Submission from the Office of Fair Trading (S040)
The Office of Fair Trading
1. The Office of Fair Trading (OFT) is the UK’s consumer and competition authority. The OFT’s aim is to make markets work well for consumers. It performs this role by deploying a variety of tools including the enforcement of consumer and competition law and advice to policy makers where wider government policies affect competition and markets.
2. This submission provides an outline of the OFT's concerns regarding competition in retail banking and the actions it has taken, and is planning to take, to address these concerns. This relates primarily to the level and effectiveness of competition in retail banking and the effects of this (as set out in question 4 of the call for evidence) and actions that regulators and competition authorities can take to address the lack of competition in these markets (in response to questions 5 and 6).
3. The OFT's response can be summarised as follows:
· the relationship between competition and standards in retail banking is complex, as is the case in many other sectors. Standards may suffer either where competition is weak with providers not losing customers when they fail to provide a high quality and well priced service, or where there is intense competition on a headline aspect of a service at the expense of other important aspects of the service. The latter may lead to low headline prices but an increase in less visible ancillary charges;
· The OFT’s concerns in relation to competition in retail banking include:
o high levels of market concentration and problems for new entrants and smaller banks in competing effectively in the market;
o low levels of transparency over the costs of using some financial services as well as real and perceived problems with switching providers, which limit the extent to which consumers are engaged with these services and can drive effective competition; and
o concerns around the control of payment systems by banks and a consequent lack of focus on customer needs and innovation.
4. Over the past few years the retail banking sector has been subject to significant scrutiny by the UK's competition authorities including the OFT. These interventions have led to a number of improvements.  However, concerns about the functioning of competition in the retail banking sector remain and progress appears to have been slower than might have been expected, with a lack of consumer focus in much of the sector.
5. As a result of these concerns, the OFT launched a programme of work on retail banking in July 2012. This is designed to achieve a more competitive and consumer focused retail banking sector.
6. The programme of work will also help inform the OFT's response to the Independent Commission on Banking (ICB). This recommended that the OFT consider making a market investigation reference to the Competition Commission by 2015 if it had not already done so and if sufficient improvements in the market have not been made by that time.
Evidence about the level of competition in banking markets
7. Competition in the banking sector has not been effective for some years. The Cruickshank report on Competition in UK Banking  highlighted concerns about a lack of effective competition in 2000, in particular that:
· the market was highly concentrated, especially for small and medium-sized enterprises (SME) banking;
· customers perceived significant obstacles to switching current accounts and there was a lack of information provided to personal customers and SMEs; and
· the banks were effectively in control of the money transmission service.
8. Since then there have been a number of reviews and interventions by competition authorities, consumer bodies, regulators and the Government. The OFT considers that these have brought benefits but progress has often been slow and incremental, and fundamental concerns remain about competition in these markets. This was confirmed by the report of the Treasury Select Committee on competition and choice in retail banking in April 2011  and the Independent Commission on Banking (ICB) in September 2011. 
9. This submission addresses three themes identified in recent reviews and studies as well as two further indicators of concern with the retail banking sector:
· concentration and barriers to entry: the level of competition in the sector and problems that new entrants and smaller banks face in competing effectively with larger established providers;
· transparency and switching: low levels of transparency over the costs of using current accounts combined with both real and perceived problems with switching providers which limit the extent to which consumers can drive effective competition;
· payment systems: concerns around control of payment systems by banks and a consequent lack of focus on customer needs and innovation;
· customer complaints: the level of complaints from customers can provide an indicator of incentives to improve customer service and maintain high professional standards more widely; and
· sales of linked products: levels of sales of linked products and the potential for miss-selling are indicators of concerns in relation to banking standards.
Concentration and barriers to entry
10. The Cruickshank report found in 2000 that the retail banking market was highly concentrated, especially for SME banking, and the Competition Commission (CC) inquiry on the Lloyds TSB / Abbey National merger in 2001  found that the big four banks had a strong and entrenched position in the personal current accounts (PCA) market.
11. Most banking markets experienced little change in concentration between 2000 and 2008. The OFT's market study of PCAs in 2008  found that overall the relative market shares of the four established banks (Lloyds TSB, RBSG, Barclays and HSBC Group) and the challenger banks (HBOS, Abbey, Nationwide and others) were almost unchanged between 1999 and 2007, although HBOS's position had strengthened.
12. More recently and during the financial crisis however, concentration in the sector rose, with the merger between Lloyds TSB and HBOS in 2008 removing a challenger bank which had been a driver of competition in the market, and increasing the size of the existing market leader.  This increased concentration in an already concentrated market. The ICB reported in 2011 that the largest four banks accounted for 77 per cent of PCAs and 85 per cent of SME current accounts. 
13. The OFT's review of barriers to entry, expansion and exit in retail banking  found that the greatest barriers to entry and expansion were the challenges faced by new and expanding providers in attracting personal and SME customers to switch their accounts. The difficulty of expanding market share can deter firms from entering these markets.
14. Switching rates are low in the PCA market and are only slightly higher for SME banking and savings accounts. Historically, switching was noticeably higher for mortgages and credit cards, although there has been a substantial fall in mortgage switching since 2008.  ,  , 
15. The low propensity of customers to switch providers makes it difficult for new entrants to achieve the necessary scale required to recover fixed costs, in particular, the significant IT investment required to provide retail banking services. 
16. The OFT's review also found evidence for the following barriers to entry: 
· some firms reported difficulties and uncertainties around the process of obtaining authorisation from the FSA to accept deposits and offer mortgages, which delayed entry and made it harder to raise capital;
· it appeared that new capital requirements, along with liquidity standards, could have the potential to exacerbate differences between incumbents and new entrants, for example, by imposing higher fixed costs of compliance;
· credit risk information about the smallest SMEs was limited, which could make it harder for new banks to lend to the smallest firms; and
· the ability of some firms to expand or, in some cases, maintain existing operations had been constrained by the lack of interbank lending from the financial crisis and recession.
17. If providers face significant difficulties in entering and competing in the market, they will be deterred from doing so and incumbent providers will not face the threat of new entrants challenging them for business. In addition, the low levels of switching in PCAs may indicate that competition between incumbent providers is limited with reduced incentives to innovate, increase their quality of service, reduce costs and price competitively in order to attract and retain customers.
18. Moreover low switching rates themselves can also represent a further barrier to expansion in other retail banking product markets (such as savings and credit products) because current accounts may act as a gateway for the sale of additional products. 
19. The effect of these competition problems on standards in retail banking is complex, as is the case in many other sectors. Standards may suffer either where competition is weak with significant barriers to entry with providers not losing customers and their revenues when they fail to provide a high quality and well priced service, or where there is intense competition on a headline aspect of a service at the expense of other important aspects of the service. The latter may lead to low headline prices but an increase in less visible ancillary charges. Competition in banking may be seen as weak and focused on certain areas with charges focused on other less visible areas of bank accounts.
Transparency and switching
20. Consumers’ decisions about whether to switch bank accounts are complex with a number of likely causes. The OFT will be exploring such issues and conducting some behavioural economics research on these issues as part of its programme of work on retail banking.
21. While there may be many reasons why consumers switch, we consider that the transparency of competing offers and the actual and perceived ease of switching are among the key determinants of consumers' ability and willingness to change provider. These elements of transparency determine the degree of competitive constraint on providers to meet their customers' needs in order to retain them.
22. The OFT's market study on PCAs in 2008 found that it was difficult for consumers to compare accounts because of the lack of transparency of account costs. The two most significant costs for consumers are the least transparent – interest foregone (by holding money in a current account rather than in a higher rate in a savings account) and insufficient funds charges (where providers charge consumers for using either arranged or unarranged overdrafts).
23. The market study found that it was difficult for consumers to access the information they need in order to work out the cost of running their account and therefore to make comparisons across providers. It was particularly difficult for consumers to compare insufficient funds charges across banks because this requires a comparison of both the amount of the charges as well as how they are applied, which is complex and varies between provider.  This study also noted that the quality of service is not easily observed by consumers before selecting a provider, again making an accurate comparison difficult.
24. The study also found that real and perceived difficulties with the switching process  were also acting as a barrier to consumers switching provider. Consumers were particularly concerned about miss-directed payments and having to rectify any problems. 
25. The market study concluded that consumers’ lack of appetite for switching may generate little pressure on banks to raise the standard of their provision of banking services in order to retain customers, with implications for customers and the public's view of the banking sector. It found that the overall picture is one of consumers who are not well informed, are relatively unengaged in the market for current accounts and are uninterested in switching. 
26. The CC's investigation of the PCA market in Northern Ireland in 2007  similarly found significant obstacles to searching and switching to alternative suppliers. It found a lack of clarity and a level of complexity in charging structures and practices that would be likely to impede searching and switching by customers. While some obstacles were perceived rather than real, these perceptions affected consumer behaviour, leading to a high level of customer indifference and a lack of searching and switching.
27. The OFT notes that the Department for Business, Innovation and Skills has launched a consultation on its Midata proposals.  If implemented, these may provide consumers with useful data on their use of bank accounts which may enable a more detailed comparison of the cost of these accounts and allow consumers to see the extent of benefits from switching provider.
28. Some of the Cruickshank report's concerns about payment systems also remain. Payment systems are still under the control of banks. Although it reversed its position in July 2011, the Payments Council's decision to consider the abolition of cheques raised questions about the extent to which consumers' views are reflected in its governance. There are also questions about the pace of innovation when it is organised collectively, reflected, for example, in the time it took to introduce Faster Payments. Some questions have also been raised about whether the need for access to payment systems creates a barrier to entry, although both the OFT  and the ICB  found limited evidence to support this view.
29. In July 2012, the Government consulted on options for reforming the regulation and governance of payment networks because they hadn't responded effectively to the needs of consumers and in order to facilitate competition by permitting open access to participants on reasonable commercial terms. 
30. The OFT notes that levels of satisfaction and complaints in relation to retail banking, particularly when examined over time may be useful indicators of the level of dissatisfaction with banks, and can provide evidence of changes in incentives to maintain professional banking standards. Data from the Financial Ombudsman Service covering specific complaints on retail banking and credit products may be considered alongside evidence on levels of switching across the retail banking sector.
Sales of linked products
31. This submission concentrates on the areas of retail banking in which the OFT has carried out most work and where it is seeking to undertake further work. However, there are other areas where the OFT has carried out less recent work, which may still be useful indicators of professional standards being below that which many might expect.
32. One example of this is the sale of payment protection insurance (PPI), where the OFT carried out work between 2005 and 2007. 
33. In June 2012, HSBC, Royal Bank of Scotland and Lloyds Banking Group agreed with the FSA to compensate some customers who were miss-sold PPI after the FSA found evidence of serious failings in the way PPI was sold to customers. Such widespread miss-selling may represent another indicator of a lack of incentives on banks to maintain high professional standards in their dealings with customers.
34. These themes all indicate a lack of customer focus on the part of current account providers, which may be viewed as a diminution of standards of provision. Providers could be argued to be exploiting consumers' particular behavioural biases together with their inability to access and assess information and hence to make effective decisions, rather than helping consumers find the most suitable account. The PCA market study found that banks profited from these factors by earning much of their revenues from less transparent sources, such as foregone interest and unarranged overdraft charges. In particular, the lack of visibility of insufficient funds charges and consumers' inability to understand and control them meant that some banks appeared to see them as a way to generate additional revenue without affecting demand for their accounts. 
35. In 2008, the OFT expressed concerns around the merger between Lloyds TSB and HBOS. One concern expressed was that Lloyds' greater share of the market, coupled with characteristics of the market, would encourage it to attach more weight to enhancing margins on current customers than to acquiring additional customers. 
Action taken by the OFT to address competition concerns
36. In October 2009 and following its 2008 market study, the OFT set out initiatives it had agreed with PCA providers and industry to make PCA costs more transparent and the switching process more reliable and trusted.
37. To improve transparency, so that consumers could more easily understand the costs of their accounts and compare with others, banks:
· introduced annual summaries of the cost of their account for each customer, which will help them to focus on the value they are getting in a similar way to annual car or house insurance renewal quotes;
· made charges prominent on monthly statements, so that consumers are more aware of the charges they pay;
· provided average credit and debit balances, which will help consumers to estimate the potential benefits of switching bank; and
· produced illustrative scenarios showing unarranged overdraft charges, giving consumers an idea of the costs for different patterns of use.
38. To improve the switching process, the following measures were introduced following work with Bacs, the payment processor:
· steps to reduce problems that arise from transferring Direct Debits;
· measures to reduce the impact on consumers of any problems with transferring Direct Debits; and
· a new consumer guide and website as part of efforts to increase consumer awareness of the automatic switching process.
39. Following the OFT/FSA banking test case which examined whether unarranged overdraft charges could be examined in full for fairness, the OFT held discussions with PCA providers in relation to its concerns around unarranged overdrafts. As a result, in March 2010, the OFT noted that unarranged overdraft charges had changed in the following ways:
· unpaid item charges, levied when a bank refuses to make a payment, fell from an average of around £34 in 2007 to around £17 in 2010;
· per transaction paid item charges, levied when an unarranged overdraft is granted, fell from an average of around £30 in 2007 to around £22 in 2010;
· the majority of PCA providers now use Faster Payments for standing orders and one off payments; and
· commitments were secured from the banks to improve transparency for customers about their accounts as well as making it easier to switch accounts.
40. The OFT’s discussions led it to expect significant developments between 2010 and 2012, including:
· greater ability for customers to opt out of being granted unarranged overdraft facilities and the charges associated with them;
· more tools available for customers to control their balances and avoid going overdrawn; and
· better treatment of customers who do go overdrawn and get into financial difficulty.
41. These improvements were supported by wider banking industry commitments, which were also announced in March 2010:
· the development of minimum standards to apply when offering customers the ability to opt out of unarranged overdraft facilities;
· the development by banks of best practice for customers in financial difficulty who incur unarranged overdraft charges; and
· an industry working group to develop ways of giving consumers greater control and access to real-time information on their account.
42. New entrants in the market, including some big brand names, were also expected to stimulate further competition during that time.
43. The OFT committed to report back on the impact of these initiatives on the market during 2012.
Further actions for regulators and competition authorities
44. The ICB made a number of recommendations aimed at increasing competition in the PCA market. These included a switching re-direction service, an enhanced competition role for the Financial Conduct Authority (FCA) and OFT to take steps to improve competition. 
45. The Government’s Consumer Credit and Personal Insolvency Review  announced further initiatives to improve the transparency and control of unarranged overdraft charges for consumers. These included giving consumers the option to receive a text or email alert when their balance fell below a certain level, making them aware of a grace period when they can credit funds to put their account back within their overdraft limit and so avoid being charged and a small buffer zone within which unarranged overdraft charges would not be levied.
The role of regulators
46. The OFT notes that it is important to ensure that regulatory processes do not act as a barrier to entry, preserving incumbents and restricting unduly the competitive constraints providers face, which may lead to a reduced focus on professional rigour and standards. The OFT considers that competition and financial stability are consistent, providing there is proper regulation to tackle excessive risk taking, but not overly to restrict competitive constraints that can discipline providers.
The Prudential Regulatory Authority
47. The OFT has committed to providing support to the Prudential Regulation Authority in its review of the application of prudential requirements in order to ensure that new entrants and smaller banks are not disproportionately affected by, for example, requirements to hold proportionately more capital than major incumbents. Competition from outside the traditional banking model may also create challenges for the process of granting authorisation. It is important that regulators do not unduly constrain competition by taking the business model of incumbent and traditional banks as the starting point for the design of new rules in ways that could disadvantage new technologies and innovative providers.
The Financial Conduct Authority
48. A key potential source of change in the banking sector in terms of regulation is the establishment of the FCA. It has a clear remit to place effective competition at the heart of its regulatory approach, expressed in terms of using its powers to make markets work well for consumers, so that competition is regarded as a key mechanism for achieving effective outcomes for consumers.
49. The FSA signalled a change in approach by the FCA:
‘The creation of the FCA provides an opportunity to develop a new approach to conduct regulation, addressing the problems which have beset UK retail financial services for 20 years.... A key task will be to ensure that the conduct of participants is compatible with fair and safe markets. The FCA will, therefore, focus more closely on wholesale conduct than the FSA. It will adopt a more issues and sector-based supervisory approach across the 24,500 firms which it will regulate for conduct and prudential purposes.’ 
50. The OFT and FSA are developing a concordat to clarify the respective responsibilities of the OFT and the new FCA regarding competition.
The OFT's programme of work on retail banking
51. On 13 July 2012, the OFT launched a programme of work on retail banking with the objective of achieving a more competitive and consumer-focused sector.
52. The OFT considers that a well-functioning retail banking sector would have the following characteristics:
· Barriers to entry and expansion would be lower
· Consumers would be sufficiently engaged with their banking services to drive competition.
· Consumers would have a broad choice of provider.
· Competition would be driving providers to operate more efficiently and to innovate.
· Providers would be more customer-focused – serving customers with products that are well-suited to their needs and in a way that makes it easy for customers to make well-informed decisions about when and how they are used.
53. The first project in this programme of work is a review of the PCA market. The OFT committed in 2010 to a detailed review of the PCA market in 2012.
54. In seeking to establish how the market has evolved since the OFT's market study in 2008, this review will look at whether the initiatives the OFT has agreed with the banks, and described above, have been successful at improving the switching process, increasing the transparency of PCA charges and allowing people to manage their accounts more effectively.
55. The programme of work will also involve the OFT considering the operation of payments systems and the SME banking market. It is also planning to consider in more detail at the way consumers make decisions and engage with retail banking services, including through the application of research on behavioural economics.
56. The OFT notes that there is scope for greater competition in this sector, with recent entry from Metro Bank and Virgin Money (through the acquisition of Northern Rock) and stimulus given to the market by means of the planned divestments from Lloyds Banking Group to the Co-op. More fundamentally, new technology may increase the scope for competition from outside the traditional banking model, for example from online or mobile innovation. However, whether these developments will generate increased competition will depend in part on whether consumers have sufficient information and are now more engaged with these services such that they can drive competition among providers. Effective competition would be expected to generate benefits including lower prices and higher standards and quality of service.
57. In the event that the OFT does not see real change from providers over the course of this programme of work, a more radical approach may be considered necessary. The ICB recommended that the OFT actively consider making a market investigation reference to the CC  by 2015 if it had not already done so and if sufficient improvements in the market had not been made by that time.  The OFT's programme of work is aimed at informing its response to this recommendation, although a reference remains a possibility at any time if the legal test is met.
4 September 2012
 For example, the OFT’s focus in its 2008 market study was on the charges for unarranged overdrafts and this focus continued during and after the OFT’s test case on whether unarranged overdraft charges could be assessed for fairness.
 The OFT’s progress update for the PCA market in March 2011 found reductions in 2010 relative to 2009 in both unpaid item charges and the revenues from consumers incurring unarranged overdraft charges from the largest banks in Great Britain (Personal current accounts in the UK – progress update, March 2011).
 Competition in UK Banking, a Report to the Chancellor of the Exchequer, Don Cruikshank, March 2000.
 Competition and choice in Retail Banking, Treasury Select Committee, April 2011.
 Final Report Recommendations, Independent Commission on Banking, September 2011, p.16.
 Lloyds TSB Group Plc and Abbey National Plc: A report on the proposed merger, Competition Commission, July 2001, p.4.
 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.25-27.
 Anticipated acquisition by Lloyds TSB of HBOS plc Report to the Secretary of State for Business Enterprise and Regulatory Reform, Office of Fair Trading, October 2008, p.5.
 Final Report Recommendations, Independent Commission on Banking, September 2011, p.16.
 Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, pp.6, 10, 63.
 Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, pp.125-129, 135-6.
 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.31-2.
 Final Report Recommendations, Independent Commission on Banking, September 2011, p.180.
 This could account for up to two thirds of start-up costs, much of which would be likely to be sunk and not recoverable in the event of exit from the market.
 Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, pp. 7-9.
 Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, p. 10
 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp. 89-90.
 45 per cent were not very or not at all confident that it would go smoothly.
 Such concerns are at least partly justified given that in the OFT's survey 28 per cent of those that had switched reported some kind of a problem. It was particularly significant that 33 per cent of switchers would be unlikely or very unlikely to recommend switching. Source: Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.99-104, 107.
 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp. 85, 107-108.
 Personal current account banking services in Northern Ireland market investigation, Competition Commission, May 2007, p.10.
 Midata 2012 review and consultation, see: http://www.bis.gov.uk/Consultations/midata-review-and-consultation
 Review of barriers to entry, expansion and exit in retail banking, Office of Fair Trading, November 2010, p.9.
 Final Report Recommendations, Independent Commission on Banking, September 2011, p.173.
 Setting the strategy for UK payments, HM Treasury, July 2012.
 In September 2005, Citizens Advice submitted a super complaint to the OFT regarding PPI, and in response to this the OFT carried out a market study from April 2006 and made a market investigation reference to the Competition Commission in February 2007.
 Personal current accounts in the UK, An OFT market study, Office of Fair Trading, July 2008, pp.2, 4-6.
 Anticipated acquisition by Lloyds TSB of HBOS plc Report to the Secretary of State for Business Enterprise and Regulatory Reform, Office of Fair Trading, October 2008, pp.5-6.
 Final Report Recommendations, Independent Commission on Banking, September 2011, p.17.
 Consumer Credit and Personal Insolvency Review Formal Response on Consumer Credit, HM Treasury and Department for Business Innovation and Skills, November 2011.
 The Financial Conduct Authority – Approach to regulation, FSA, June 2011.
 The CC can take a detailed and fresh look at the market and has a range of behavioural and structural remedies at its disposal, up to and including requiring the break-up of incumbents.
 Final Report Recommendations, Independent Commission on Banking, September 2011, p.18.