Written evidence submitted by Virgin Money
1.0 EXECUTIVE
SUMMARY
1.1 Retail banking does not seem very competitive.
It is dominated by five large banks with broadly similar products,
prices and customer service. As a strongly pro-competition new
entrant, we would like to see greater competition, and we believe
that competition in retail banking would benefit from more providers
and from greater diversity of providers. But smaller providers
and new entrants will make little difference to overall competition
in retail banking if entry is difficult, and if those which do
enter simply compete with each other for such switching business
as is available in a "two tier" market of large incumbents
and smaller providers.
1.2 Our view is that smaller providers and new
entrants will only be able to compete effectively with the larger
incumbents if actions are taken to reduce or eliminate some significant
barriers which are discussed in this paper. Our conclusions, from
consideration of these barriers, support our specific recommendations
at the end of this submission.
2.0 BACKGROUND
AND INTRODUCTION
2.1 Virgin Money was established in 1995. It
now has over two and a half million customers, and currently offers
a range of financial products across lending (including credit
cards), savings (including tracker funds) and protection (including
motor insurance).
2.2 Virgin Money's experience is that initial
entry to financial services through the provision of a limited
product proposition is not particularly difficult. We have maximised
income opportunities by concentrating on "transactional"
products such as credit cards and motor insurance, where customers
are willing to switch between providers, and have minimised costs
by outsourcing product "manufacturing" activities to
established providers, and by limiting access to direct channels—mainly
the internet.
2.3 Despite Virgin Money's success so far, we
recognise that this business model has some limitations. Because
of its limited product range and the absence of branches, it does
not appeal to all customer segments. In considering how to expand
our business to the benefit of a wider range of customers, and
become a credible alternative to large incumbent banks, we believe
that it is important for us to become a full-service bank, offering
"relationship" as well as "transactional"
banking products. As a first step towards establishing full-service
banking capabilities, to support our business expansion, we acquired
a small bank, Church House Trust, in January.
2.4 Our business plan to become a full-service
bank sounds simple. We aim to add a range of "relationship"
banking products—deposits, mortgages and personal current
accounts (PCAs), and, if possible, banking services for small
business (SMEs). To meet customer needs and expectations, we plan
to open a limited national branch network. And, to maintain our
"Virgin" reputation for product innovation and good
customer service, we intend to establish some in-house "manufacturing"
capabilities.
2.5 In planning this business expansion, we are
encouraged by the demand for Virgin to offer a credible alternative
to the large incumbents. Quantitative research from February 2010
shows that consumer consideration for Virgin as a banking provider
has grown to reach the same levels as the incumbent big four high
street banks (NatWest, Lloyds TSB, HSBC and Barclays). However,
despite consumer consideration on a par with the incumbents, we
observe that a number of barriers make the implementation of our
plan more difficult than it sounds—or, we think, than it
would be in many other industries. We discuss a number of such
barriers in the next section of this submission.
3.0 BARRIERS
TO ENTRY
AND EXPANSION
Market structure
Barrier
3.1 It is difficult for new entrants to compete
with the large incumbent banks in retail banking because of the
large banks' dominant market shares in most banking products,
particularly in the key relationship banking products, PCAs and
SMEs.
Commentary
3.2 The UK market in retail banking is highly
concentrated. Four large domestic banks (Lloyds, RBS, Barclays
and HSBC) and the UK subsidiaries of the large Spanish bank Santander,
together account for almost 90% of PCAs and over 90% of SMEs.
Lloyds Banking Group (formed by the merger of Lloyds TSB and HBOS)
alone accounts for 30% of PCAs and over 20% of SMEs.
3.3 In such a concentrated market, these five
banks enjoy competitive advantages from substantial economies
of scale in their operational and marketing costs, and from their
extensive branch networks.
3.4 Twenty years ago, there were many more providers
of personal banking services and a much greater variety of providers.
In addition to the "Big Four" (Barclays, NatWest, Lloyds
and HSBC), customers could choose as alternatives the two Scottish
banks (RBS and Bank of Scotland), the unique TSB, the converted
bank Abbey National and the about-to-convert Halifax, and a number
of building societies with national distribution including Nationwide,
Cheltenham & Gloucester, Woolwich, Northern Rock, Alliance
& Leicester and Bradford & Bingley. Many of these providers
were retail-only, and they competed effectively with the "Big
Four" by offering a different product focus or service proposition,
reflecting the priorities of their stakeholders. Now, in the UK,
there is no credible alternative to the large banks for full-service
banking, except to some extent Nationwide and the UK subsidiaries
of NAB.
Conclusion
3.5 The UK banking market has evolved to the
point where there is a limited oligopoly of incumbent banks that
have very little differentiation. As we will discuss in the following
sections (3.6 to 3.14), their control of the PCA and SME markets
makes it very difficult for a new entrant to compete effectively
and grow successfully in this market.
Personal Current Accounts (PCAs)
Barrier
3.6 In personal banking, PCAs are key "relationship"
products, enabling banks to establish long-term relationships
with their customers, to gather information about them and to
offer them other suitable products. However, PCA switching rates
are low, and it would take some time for a new entrant to achieve
scale in PCAs—during which time incumbent banks could respond
to threats from new entrants.
Commentary
3.7 We believe that "free" banking
contributes to the low rates of switching in PCAs:
- The widespread availability of "free"
banking means that all banks seem the same to consumers, and there
is no obvious financial incentive for customers to switch their
current accounts.
- Even if customers are considering switching between
current account providers, "free" banking means that
it is not easy to assess likely charges, and it is not possible
to compare the levels of service offered by different banks, except
by hearsay.
"Free" banking makes it very difficult
for new entrants to the PCA market:
- New entrants are not able to compete by offering
lower prices (than zero) or by innovating with simpler, lower-cost
products.
3.8 Of course, "free" banking is not
free. Free banking for good customers is subsidised by "insufficient
funds" charges, which are generally paid by customers who
are less affluent or less well-informed. We believe that it would
be fairer for all customers to impose or at least encourage a
more rational pricing structure, with lower insufficient funds
charges and with some appropriate fees for PCA services. As well
as being fairer, this more rational pricing structure would make
it easier for customers to compare their likely charges, and would
enable new entrants to compete on price and through innovation.
Conclusion
3.9 We recommend that the TSC should acknowledge
the need to bring fairness and transparency to current account
bank charges.
Small Businesses (SMEs)
Barrier
3.10 It is desirable that a new entrant to retail
banking should be able to offer SME as well as personal banking
services, to serve the needs of communities, including many small
businesses where personal and business activities are inter-related,
as well as to generate additional income to justify the necessary
investment in people, infrastructure and branches. However, organic
entry to SME banking is very difficult.
Commentary
3.11 To enter SME banking, a new entrant would
have to offer current accounts and other SME banking products,
recruit experienced customer-facing and credit personnel, and
invest in appropriate infrastructure—and would probably
have to open branches, since many SMEs visit branches frequently
for advice and to make payments. Credit management is also challenging
for a new entrant, without historic customer information.
3.12 Even if these could all somehow be resolved,
there would remain the difficulty of demonstrating a reputation
for good service in SME banking. SME banking is different from
many other businesses in that both the customer and the bank expect
a long term relationship in which the unquantifiable aspect of
service is as important as the quantifiable aspect of price. A
reputation for delivering the required quality of service can
only be achieved through being in the business. So, in a perverse
sense, an SME bank "has to be in the business to enter the
business".
3.13 A new entrant without a reputation would
find it hard to compete on price alone, because switching rates
of existing SMEs are very low, and new SMEs are offered free banking
for an initial period—and so, given the absence of a price
advantage from new entrants, new SMEs (and their financial advisors)
are likely to "play safe" with established incumbents.
Conclusion
3.14 Given the barriers to organic entry and
expansion, including the necessary up-front investment in people,
products, infrastructure and branches, the absence of a reputation
in SME banking and the time it would take to achieve scale, it
is clearly difficult for a new entrant to become a significant
challenger to the large incumbents within a reasonable period
by this route.
Growth by a new entrant through acquisition
Barrier
3.15 An alternative route, to accelerate entry
and expansion for a new entrant, would be the acquisition of a
suitable banking business. However, in practice, entry by acquisition
is difficult—possibly even more difficult than organic entry.
Commentary
3.16 Although theoretically attractive, it is
not easy to enter retail banking through the acquisition of a
suitable banking business:
- In the UK, no small banks with suitable characteristics
exist.
- It is clearly not possible for a new entrant
to buy a large incumbent bank.
- Acquisition of another new entrant would add
scale in "transactional" products such as credit cards
and insurance, but would not address the strategic objective for
a new entrant of entering the market for PCAs and SMEs, and establishing
branches.
- Acquisition of a building society would add capabilities
in mortgages and deposits, and branches, but the acquisition of
a mutual building society is a prolonged process and is vulnerable
to interloper risk. Other than Nationwide, building societies
have only limited regional networks.
3.17 It is extremely unlikely that incumbent
banks would wish to sell any of their core retail banking assets.
If such banking assets do become available, as a result of financial
difficulties experienced by incumbents, it is still very difficult
for new entrants to take advantage of such opportunities:
- The first of the EC-mandated disposals, the sale
of the RBS assets (in which Virgin Money expressed strong interest,
and for which it received indications of material financial support)
to Santander, shows that a new entrant can be beaten by an incumbent
which is able to deliver cost-saving synergies and funding benefits
by integrating the acquisition with its existing business, while
meeting the market share threshold set by the EC (regardless of
other competition issues).
Conclusions
3.18 Growth through acquisition is challenging
for a new entrant - and this makes the disposals being made of
RBS, Lloyds Banking Group and Northern Rock assets critically
important if further competition is to be introduced into UK banking.
3.19 These disposals should be subject to the
normal OFT/Competition Commission review on their likely impact
on competition in the UK, but in addition should also benefit
from a public interest test where the long-term economic implications
of proposals made to acquire the assets are understood. Such a
public interest test should consider, for example, the retention
of jobs and the commitment to lending made by a potential acquirer.
3.20 This will ensure that the RBS, Lloyds Banking
Group and Northern Rock disposals are not judged just on the short-term
economic value they deliver to shareholders, but also on the long-term
value they create for society, including stimulating greater competition.
3.21 In addition, the disposals of RBS, Lloyds
Banking Group and Northern Rock assets should be structured such
that there is a level playing field for banking incumbents and
new entrants (for example, by enforcing the provision of cost
cover for due diligence for all parties).
3.22 In particular, we believe a public interest
test should be applied to the RBS asset disposal before the transaction
is completed and the assets sold to Santander.
Regulation
Barrier
3.23 Basel II regulations place new entrants
at a financial disadvantage relative to the large incumbents,
despite the fact that retail-only new entrants such as Virgin
Money are essentially low-risk, while the large incumbent banks
have high-risk activities in investment banking, including complex
products and proprietary trading.
Commentary
3.24 Pillar I of Basel II prescribes how banks
must calculate capital for credit, market and operational risks.
New entrants, without a sufficient track record, must use a standard
approach. Large incumbent banks are allowed to use their own statistical
models to estimate their capital requirements, which have generally
been lower than would be required by the standard method, despite
the limitations of the models in extreme situations.
3.25 In addition to the Pillar I requirements
of Basel II, the local regulator requires additional capital to
be held under Pillar II for other risks, and for stress tests.
Although the local regulators' requirements for individual banks
are not disclosed, it is believed that new entrants may be subjected
to more onerous requirements, compounding the Pillar I imbalance.
3.26 The disadvantage of requiring proportionately
more capital is not particularly onerous at entry, when the amounts
of capital are relatively small. However, as a new business expands
and requires more capital, the cost disadvantage from having to
carry proportionately more capital could become a significant
barrier.
Conclusion
3.27 A level playing field in capital requirements
between incumbents and new entrants would reduce this barrier
to new entry and expansion, and would encourage greater competition.
Given the riskiness of the business models of large banks, and
the limitations of their risk models, our conclusion is that a
level playing field should be achieved by requiring large banks
to hold at least as much capital (proportionally) as new entrants—and
perhaps more at some times in the economic cycle.
Government initiatives
Barrier
3.28 It seems unlikely that a more competitive
market in retail banking will emerge unless the authorities are
willing to impose more pro-competition measures than have so far
been indicated.
Commentary
3.29 Policy initiatives over recent years have
been disappointing for new entrants. The Cruickshank Review quantified
"excess profits", but did not suggest structural changes
or actions to improve competition. The Supreme Court failed to
support the OFT ruling that current account insufficient funds
charges should be reduced, preventing the possibility that banks
might start to charge for some current account services, to offset
their reduction in income—a move which, we believe, would
have encouraged greater competition and more switching in PCAs.
The acquisition of HBOS by Lloyds TSB was allowed.
3.30 Although only two of the five large banks
(RBS and Lloyds) received state aid, all banks benefited from
actions taken to protect the banking system, and now they all
benefit from being perceived as "too big to fail":
- There is no incentive for customers to move deposits
from a state-aided bank, or from a bank that is "too big
to fail".
- In an environment where bank lending is restricted,
banks have greater power than their borrowers to determine the
availability and pricing of loans.
- The large banks, whether overtly supported or
not, are all benefiting from funding rates lower than they would
otherwise be—and lower than new entrants.
3.31 These factors make it difficult for new
entrants to benefit significantly from the financial and reputational
difficulties suffered by many large banks in the financial crisis.
In other industries, where large providers are not protected,
strong challengers can gain at the expense of weakened incumbents.
3.32 Banking initiatives have tended to concentrate
on one aspect of banking at a time, without considering the possible
unintended consequences on other aspects. In particular, the need
to create a more competitive framework has been subordinated to
financial stability issues. We therefore welcome the current initiative
by the OFT and the TSC to look at competition in retail banking,
and the establishment of an Independent Commission to consider
at the same time financial stability, possible reforms and competition.
3.33 However, it is disappointing that, while
the sale of Government-owned shares in RBS and Lloyds have been
deferred until after the Independent Commission has reported,
and will be sold with a view to encouraging greater competition,
the disposal of RBS's retail banking assets, which could have
been a key component in the creation of a more diverse and competitive
retail banking market, has been allowed to proceed.
Conclusion
3.34 In view of the continuing benefit that all
large banks are gaining from their "too big to fail"
status, we believe that the Government will have to introduce
some significant legislative or regulatory reforms such as those
recommended below, to redress the detriment to competition caused
by the "too big to fail" status of large banks and by
the prioritisation of financial stability above competition, and
to deliver the cross-party pre-election consensus of the need
for a more competitive and diverse retail banking market.
4.0 RECOMMENDATIONS
4.1 Structural reforms
Consider splitting large retail banks into smaller
units as well as to splitting large banks between retail banking
and investment banking.
4.2 Current accounts
Acknowledge that the ending of the apparently unfair
cross-subsidy in current accounts caused by unauthorised overdraft
charging would be fairer for all customers, and would enable competition
in the PCA market to be more easily created.
4.3 Regulation
Remove any regulation which, however well-intended,
is unfairly onerous for new entrants to retail banking and could
therefore discourage new entrants.
4.4 New entrants
Consider what legislative or regulatory reforms are
required to encourage the creation of new building societies,
banks, credit unions and community banks, as the Conservatives
promised before the election.
4.5 Acquisitions
In relation to retail banking assets being sold now
or in the future, take a wider view of public interests (including
in particular the expected impact on competition) than has been
the case during previous banking consolidation.
September 2010
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