Competition and choice in the banking sector

Supplementary written evidence submitted by HM Treasury

1. Background

1.1. This note follows the oral evidence provided to the Committee by the Financial Secretary to the Treasury on Wednesday 2 February 2011.

1.2. It provides additional background information on:

· the relationship between HM Treasury and UK Financial Investments (UKFI);

· divestments by the investee banks and the return of the investee banks to private ownership, and the framework for thinking about competition in this context;

· further information on the Financial Services Compensation Scheme funding model; and

· Confirmation of the current membership of the Banking Reform Committee.

1.3. The Treasury Committee has conducted an authoritative and wide-ranging inquiry. The Government hopes that this note will further inform the debate and looks forward to receiving the Committee’s final report.

2. Relationship between UK Financial Investments and HM Treasury

UKFI

2.1. UKFI’s mandate is to develop and execute a strategy for disposing of the Government’s investments in financial institutions in an orderly and active way, within the context of protecting and creating value for the taxpayer as shareholder, paying due regard to the maintenance of financial stability and to acting in a way that promotes competition. This overarching objective includes:

· Maximising sustainable value for the taxpayer, taking account of risk, consistent with HM Treasury’s stated aim that it should not be a permanent investor in UK financial institutions;

· Maintaining financial stability by having due regard to the impact of the transactions; and

· Promoting competition in a way that is consistent with a UK financial services industry that operates to the benefit of consumers and respects the commercial decisions of the financial institutions.

2.2. The Framework Document agreed between HM Treasury and UKFI requires that UKFI manage the investments on a commercial basis and not intervene in the day-to-day management decisions of the investee banks, including with respect to individual lending or remuneration decisions. The nature of UKFI's engagement with the investee banks is required to be proportionate to HM Treasury's ownership interest. UKFI engages with the wholly-owned investee banks – Northern Rock Plc, Northern Rock Asset Management and Bradford & Bingley – in a manner similar to that in which a financial sponsor would engage with a wholly-owned portfolio company. UKFI engages actively with the listed investee banks – the Royal Bank of Scotland (RBS) and Lloyds Banking Group (LBG) – in accordance with the Financial Reporting Council’s Stewardship Code, to which UKFI is a signatory.

2.3. HM Treasury is determined that the investments in financial institutions do not prevent or distort effective competition, or contravene normal merger control or competition law restrictions. The Framework Document requires that UKFI:

· Ensures there are no cross-directorships between the investee banks, in relation to the appointments in which UKFI has a specified role, as well as UKFI itself;

· Puts in place robust barriers to ensure that commercial information relating to any investee bank is not exchanged with or leaked to any other investee bank;

· Exercises its rights in relation to the investee banks individually if required to comply with merger control and competition law restrictions;

· Does not manage the investments in a manner which may prevent, restrict or distort effective competition; and

· Abides by the Code of Market Conduct and other rules and guidance laid down by the Financial Services Authority.

HM Treasury

2.4. UKFI is a company that is wholly owned by HM Treasury. The success of the relationship between HM Treasury and UKFI depends on the nature and quality of the relationship between the UKFI Board and Treasury Ministers and officials. In particular, overall responsibility for ensuring that the intentions set out in the Framework Document are carried out in practice lies ultimately with the Chairman of the UKFI Board and the Chancellor of the Exchequer.

2.5. UKFI’s Investment Mandate describes the extent to which decision-making requires the prior approval of HM Treasury. It states that UKFI must obtain HM Treasury’s approval before undertaking any disposal transaction. It also sets out that representatives of HM Treasury and the UKFI Board (or other UKFI representatives) should meet regularly to review the strategic options available for delivering UKFI’s objectives. These meetings take place on a quarterly basis and focus on UKFI consulting and engaging with HM Treasury on actions and decisions taken, or proposed to be taken. In addition to these meetings, UKFI is required to keep HM Treasury informed about the status of any disposal transactions, as well as UKFI and its advisers’ views on the design, development and execution of any transactions.

2.6. HM Treasury remains responsible for coordinating the Tripartite Authorities’ actions in relation to the investee banks.

2.7. HM Treasury also remains responsible for the Government’s overall policy stance on the financial services sector. This includes the commitment made by the Government to foster diversity and promote competition in the banking sector.

3. Divestments and the return of the investee banks to private ownership

Divestments by the investee banks

3.1. Divestments by RBS. As a condition of EU State Aid approval for the aid they have received, RBS are required to execute a number of divestments including a UK retail divestment amounting to a 5 per cent market share in the UK SME market along with 318 branches.

3.2. The terms of the State Aid agreement required that the buyer of the divestment must, in combination with the divestment business, have a UK SME market share of no more than 14 per cent.

3.3. On 4 August 2010 RBS announced the sale of this divestment to Santander UK. Santander UK currently have a small presence in the UK SME market and the sale will serve to increase competition in that sector. Both banks continue to work closely to enable the separation and transfer of the business. Before the deal can close the FSA has to approve that an acquisition by Santander UK is consistent with financial stability.

3.4. Divestments by LBG. As a condition of EU State Aid approval for the aid they have received, LBG are required to execute a UK retail divestment amounting to a 4.6 per cent market share of the personal current accounts (PCA) market and at least 600 branches.

3.5. The terms of the State Aid agreement require that the buyer of the divestment must, in combination with the divestment business, have a UK PCA market share of no more than 14 per cent.

3.6. LBG are working on a longer timeframe than RBS to complete their divestment and are currently engaged in the complex process of identifying and separating the branches, customers and associated assets from the Group for eventual sale. LBG are required to approach potentially interested buyers no later than the 30 November 2011, and are required to complete the divestment by no later than the 30 November 2013.

Return of the investee banks to private ownership

3.7. The return of Northern Rock Plc to private ownership. UKFI is tasked to develop and execute a strategy for returning Northern Rock Plc to the private sector. There is no presumption at this stage that any particular option will be pursued and the sale process has not yet been formally initiated. Northern Rock Plc is a savings and mortgage bank (distinct from Northern Rock Asset Management) that holds and services all pre-existing customer savings accounts and some pre-existing mortgage accounts.

3.8. As of 30 June 2010, total assets of the company were £19.8 billion, of which £11.2 billion were mortgages. Northern Rock Plc is authorised and regulated as a deposit taker by the Financial Services Authority. The Government injected £1.4 billion of equity to capitalise the bank at inception. As a result of the restructuring, there are a number of state aid measures Northern Rock Plc has to adhere to, such as limiting new lending volumes to £4 billion in 2009, £9 billion in 2010 and £8 billion in 2011, 2012 and 2013 (for 2012 and 2013 the cap only applies if Northern Rock remains under HM Government ownership).

3.9. Disposal of HMG shares in LBG and RBS. As outlined above, UKFI’s remit is to devise and execute a strategy for disposing of the Government’s investments in an orderly and active way in line with its overarching objective to create and protect value for the taxpayer, paying due regard to financial stability and competition.

3.10. UKFI will look at a full range of alternatives for the transactions they are responsible for, and will make decisions based on market conditions and investor demand at the time when a transaction is considered. Because any decision needs to be taken in the context of changing economic and market conditions, UKFI do not think that it is possible or desirable to state hard goals (such as price or timetable) that would drive the sale of HM Government’s shareholdings. Circumstances under which UKFI are likely to be able to sell shares will be those in which the economy and investor confidence is recovering and in which bank share prices are stable.

3.11. Given the size of the holdings, UKFI expect to undertake several capital market transactions in each bank’s shares and expect that these transactions will take place over a sustained period. This has several implications for the conduct of the sale programme. In particular, UKFI have said that they would expect to deliver better pricing for the taxpayer over the course of the disposal programme if they are able to earn investor confidence. Conversely if they are seen to act opportunistically or unreasonably in general or in any given transaction, then UKFI consider that they could face resistance from buyers in the future, resulting in investors seeking a "risk premium" for participating in a UKFI transaction.

Governance

3.12. Divestments by LBG and RBS. Subject to complying with the terms of the State Aid agreement with the European Commission, the sales are being managed and led by each bank’s independent management team with a view to maximising shareholder value (including that of HM Government).

3.13. In accordance with State Aid requirements, and with the Commission’s approval, LBG have appointed Mazars LLP as monitoring trustee with the overall task of monitoring and ensuring, under the Commission’s instruction, compliance with the State Aid requirements. Likewise, RBS have appointed Grant Thornton as monitoring trustee to monitor and ensure their compliance with the State Aid requirements. The UK authorities have also committed to submit regular reports on the measures taken to comply with the State Aid requirements.

3.14. Disposal of Northern Rock Plc and of HM Government shareholdings in LBG and RBS. When UKFI believe the conditions for a potential disposal are right, they will make a recommendation to the Chancellor of the Exchequer in line with the UKFI Investment Mandate. This necessarily requires them to consider the Exchequer impact, financial stability and competition aspects of their recommendation.

3.15. The Investment Mandate agreed between UKFI and the Treasury requires UKFI to seek the Treasury’s views in relation to disposal transactions before entering into any substantive engagement with the investee banks.

Competition framework in this context

3.16. The UKFI Framework Document makes clear that any disposal recommendations put to HM Treasury must have due regard to competition. Without prejudice to any future recommendations that UKFI may make, the factors that HM Treasury would expect to be considered as part of a competition assessment include:

· The expected impact on the structure of the UK banking market. This may include consideration of the market shares of different institutions before and after the transaction in question, as measured by numbers of accounts or volumes of activity. The expected impact may be different for different product segments (such as mortgages or savings products).

· The expected impact on bank customers. This may include consideration of a range of factors relating to outcomes for bank customers. The expected impact may be different for different customer groups and / or regions within the UK.

3.17. HM Treasury expect that the analysis would consider both the short-run (static) and long-run (dynamic) changes the transaction may precipitate. For example:

· Short-run changes may include the transfer of customer accounts between financial services providers, or any immediate changes in the scale and reach of branch networks at the affected institutions.

· Long-run changes may include transformational changes in the market that flow from the behaviour or business strategy of one or more affected institutions. Some long-run benefits may accrue to bank customers generally even if they are not directly affected by the transaction being assessed (by virtue of the impact on overall competition in the marketplace).

3.18. Necessarily the analysis will incorporate both quantitative and qualitative work. HM Treasury recognises that many of the issues are inherently uncertain and that a significant degree of informed judgment will be required in any assessment.

3.19. The detail of any assessment that may be made will depend in large part on the specifics of the particular transaction in question. HM Treasury notes that there need not be an assumption that competition and value benefits will need to be traded off against one another. It is both conceivable and desirable that one or more options may deliver good outcomes against both criteria.

3.20. Any recommendation made by UKFI must also comply with UK and European competition law, including normal merger control and anti-trust rules.

Final decisions on disposals

3.21. The UKFI mandate was constructed to reflect the key factors that will drive the Government’s decisions about the investee banks. Good outcomes for the Exchequer, financial stability and competition are all clearly in the public interest.

3.22. As described above, the Chancellor of the Exchequer retains ultimate responsibility for the disposal decisions required to return the investee banks to private ownership. HM Treasury believes that this delivers the right outcome in terms of final accountability for the public’s stakes in the banks.

4. The Financial Services Compensation Scheme (FSCS) funding model review

4.1. The funding model for FSCS compensation payments has operated since 1 April 2008. It comprises five broad classes: deposits; life and pensions; general insurance; investments; and home finance. All of these (except the deposits class) are further divided into provision and intermediary sub-classes. Each sub-class has an annual limit as to the amount it can be asked to contribute to compensation costs. Once this limit is reached, any further levy requirements are met by the parent class, and then by other classes as necessary.

4.2. Deposit taker and investment intermediary defaults over the past two years have generated pressure for the FSA to review this model. This pressure, combined with amendments to the existing European compensation related directives (the Deposit Guarantee Scheme Directive, the Investor Compensations Schemes Directive and the potential Insurance Guarantee Scheme Directive) resulted in an FSA commitment in 2009 to a fresh review of the FSCS funding model.

4.3. This review is considering numerous issues relating to FSCS funding including class (and sub-class) composition and structure, the annual compensation thresholds for each class, the methodology for apportioning levies to individual firms, and the cross-subsidy between different classes.

4.4. In October 2010 the FSA took the decision to delay proposals on the review. This is because European proposals, along with changes to the domestic regulatory architecture, may have consequences for the funding and structure of the FSCS. In particular, negotiations to agree a revised Deposit Guarantee Schemes Directive and Investor Compensation Schemes Directive are underway in the EU Council and Parliament. Both draft Directives include proposals to reform schemes’ funding arrangements. The revised Directives are expected to be agreed in summer or early autumn this year. With this in mind, the FSA believe it is not appropriate to consult on funding arrangements to the timetable originally planned. Once the debate on the European proposals is clearer the FSA will contact industry stakeholders with a revised timetable.

5. Membership of the Banking Reform Committee

5.1. The Banking Reform Committee (BRC) has the following membership:

5.2. The membership of Cabinet committees is in the public domain and is published on the Cabinet Office website at: http://www.cabinetoffice.gov.uk/resource-library/cabinet-committees-system-and-list-cabinet-committees

6. The Minister of State for Trade and Investment

6.1. The Department for Business will write to the Committee with respect to the questions raised by the Committee regarding Lord Green’s appointment to the BRC.

February 2011