Is more competition really the panacea for the ills of British banking?
The Parliamentary Commission on Banking Standards has now published its final report. The headline-catching recommendations include a criminal offence of acting in a ‘reckless manner’ and deferring bonus payments for up to ten years. Less noticed but important proposals would give directors a legal responsibility to prioritise financial safety over shareholder interests and require boards to assign a non-executive director to oversee fair and effective whistle-blowing procedure (This ought to be dubbed the Paul Moore clause in honour of the former Head of Group Regulatory Risk at HBOS who was dismissed shortly after raising concerns about the bank’s business strategy. He testified before the Commission in October 2012 and found a receptive audience).
Whatever now happens to these proposals, the Commission can already claim to have influenced the policy debate on bank regulation. At the start of 2013 the Commission’s Chairman, Andrew Tyrie MP, publicly prodded the Chancellor into agreeing to ‘electrify’ the ring-fence which will soon separate the retail and investment arms of the largest banks. If banks are found to have gamed the ring-fence, the Government will now have the reserve power to forcibly break them into two entirely separate companies.
This is all very impressive. Yet in one respect the Parliamentary Commission’s report is amazingly orthodox. Like Labour and the Conservatives, the Treasury Select Committee and the Bank of England, the Commission argues that ‘the UK banking sector is not as competitive as it should be’ and that ‘the discipline of the market can and should be an important mechanism for raising standards (in the banking sector) as well as increasing innovation and choice and improving consumer outcomes’.
The resulting policy recommendations are a bit thin. The Commission suggests that the Prudential Regulatory Authority be given a formal mandate to increase competition; that the Competition and Markets Authority commence a study of competition in the retail and small business banking sectors; and that the Government establish an independent panel of experts to find ways of making it easier to transfer bank accounts. The sentiment being expressed by the Commission is however a strong one. Competition is good because it will keep the banks in check and force them to fight for their reputations by offering customers a better service.
Yet it seems reasonable to argue that competition was actually one of the key causes of the whole financial crisis. In the late 1980s and early 1990s attempts to increase competition by, for example, de-mutualising building societies, like the Northern Rock, drove down the largest banks’ profit margins on mortgage and business lending. This was textbook economics in practice with consumers supposedly coming out the winners.
But, in order to maintain their pre-tax profits, returns on equity and share price in this tough new environment, the banks found themselves with a strong incentive to seek out new profits by either lowering their credit standards to increase market share (the strategy settled on by HBOS) or by re-engineering their balance sheet away from lending and toward financial trading in securitised assets (RBS’s strategy). Competition drove the banks toward what we now know to be unsustainable risk-taking.
Profits proved addictive. In 2005 Northern Rock introduced a ‘Together’ mortgage which allowed customers to borrow up to 125% of the value of their house. As a result, HBOS’s share of the new mortgage market fell from 20% to 8%. HBOS’s share price slumped; the company’s net worth fell by £1bn; and senior management came under intense pressure to recover lost ground. What happened next is instructive.
Executives pressed the bank’s retail division to match the kind of offers being made by Northern Rock, whilst simultaneously ordering the corporate lending division to double its profit targets. Peter Cummings, the Head of Corporate Banking who was fined £500,000 by the Financial Standards Authority in 2012 for his part in HBOS’s downfall, gave evidence to the Parliamentary Commission that he was under pressure to keep increasing profits. Why? Because, he said, ‘there was a point where the retail bank was not performing and I was asked to step in’. For its part, the FSA concluded that ‘the increasing pressure to increase growth (at HBOS)… meant that less attention would necessarily be paid to risk management’.
This is a story which could be re-told for any number of the largest British, European or American banks. Competition, when combined with the pressure to maintain share price, stave off the threat of take-over and keep their jobs, drove bank executives onwards and, eventually, downwards.
So does this mean that the UK’s political parties ought to be campaigning for less competition and higher bank profit margins? Not in so many words and certainly not if they want to be elected. But, given their responsibility to promote financial stability, regulators ought to be wary of the Parliamentary Commission’s assumption that greater competition will beget higher standards. A stable banking system might be best achieved via a stable market structure which gives the largest banks the opportunity to pluck profits from domestic lending.
This is actually an important part of the story of what went right in the Canadian and Australian banking systems in the 2000s, just as much as it is an important part of the story of what went wrong in the UK and US. Large pre-tax profits may be indicative of a bad deal for consumers, but people are taxpayers as well as consumers. In this context too, it is worth remembering not only that profits can be taxed, but that the gains from more competition and better mortgage deals need to be set against the £133bn cash outlay from taxpayers (£2,000 per person) to bail out the banks in 2008-9. There is a downside as well as an upside to competition in banking.