Written evidence submitted by Sir Don
Cruickshank
NOTHING MUCH
CHANGES
Since the Banking Review of 2000, there have been
some 15 formal competition investigations of banking markets and
numerous other studies, some by the Treasury Select Committee.
Yet the competition analysis of the 2000 Review would broadly
stand today. There have been some advances eg money transfer and
governance of credit card infrastructure, but these are probably
outweighed by further concentration of supply, notably the creation
of the Lloyds Banking Group. This is an odd outcome. Why should
it be so? The answer, I believe, lies in understanding the nature
and effect of the "regulatory contract" between government
and banks. Chapter 2 of the 2000 Review described it thus:
"In return for cooperating in the delivery of
government objectives of delivering public confidence in the banking
system and avoiding systemic failures, the banking industry escapes
the rigours of effective competition. This leads to unnecessary
barriers to entry, discriminatory access to money transmission
systems, barriers to efficiency and innovation, barriers to consumers
switching suppliers and significant information problems for consumers."
Notwithstanding that over the centuries the banks'
side of this contract has been repeatedly broken, governments
across the world have systematically returned to it as the best
means of managing the flow of money through the economy and, in
particular, of effecting the art of transformation of short term
deposits into wealth producing long term investment. Governments
have, in principle, been right to do so. So the question is not
"How to get rid of this special regulatory contract and expose
banks to fully effective competition?" but the more subtle
"How continuously to modernise the regulatory contract in
the best interests of the economy at large?". That is the
question we asked and attempted to answer in the 2000 Review,
leaving the detail of the precise terms on which banks do business
with customers on say, credit card penalties or current account
pricing, to the competition authorities from time to time. We
found that the contract as it was in the late nineties was already
far too generous to the banks, their shareholders and managers,
and the Review's recommendations focussed on getting a better
balance between benefits for the economy and profits for the banks,
while keeping the essence of the contract "secure systemic
soundness" firmly in place. The government's response was
wordily positive eg "We will legislate to ensure that the
UK payments system is open to new competition" (Chancellor,
Budget Speech 2000). But nothing much happened, so not surprisingly,
nothing much has changed.
FAILURES IN
GOVERNMENT RESPONSE
There are at least three recommendations of the 2000
Review that still merit action today: that the industry specific
regulator (the FSA but now to be the CPMA ) should have a statutory
objective to promote competition in banking markets: that the
banking industry should be stripped of its control over the shared
network infrastructure over which banks provide services: and
the regulatory framework should provide better clarity and integration
of prudential and consumer protection regulation. There were other
second order recommendations that would be helpful if implemented
eg divestment in the markets supplying SMEs and provision of basic
banking services , but I would like to concentrate my evidence
on these three and to add an over arching comment on the sector's
failings.
COMPETITION OBJECTIVE
While we were conducting the 2000 Review, the FSMB
was wending its way through Parliament. It is often forgotten
that we published an Interim Report in 1999 "Competition
and Regulation in Financial Services: Striking the Right Balance"
recommending some profound changes to the Bill. It is appendix
F to the final report and may well be the most useful section
of the 2000 Review for Committee members to peruse. The Interim
Report was embarrassing for Treasury Ministers and officials and
led to a distinct breakdown of relations between the Review Team
and senior Treasury officials (notably Andrew Turnbull and Gus
O'Donnell) to the extent that one member of the bill team was
given, and presumably rewarded with a bonus for achieving, the
objective "minimise changes to the Bill following the BRT
report". Treasury officials' anxieties were understandable.
The Bill was on their own admission badly drafted. They said they
had almost 2000 amendments to get through Parliament. Our recommendations
were disruptive of the basic shape of the Bill. So we were rebuffed,
and the FSA came into being shorn of powers either to give proper
weight to the effect of their actions on competition or to pursue
banks for abuse of their dominant position. Only since John Fingleton's
arrival at the OFT has there been the energy to tackle the weakness
of competition constraints on banks' behaviour. Some of the OFT's
investigations have been useful, but taken together have not produced
material improvements for customers or the wider economy.
Therefore, my first recommendation is to accept the
case made in the 2000 Review's interim report and arm the new
CPMA with a primary objective to promote competition. I note that
in its only conclusion to date, the Vickers Commission concurs.
CONTROL OF
MONEY TRANSMISSION
SYSTEMS
However, this change on its own is unlikely to be
sufficient. We must also recognise that there are some serious
peculiarities in the banking system, and special rules and regulations
are needed if competitive dynamics are to operate to customers'
and the economy's benefit. Government intervenes with special
rules in many parts of the economy to good effect—for example
in utility markets and the delivery of health services where I
have some direct experience. Banking markets suffer from more
underlying problems than these other sectors.
The 2000 Review focussed on one such problem—control
of money transmission systems—the major source of banks'
market power and their capacity to consistently earn super normal
profits. Would we allow Google to manage the internet? Would we
allow BT to re-establish its control over the UK numbering system
and the terms of access to its dominant network? No. Never. So
why do we allow banks, acting in concert, almost absolute control
over the money transmission systems over which all financial transactions
take place?
The 2000 Review identified in some detail in Chapter
3 and Annexes D and E the authority that should be exercised by
an independent regulator over these systems, analogous to the
powers of Ofcom or ICANN. We were criticised at the time for recommending
the creation of another regulatory office but that was the necessary
logic of the Treasury's refusal to give the FSA the required authority
via the FSMA. It would now be possible, Treasury officials willing,
to give the CPMA those powers set out in the 2000 Review.
A second criticism levelled at the 2000 Review recommendations
on money transmission was that it wasn't clear what benefits would
flow from the actions of the new regulator. On rereading the Review,
I have some sympathy with the critics, so let me summarise the
case for such a change. Retail banking markets lack a dynamic
seen in most parts of the economy in that customers chose not
to switch supplier even after having been subject to high costs
and/or very poor levels of service. The obstacles to switching
are several. Most obvious is the cost to the customer of time,
hassle and, it is feared, the potentially costly disruption of
relationships with providers of other services who rely on standing
orders or direct debit payments. Despite recent improvements to
the switching process, this is still a major problem.
But there are other reasons for banking markets being
undynamic. Some products are very long term.. So, whether a product
or service is good value for money may not be obvious or easy
to judge for some time, so what's the rationale for switching
provider thinks the customer? Another reason is that the cost
of core banking services such as a current account is very hard
to compare—this is one reason, incidentally, why UK banks
are so tied to "free" banking. And finally, customers,
especially small business customers, fear that by switching banks
they may be penalised at some future date when they have a financial
problem. Surely, loyalty will be rewarded if they stay with their
present supplier? More fool them, as the current crisis has shown—and
not for the first time.
Interestingly, banks also face a problem here. For
a number of their products they don't know how expensive the product
is to provide until long after they have sold it. Loans, insurance
and annuities fall into this category. So, even if consumers are
willing to switch, the usual motivation on the supplier side may
be muted.
But for whatever reason, without this dynamic of
more people and businesses being able and confident to switch
banks and deal with multiple banks, managers of banks sleep easily
knowing that there is little chance of a sudden loss of market
share or profitability. Their pricing and service behaviour towards
customers betrays this knowledge and we have the anomalous situation
that the subsidy that the economy keeps paying into the banking
system (mainly in the form of cheap money) stays inside the banking
system, with far too much of it going to senior executives. The
fact that this subsidy doesn't get competed away and that banks,
even in dire times like today, make super normal profits is the
surest sign of uncompetitive markets. The fact that successive
formal competition investigations have failed to effect any material
change is because they focus on either behavioural remedies or
specific, quite slight , interventions in pricing of banking services
eg the requirement to pay interest on SME current accounts or
offer "free banking" to SMEs (CC 2000) or the requirement
to provide more information to customers. In my judgement, none
of these investigations in the last 10 years have effectively
improved the dynamic of banking markets.
Even new entry—and it is telling that we seem
to have had only one really new high street bank in the last 100
years, and that was this year—may not have the desired effect.
Making it easier for new entrants into retail banking may be missing
the fundamental point about these markets. Indeed the capacity
of investment banks, in markets where there is no shortage of
players, to hold onto the subsidy offered by cheap money makes
the point well. However, a regulator, armed with independent authority
over money transmission systems would make a huge difference,
certainly in retail markets where the current account market is
key. Why shouldn't a retail customer's bank account numbers be
personal and recognised as that by the systems used to communicate
between banks and to transfer value between bank accounts? Why
shouldn't the hassle and cost of transferring a personal account
from one bank to another be suffered by the banks and their engineers
(who incidentally, if my experience of introducing number portability
for telephony is anything to go by, would relish the challenge).
There are other changes that an independent regulator of money
transmission systems could deliver eg credit card transactions
at cost, but improving the dynamic of the market for current accounts
would be key.
Therefore, my second recommendation is to provide
for the CPMA to have the powers with respect to money transmission
systems set out in the 2000 Review.
INTEGRATION AND
CLARITY IN
BANKING REGULATION
But there is a pattern here. We have regulation that
is either narrowly consumer protection or prudential. Consumer
protection interventions use a conventional "normal"
competition framework of analysis. Prudential regulation floats
free from integration with market dynamics. Neither approach gets
to the bottom of the problem, and neither creates market dynamics
that operate in the customers' and wider economy's interests.
This, in my view, is unsurprising. Banking markets, more than
most markets, are highly interconnected systems with very high
levels of trading between the players. Recognition of that and,
therefore, recognition that consumer protection and prudential
regulation interact, is vital.
The 2000 Review wasn't asked to opine on prudential
regulation of banks but my experience of telecommunications regulation
said very clearly that competition in, and regulation of, a market
are inextricably intertwined. Indeed, all markets are regulated
to some degree. They are all man made. The questions to be answered
are "What regulation is required beyond the operation of
general competition law?" and "What regulatory structure,
statutory objectives and powers for the regulatory body or bodies?".
The 2000 Review identified serious weaknesses in the objectives,
structures and powers of the soon to be created FSA. The most
serious was the absence, anywhere in the regulatory regime outside
the general competition bodies, of an objective to promote competition,
and, to make things worse, structures and processes within the
FSA favoured the very banks (and other financial organisations)
being regulated. The absence of a duty to promote competition
is discussed above. Other recommendations are summarised in paras
23 to 35 of the Executive Summary to the Review. Some, but by
no means all were implemented by the government over the following
years.
These recommendations flowed from the fact that banking
markets are so different from other markets in the economy that
they must be subject to a whole raft of laws and regulations,
growing by the day, some national, some international, that have
as their principal objectives securing (1) systemic soundness
and (2) a level playing field for the operation of global banking.
These aspects of regulation are not, I know, the subject of this
enquiry by the Committee, but I would comment in passing that
any ill thought through unilateral action by the UK government
or regulators, sometimes even the discussion of such possible
action, on matters such as "breaking up the banks" or
"UK determined bonus arrangements" is harmful to the
UK economy—probably already has been harmful as the puzzled
enquiries I receive abroad about "what do you think you're
doing to London?" exemplify. This another example of the
network issue I touched upon earlier. The banking system is not
national. It is global. This does not mean that nothing can be
done locally (for instance my recommendations above would have
the effect of making UK banks more competitive internationally)
but it does mean that actions taken within a single jurisdiction
can have unexpected consequences unless this interconnectedness
is taken into account.
The 2000 Review, even though it was not faced with
the crisis of the past few years, nevertheless identified serious
weaknesses in these aspects of regulation and it made some specific
suggestions concerning the relationship between HMT and the FSA
and the operation of, or rather the predicted almost certain failure
of, the MOU between HMT, Bank of England and the FSA. Some of
these were about process and might have been helpful if implemented.
Others were more fundamental. For instance, uniquely amongst sector
regulators in the UK, the Chancellor has no powers to instruct
the FSA, although its powers to instruct the Bank of England are
untrammelled, save with regard to monetary policy. The naivety
of this policy was amply demonstrated from the Northern Rock debacle
onwards. The FSMA disapplies general UK competition law when a
firm's behaviour is required or contemplated by the FSA. This
is an unnecessarily wide defence. The MOU was (and continues to
be) silent on who makes the final trade off between different
outcomes. It is, and will continue to be, not "integrated"
in one organisation. Nor is it "hierarchical" with one
organisation having the final say. Neither is it "arbitrated"
by an outside body—although arguably the bond market de
facto plays this role! No, it is just seen as "no problem".
HMT's rather woolly consultation paper "A New Approach to
Financial Regulation" (July 2010) doesn't deal with this
issue. Indeed, at 3.15 is the giveaway: "the Government will
specify in secondary legislation precisely who does what"!
Therefore, my third recommendation is that the legislation
giving effect to the CPMA , PRA and consequential changes to the
Bank of England responsibilities and powers must address these
and other similar flaws in the present arrangements. An updated
analysis along the lines of the Interim Report of the 2000 Review
would identify the necessary policy. I am presently gloomy on
this as there is precious little in the Treasury's "consultation"
document to suggest that such an analysis is underway.
SYSTEM WIDE
FRAME OF
REFERENCE
There is one final point I would like to make in
relation to any competition or regulatory analysis of the banking
sector. My observation of the crisis, albeit from a distance,
is that a decade of failing to look at banking and financial services
as a system applies to the banks as well as the government and
regulators. There are very large (orders of magnitude) difference
between the gross and net assets and liabilities of the financial
system taken as a whole. The objective of the finance sector in
the economy is to provide services to the wider economy and to
customers. Banking is, after all, an intermediary service. How
then was that objective promoted by the ballooning of the gross
positions within the sector. The 2000 Review had a table showing
the gross liabilities of the major banks in 1999 totalling c1.2
x the UK's GDP. By 2007 that ratio was over 3. Over the same period
the total indebtedness in the economy doubled. Did that lead to
more efficient and effective services to the rest of the economy?
The industry claims this to be the case and justify the myriad
"innovations "because this is what they claim they achieved.
I have never seen any end to end, system wide, analysis that even
begins to justify this claim.
Much of this activity within the sector is also highly
compartmentalised, in part because of the complexity of banks'
"innovation". As was amply demonstrated at the time
of crisis, the banks did not seem to have a good picture of their
overall position, nor how one bit related to another, especially
in liquidity crisis mode. Now, in the aftermath of the crisis,
much of the problem seems to have stemmed from the banks not knowing
where their assets and liabilities really were, or the risks attached
to them. Each knew about its narrow activities, but no-one seemed
to know how they all fitted together, even within the same bank.
This ignorance—shared by the government and regulators—is
what allowed the alchemy to flourish. The apparent disappearance
of risk, the flawed mathematics, the generation of apparent not
real profits, the failure to distinguish between the creation
of value and the random outcome of necessarily uncertain investments,
and the outcome of complex zero sum games.
This sort of behaviour—by market participants,
government and regulators - would not be tolerated in other parts
of the economy that exhibit the same degree on network connectivity
and interdependence and the same importance to the economy. At
Oftel, I spent a lot of time developing rules that were more specific
than general competition law to make sure that the interconnection
conditions were right for both system stability and the right
competitive dynamic to serve customers. Ofgem and other regulators
have done the same. The internet has independent regulation and
rules. This does not happen by accident. It requires the regulators
and the firms affected by the regulation to understand how the
system operates and how to improve it. In financial services,
many of the issues have been left to the industry to resolve.
Not surprisingly, they have resolved the issues in their own interests.
Therefore, my final recommendation is that developing
some sounder system wide frame of reference for government, regulators
and competition authorities is required. This Committee's findings
would be a good place to start. And I am hopeful that John Vickers'
recommendations will improve our understanding of how better to
integrate sound prudential regulation and dynamic markets. There
is no silver bullet. Change is likely to be slow and steady—and
will certainly be opposed by the banks. In the meantime, action
"Monday morning" by the government and its agencies
is likely to be counterproductive and best avoided, especially
anything that risks the UK's position as a leading provider of
financial services to the world. In particular, the government's
rearrangement of regulatory structures needs to provide for HMT,
the Bank of England and regulatory agencies to have a shared system
wide frame of reference and an agreed process for making trade
offs.
November 2010
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