LONDON, MONDAY 15 NOVEMBER 1999
Howard Davies
Chairman, Financial Services Authority

PROFITABILITY AND COMPETITION IN UK BANKING

Earlier this year in a Financial Times article George Graham contrasted the image of a banking industry "bewitched by technical change, bothered by new competitors and bewildered by an uncertain economic outlook" with the reality of recent banking profits. Bewitched, bothered and bewildered banks may or may not be. What we do know is that in 1998 large UK banks in aggregate earned a pre-tax return on equity of almost 30 per cent, three times what they earned in 1992, after a sixth successive year of strong profit growth.

Despite the more uncertain economic environment banks appeared to be facing as they entered 1999, profitability has continued to rise this year: first half results reported by the major banks showed pre-tax profits up 7 per cent on a year earlier, ahead of market expectations. This is a remarkable performance, by any standards, and the high profits of recent years have been achieved in spite of the costs incurred in getting ready for the introduction of the euro on the continent, and in coping with Y2K: the latter has, according to the BBA, cost the banks more than £1 billion in total.

While it is true that bank profitability has been stable or improving in most industrial countries in the second half of the 1990s – the notable exception being Japan – the profitability of UK banks has been exceptional by international standards. UK banks’ return on equity has comfortably exceeded that achieved by US banks, and exceeded that achieved by banks in the other main European countries by a still wider margin. In absolute terms, the return on equity achieved by Japanese banks in 1998 was not very different from that recorded by UK banks, but in the Japanese case the return was negative. In Korea, banks return on equity in 1998 was close to minus 60 per cent.

Indeed over the last five years the seventeen major Japanese banks still solvent made net post-tax losses totalling 10.1 trillion yen, after total loan loss provisions of 37.8 trillion yen; and that compares with total equity which had fallen last year to 13.1trillion yen, before the injection of 7 trillion yen of public funds. [A trillion here, a trillion there, and pretty soon you’re talking real money].

A recently published international comparison by the Bank for International Settlements, which focused on an alternative measure of profitability, return on assets, shows UK banks’ return – at 1.19% – close to double that achieved on average by banks in the euro-zone – 0.63% – though behind US and Australian banks. Japanese banks returned minus 0.74% on assets.

By contrast, UK non-financial corporations have tended to earn lower returns on average than their counterparts in most other major countries; and their profitability has improved much less dramatically since its recent trough in 1992: figure for non-oil private non-financial corporations published just last week showed their net rate of return in 1998 up by about a quarter since 1992 and still lower than it was at the end of the 1980s.

The recovery in UK banks profits has been reflected in the stock market. Since the beginning of 1992 the total return on bank shares has outperformed the return on the FT all shares index by a factor of three. The market capitalisation of UK banks is now remarkably high by international standards. Lloyds TSB, for example, now has a market capitalisation that is around 75% greater than that of Deutsche Bank.

How have UK banks achieved their remarkable results? And can this performance last? Some, perhaps not well represented in tonight’s audience of bankers, might indeed dare to add the question: should it last?

There are some straightforward reasons which may at least partially explain the outperformance. Clearly the economic environment of recent years has been very helpful for banks. Over the last seven years GDP growth has averaged around 2¾ per cent a year, and even during the slowdown in the last year or so GDP growth over any four quarter period did not fall below 1.2 per cent. Unemployment has fallen to levels not seen for nearly two decades. And after a collapse in many areas at the end of 1980s/ early 1990s, property prices have been rising in – for most of the time – a moderate and orderly way. Rising property prices obviously reduce the risks of banks making losses on secured lending: they mean that collateral values are normally higher than when a loan is agreed, so even if a borrower gets into trouble banks have a good chance of not losing money. And the low interest rates we have seen in recent years mean that when a borrower is unable to service debt the amount owed snowballs at a less alarming rate while the bank is trying to get its money back. This UK record is in sharp contrast to the experience in Japan, where property prices have been falling for almost a decade, and may still not have bottomed out.

Just to give you one piece of evidence of the importance of the cycle to banking profitability, Salomon Smith Barney’s well-regarded and well-paid banking analysts raised their forecast of 1999 pre-tax profits of four major banks by almost a quarter between January and April this year, mainly in response to their house economists upping their 1999 GDP growth forecasts from 0.4% to 0.8% and to an improved outlook for unemployment.

And it is perhaps not just the stability of recent years that has been important – continental Europe has also been stable, if with generally higher unemployment and, in some cases, slower growth – it is also that stability is much more unusual here. Bankers may well have been taking lending decisions on the basis that the UK’s past record of economic instability would be repeated: the stability we have enjoyed has meant that bad debts have been less than expected and profits correspondingly higher.

Clearly the fall in bad debts has played a very significant part in the recovery in profits. In 1992, in what we classify as the Major British Banking Group as a whole, new provisions net of recoveries equalled 80.2 per cent of net income, leaving pre-tax profits at 19.8 per cent. In 1998, net new provisions were 16.6 per cent of net income, and pre-tax profits 83.4 per cent. It is true that the composition of the MBBG changed between those two years, but that compositional effect is only a small part of the total change.

Another contributor to recent profitability for some banks has been rapid growth in consumer credit, which is up by around 80 per cent over the last five years. This is high margin lending business and very remunerative when times are good. (It is also liable to be the source of much anguish for bankers when times are bad). In the event times have been good, and while there has been some rise in related provisions recently, so far this rapid expansion of consumer credit has been profitable ex post as well as ex ante.

But I do not think that the economic cycle can explain all the profit growth we have seen. Cost control is another important part of the story. In part, no doubt, because it is easier and less expensive to reduce staff numbers in the UK than in most European countries UK banks have cut employment numbers in response to technological change faster than have banks in most other countries. The study by the BIS that I mentioned earlier, which covers seventeen industrial countries, showed that only in Norway and Finland had banks cut employment numbers by a larger percentage amount from their peak in the late 1980s than had banks in the UK.

A 16.8 per cent cut in UK bank employment from its 1989 peak contrasts with an average fall in bank employment in the euro zone of only 2.3 per cent from its 1992 peak (in Japan and the US banks’ employment had fallen by 9 and 9.7 per cent from their respective peaks). And whereas in the early 1980s only in Germany and Austria were staff costs higher in relation to banks’ income than in the UK, by the mid 1990s this staff cost/ income ratio was lower in the UK than in other European countries (with the exception only of the Scandinavian countries, whose banks had a particularly torrid time at the beginning of this decade).

Or take another element of restructuring to cut costs: changes in the number of branches. The UK has seen branches of deposit-taking institutions cut by almost a third since 1985; only one country (Finland) has seen a bigger proportionate cut. In the US and in the euro-zone as a whole the number of branches was still rising up to 1997; in Japan it had barely started to fall.

UK banks have also benefited from good strategic choices and from the historical fact that they have not played the same role in relation to industrial finance as banks in Germany, for example – much to the chagrin of commentators such as Will Hutton. With capital markets providing increasingly keen competition for the banks in financing industry, particularly large industry, it has been easier to maintain margins and make money from retail business.

Describing the strategy of the UK’s most profitable major bank, The Economist said earlier this year:

"Every so often Lloyds TSB buys another bank, strips out costs and adds some splendidly cheap deposits. Sir Brian Pitman can easily resist the lure of investment banking: there are profits aplenty to be made on the retail side".

Journalists can make it sound so easy!

UK banks also benefit from not having to compete with home-grown nationalised and state-owned banks. And they have been generally successful in recent years in avoiding egregious errors in foreign lending. They were, for example, much less severely affected by the Asian crisis than their French or German counterparts.

These factors, taken together, may explain a good proportion of the high profits we have seen. But perhaps they do not paint the full picture. What of the possibility that high profits reflect to some degree a lack of competition in banking? Here the arguments become less straightforward. Indeed, while high profits may often be regarded as an indication of protected, or uncontested markets, the evidence I have just given about cost-cutting could be taken as an indication that competitive pressures are strong. As the Treasury argued in a section entitled "the impact of competition on productivity" in last week’s Pre-Budget Report, "In competitive markets, firms face a direct, sharp, ongoing incentive to improve continuously the efficiency with which they produce goods and services".

Of course incentives to cut costs can come from the threat of take-over, even if the industry is protected from new competitors by barriers to entry. But we know that there is no shortage of new entrants at the moment – of which more later. And we know also from survey evidence that the industry itself, and its customers, believe it is open to entry. Of 59 countries covered by this year’s Global Competitiveness Report, published by the World Economic Forum, survey respondents placed the UK third for the degree of competition that domestic banks faced from foreign banks; and twelfth for ease of entry of new banks into the domestic banking industry. There are 421 banks licensed to take deposits in the UK – over 300 of which are foreign owned.

It is also the case that, in the UK, banks face competition from non-banks in many areas of their business, reflecting the lack of impediments to cross-sectoral competition, which also lay behind the move to introduce a single financial regulator.

I will admit that financial regulators are instinctively bound to have some qualms about the doctrine of the survival of the fittest since they have reason to fear obloquy if even the least fit fail to survive. But I certainly do not believe that the long term health of any industry would be helped by encouraging it to get fat and complacent behind barriers to competition. Vigorous competition is likely to be the best guarantee that consumers are offered a fair deal in future. And under the terms of the Financial Services and Markets Bill, the FSA will, as the Chancellor announced last week, in future be giving full weight to competition concerns and taking account of the effect of its rules on competition. We will also be charged in future with reporting on the impact of regulation on competition, which will require us to think harder about competition issues than financial regulators have been obliged to do in the past.

We will no doubt be helped to do so by Don Cruickshank’s impending report on competition in UK banking, which should cast further light on the question of whether there are barriers to entry, or to effective competition.

Having discussed some of the possible sources of UK banks high profitability, I will now turn to possible threats to those profits.

The first, of course, is that the benign economic environment in which we now luxuriate is not necessarily going to last for ever. The business cycle will never be entirely abolished and neither politicians nor central bankers should be expected to achieve miracles in the degree to which they can prevent economic fluctuations. The longer the economy continues to prosper, the greater the risk that some bankers will forget it can sometimes falter, and forget the scale of losses banks can incur when the economy turns down.

Quite apart from economic fluctuations, the so-called "death of inflation" poses its own challenges for banks. One is the extinction of endowment income: the profit that banks get in an inflationary climate from non-interest bearing deposits. Quite apart from that it will be difficult further to reduce interest rates on lower tranches of some savings accounts. Of course the days of 20 per cent inflation are now long gone and banks have been operating in a relatively low inflation environment for some time. But it is certainly possible that the future holds in store still lower interest rates, which would further reduce banks’ ability to cross-subsidise services to depositors from interest margins. There is no reason in principle why the replacement of "stealth" charges by explicit charges should damage profitability, but clearly the transition could raise presentational issues which affect profits, at least for a time.

The "death of inflation" would also mean that there would be more likely to be periods of falling property prices at least in some areas, so collateral would be less sure to bail banks out of bad lending decisions.

In a competitive market high profits naturally attract new entrants and a striking feature of the British banking scene in the last couple of years or so has been the entry of new players: supermarket banks, banks started by insurers and so on. Egg, a brand of Prudential Banking, was launched in October of last year offering market leading rates; since April it has only been accepting applications over the Internet. Its total deposit base has now topped £7bn. Standard Life Bank is a call centre operation based in Edinburgh. It commenced operations in December 1997 and has been highly successful at attracting deposits and from January mortgages (£4.7bn of offers made by end-Sept). Standard Life Bank’s mortgage product has managed to attract 10% of the mortgage market (in fact its market penetration peaked at 17.2% of the mortgage market in May).

Of course the challenge for new ventures like these is to show that they can earn decent returns over time, and that they are not just buying market share expensively.

Another interesting type of new entrant is First-e - in the UK it is an Internet-only bank, currently offering over 6% on deposits, but it is in fact an operation of Banque d'Escompte, a French bank whose status in the UK is "European Authorised Institution entitled to accept deposits on a cross-border basis". This could be the first indicator of much more genuine cross-border competition in the retail banking market in the EU.

Over the last year, these and other new entrants have generally been offering a positive spread over base rates on 90 day notice accounts, and competitive pressure from new entrants has almost certainly contributed to a big reduction in the negative spread on products of this type offered by established banks and mutuals: the average negative spread on these products across a large sample of established banks and mutuals had halved from 1.8 per cent at the end of 1995 to 0.85 per cent this autumn. Several new entrants have also been offering rates in excess of base rates on instant access accounts – last time I checked, Egg, for example, was offering 6% on a minimum balance of £1 – though there seems to be enough inertia in this type of deposit to allow established providers to maintain very large negative spreads in some cases.

Some of the mortgage banks have, however, suffered a significant loss of deposits to the new providers. This may cause some to rethink their strategic approach.

If bancassurers and bank/supermarkets prove that they can make significant amounts of money by using the information they acquire about their depositors to

cross-sell insurance products or, indeed, baked beans, this may have a significant impact on the economics of the industry. But cross-selling of financial products has not been easy to achieve in the past, and bancassurance remains an unproven model in the UK.

Technological change in general and the Internet in particular, are more certain to have an impact on both the structure and profitability of the industry. The Economist estimated earlier this year that 85% of banks around the world have Internet sites, although the proportion offering a fully interactive service would have been much lower.

Internet banking offers considerable attractions to both customers and banks. From the producer prospective, a recent Booz, Allen survey suggested that Internet bank transactions typically cost 1% of branch transactions. This may exaggerate the cost differential, but a recent ECB paper offered a range of estimates which demonstrated that the costs of Internet banking were likely to be between 1 and 25% of the cost of transactions handled manually.

In most industries, a reduction in costs is good for profits in the short term, because businesses can generally avoid passing on all the benefit of lower costs to their customers, at least for a while. I was however a little surprised and even a little

alarmed by the ECB’s finding that banks generally expect a rise in medium to long-term profitability as a result of technological progress, with particularly significant gains for retail payments, retail securities business and retail lending. Deposit business was expected by some banks to become less profitable, as customers might find it increasingly easy to access new investment alternatives offering higher yields. However, even there, the majority of banks were expecting gains.

One of the most important things about the Internet is that it empowers the consumer and makes it far easier to switch from one provider to another. That must be worrying for an industry that in the past has benefited so much from customer inertia. If you look at the mortgage market, for instance, the so-called "back book"/ "front book" difference – the gap between what existing mortgagors are paying and the terms for new and re-mortgagors – is often well over 100 basis points: so overall margins clearly are very sensitive to inertia keeping enough mortgagors on higher "back book" margins.

The Internet lowers barriers to entry, including geographical barriers to entry: in particular it removes the need to build a branch network. So for an industry with high profitability and already attracting new entrants, the Internet may well speed up the process of profit erosion. And our intention as regulators is to ensure that we do not get in the way of competition based on new technology. We have said that our new rulebook will be technology-neutral.

So the ECB report was right to warn that "increases in competition may lower prices and force banks to pass cost savings on to customers to a greater extent than is currently anticipated". And if we are thinking about the overall profitability of the banking industry we need to remember that new specialised banks operating only via remote channels may well be loss-making for a while.

New technology also involves various types of risk which I suspect may not be entirely symmetric: they are more likely than not to be bad for profits.

A fast pace of change increases uncertainty and the risk of strategic error: of excessive investment in areas that turn out not to be profitable, of excessive competition in what all banks had expected to be the most profitable customer segment.

There be will be new and greater legal risks: uncertainty about applicable laws and regulations, exposure to fraud, uncertainty over applicable jurisdiction (in the case of cross-border Internet transactions), and over legal responsibility in the event of a breakdown of operating systems.

There will be operational risks: costs of IT disruptions, mistakes with use of IT (inputting the wrong number of zeros, and so on); though with luck the industry will not be hit in future with any problem as massive as the millennium bug. And one should not forget the reputational risks from IT failures, vividly demonstrated by the Encyclopaedia Britannica in the last couple of weeks.

But there are producer benefits on the other side of the account. On the whole IT helps to reduce credit risks – it has made it easier to quantify, price and manage risks through the development of credit risk models and formalised credit scoring techniques. But there can be dangers in over-reliance on models, which may prove seriously unreliable in extreme situations, and market fluctuations can be amplified if all institutions estimate and use almost identical models.

I said earlier that one important aspect of the Internet is that it empowers the consumer. I would add that another aspect of empowerment of the consumer is education; educating the consumer is something to which the government attaches great importance to and is an area in which the FSA will have a key statutory role. Other government interventions, such as CAT-marks on ISAs, will also tend to make consumers of financial services more conscious of value for money and more active in searching out good deals. Again, for an industry that benefits at present from a degree of customer inertia, consequences for profit margins may be negative.

Finally, there is a risk that the issues that banks face on social exclusion will become more rather than less difficult. One risk for established banks is that some of their most profitable customers migrate to new entrants who have no branch networks to maintain, while they come under pressure not to close increasingly underused branches. Against this it may be argued that once access to the Internet is sufficiently widespread, the need for access to local branches will be less keenly felt, and branch closure may become easier. But that is not the way the argument is perceived today.

How do these arguments net out? Will UK banks be as profitable in the next decade as they have been in the last?

It would be a brave woman who sought to give a categorical answer to that question. My own hunch is that most of the markets in which UK banks operate – certainly the retail markets on which I have focused tonight – will become more strongly contested, by both existing and new providers. Barriers to entry will fall as new technology reduces the significance of branch networks. But whether banking shifts from bricks and mortar to clicks and mortar, or to clicks alone is less clear. You, and we as your regulators, will face an interesting and exciting few years while the answer to that question becomes clearer.

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