Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum submitted by the Competition Commission

  Thank you for your letter of 20 May and the copy of the transcript of your hearing with the four major clearing banks.

  The points you raised are similar to those on which we commented to you in my letter of 17 May. I should also add that we are of course not in a position to add to our report. But I hope that you will find it useful to draw your attention to the relevant extracts of that report.

  Firstly we reject the banks' claims that we did not examine a full business cycle. We did base our analysis of profitability primarily on recent years, but, as we discussed at some length in paragraphs 2.371 to 2.383 of the report, and as noted in my letter of 17 May, we acknowledged that the most recent figures of bad debt reflected the fact that the economy has been in a relatively benign phase and that some adjustment for a more sustainable level should therefore be made. As apparent from the figures in Table 2.10, for example, over the period 1996 to 2000, the SME bad debt ratio (bad debt charges against profit as percentage of total loans) of the largest banks was 0.5. Over the seven years from 1989 to 1995, that figure was 2.4 per cent, and over the whole 12 year period 1.6 per cent.

  However, we also noted (2.375) that the last severe recession, in the early 1990s, was characterised by monetary policy explicitly aimed at the external value of the pound rather than domestic considerations, resulting in interest rate levels much higher than domestic conditions warranted. Second, and of more particular significance, bad debts reflect the banks' level of efficiency in handling credit risk. The clearing banks said they had improved their processes for credit appraisals since the early 1990s as a result of their experience at the time. We also noted changes in ownership of some of the clearing banks which should have reduced the prospect that some of the unwise lending of the early 1990s would be repeated. The extent of bad debts in that early period also reflected substantial loans connected with commercial property and the subsequent decline in property values.

  As we noted in paragraph 2.378, we believed it right to discount the experience of early 1990s to some extent to reflect the second of these factors, namely the improvements in credit appraisal and monitoring. We therefore felt it appropriate to discount the experience of the early 1990s by one third, adopting a figure of 1.2 per cent for the long-term bad debt ratio. We felt that figure of 1.2 per cent may be a high figure, but we believed it right to err on the side of caution. The effect of that adjustment therefore was to adopt an actual bad debt charge almost two and a half times that of recent years, significantly reducing our estimates of excess profits. The figure we adopted of 1.2 per cent was consistent with a four to five fold increase in bad debt from current levels in a future recession. We made no adjustment to reflect that the recession of the early 1990s might, for the reasons given, have been more severe than would now be anticipated. Those years were therefore incorporated into our analysis.

  As noted in my letter to you of 17 May, we also examined the extent to which, if at all, it was appropriate to adjust for the current levels of economic activity on other aspects of banks revenues: but found the data indicated that any such additional adjustment was not warranted.

  You also asked for comments on the banks' claims that their overall profitability was comparable with international levels and lower than that of a number of other business sectors within the United Kingdom. We were of course only examining the profitability of services to SMEs rather than the overall profitability of the clearing banks. We did, however, in paragraphs 2.407 to 2.413 of our report consider the relevance of comparisons with returns in other sectors of the economy. As mentioned in my letter of 17 May, we noted that accounting returns on the book value of assets greater than the cost of capital may indicate factors such as the presence of intangibles, inclusion of tangible assets at historical costs rather than replacement value, risks or survivor bias. We sought to identify and quantify such factors as applied to the banks and adjusted for them as appropriate before reaching conclusions as to whether there remained any excess returns not accounted for, which could be treated as reflecting persistent excess profit, in turn indicating excessive prices and a failure in competition. The profits of the clearing banks from SME activities was still evident after adjusting for those factors: that may well not be the case for other sectors, but it was clearly not appropriate nor indeed practical for us in any one inquiry to investigate the circumstances of other industries.

  In paragraph 2.410 we also considered arguments as regards comparisons with overseas banks. We noted, however, that an additional difficulty in making such comparisons is the inconsistency in accounting figures, particularly when applied to specific activities, such as SME banking, within companies. Given such factors, as noted in paragraph 2.411, here also we did not consider it would have been practical in our enquiry to investigate the circumstances of the equivalent industry in other countries. We did refer in paragraph 2.410 to one study we saw indicating higher profitability in UK SME banking than elsewhere in Europe, but the banks commented that this comparison was misleading. We were not in a position to verify this but accepted that this comparison might also not be on a meaningful basis and made no use of the material.

  As to other points raised by the clearing banks, these clearly ranged considerably wider than the services to SMEs examined by the Commission. It may be useful to comment on two further points relevant to services to SMEs.

  The banks all argued to you that they did not make excessive profits or charge excessive prices on such services, as they did to us. We did not accept those arguments. We believed that in the circumstances of the supply of banking services to SMEs, for all four main suppliers to have a return on capital significantly greater than the cost of capital on a basis adjusted to represent long-term profitability was indicative of excess profits and of excessive prices and of an absence of fully effective competition (paragraphs 2.415 and 2.426).

  The banks also argued (eg Mr Ellwood on p43) that a main effect of our proposed requirement to pay interest on current accounts would be to limit the ability of new entrants to compete. We noted (paragraphs 1.11 and 2.513) that our preference was to remedy the adverse effects identified by encouraging competition, but despite the behavioural remedies we put forward, many constraints on SME switching suppliers and on competition and entry would remain. We considered the effects of entry in paragraph 2.578, but took the view that entry had not to date been effective in reducing excess profits and prices, nor was the prospect of new entry sufficient to reduce excess profits and prices in a reasonable time period.

  The remedies we have put forward in our view do no more than bring the level of SME bank charges closer to an appropriate and competitive level, so effective competition would not be deterred. Indeed, we noted in paragraph 2.596 that this remedy could be seen (particularly when taken together with the various behavioural remedies we have proposed) merely as an anticipation of natural competition, in that a new market entrant or smaller competitor paying interest on SME current accounts would be expected, if competitive pressures operate as they should, to cause existing players to replicate the innovation in order to retain market share. If effective competition does emerge, the need for regulation would in our view prove temporary: hence our recommendation for a review after three years.

  I hope you will find the above comments helpful.

30 May 2002

previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2002
Prepared 4 September 2002