Since the financial crisis, most banks have been hit by a tsunami of regulation. Just as there is a credit cycle, there is also a regulatory cycle, with a violent swing away from a faith in banks’ own internal models and “light touch regulation” to the more hands on approach we have today. Such a reaction was inevitable given the sins of the past. But one unintended consequence has been that tougher regulation has tended to reinforce the status quo: Too Big To Fail global banks. For instance, Metro Bank founder Anthony Thompson, has said it took 20 months for the firm to get a licence and the process was fraught with ‘Catch 22′ problems around raising capital and building infrastructure before the bank could receive the approval of regulators.
But a little noticed report published in March this year (A review of requirements for firms entering into or expanding in the banking sector [FSA / Bank of England: March 2013]) has induced a seven-fold increase in applications to start new banks. Moreover this is being encouraged by the UK regulator, Nicola Wildman of the FCA, speaking at a conference in November, expressing the hope of approving banking licence applications for the 21 challengers within nine months.
The flurry of activity has followed the Bank of England and FSA’s review into the requirements of firms entering or expanding in the banking sector. The reforms take a holistic approach, both making it easier to understand what information the regulator needs, setting clear milestones along the path to authorisation as well as speeding up the process. The thinking behind this major shift is that bank failure should be seen as a normal market process, as long as failure does not threaten system wide stability. In short, the UK regulator is no longer seeking, in their own words: “a zero failure regime.”
But the changes are not just around attitude. Previously, the regulator had suggested start up banks, with little historic data and untested systems needed a higher level of equity funding than long established banks with sophisticated Advanced Internal Ratings Based Basel compliant capital models.
For instance, Basel II tended to favour banks with a back book of customers, who were 15-20 years into their mortgage, with LTV of perhaps 30 percent or lower. Although lower capital requirements for such customers were justifiable given the low probability of losses; these low-risk customers were probably cross-subsidising riskier lending in the run up to the crisis. In fact, the low capital requirements meant these loyal customers were extremely valuable to a dominant bank able to achieve monopoly-like returns. It stands to reason that their long term customers with lower balances would, by definition, be less price sensitive. So despite requiring less capital allocated to them, they would be hardest customers for a new entrant to cherry pick, with for example a price-led strategy or flashy marketing campaign. More likely, as we have seen time and again, new entrants ended up lending to the riskiest customers at the wrong point in the cycle.
|Name||Started||profit (loss)||profit (loss)|
|Scottish Widows Bank||1995||17||bought by Lloyds|
|Goldfish||1996||-30||bought by Barclays|
|The One Account||1997||27||-8|
|Tesco Personal Finance||1997||160||176|
|Egg||1998||-34||bought by Citi, then sold|
|Standard Life Bank||1998||5||bought by Barclays|
|Marbles||1998||not reported||bought by HSBC, then sold|
|Smile||1999||not reported||Co-op internet bank|
|Cahoot||1999||-15||Abbey internet bank|
|Intelligent Finance||2000||-53||Hfx internet bank|
|Zurich Bank||2001||Closed 2003|
All this partly explains the rather poor track record of new entrants in the UK market. Below is a slide put up by Royal Bank of Scotland a decade ago. Despite the internet being seen as a potential dis-intermediator of branch based banking, almost all new entrants, including internet bank set up by existing players such as Abbey and Halifax (Cahoot and Intelligent Finance, respectively), failed or were bought by existing banks at distressed valuations. With the exception of the supermarkets, who continue to struggle onward, with very limited success.
But the environment is changing. The regulator will now apply just 4.5% minimum core tier 1 capital to start up banks versus 7% to 9.5% for major existing banks. The new banks will also enjoy reduced liquidity requirements.
If judged by the flurry by the new applications for approval, the policy might already be judged a success. Before becoming to unequivocal though, we should remember attempts by politicians and regulators to increase competition in banking are not new.
About 15 years ago the UK government commissioned the Cruickshank review, and Don Cruickshank was asked to look at making SME banking more competitive, because the market shares of the biggest 4 UK banks were so concentrated and had steady over time. The Cruickshank Report identified UK bank overcharging on business bank accounts by an amount between three and five billion pounds. Gordon Brown largely ignored the report and the suggested remedies were watered down.
Analysts and regulators both tended to assume competition would come ‘new entrants’. Actually, in the years since the Cruickshank Report, though SME banking remained uncompetitive, mortgage margins did fall dramatically from around 200bp in 1998 to 20bp just before the credit crisis. Yet this was not caused by new entrants, instead it was new capital (or more precisely cross border wholesale funding) going to existing players, such as Northern Rock and HBOS, who used it to increase leverage, then compete too aggressively and destroy returns in the mortgage market.
Equity shareholders think very differently to short term debt holders who can rush for the exit, and have no need to stick with a company long term. A thought experiment demonstrates why. What would have happened if Northern Rock had said 15 years ago, “ok, we are NOT going to fund our lending through securitisation and wholesale markets, let’s do a MASSIVE rights issue and increase our equity base by tens of billions”. Shareholders would have asked what they would do with the money? And would not have been very pleased with the answer, we are going to chase market share and drop prices for mortgages from 200bp to around 20bp. Short term debt holders appeared unconcerned about the fall in UK mortgage margins, and only rushed for the exit very late in the credit cycle.
Hence, the new banks starting up should probably avoid the UK mortgage market. Instead more competition in the UK could help productive SMEs starved of capital and currently receiving poor service from banks. Certainly the Andew Large Independence Review into RBS’s failure to hit SME lending targets suggested that internal complexity and unclear lines of responsibility were a major part of this failure. That is RBS had become too big, and too complex to serve it’s core customers. New entrants could potentially address this short coming.
Natural barriers to entry in SME banking, such as ease of access to the payments system, scale and brand remain. But we are seeing a sea change in regulators attitude to new entrants. SME customers were poorly served by the previous situation, the next ten years could look very different.