Memorandum submitted by the Office of
Your letter of 20 May invited me to comment
on the evidence provided by the four major clearing banks on the
provision of banking services to small and medium-sized enterprises
(SMEs). In particular, you referred to my comments on the Competition
Commission's assessment of profitability in my advice to the Secretary
of State for Trade and Industry and the Chancellor of the Exchequer
of 12 December last year.
I should perhaps point out, for the avoidance
of doubt, that the OFT has not itself analysed the profitability
of the banks. Our assessment was based purely on a review of the
information set out in the Commission's report. Nevertheless,
I concluded that the Commission's conclusions did not appear unreasonable
and Sir Bryan Carsberg reached a similar conclusion in his report.
At your request we have examined the oral evidence given by the
four major clearing banks, and the written memoranda submitted
by Barclays and Lloyds TSB, to assess whether it would lead me
to revise my conclusion. In short, it does not.
In their comments on the Commission's assessment
of profitability the banks, or at least some of them, appear to
be making the following four main points:
that the Commission only examined
profitability over the last three years, which do not reflect
the position across the business cycle. In particular, it is alleged
that the Commission has not taken account of the costs of bad
debts during the early 1990s (questions 134 and 137; paragraph
12 Barclays' memorandum);
that if the Commission's approach
were applied to other listed companies many other industries (22
out of 38 sectors according to Barclays and 15 sectors according
to Lloyds TSB) would be found to earn excess profits (questions
137 and 156; paragraph 11 of Barclays' memorandum; paragraph 18.3
of Lloyds TSB's memorandum);
that the returns on equity earned
by UK banks are no higher than in other countries (question 156);
that the banks' price/earning ratios
indicate that they are not earning excess profits (question 176).
I will deal with each issue in turn.
On the first issue, while it is true that the
Commission focused on the profits earned over the past three years,
it is not correct to say that the Commission ignored the costs
of bad debts incurred during the recession of the early 1990s.
The Commission rightly based its analysis on the most recent years
for which data were available, since this is the information that
is most relevant in assessing the current level of competition,
and information on earlier years can be more difficult to obtain.
However, the Commission recognised that bad debts will vary over
the course of the business cycle and that in recent years the
level of bad debts has been much lower than the long-run trend.
For this reason they adjusted upwards the costs of bad debts to
reflect the higher costs incurred in earlier years.
The Commission took account of evidence on the
level of bad debts over the period 1989 to 2000. It did not equate
its adjustment to the full cost of bad debts across this period,
since evidence suggested that the banks have improved their performance
in credit risk assessment over the past 12 years. The Commission
therefore applied a one-third discount to the period 1990-94.
This produced an estimate for the long-run bad debt ratio of 1.2,
compared to the average outcome for the four banks of 1.6 over
the period 1989-00 and 0.48 over the most recent full year.
In his oral evidence at question 134, Mr Ellwood
stated that the Commission had used a figure of 0.8 while his
bank had incurred a bad debt ratio over the 12 year period of
2.0. This is incorrect since, as stated above, the ratio used
by the Commission was 1.2. Although it is correct to say that
LloydsTSB incurred a ratio of 2.0, this was higher than the other
three main clearing banks, who appear to have been more effective
at managing bad debts.
Turning to the second issue raised by the banks,
in order to identify excess profits it is necessary to compare
the return on equity earned by firms with their cost of equity
(the return they must provide in order to entice investors to
invest in that business). The cost of equity will vary between
different sectors of the economy reflecting factors such as the
risk profile of returns and the maturity of the industry. The
fact that some sectors earn a higher level of return on equity
(as identified at question 156 and at paragraph 18.3 of LloydsTSB's
memorandum) therefore does not necessarily imply that companies
in those sectors are earning excessive profits. It is not clear
whether Barclays has calculated the appropriate cost of equity
for each sectorwhich would be a significant exercisebefore
concluding that 22 sectors would be found to be earning excess
profits using the Commission's methodology. If not, Barclays'
analysis may partly reflect the fat that the cost of equity will
be higher in some sectors than in others.
It is important also to view returns on equity
in a wider context. There are many reasons why companies might
achieve high levels of return on equity. The exploitation of market
power is one possible explanation, but high returns might instead
reflect, amongst other possible explanations, high levels of innovation
or short run increases in demand. The Commission examined a wide
range of evidence on competition in the provision of banking services
to SMEs in addition to the return on equity earned by the banks.
Important issues included high levels of market concentration,
the stability of market shares over time and the reluctance of
SMEs to switch banks. It was the combination of high returns with
these other factors that led the Commission to identify an adverse
effect on the public interest.
The third issue raised was a comparison of the
returns earned by UK and overseas banks. There are a number of
potential problems with this comparison. Accounting practices
may vary between different countries and the information quoted
at question 156 appears to relate to other banking businesses
as a whole, rather than the provision of services to SMEs. This
evidence also involves the implicit assumption that the cost of
equity faced by banks does not vary between different countries
and, of course, that banks operating overseas are not earning
The last issue raised was about the bank's price/earnings
ratios. This is the ratio of share price to earnings per share.
The price/earnings ratio will reflect a number of factors, primarily
investors' expectations of future growth in profits and dividend
payments. I cannot see why this ratio would provide a useful measure
of whether or not a firm is, at present, earning excess profits.
And an oligopolist with market power in a mature industry, for
example, could very well have a lower price/earnings ratio than
a firm in dynamic competition.
In conclusion, much of the evidence provided
to the committee reflects the evidence which the banks provided
to the Commission, and which was taken into account by the Commission
in reaching its conclusions. Inevitably, the Commission had to
make a number of judgements in reaching its conclusions. The banks
have identified some areas where the Commission could have been
more favourable to them in its assumptions. However, as both my
advice to the Secretary of State and the Chancellor and Sir Bryan
Carsberg's report noted, there are also areas where the Commission
made conservative assumptions which may have led to cautious estimates
of the level of excess profits earned by the banks. To the extent
that the banks have raised new arguments in their evidence to
the Committee, these do not appear to me to be compelling and
they do not lead me to alter the conclusions I set out in my advice
to the Secretary of State and the Chancellor.
Director General of Fair Trading
21 June 2002