Competition and choice in the banking sector

Executive Summary

Intellect believes that the current regulatory focus on the banking sector in the UK must be supplemented by a greater understanding amongst policy-makers and regulators of the critical role that technology plays in the functioning of this critical industry.

Technology and financial services are inextricably linked. A durable and effective regulatory programme that tackles the issues of competition, transparency, systemic risk, and lack of capital for SMEs (amongst other issues) must reflect what technology can facilitate today and, crucially, what it will enable in the future.

Intellect believes that there are a number of competition challenges that need to be dealt with by Government and industry together if issues such as lack of choice for consumers are to be rectified. These include:

· Customer inertia – how can competition be increased (and new entrants be encouraged to participate in the market) when customers are not inclined to change banks?

· Poor flows of financial risk information on SMEs – an untapped market that banks do not currently want to tap

· Costs of complying with regulation and high capital requirements

· High cost of establishing a branch network – how can this be overcome by new entrants?

· Banks that are unable/unwilling to exit unprofitable markets

Intellect believes that there are a number of ways that competition and choice within the retail banking market could be improved. These include:

· Individual bank account numbers that can be taken from bank to bank – to facilitate easier switching

· Offer innovative, convenient, technology-facilitated banking products for customers that do not necessarily have to rely on a branch network

· Use of innovative back-office IT to reduce up-front capital expenditure and counter-balance other high entry costs

· Increase the quantity and accuracy of financial risk information (especially on SMEs) that is collated and flows between banks

· Engagement with industry, via a continuing dialogue, to maximise the opportunity for innovative technologies to improve the process – be it in payments, online access, or, fundamental for all services, flows of information

1.1 Intellect is the UK trade association for the IT, telecoms and electronics industries. Our members account for over 80% of these markets and include blue-chip multinationals as well as early stage technology companies, and play a crucial role in virtually every aspect of our lives. In the UK these industries together generate around 10% of GDP and 15% of trade, directly employing over one million people.

http://www.intellectuk.org/content/view/23/3/

1.2 We are a trusted partner for Government, both in terms of policy development and policy implementation across numerous sectors. We look to ensure that all relevant engagement of policymakers and regulators with industry is both easy and as valuable as possible in order that the technology industry may play the fundamental role it merits in the success of UK plc.

1.3 Intellect’s Financial Services Programme brings together over 150 suppliers of information systems, services and consultancy to the financial services sector. Global IT service providers sit alongside many specialised smaller companies and all play an active role in imparting their expertise and experience to better inform the development of financial services policy at a cross roads in the industry’s development.

1.4 Many of Intellect’s members are heavily involved in providing the fundamentally important technology

platforms upon which the UK’s financial services industry is built. For example, these members help facilitate the 5.7 billion automated payments that are made through the banking system on an annual basis. Indeed, through Intellect our members are working with the Payments Council to develop the future technology that will afford consumers and businesses alike more convenient, secure and efficient ways to conduct their transactions. Similarly, the 40 million online bank accounts that are registered in the UK would not function without the technological capability that our members design and supply.

1.5 The relationship between the financial services industry and the technology sector is one of fundamental importance. Technology not only plays a critical role in the functioning of the financial services industry, it is a hugely important factor in ensuring that these institutions can operate more responsibly and remain competitive in the global marketplace.

1.6 Consequently, if the UK’s banking sector is to be reformed to meet the challenges posed in recent years and provide the backdrop to economic recovery, policy not only needs to reflect what technology can facilitate today, but what it will enable in the future. Regulation will only be effective and durable if it takes into account how it will be implemented and how the application of technology can be complementary. For an industry like financial services that relies so heavily upon technology, it is essential that policy is developed at all stages with a full understanding of it.

2.1 Please note: Intellect has not responded to all the issues set out in the Inquiry’s Terms of Reference. Answers that are given to questions below are based upon Intellect’s Members’ expertise in the field of financial services.

2.2 Given the word limit for this response, Intellect is unable to cover the wide spectrum of issues in great detail. However, more detail on issues of interest to the Select Committee is available upon request.

3.1 Intellect welcomes the focus that the Government, Independent Banking Commission and other authorities are taking on competition within the banking sector. However it is clear that there needs to be a shift in attitude amongst policy-makers and regulators about the role that technology has in this particular industry. Whether it is because of the dominance of the ‘traditional’ stakeholders in this industry, or a prevailing misconception that technology is merely a means to implement legislation and is treated as an afterthought, to date there has been insufficient attention paid by the Government to how technology can offer solutions to many of the challenges the financial services industry currently faces.

3.2 Technology has played a significant role in the development of the banking market in recent years. The banking system as we know it would not function without the fundamental technology platforms that underpins all activity, both customer-facing and back office. This will continue to be the case as consumer technology converges and organisations (not necessarily just retail banks) develop a variety of technologies to provide banking services to an increasingly digitally-native market. In the future, how technology is applied will be a key differentiator between operators in a market that is in a state of flux. Those willing and able to embrace new technologies (both front-end and in terms of infrastructure and back-office) will be able to adapt to accommodate changing consumer demands and expectations. Not only can technology reduce systemic risk and increase flows of capital to SMEs, it can increase competition and provide a platform for new entrants to expand within the retail banking industry.

3.3 As the UK’s financial services sector is reformed to meet the challenges posed by the recent banking crisis and provide the backdrop to economic recovery, the development of policy must reflect an understanding of how technology continues to be the driver of change in the financial services industry. Understandably there may be an inclination in some quarters to move from principles-based regulation to a rules-based approach. Whilst not offering arguments in favour of either, Intellect believes that before committing to any changes to the regulatory system, the possibilities that technology offers for increasing competition (and increasing transparency, stability and consumer protection) should be examined in detail by policy-makers and the financial services industry alike.

3.4 Currently the level of understanding amongst policy-makers and regulators about the technology systems that provide the fundamental platforms for nearly every transaction across the financial services industry, is poor. It is common sense that if policy-makers and regulators are to ensure that regulation is effective, but not unnecessarily restrictive, they need to have an understanding how banks operate. It is now impossible to do this without appreciating the technology that not only underpins existing institutions in this sector, but will also underpin new entrants to the market as well and is constantly evolving. Intellect provides an ideal source of neutral expertise for policy makers and regulators to tap into, representing the aggregated expertise of the companies that provide the platforms which underpin much of the financial services industry.

4.1 As outlined above, the application of technology will afford new entrants the opportunity to build up a foot print within the retail banking market. This increase in competition will have resulting benefits for customers (both individuals and SMEs) and will have the effect of diversifying the risk that is posed to an economy that has been overly reliant upon a small number of large banks.

4.2 Intellect believes that there are a number of competition challenges that policy-makers will have to deal with over the coming months. However, more often than not there is a technology solution that can complement or even reduce the need for regulatory activity. Some of these challenges and solutions are set out below:

4.3 Customer inertia

Both the Office of Fair Trading and HM Treasury have identified customer inertia as a key barrier to competition within the retail banking industry. As noted in HM Treasury’s Reforming Financial Markets consultation paper of 2009, both the reality and the perception of the difficulty of switching bank accounts increase customer inertia. Nearly two-thirds of people have held their current account for more than 10 years and 60% of people are still using the first current account that they ever opened (HM Treasury).

4.3.1 In the banking sector especially, customer inertia represents a significant challenge not only to potential new entrants, but to any provider of financial services that is looking to expand their customer base. If banking providers are aware that customers are more inclined to stay with them than leave, then there is less motivation to ensure that its customers are its number one priority. However, there are a number of technology-based means to reduce customer inertia:

4.3.2

· Individual, portable bank account numbers

Intellect believes that by creating a bank account number that is specific to the individual rather than the bank and that could also be transferred from one bank to another, market stagnation that results from customer inertia will be alleviated to a significant degree and competition within the banking sector will be enhanced (with knock on benefits for the availability of capital for SMEs and individuals – through greater choice). There has been significant regulatory focus in recent years on the porting of individual phone numbers as a means to increase competition in the mobile phone industry and from April 2011, mobile phone customers will be able to transfer their existing number to a new provider in just one working day rather than the current two days. That switching of bank accounts takes a matter of weeks, not days and is a significant barrier to competition suggests that this should be a priority issue for Government.

4.3.3

· ‘3 Cs’ technology-facilitated products

By using technology to provide banking products and services of convenience to their customers, such as mobile payments, online banking and use of social media, financial services providers will challenge customer inertia in some sectors of the market where ‘digitally native’ consumers look for banking services that encompass the ‘3 Cs’ – Customer Focused; Convenient and Converged. The development of these products will ideally be demand-led. Those banking providers that are able to accurately anaylse customer sentiment and quickly develop technology-enabled products that cater for a relevant market sector will find that they are in a good position to increase their market share. The challenge for established banks (as outlined below) is that their legacy IT systems, which are comprised of layer upon layer of IT platforms that have been built upon over many years, do not easily allow new systems for new products to be easily added without significant disruption to existing services. New entrants will find that because of their ‘technological blank slate’ they are more agile when it comes to rolling out innovative technology-led services for their customers.

4.3.4

· Flexible and efficient payment systems

The main objectives for new entrants into the banking sector will be simplification, quality of service and lowering costs. It is anticipated that new entrants, because of their technological blank slate, will drive towards integrated systems that can handle payments from any channel, whether consumer or corporate, from start to finish - with no redundancy of technology or duplication of processes and labour. This type of integration will enable financial institutions to manage transactions quickly and effectively, with less need for manual intervention and costly interfaces between different systems. Crucially, it will allow these new entrants to consider all payment forms – from smart phone applications to contactless payments – based on customer demand. This will be tied in with the likelihood that new entrants will turn away from large traditional back office IT departments which require an initial high outlay of capital, to outsourced IT operations that can expand as the new entrant expands. Increased use of Software as a Service (SaaS) and cloud computing, provided by IT outsourcers directly to new lenders, will mean that their services are scalable, easily updatable and importantly, new entrants will only pay for what they use. In the short to medium term this will represent significant cost savings as new entrants will be able to ‘rent’ the services they require without any upfront capital costs.

4.4 Costs of compliance and capital requirements

With such a wide ranging raft of regulation on the horizon, all of which requiring changes of varying cost to individual financial services providers’ internal systems, coupled with the huge cost that capital reforms (Basel III) will have across the industry, the drain on resources is going to be acute over the coming months and years. Such high costs, in addition to the costs of setting up a bank, will act as a deterrent to entry to potential new entrants to the retail banking market.

4.4.1 It is therefore critical that if new entrants are to be encouraged to participate in the retail banking market, that they are not over burdened with compliance costs for regulation whose objectives could be achieved through other means. Lessons can be learned from recent regulation which, in some cases, is still being implemented. The estimated costs of changes to the IT infrastructure of deposit takers to implement the Financial Services Compensation Scheme’s Single Customer View (SCV) initiative – circa £1 billion – is huge. Although Intellect welcomes technology investment by financial institutions, there is a question whether the requirements of the FSCS’s SCV could have been met by the commercially focused SCV that many banks were already working towards, with a reduction in associated compliance costs. New entrants, if they are to comply with this specific legislation and develop a means to better identify their individual customers, will therefore have to pay to implement two versions of a Single Customer View.

4.4.2 Whilst Intellect fully supports regulatory efforts to improve the stability, transparency and performance of the financial services industry, we believe there is a responsibility for regulators and industry to take a broader view of how proposed policy/regulation is going to be implemented in reality – especially with regard to likely impact that changes will have upon financial service providers’ IT systems. This should be undertaken at an early stage to avoid unnecessarily expensive or time-consuming changes that could further add to the start-up costs for potential new entrants, and indeed reduce disruption to existing institutions, the market and customers. A means to achieve this could be through an adaption of Intellect’s Government-supported Concept Viability scheme.

4.5 Inability of established banks to exit specific markets

One of the major obstacles to competition in the banking sector stems from a specific barrier to exit – large incumbent banks offering products and services that are loss leaders, but whom are unable/unwilling to exit the market for these products and consequently allow other actors to enter and expand.

4.5.1 As banks on the most part do not employ detailed analytics that can offer information on product profitability they are, in many cases, unable to determine which products to discontinue and which to actively promote. Amongst other reasons, products may be failing because they do not reflect the needs of customers or that they may not be targeted at the right sectors of the market. However, the real issue is that a market awash with similar products combined with a public that is, generally speaking, more inclined to take up products from their incumbent banking provider than shop around (regardless of whether or not these products are the best fit for them), makes it hard for new entrants to compete on a level playing field and gain a foothold in the banking market. If banks can be encouraged to identify their unprofitable products, it would be better for them, the wider market and the consumer.

4.5.2 Where products have been removed from a market, there has not been enough importance attached to learning how and why these projects failed. By establishing what could be done better, there is an opportunity to ensure that new entrants to the retail banking market can offer technology-facilitated banking products and services with a reduced chance of them failing. Product failure at an early stage of a new entrants’ existence could also have significant negative consequences on its reputation, its resources and its ability to gain a foothold in the retail banking market.

4.5.3 Intellect believes that there could be a role for regulators to ask banking providers for their views on why particular projects did not succeed so that the wider market, and indeed the consumer, can benefit from this hindsight. Similarly, for the sake of greater competition and efficiency, Intellect believes that retail banks should be encouraged to actively evaluate the performance of their products in this sector. State-owned retail banks should, in the interests of reducing costs, be compelled to do so. In both instances, a short term investment in appropriate analytics software would be required, but the longer term savings made from leaving unprofitable markets and greater insight on how to target more profitable products would justify this expenditure many times over.

4.6 Legacy systems

In the instance that an unprofitable product is identified, it is often difficult for banks to remove them from the market because of the effect that doing so would have upon their interdependent legacy IT systems. These legacy systems, the multiple layers of IT platforms within banks that have been built upon over many years, are at the heart of established financial service providers’ operations. They are business critical, intertwined with other elements of a bank’s IT infrastructure and are often running 24 hours a day. Adding new elements or removing them from these legacy systems (i.e. to remove IT systems that facilitate specific banking products or services) is a very complex and expensive process that will impact upon a multitude of different aspects of the bank’s operations. In many cases it is not in the broader interests of a bank to remove a product from the market because of the costs and the disturbance to core systems that unwinding these un-needed systems would incur.

4.6.1 A lack of information about the performance of specific products can be addressed more easily than the issue of IT legacy systems. For this very reason Intellect believes that regulators should do more to understand the impact that legacy systems have upon banks’ abilities to provide high standards of customer service and remove loss-making products from the market. Incentives, such as capital tax breaks, could be made for banks to replace their ageing legacy systems and allow them to become more efficient and customer friendly. For state-owned banks, a reduction in the repayment of public debt could be made in the immediate term so that investment could be made in banks’ IT systems. This would allow a quicker repayment of public money in the medium term as the banks become more efficient and more commercially viable.

4.6.2 However, as outlined above, where legacy IT systems reduce established banks’ abilities to innovate, their existence does provide a significant opportunity for new entrants to the retail banking market to establish a foothold. Every year, banks invest hundreds of millions of pounds in new technology, yet it can take years before a new product reaches the consumer. New entrants without these legacy systems hold a distinct advantage as they are able to adapt quickly to changing customer demands or the availability of new technology.

4.7 FSA licensing regime – auditing of ICT suppliers

Intellect fully supports the ‘litmus-testing’ of organisations wanting to enter or expand their provision of banking services and the protection of the customer (and of the wider economy) is of paramount importance.

4.7.1 However, Intellect does believe that there should be a balance between transparent and appropriate auditing of suppliers to potential entrants in the retail banking market, and unnecessary and costly oversight that prolongs the licensing process (extending ‘go to market’ time for the entrant) and which ultimately will itself act as a barrier to entry. The role that the Financial Services Authority (FSA) currently plays, whilst necessary, should be evaluated and refined where appropriate (especially if this role is passed on to a new prudential regulator within the Bank of England) to ensure that it does not suffer from ‘mission-creep’. A specific issue is the FSA’s ‘adopted’ role of scrutinising the contractual relationships between the market entrant and its service suppliers – especially ICT suppliers that supply its systems and infrastructure. This could potentially cause a barrier to entry as the FSA does not have the necessary level of technical expertise to adjudge what ICT technology is appropriate, what represents a satisfactory level of risk and what is in the consumers’ best interests with regards to ICT provision. A solution to this would be the development within the FSA (and its successor) of a greater level of technology-based knowledge amongst relevant staff. Intellect provides an ideal source of neutral expertise for policy makers and regulators to tap into, representing the aggregated expertise of the companies that provide the platforms which underpin much of the financial services industry.

4.7.2 This prolonged time frame, as a result of increased FSA scrutiny, could also have the effect of discouraging smaller ICT providers from forming commercial relationships with prospective and new entrants to the retail banking sector. It is simply not as profitable for smaller ICT providers to be involved in such projects as it would be for them to be involved in other, less scrutinised markets. If it is taken that innovative IT-enabled customer services and infrastructure are important to new entrants’ entry and expansion in order to differentiate themselves from incumbents a reduced field of suppliers to choose from will harm this ability. The public sector has, in recent years, seen a similar problem where smaller, innovative suppliers were discouraged from tendering for government contracts because of the costs of embarking on a time consuming and administration-heavy process. There is a danger that through increased regulatory scrutiny of ICT suppliers, the financial services industry could be sleep-walking into a similar situation.

5.1 Intellect acknowledges that the limited availability of capital for SMEs from banks is a separate (but related), ongoing concern for Government at the current time. However, it is also the case that by addressing this issue, a side benefit could be an increase of competition within the banking sector.

5.2 Financial services organisations generally have a good track record on information sharing. For example, the advent of increasing customer applications for credit, have heightened the industry’s interest in information sharing. Furthermore, collaborative events to tackle financial crime have increased the speed in which information sharing can take place. However, these incidences typically relate to data sharing on individuals, a similar flow of information between institutions on potential SME customers is not nearly as developed. Generally, ) larger incumbent banks have been guilty of viewing SMEs as one large group (or groups by sector & size), all posing the same level of risk regardless of their own specific business models, financial health etc. This has led to a reduction in the availability and cost of credit to SMEs – a lack of detailed information sharing on SMEs has led to risk-averse banks becoming even less likely to lend to SMEs, and the conditions that are attached to the loans that they are willing to make are often so high that they do not represent realistic options for SMEs.

5.3 Now, more than ever, it is critical that access to financial risk information is available to all operators in the financial services market. On a general level, higher levels of data interoperability can facilitate better credit flows between banks, ensure greater accuracy of data and consequently more informed decisions on lending can be made. Technology has a crucial role in facilitating the flow of credit to individuals and SMEs in the UK, but has to be accompanied by a change in mindset within the banking community – i.e. that SME’s are an important source of business for the retail banking industry, and that the availability of credit will beget more business for banks that are willing (and able) to lend to them.

5.4 The challenge for smaller and new entrants to the retail banking sector is to expand their information base to gain as comprehensive a picture of their potential SME customers as possible. If the range and quality of information that can be gleaned can be increased, not just from potential customers but also from other financial institutions, smaller and newly established banks will be able to make more informed decisions about who they lend money to in the SME sector and, in theory, acquire more SME customers. In order to achieve this, data interoperability standards across the financial services ecosystem need to improve significantly.

5.5 Additionally, the issue of data accuracy is also applicable here. However effective the ability to share information might become, it can only be as useful as the accuracy of the information being shared. The greater the ability to make an accurate assessment of the credit worthiness of individual SMEs, the greater the ability of new or less-established entrants to attract more commercially-viable business from SMEs. This will lead to greater competition and choice in the banking sector, with a beneficial effect on the UK economy in the longer term.

5.6 Lack of a Single Customer View (SCV)

Competition in the retail banking sector will be restricted if new entrants are unable to form a SCV of their individual SME customers. As outlined above, a SCV is a longstanding commercial aim of the retail banking industry and will allow lenders to not only build up a detailed view of a customer’s individual credit risk, but also to identify other services and products that can be sold to the customer. It is equally important to have a similar SCV of SME customers if a new entrant is seeking to grow its business. Generally, in the experience of Intellect’s members, new entrants in the retail banking field do not have a common facility management system in place that can facilitate a single point of access to information about a specific SME customer. Consequently they are not as adept as more established operators at spotting risk, increasing processing efficiencies and generally providing customers with a more tailored customer service. This has a knock on effect on customer retention and growth of existing customer business.

5.6.1 The simple solution to this is that a common loan origination system should be in place for all new entrants to the retail banking sector. If better flows of information between banks on SMEs can be supplemented by better use of information within individual banks, it will have benefits for the banks themselves, SMEs and ultimately the economy.

6.1 Intellect believes that three is currently an opportunity to ensure that efforts to safeguard the future safety of the wider financial services sector also act as a catalyst for greater competition and benefit for consumers. As Intellect has looked to demonstrate in this submission, technology must be the foundation upon which competition is enabled – as it is the foundation upon which the banking sector is already built and upon which it will continue to be developed.

6.2 The aim for all parties must be to facilitate a retail banking market that encourages participation from new entrants, has unhindered opportunities for expansion and does not artificially block retirement from specific markets for banks or products that are commercially unsustainable.

6.3 Intellect would urge the Treasury Select Committee to recommend that the Government thinks laterally in its approach to competition in the banking sector (as new entrants to the retail banking market will be doing). It should consider:

· A greater focus on the fundamental technology platforms that the banking system is built upon, as a means to increase competition. The appropriate application of technology within the banking sector will go a long way to increasing competition and it should be considered alongside and, potentially, instead of some legislative remedies

· A greater focus on increasing the quality of the analysis and flows of information, both within and between banks

· Ensuring that financial services regulators and policy makers have a greater understanding of how technology impacts upon the functioning of the banking sector.

6.4 Those banking providers that are able to harness convenient, demand-led banking products, greater analysis/information and cost efficiencies that the application of technology can bring, will give themselves a greater chance of establishing themselves in this market. This is to the benefit of the consumer, the shareholder and, of course, UK plc.

September 2010