Competition and choice in the banking sector

Written evidence submitted by the Financial Services Authority

1. We are submitting this memorandum as part of the Committee’s inquiry into competition and choice in the banking sector and in advance of our evidence session on 23 November. The initial sections cover:

· the FSA’s overall role and responsibilities in relation to competition;

· the consolidation of banks and building societies;

· new entrants into the banking sector; and

· the FSA’s consumer protection activities and competition.

2. The final section of our memorandum offers some broader reflections on competition issues in financial services and explores how these could be taken forward in the future regulatory regime in the UK.

The FSA’s overall role and responsibility in relation to competition

3. We are not a competition authority and do not have a statutory objective to promote competition. However, under the Financial Services and Markets Act (FSMA) we must have regard to the need to minimise the adverse effects on competition that may arise from our rules, guidance and policies, and to the desirability of facilitating competition between those subject to our regulation. Under FSMA, the Office of Fair Trading (OFT) must keep our rules and practices under review and consider whether they have a significantly adverse effect on competition. If the OFT considers that they do, it may make a report to the Competition Commission. Ultimately, this could result in the Treasury requiring us to take specific action to remedy a situation. [1]

4. M uch of our work is focused on addressing market failures that affect our ability to deliver our statutory objectives. These market failures include information problems (e.g. poor explanation of the key features of a product) , negative externalities (e.g. when the failure of a bank causes depositors of other banks to withdraw deposits, resulting in a run on th ose bank s ) and moral hazards (e.g. if a bank knows it is protected by a lender of last resort, it may make riskier decisions than it would if it were not protected). In developing policy to address these, knowledge of how competition works in the relevant market(s) and a thorough assessment of the likely effect of proposals on competition are key to achieving the desired outcomes, and may be relevant in public law terms to our decision on whether we take action. We undertake this assessment by conducting market failure analyses and publishing a cost-benefit analysis (CBA) with any proposed changes to our rules. Our CBAs for strategic policy initiatives consider the impact of proposed rules on the effectiveness of competition. For example, in our analyses prepared to support our Mortgage Market Review (MMR) and Retail Distribution Review (RDR) we commissioned competition impact assessments of our proposals, which became an integral part of our CBA.

5. Many of our rules implement European Directives designed to increase competition within the internal market. Some European legislation specifically precludes us from taking economic considerations (of which competition may be one) into account when taking certain decisions. For instance, the Capital Requirements Directive prohibits member states from examining an application for authorisation by a credit institution in terms of the economic needs of the market.

Consolidation of banks and building societies

6. There are two major types of bank and building society consolidation:

· mergers and acquisitions, which aim to achieve scale and scope economies, better efficiency and improved financial metrics; and

· consolidation, which supports one critically weak firm by merging it into a stronger one.

7. In our supervisory capacity, banks and building societies must satisfy us that a proposed merger can be properly undertaken and that, for example, the merged institutions will have a viable business model, adequate capital and liquidity , and will not lead to detriment for the customers of the two merging entities . We expect to discuss a proposed merger with the firms involved early on to address these issues before they make a public announcement. We engage with firms to ensure t hey review all available options. For building societies , this includes a consideration by its board of whether members’ interests would be best served by merging with another, stronger society. When a firm’s board decides a merger is the best option, we work closely with the firm to facilitate the process. Our key priority in reviewing proposed mergers and acquisitions is to ensure the prudential soundness of the merged firm, to maintain stability in the financial system and to protect consumers. We do not consider the impact of the merger on competition in the relevant sector. The OFT undertakes an initial review of any competition issues arising from such mergers.

8. Our intensive supervision approach has led us to take a more challenging and intrusive stance on mergers and acquisitions than in the past. For a number of mergers or acquisitions over the last 18 months, we have been at the heart of the analysis and judgements being made by the relevant firms’ senior management, ensuring that customers’ interests are protected, that there are financially viable plans in place, that integration does not bring undue regulatory risk and that management and governance are able to deliver. In the past our role was more passive in assessing the change of control of the firm, and much later in the process.

9. We will continue to proactively challenge acquisitions, as we recently did in relation to the proposed Prudential takeover of AIG’s Asian operation, American International Assurance. However, our focus will remain on the prudential soundness of the merged institution rather than on the impact of the merger on competition in that sector.

Our role in the consolidation of banks

10. Before the 2007 to 2009 crisis, most bank mergers in the UK aimed to achieve economies of scale, efficiencies and better financial metrics. Since the start of the crisis, most consolidations have arisen because a critically weak firm required support (e.g. the HBOS-Lloyds TSB and Alliance & Leicester-Santander mergers). Working closely with the Treasury and the Bank of England, we have been involved in negotiating the consolidation transactions and their terms and conditions, as well as their suitability and longer-term viability, and any potential detriment to the firms’ clients. For instance, we conducted stress-testing and peer-analysis exercises before we approved the transactions.

Our role in the consolidation of building societies

11. In relation to building society mergers w e have a prudential supervisory role (under FSMA) and a regulatory role (under the Building Societies Act 1986 – ‘the Act’) . The Act sets out the regulatory procedures and processes to be followed in mergers , including three roles we must undertake: giving consent (if we deem it appropriate) for the merger to be approved by board resolution (if requested); approving the Transfer Statement sent to members requesting their agreement to the merger; and confirming the merger against statutory confirmation criteria (if these have been satisfied) , after considering any representations from members .

12. In addition to mergers that have come about solely on the basis of discussions between two boards, where a building society is under financial pressure, including where it is considered it may not be viable as a continuing basis, we engage proactively with the board to ensure it reviews all available options. This includes whether the interests of members would be best served by a merger with another, stronger building society. Where a board then decides that a merger is the best option, we work closely with the society to facilitate the process, while at the same time ensuring that it carries out effectively and appropriately its regulatory functions under the Act.

13. If we consider it will best protect shareholders’ or depositors’ interests, we can use our regulatory powers under the Act to direct a building society to merge with another society (without a vote being required ) . We used this power four times in 2008 and 2009 ( in relation to the Derbyshire, Cheshire, Barnsley and Scarborough Building Societies).

Our role in support of credit unions

14. We recognise that credit unions contribute to competition in, and the diversity of, financial services markets. Successive governments have generally seen credit unions as a way to combat financial exclusion and provide services to people who are not served by mainstream financial institutions. We register credit unions under credit union legislation and regulate them under FSMA. To improve the resilience of the sector , we are planning to increase the minimum levels of capital and liquidity required by most credit unions and to focus our supervision on credit unions’ governance standards. These plans are proportionate, supportive, and take account of the special characteristics of credit unions. They will come into effect at the same time as a Legislative Reform Order , which aims to increase the extent to which credit unions can be an alternative to other institutions. We support these reforms, and have worked closely with the Treasury to ensure they are consistent with our regulatory responsibilities.

New entr ants into the banking sector

15. Our overall philosophy is to encourage new entrants in financial services, on the basis that it is , in principle, good for consumers. We facilitate competition by operating a transparent and efficient process for considering applications from new entrants. Our role remains, however, an enabling one; we do not proactively seek to generate new applications.

New authorisations

16. Since 2008, several new banks have gained authorisation (see the table in paragraph 17). Some are new entrants to the UK market while others are the result of an internal reorganisation and the creation of a new legal entity requiring authorisation. There has only been one new ‘start up’ retail bank since 2008 – Metro Bank. In addition to those that have gained authorisation, seven withdrew their applications, with four re-submitting when they could meet the threshold conditions.

17. The details of bank authorisations since 2008 are as follows:



Intelligent Management Services Ltd

European Finance House Ltd

Guaranty Trust Bank (UK) Ltd

Macquarie Bank International Ltd

The Access Bank UK Ltd

Gatehouse Bank Plc

First Rand Bank Ltd

Intercontinental Bank (UK) Plc

DBS Bridge Bank Ltd [1]

China Construction Bank (London) Ltd

Northern Rock plc [1]

Emirates NBD PJSC

Metro Bank PLC

Export Import Bank of India

Bank of Ceylon (UK) Ltd

As well as the new authorisations listed above, we allowed one firm to vary its permission to become a bank and four UK banks have been subject to a change in control.

The authorisation process

18. T o be authorised, banks must meet our threshold conditions in relation to legal status, location of offices, suitability and adequacy of resources. In addition , they must have no close links that could prevent effective supervision.

19. As part of intensive supervision we have strengthened our scrutiny of new applications, whether they are new start-up banks or existing authorised firms applying for deposit-taking permission. We have lea r nt the lessons of the financial crisis and consider it critical that only prudentially sound and well - managed firms enter the banking sector. We also now place much greater emphasis on the role of senior management in firms and interview individuals holding Significant Influence Functions, such as the Finance Director. Our aim is to ensure that new entrants to the banking sector do not pose risks to consumers, financial stability or market confidence.

20. Our authorisation process is necessarily robust, and we do not consider it to be an unfair or unreasonable barrier to entry. Following feedback from firms seeking authorisation we have implemented a number of improvements to support applicants and help create a smooth process, while maintaining appropriate entry standards:

· We encourage potential applicants to attend pre-application meetings with us. Through these we can better understand the applicant’s business model and offer tailored guidance on the threshold conditions and how applicants can provide evidence that they meet them.

· While processing the application, where appropriate, we provide a letter saying we are ‘minded to’ approve the application subject to any remaining conditions being met.

· We keep applicants better informed about how their application is progressing.

· We have updated our website to explain the high-level framework within which deposit-taking applications are assessed.

Foreign entrants

21. The nationality of bank ownership is not a factor we take into account when determining whether to grant an authorisation. In the European Economic Area (EEA) the principle of a single home country authorisation applies. Under this principle, a bank authorised in an EEA country can conduct business in other EEA countries without being subject to further authorisations by the host countries. The standards applied on entry vetting are agreed at European level in EU law. The EU is currently establishing European Supervisory Authorities to ensure consistent supervisory standards that will help prevent the problems suffered in the crisis.

FSA consumer protection activities and competition

Our overall consumer protection strategy

22. Our overall approach to consumer protection has historically been principles-based and essentially reactive. We have tended to focus on high-level systems and controls analysis and information disclosure by firms to consumers, and we reacted to crystallised risk and consumer detriment when observed. This approach reflected among other things our view that, equipped with the right information, consumers could exercise informed choice on which products and services were suitable for their needs. It was also designed to help improve competition on quality and price between suppliers through consumers understanding and comparing the quality and costs of financial products and being able and willing to shop around.

23. However, in the light of experience we have concluded that, overall, a more interventionist approach is required. Our new conduct risk strategy (launched in March 2010) signalled a move to a more prescriptive regime. We now seek to proactively intervene earlier in the product’s life cycle (influencing product design, not just sales and marketing processes) to anticipate consumer detriment and to stop it before any significant detriment is caused. This strategy includes analysing business models, using intensive supervision to identify and mitigate conduct risks, using enforcement tools more aggressively, making sector-wide interventions and improving the delivery of redress to consumers.

The role of consumer information in consumer protection

24. Our rules on product disclosure and financial promotions aim to support informed decision-making by consumers . For instance, we require a standardised form of charges disclosure for investment products to h elp in the comparison of product costs. And w e regularly sample the quality of the information provided by firms to consumers and require them to improve it where necessary .

25. However, although we supervise and enforce our rules to ensure retail consumers receive the prescribed disclosure documents, there is substantial evidence to suggest that consumers generally do not use the information provided to make decisions or shop around. Even when they read the documents, research indicates that many find them daunting, with some terms difficult to understand. Products are becoming increasingly complex (the growth of the structured product market is one example), and as a result it is increasingly difficult for consumers to understand descriptions of a number of mainstream retail products. Even when consumers read and understand the prescribed documents, they may rely on other sources of advice, such as friends and family. As part of our new conduct risk strategy, we acknowledge the limitations of disclosure, by itself, to facilitate effective consumer choice and to secure good outcomes for consumers.

26. At the same time, we recognise that consumers need skills and confidence to make the best use of information provided by firms. The Financial Services Act 2010 established the Consumer Financial Education Body to take forward the financial capability work we previously undertook and to help consumers understand financial matters and manage their finances better.

Banking Conduct Regime

27. We took over regulation of banks’ and building societies’ conduct of retail banking services (excluding non-mortgage lending) on 1 November 2009. This replaced the previous self-regulatory regime under the Banking Code. Our new rules help consumers make informed and timely decisions, so they can choose the best accounts and know what they are entitled to expect from their account providers. The rules require banks and building societies to provide important information at the points when people really need it. Banks and building societies must also provide a prompt and efficient post-sale service, such as when switching accounts. This should help to enhance competition.

28. In line with the overall approach outlined above, we intervene early when we find that banks and building societies are not meeting expected standards. For example, earlier this year, we found that firms were not dealing with unauthorised transactions properly, as they were failing to provide immediate refunds to their customers. All major banks and building societies (representing around 90% of the current account market) have now improved their processes so that customers get the immediate refunds to which they are entitled. We are monitoring this to make sure it is happening.

Retail Distribution Review (RDR)

29. Competition problems can also arise in markets where there are large numbers of participants. Although the market for retail investment advice in the UK is very diverse – involving banks, building societies, thousands of independent financial advisers and other players, competition is hindered by information and incentive problems, with the result that firms’ and customers’ interests are not aligned in full. We set up the Retail Distribution Review to review how investment products are sold in the retail market and to address these problems. Our new rules, in force from 2012, will apply to all firms that give investment advice, including banks. The changes aim to:

· improve the clarity with which firms describe their services to consumers;

· address the potential for adviser remuneration to distort consumer outcomes; and

· improve advisers’ professional standards.

30. Banks, like other investment product providers, will no longer be able to offer commission in return for adviser firms recommending their products. Instead, adviser firms will charge for their services. Equally, where they distribute through in-house investment advisers, banks must separate their product and adviser charges to ensure equivalent standards apply across the whole industry.

31. In preparing the RDR, we commissioned an analysis by economic consultants [2] of the impact of the proposals on competition and the supply of advice. They recognised that market exit by firms may lead some consumers to experience reduced choice in the short term. However, even if demand outstrips supply, the consultants reported that entry barriers are unlikely to be prohibitive and, in the longer term, new entry or expansion by existing players is likely to fill the gap.

Broader reflections on competition in financial services

32. The reform of the regulatory structure in the UK, including the establishment of the Consumer Protection and Markets Authority (CPMA) , provides an opportunity to improve consumer protection legislation and regulation in the light of experience. In this section we set out five issues which we suggest the Committee may wish to consider :

· the nature of effective competition;

· the right level of concentration;

· the consequences of ‘free banking’ and other forms of bundling for competition;

· a possible competition mandate for the CPMA; and

· potential structural options for a competition mandate for the CPMA .

And we conclude with some observations on the relationship between competition and financial stability, on which the Committee has invited comment.

Effective competition

33. We believe that, generally, effective competition works in consumers’ interests and leads to better products, services and outcomes for consumers. To achieve our statutory objectives, we seek to remedy underlying market failures, such as information asymmetry and negative externalities, which prevent competition from being effective.

34. The OFT and the Competition Commission have found important competition weaknesses in markets related to retail banking, including the provision of current accounts, lending to small businesses, and payment protection insurance. As a sectoral regulator with a different kind of remit, the FSA starts from a different place. We allocate resources in response to the risks of consumer detriment or of negative externalities in the markets we regulate. However, when we act to limit those risks, we have to take into account how competition works in those markets in analysing why the risks arise. We also consider the impact on competition of different options to resolve them.

35. It is crucial to understand, however, that the concept of competition relates to more than market concentration. Our experience suggests that in financial services non-size based barriers are more important. As noted earlier, competition can be ineffective even where there are many providers. It can also be difficult for consumers to understand and compare products and their charges – particularly if the product is complex. Besides, in many markets, such as long-term investment or insurance products, consumers often cannot learn from their mistakes in ways that allow them to discipline providers. In such circumstances, firms may seek to benefit from using opaque charging structures or lowering quality levels.

36. As noted above, through the RDR we are implementing major structural changes in the investment advice market to align intermediary and consumer interests. Due to a combination of information problems and mis-aligned incentives the demand side of this market has not adequately responded to differences in the prices and quality of products and services firms offer. This kind of demand-side weakness is characteristic of retail markets that do not work well: as a result even where there are only a few providers, the main reason why competition is ineffective is down to non-size based factors.

37. Overall, our experience leads us to believe that it is inherently more difficult for competition in retail financial services to be as effective as it is in other consumer sectors. In retail financial services a contestable market with a number of providers and clear product information is often a necessary but not sufficient condition for good consumer outcomes. In response to the persistent and sometimes intractable market failures outlined above, our new conduct strategy takes a much more direct approach. It seeks to achieve, through regulatory action, outcomes which should have been delivered by effective competition.

38. Nor are wholesale markets immune from weak or distorted competition, through incentive effects and information problems. For example, there is now broad consensus that competition in the market for credit ratings was not working well and that this ultimately had adverse effects on financial stability. We also note the OFT’s investigation into competition in providing investment banking services.

What is the right level of concentration?

39. The right level of concentration in financial services is one that balances consumer and producer benefits so consumers benefit from the lowest price that is consistent with producers earning a risk-adjusted return equal to their cost of capital. This ensures that producers fully account for all the risks they incur in providing financial services. In theory, the market will tend to this level of competition if it is contestable and free from subsidies that favour particular producers. By ‘contestable’ we mean the ability of a producer to easily enter and exit the market.

40. The EU single market has helped remove regulatory barriers to contestable markets in UK financial services. Under EU Directives, credit institutions in other EEA member states enjoy freedom of establishment and freedom of services. EEA firms from outside the UK, such as Santander UK, have a considerable presence in the UK banking services market and have contributed significantly to competition in the UK.

41. It should be noted that competition in the banking sector derives not only from other banks, but also from other products that are substitutes for the credit and deposits that banks offer. For instance, non-banks provide credit in the form of bonds, trade credit and store credit, while savings can be invested in bonds, unit trusts and other securities – not just deposits.

42. Competition takes place within a broader social policy context. Deposit guarantees effectively standardise the risk that an insured deposit represents: it may tend to push competition toward being based on return alone rather than on a combination of risk and return. To the extent that governments follow a ‘too big to fail’ policy, this effect would extend to wholesale funding as well as retail deposits. But correcting such distortions is not something that competition policy can cure – that is for resolution policy.

43. Competition will not necessarily correct shortcomings in the ability of consumers and/or businesses to evaluate financial products. Society therefore considers it necessary to require firms to take measures to ensure that their products are suitable for the client, that loans are affordable and that customers are treated fairly. These are requirements that all producers must meet, and they impose a mixture of fixed and variable costs on firms. Ultimately, customers in aggregate must pay for these costs, if financial firms are to earn a sufficient return.

Consequences of ‘free banking’ and other forms of bundling and cross- subsidisation on competition

44. One factor which affects the ability of new institutions to enter the banking market is so-called ‘free banking’. Consumers in credit typically receive minimal interest on their balances and lose interest during settlement: the interest on these balances and flows give banks a major source of income. In return, consumers receive a bundle of services at no cost, including payment and collection services and, in some cases, a committed overdraft facility without the payment of a commitment fee. During the crisis, the volume of transaction services provided to consumers has remained steady or has risen slightly; the compensation banks have received for providing those services has fallen (due to the decline in market interest rates, consumers are forgoing less interest in exchange for services). So the price of transaction services has fallen.

45. We have also seen the number of customers with packaged accounts increase significantly over the last few years. Customers pay a monthly fee for these accounts, which include a mixture of banking services, insurance policies, and unregulated services. We believe that over 14 million customers hold such accounts. These accounts now provide a significant source of fee income for banks.

46. It is possible that ‘free banking’ is one source of limited competition in the retail markets in which banks operate. The OFT has stated that the opaqueness of the effective costs to consumers (implicit in the free-in-credit model) reduces the incentives for banks to compete on these costs. However, previous OFT studies have also highlighted brand recognition and branch networks as key challenges to successful competition in retail banking. This is probably why the main interest in entry comes from large firms with strong brands, or from large overseas banks, and takes the form of competition to purchase established networks and customer bases.

47. Current accounts are of course only one part of the services provided by banks. Cross-subsidisation arises in the retail banking business model not just through packaged products, but in other ways. The model is based on providing a range of services such as deposit-taking, savings accounts, home loans, unsecured credit, and insurance. Cross-selling and cross-subsidisation are integral to this model, and the advantages of offering a portfolio of services can have major effects on the scope for entry. It would be very challenging for firms to enter and compete solely as deposit-takers against banks providing an integrated portfolio of services. Similarly, it would be difficult for a firm to enter the loan market profitably as it risks taking on poorer quality credit, as shown by the experience of the former building societies which competed aggressively in mortgage lending. Overall, there are strong drivers forcing potential new entrants to adopt an integrated model, and this acts as a barrier to entry to any firms without substantial resources and banking expertise. This barrier is in addition to the need to have a branch network and trusted brand .

48. If banks were required to charge for in-credit banking services, consumers might be better able to understand and compare these charges, so providing a greater incentive for them to switch banks and for banks to compete on the level of these charges. However, the complexity of banks’ business models, barriers to entry such as branch networks, and the weakness of demand-side disciplines, means there can be no guarantee that the charges paid by consumers would fall or that this would create additional opportunities for new entry.

Competition mandate for the Consumer Protection and Markets A uthority

49. The government proposes to provide the CPMA with a primary objective of ensuring confidence in financial services and markets, with a particular focus on protecting consumers. This provides an opportunity to consider afresh whether new regulatory approaches, such as a competition objective, should be part of the CPMA regulatory toolkit. There are several issues to consider in this debate, including the need for adequate analysis, powers and challenge. As noted above, we have adopted a more interventionist conduct strategy due to the persistence of ineffective competition, information problems and incentive problems in retail markets. To protect consumers effectively, the CPMA must also be able to recognise and understand how the particular conduct problems it deals with may arise from ineffective competition. In doing so, it could build on our consumer protection strategy and consider what role competition tools could play in its consumer protection toolkit.

50. It is clear that, in order to discharge its responsibilities, the CPMA will have to analyse problems related to whether there is a competitive working market. The issue will be how the CPMA will interface with the competition authorities, so their powers can be brought to bear where structural remedies or other competition policy tools are needed to protect consumers.

51. The new framework will also have to take into account the uncertainties and limitations around the use of regulatory tools, and to manage the risk that some interventions may distort the way competition works. One way to mitigate this risk would be for the CPMA, in addition to carrying out CBAs, to be obliged to monitor markets and to review the impact of regulatory interventions.

Potential structural options on a competition mandate for the CPMA

52. There are three broad ways that the CPMA could take competition considerations into account. These are for the CPMA to inherit the existing FSMA requirement to have regard to the need to minimise the adverse effects of regulation on competition and the desirability of facilitating competition (see paragraph 3 above); the removal of this requirement, to allow the CPMA to focus purely on consumer protection; and for the CPMA to have a more explicit competition mandate.

53. If the CPMA has a more explicit competition mandate, there are at least three ways in which it could be delivered.

· A mandate to deliver better markets for the benefit of consumers through specific market interventions The CPMA could be explicitly directed to deliver effective competition in retail markets by intervening to remedy market failures, but falling short of intervening to change industry structures or market concentration. The simplest way of requiring this would be by giving the CPMA the power to make its own market references to the competition authorities. This power could of course be allied with changes to the mandate of those authorities. There are also other options, including:

o giving the CPMA the power to make rules on competition and consumer protection grounds;

o using powers that currently sit in the FSA to make rules on abusive product features or charging structures where it deems this necessary – short of requiring product approval; and

o conducting periodic market studies, with the necessary resources and powers to obtain information and to follow up as appropriate.

These interventions, deployed in a way careful to minimise the risk of harmful unintended consequences, would seek to ensure effective competition that would deliver good value products to consumers.

· A mandate to deliver structural change The CPMA could be asked to deliver better outcomes for consumers through structural change in markets. There may be markets where competition can be made more effective by increasing the number of providers. However, as previously noted, competition in retail markets can be ineffective even where there are many providers and products. In this case, the typical structural approach – breaking up firms – may not improve the position. The kind of structural change that is more relevant to consumer protection may often be forcible separation of bundled products in certain markets, as the Competition Commission has concluded is necessary for the sale of certain kinds of payment protection insurance.

· A mandate to deliver economic regulation on the model of utilities regulators In one sense, the CPMA will inevitably be an economic regulator, as we are now, as it will seek to achieve better outcomes for consumers – with some combination of lower prices and better quality by affecting market incentives and influencing how competition works. However, most financial services markets are not characterised by the same kind of natural monopoly power as utility networks. Retail financial services markets offer a higher number of products, which are also more varied. Setting efficient prices for more than a handful of retail financial services or products would be a task beyond any conceivable regulatory model. Price regulation would directly affect firms’ business models and their ability to raise finance, so it would have to be closely coordinated with the Prudential Regulation Authority. Price regulation in financial markets could be carried out by the CPMA or another body.

Relationship between competition and financial stability

54. There is a complex relationship between competition and financial stability. Reflecting this, the government has set up the Independent Commission on Banking, chaired by Sir John Vickers, to consider the UK banking sector’s structure and look at structural and non-structural measures to reform the banking system and promote competition reducing systemic risk, moral hazard and the likelihood and impact of firm failure, while ensuring that banks’ customers and clients’ needs are met. However, it is important to note that, although the UK banking sector may look concentrated relative to Germany and US, this is not the case relative to Australia, Canada, France, the Netherlands, and Sweden. It is also notable that some of the countries perceived to have had weathered the financial crisis better than others (Australia and Canada) have concentrated banking industries.

55. The objectives of competition and financial stability can be in conflict, but they can also be mutually complementary. On the one hand, more competition in banking could lead to more risk-taking by banks. Taking on more risk is not necessarily problematic for banks, as long as the risk is accurately priced and fully capitalised. Banks may seek to maintain profit rates by taking on more risk on other parts of their balance sheet where competition for deposits or loans leads to lower margins for these products. This may result in banks under-pricing risk in loans to consumers and/or businesses, resulting in them temporarily benefiting from the increased risk-taking. Although taking on greater credit, market or funding risk usually raises returns, it leads to greater losses in economic downturns. Banks may not take full account of the potential for losses in extreme circumstances, due to uncertainty, myopia and if they believe that governments will act to support the banking system in a crisis. For this reason, regulation to protect financial stability may be more important in countries with more competitive financial markets.

56. On the other hand , effective competition and financial stability can also go hand in hand. The financial crisis has shown that individual financial institutions can be a risk to financial stability due to their size, complexity, and interconnectedness. Addressing these problems, and allowing firms to exit the market safely, may make competition more effective. Those banks currently considered to be ‘too important to fail’ benefit from lower wholesale borrowing costs. Reducing expectations of public support would reduce this benefit and so make banking markets more competitive.

57. We are working with international regulators to agree strengthened capital adequacy and liquidity standards and to align these more closely with the risks banks take and their potential impact on financial stability. Strengthening these standards need not reduce competition or create new barriers to entry.

14 October 2010

[1] We have not been required by the Treasury to take a specific action to date.

[1] Formed as a resolution vehicle for Dunfermline Building Society.

[1] Northern Rock plc is a new banking entity that arose from the split of the good/bad assets of the previous bank.