Memo to Ed Miliband – you cannot regulate your way to competition

Today Ed Miliband made a speech on policy in UK banking. There is much wrong with that market and important reforms should involve ensuring that the providers of capital to banks always bear the costs of failure whilst the bureaucratic nature of regulation is reduced. However, Miliband’s speech appeared to hit all the wrong notes (the full speech had not been published at the time of writing). For instance, I can find no evidence at all for his assertion: ‘Of course, financial services are an important industry in itself. But for an industry that calls itself a “service”, it has been an incredibly poor servant of the real economy, not just since 2010 – or 2008 – but for decades in this country.’

Indeed, his argument looks especially strange when you look at his proposals. He does not want competition at the margins with a few small ‘challenger’ banks but new large banks. He complains about a banking market in which five banks control 85 per cent of the market and suggests that the same problems exist as in the energy market (in which there are six companies with a large share of the market). So, what is the right number of companies exactly? Clearly not five, or even six. Is it seven or eight? And how can we get to a banking market where eight companies rather than five control the lion’s share of the market? It is something that would be impossible to achieve in practice through state regulation.

The key policy proposal seems to be a cap on market share through a requirement to sell off branches once market share reaches a given level. This seems to be designed to reduce competition and customer service. The likely response by the banks is that they will sell off the least-used branches and thus reduce branch coverage. However, the proposal will undermine competition. What will happen when a bank nears the statutory limit on the share of the market? Tesco has been a market leader amongst supermarkets in recent years. Its market share increased to nearly 30 per cent simply because it was better than the rest. Now, its market share is falling again as new entrants (Lidl and Aldi) and niche players (Waitrose) expand and provide for customers’ changing needs. Imagine if Tesco’s market share had been capped at 25 per cent. What would its response have been as it reached that market share? Presumably it would have put up prices and/or reduced service levels. The idea that a statutory limit on size would make good performers perform better is at best counterintuitive and certainly unproven.

But what about the assertion that the industry performs badly? Well, a host of studies certainly do not confirm that hypothesis. A study by Dutch academics has the UK banking industry the fourth best in the EU (after excluding two countries with insufficient observations) and two of the better performers are Switzerland and Luxembourg which are special cases. Another study does show British banks providing much less capital to smaller businesses than their EU counterparts, but the UK also has a much larger market in non-bank finance – that has always been the case. A further study suggests that profit margins are around average for British banks but net interest margins are very, very low by international comparisons. This is the difference between interest rates on deposits and other forms of finance used to fund lending and interest rates on lending, so it is a good indication of whether customers are getting a good deal. A high margin means that customers are paying much more for a mortgage than they are getting on deposits. Insofar as margins have increased in the UK, government schemes such as Funding for Lending have been at least partially responsible as has the huge increase in bank capital regulation.

Of course, there have been some constraints on competition in recent years and not just in the form of Funding for Lending and bank capital regulation: Ed Miliband sat in a cabinet that encouraged the takeover of HBOS by Lloyds. We also desperately need innovation. But innovation does not come as a result of stopping the best performing firms from expanding. Innovation comes from lowering barriers to entry. New banks always complain about regulatory barriers to entry; financial regulators have decided to regulate the new forms of finance (crowd funding and peer-to-peer lending) to make them less innovative and competitive. As ever, the politicians need to be more introspective and consider the fact that it may be their own obsession with regulation and intervention that is the cause of the problem.

An earlier version of this article was published on ConservativeHome.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.

3 thoughts on “Memo to Ed Miliband – you cannot regulate your way to competition”

  1. Posted 18/01/2014 at 16:35 | Permalink

    Milliband it endeavouring to bring the debate into the open. Not always in a sense that might appeal to everyone but certainly in a way that deserves some attention.

    Who could disagree with the contention that shareholders should bear the cost of failure? Who could disagree that competition has become severely impaired since the Bank of England encouraged bank mergers?

    Why not allow all authorised deposit takers in the UK to have clearing status and why allow the existing Clearers the right to exclude them?

    Perhaps a cap on banks is not the answer but perhaps limiting their size by requiring all growth to be organic might pave the way for some robust competition.

    All things proposed by the Conservatives are not always right and all things proposed by the Socialists are not always wrong.

  2. Posted 18/01/2014 at 23:16 | Permalink

    certainly this blog has never suggested that everything proposed by the Conservatives is right – far from it. I am not against this issue being opened up. A sensible suggestion could be made on competition grounds (though I don’t agree with it) to stop free banking which I am told is a significant barrier to entry. Anyway, I am interested in your suggestion and how clearers stop deposit takers clearing. Can you expand on that?

  3. Posted 19/01/2014 at 15:45 | Permalink

    I’m not sure I can improve on the commentators on John Redwoods site so, to avoid plaguerarism I repeat below

    There are about 150 UK incorporated, deposit taking banks, and about the same number EEA and non-EEA incorporated banks, licenced for deposits by the PRA (BoE). How many more do you want? However, they don’t all have “Clearing and Settlement” capabilities and reserve / securities accounts at the Central Bank. .

    A much better idea would be actually separating the Payment, Settlement and Clearing system from the Casino Banks. Systemically Important Payment Systems (SIPS), needs to be separated and directly supervised by the currency relevant Central Bank. As a Central Banks is immune from any liquidity problem in its own currency, it is the lender of last resort that keeps the system moving at the speed of light. (Just like the US FED does as a SIPS). The Casino banks could then be regulated like any other Las Vagas type casino, or a UK Bookmaker, or a Bingo Hall.

    For those who haven’t got a clue about Clearing, have a read of the BoE

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