Is free banking holding back competition?
The UK Parliament review of the banking sector following a summer of scandals across the sector has, once again, raised the question of whether the end of the British system of so-called ‘free banking’ would introduce further competition into the sector. There are many who argue that free banking is a major barrier to entry for new competitors in the sector. However there is no evidence that this is the case.
In Australia, where there is the greatest transparency the cost of banking, where almost every transaction attracts a fee, the market is dominated by the so-called Four Pillars – ANZ, Westpac, Nab and Commonwealth Bank. There are smaller players such as Bendigo Bank, but despite the lack of free banking the split of the market is almost identical to that of the UK.
A number of new entrants already operate, or have announced that they will, exclusively non-free banking. Handelsbanken, the most successful of the new entrants with over 100 branches and the highest customer satisfaction of the UK banks (see http://www.itsafinancialworld.net/2012/01/customers-love-banks-who-charge-them.html), does not offer free banking. Marks & Spencer have announced that their current account will charge fees and even Virgin Money, the consumers’ champion, has announced that its current account will charge a ‘small fee’.
So whilst there is increasing competition in the UK retail banking sector why are the new entrants not able to make any more than a small dent in the share of the big five banks (Barclays, Lloyds Banking Group, RBS, HSBC and Santander)? One of the key reasons is the economies of scale required to be profitable in retail banking.
Owning and operating the infrastructure (the ability to process standing orders, direct debits, transfer money, access to ATMs etc) required to process billions of transactions reliably requires very large amounts of capital. Whilst the recent issues that RBS recently had with processing transactions, the UK banking infrastructure is amongst the most reliable in the world. Returning to Australia, the banks there have had far more problems with their payments infrastructure than the UK, despite having far lower transaction volumes.
New entrants today are able to use the Big Five’s infrastructure. Whilst they may argue that the cost they pay is unfair and has little transparency as to the basis of the charge, it is certainly a lot cheaper than building their own. In itself these costs are not the reason that holds back their success against the Big Five.
The biggest scale advantage that the encumbents have is operating capital. This was most recently illustrated by the competition for the Verde branches that Lloyds Banking Group had been forced by the EU to dispose of following the state bail-out after the acquisition of HBoS. Whilst there are a not insignificant number of players who would like to enter or grow their footprint in the UK banking market such as JC Flowers, Virgin, Metro Bank and NBNK, they either weren’t able to or were unwilling to raise the amount of capital required to become a significant player in the market. This situation has become further exacerbated since 2008 with capital being even harder and more expensive to find. To make the situation worse the amount of capital required to be held has been raised higher following the banking crisis. Here the established banks have a distinct adavantage as the requirement for capital is lower for them than for new entrants to the market. This is clearly a major barrier to entry.
Another significant barrier to entry for new entrants is the increased scruitny and additional regulation as a result of the banking crisis. This means that it takes longer and is far more difficult for any new entrant to get a banking licence and to get its executives approved to run a bank. This was one of the major hurdles that has held up the launch of Tesco Bank.
It is very convenient for politicians to blame the lack of competition for the Big 5 on free banking, however those politicians need to reflect on their own role in making it more difficult for new competition. The UK government wants to have a safer banking sector and in so desiring and by its actions has made it more difficult for new entrants.