Banking StandardsWritten evidence from the Bank of England

Concentration in Banking Services and Stability

1. The concentration in the UK banking industry in the run up to the crisis was unhealthy for financial stability.1 A bank’s abrupt closure has a bigger impact on current and prospective customers, and so on the economy, where there are few or no competitors to move into the space left behind. Remedies exist, but will come slowly given the current degree of concentration.

Concentration and the Effects of Bank Failure

2. The UK’s economic recovery has probably been impeded by some of the banks worst hit by the crisis being those previously most important to business lending: the businesses making up Lloyds Banking Group and Royal Bank of Scotland Group accounted for over 40% of the stock of lending to UK firms at end-2007.

3. Also, there were more banks and building societies active in the UK mortgage market. Many failed, and were closed, taken over or merged.2 Together those lenders accounted for almost 20% of the stock of mortgage lending at end-2007.

4. The costs of bank failure in the UK have been felt through credit conditions rather than a breakdown of the payments system. That is partly because deposit insurance ensures some continuity in the provision of deposit and payments services. Up to a £85,000 limit, depositors are guaranteed by the Financial Services Compensation Scheme, with payout in most cases now assured within seven days.3 Alternatively, under the Special Resolution Regime created by the 2009 Banking Act, another bank can assume the insured deposit liabilities of a failed bank. In that case, depositors find themselves banking with a different bank but services are maintained.

5. There are no corresponding guarantees on the lending side. Small and medium-sized companies, without access to the capital markets and with bespoke borrowing requirements, may find it slow or difficult to arrange new credit facilities elsewhere—as might some households. Nevertheless, resolution regimes can sometimes help to preserve lending capacity, depending on the type of resolution strategy employed and the particular circumstances of the case:

(1)If a failed bank goes into Liquidation and Payout, the insured deposits are covered by the FSCS but all the assets go into administration. The lending business is, therefore, closed unless it can be sold out of administration to another bank (or other purchaser). Where loan portfolios go in to run-off or during the transitional period whilst a sale is being arranged, households and companies have to look elsewhere to refinance or renew existing loans and facilities.

(2)If, instead, the resolution authority sells the deposit book to another bank under a so-called Purchase and Assumption resolution, there are the same two broad possibilities for the loan book. Either the whole or part of the loan book might be sold to the bank buying the deposit book or to another buyer, or it goes into administration and run off. In the first case, services are maintained, albeit perhaps after a delay; the loan-market share of the buyer is increased. In the second case, customers need to find new lenders.

(3)A third resolution strategy is bail-in, involving recapitalising and restructuring a failing bank through writing off the equity, writing down sufficient debt to absorb losses, and converting part of the residual debt to equity. In that case, any sound business lines, including lending, can be sustained.4

6. Effective resolution can, therefore, reduce the consequences for the economy of bank failure in a concentrated industry; and some, such a bail-in, avoid increasing industry concentrations.

7. Another possible approach is to try to make a virtue of industry concentration. For example, some countries—for example, Australia and Canada5—are sometimes characterised as shielding their main domestic commercial banks from competition, so that domestic banking remains sufficiently profitable to reduce the temptation to launch out into risky variants of international wholesale banking. This strategy implicitly accepts concentrations, and seeks to reduce the probability of failure rather than to reduce the consequences for the economy of failure nevertheless occurring.

Other Possible Responses: Reducing Concentrations

8. Another approach would be to seek to reduce concentrations, and so to reduce the costs of failure. That can be attempted in a variety of ways.

9. One approach, which has been used elsewhere, is to prevent concentrations via an explicit cap on the market share that banks can accumulate through acquisitions. For example, the United States bans acquisitions that would result in a bank controlling more than 10% of the country’s insured deposits. (The rule does not prevent banks from crossing the 10% line organically.) The same broad approach could, in principle, be related to a bank’s share of loan markets, or to GDP etc.

10. In a recent discussion of size limits of this broad kind, Governor Tarullo of the US Federal Reserve Board concluded that, given the paucity of empirical work on economies of scale and scope in banking, policymakers are not in a position to decide what a sensible size limit might be.6

11. A different approach would be to reduce barriers to entry, including by streamlining the process through which new banks can be set up and reducing the financial requirements on new banks. At the Commission’s hearing in November,7 Paul Tucker said that the prudential supervisor can authorise banks more readily if there are lower barriers to exit. In other words, good resolution regimes can be used to help reduce barriers to entry. As described above, with rapid payout by the deposit insurer for smaller banks and a resolution regime to transfer or recapitalise the banking business of larger deposit-takers, the impact of the failure of a new bank on the financial system becomes more manageable. Where the prospective costs of failure are manageable, the board of the Prudential Regulation Authority (PRA) should feel comfortable in ensuring that line supervisors are less cautious about granting licences to new banks. Even so, a minimum solvency standard at the point of entry is warranted to avoid an excessive incidence of bank failure—not least because of the cost to surviving banks. The Bank/PRA plans to adopt this broad approach.

14 January 2013