numbers by 12,897, Lloyds TSB cut 15,058 staff, and the Royal Bank of Scotland, 11,200. Since the BBA data was compiled, Lloyds TSB announced plans to make 11,000 more staff redundant and RBS announced plans for a similar number of cuts.18

Withdrawal of support from local economies

4.11  Nor is it just a question of access for individuals. Access to banking is vital to the survival of retail and other services in many medium-sized rural communities and in less well-off suburbs, estates, and inner cities. If active people and small businesses go to bank elsewhere, they are likely to spend elsewhere, too. Those that suffer most from the loss of local amenities are the most vulnerable: older and disabled people, those with mobility difficulties, and carers.

Economies vs diseconomies of scale: Increasing returns means increasing risks

4.12  While economies of scale are important, they also bring dangers. The concept of "too big to fail" is well-documented and tends to allow returns to be increased by increasing the risk to the taxpayer. Crucially, the theory of diversification of risk through universal banking has shown to not hold true when a small number of very large banks all converge on similar portfolios. Shareholders should have control over their own risk diversification and have a broad range of divergent institutions in which to invest.

4.13  As financial institutions grow they move further and further from their customers, and the knowledge of the products they are buying, selling or trading inevitably suffers. The fact that the crisis was sparked by an international market in subprime mortgages in the United States, about which very few had any real knowledge or great understanding, underlines this point.


5.1  With others, nef has been advocating a series of reform proposals which are documented in previous publications,19 and for brevity we do not reproduce them here. Instead we focus below on one key theme: diversity.

Diversity of function

5.2  We need financial institutions to focus on specific functions and to do a good job, not to chase the latest bandwagon. Retail banking is a very different business from investment banking, but universal institutions that devote large resources to speculative activity put at risk their ability to provide core functions for their customers - payments, settlements, savings and loans. Government must see through its commitment to the creation of a Post Bank, Green Investment Bank, and Big Society Bank, which we suggest should be based closely on the recommendations of the Social Investment Task Force for a Social Investment Bank.20 However, we would also benefit from banks that focus on particular industries, customers and products.

Diversity of scale and location

5.3  Large banks, or rather banks that can service large customers, have their place in the ecology of finance, but we need many more smaller and medium sized banks that are not too big to fail. We need regional and local banks with the particular knowledge, experience and culture of the areas they serve. This notion is not fanciful as comparisons with competitor economies demonstrate. A vibrant Community Development Finance Institution sector should be encouraged by introducing a UK version of the US Community Reinvestment Act which would provide greater transparency over where banks deploy their capital - or more to the point where they choose not to.

Diversity of ownership

5.4  Britain has a long and proud heritage of mutually owned financial institutions. The sector was demolished in the 1990's to little good effect according to an All-Party Parliamentary Group inquiry.21 The government should seriously consider re-mutualisation as part of any forced demergers or sales by large banking groups. They should also remove the harsh and artificial constraints on the credit union sector, which is puny compared with competitor nations. While only about 0.5% of the adult population in the UK is member of a credit union, the equivalent figures for Ireland, the US, Australia and Canada are 45%, 30%, 20% and 16%, respectively.22

Key benefits of diversity

5.5  Greater diversity in the banking sector would:

—  help ensure that less profitable activities are not left behind;

—  provide greater clarity to savers about the use of their deposits and the potential risks and returns associated with a bank;

—  allow greater management focus at Board level on areas of banking that are considered overtly or covertly to be poor relations within large universal banks, and help reconnect senior management with high-street customers;

—  allow more focussed micro-prudential oversight, and

—  assist macro-prudential oversight and promote greater system resilience by creating "fire-walls" between different parts of the system.

We need a financial system that channels finance to ecologically sustainable activities that maximise long-term financial and social returns. We need to explicitly promote diversity and resilience as much as competition and choice, not least because the latter will be harder to achieve without the former.


For the reasons outlined above, we believe that a system that allows private control over a public good creates incoherence and instability in the banking system. We recommend that the Select Committee convenes a separate inquiry on the case for and against monetary reform, including the nature and operation of credit creation under our existing current system of fractional reserve banking, and allowing a thorough review of all alternative variations on creation and control of the nation's money supply.

September 2010


1 Merit goods confer positive externalities on the economy and society as a whole that are not enjoyed directly by the customer. This leads to too few of such goods and services being supplied in a free market, hence they tend to be subsidised or provided directly by the state.

2 Nissan S and Spratt S (2009) The Ecology of Finance (London: nef).

3 "…the fractional reserve system… permits the banking system to create money." (Federal Reserve Bank of Kansas City, 2001, p 57.); "The actual process of money creation takes place primarily in banks." (Federal Reserve Bank of Chicago, 1961, p 3); "At the beginning of the 20th century almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted." (ECB, 2000); Quoted in Werner, R, A, 2009, "Can Credit Unions Create Credit? An Analytical Evaluation of a Potential Obstacle to the Growth of Credit Unions", Centre for Banking, Finance and Sustainable Development, Discussion Paper Series, No 2/09, University of Southampton, School of Management.

4 Haldane A (2010) The $100 billion dollar question (London: Bank of England).

5 Thiel V (2009) Doorstep Robbery (London: nef).

6 An oligopolistic market is one where a handful of firms have control or extensive influence, enabling them to impose worse services or higher prices on buyers. A well-known example of this is the OPEC cartel of petroleum exporters.

7 Vickers et al (2010) Issues Paper: Call for Evidence (London: Independent Commission on Banking).

8 Public limited companies whose shares are listed and traded on stock exchanges.

9 Dymski G A (2009), The global financial customer and the spatiality of exclusion after the end of geography, Cambridge Journal of Regions, Economy and Society 2009, 2, 267-285; French S, Leyshon A and Signoretta P (2008) All gone now: the material, discursive and political erasure of bank and building society branches in Britain. Antipode, 40: 79-101.

10 Leyshon, A, French, S and Signoretta, P (2008) Financial exclusion and the geography of bank and building society branch closure in Britain. Transactions of the Institute of British Geographers, 33: 447-465. doi: 10.1111/j.1475-5661.2008.00323.x.

11  Provident Financial Group - see up-to-date information on lending rates at

12  French D (2009) Branch Network Reduction Report (London: Campaign for Community Banking).

13  Ibid.

14  List of banks compiled by the FSA on 30 June 2010. Accessed at

15  Accessed at
/$File/Chiffres_cles_des_banques_francaises_2007.pdf, p 10

16  Accessed at

17  Thiel V (2009) op cit.

18  Coney J (2010) Fury over Britain's vanishing banks, Money Mail, 3 February 2010. Accessed on 5 September 2010 at:

19  Simms A et al. (2010) Better Banking (London: nef). Simms A & Greenham T (2010) Where did our money go? (London: nef).

20  Cohen R et al (2000) Enterprising Communities: Wealth Beyond Welfare, report to HM Treasury, October 2000 (London: Social Investment Task Force) and Cohen R et al (2010) Social Investment: Ten Years On, report to HM Treasury, April 2010 (London: Social Investment Task Force).

21  Welch I (2006) Windfalls or shortfalls: The true cost of Demutualisation (London: ACCA).

22  Werner R (2009) Can Credit Unions Create Credit? An Analytical Evaluation of a Potential Obstacle to the Growth of Credit Unions, Discussion Paper Series, No 2/09, Centre for Banking, Finance and Sustainable Development, Southampton University.

previous page contents next page

© Parliamentary copyright 2011
Prepared 2 April 2011