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Speech by Thomas Huertas, Director, Banking Sector, FSA
Chatham House Conference, London
20 June 2008

Critical to the contestability of any market are the conditions for entry and exit.  Restricting entry limits competition and fosters firms' ability to build and maintain dominant positions.  Restricting exit also undermines competition.  If unsuccessful firms are not allowed to fail, they may distort pricing and so weaken the viability of firms that would otherwise be successful.

This afternoon I would like to offer a few remarks about entry and exit in banking.  Banking is a particularly important market, given its roles in executing payments, in providing credit and in serving as the principal outlet for people's savings.  Directly, banking accounts for approximately 10% of UK GDP.  Indirectly, banks play an important role in assuring that businesses and consumers generate the other 90% of GDP.  Bank deposits are money, and bank deposits are the means by which consumers and businesses predominantly settle their transactions, whether they are paying utility bills or settling multi-million pound purchases of securities. Without banks, or more particularly, without the deposits that banks provide, a modern economy could grind to a halt.  Banks are considered essential to financial and economic stability. 

For this reason, governments around the world provide special protection to deposits and special liquidity facilities to banks.  Banks' deposits are guaranteed up to certain limits, and banks have access to the central bank as a lender of last resort.  Other firms do not have these privileges.  Other firms do not have this safety net.  As the current crisis has demonstrated, the authorities have a contingent credit risk on the banking system.

For this reason, societies regulate and supervise banks.  These regulations are akin to the covenants that a commercial lender would impose on a borrower.  That is perhaps most evident in the form of capital and liquidity requirements that banks face.  But my purpose this afternoon is to focus on regulation of entry and exit from the prism of competition.

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In light of the protection afforded to deposits and the trust that the public should be able to place in banks, any institution or person seeking to own or manage a bank must demonstrate to the authorities that it or (s)he is "fit and proper".  Banks receive a license to take people's deposits, and the authorities need to be sure that they are granting that license to someone who will not simply take people's money.  For this reason, those seeking to control a bank must meet what the Financial Services and Markets Act terms "threshold conditions" -- that they have the integrity, financial and managerial resources necessary to run a bank, that they are worthy of the trust that people expect to be able to place in the bank that holds their deposits and, in many cases, their life savings.  Banks and their controllers need to meet these threshold conditions at entry and on an ongoing basis. 

Now what is the relevance of all this to competition?  Do these regulations prevent or limit competition?

Let me start with entry.  Here, I would submit that the regulations do not restrict competition.  Entry into banking, especially in the UK, is free to anyone who can meet the threshold conditions for establishing a bank.  The UK places no barriers to the ownership of banks on the basis of nationality, and under EU directives any EU-incorporated credit institution is, under the so-called passport granted to all banks under the single market, entitled to establish a branch or sell its services cross-border into the UK.  This policy of free, but orderly, entry underlies not only London's position as one of the world's leading financial centres, but also contributes to competition in retail banking. 

The wholesale side of the story is apparent just from looking at the London skyline.  Banks from around the world populate the towers of Canary Wharf and the City, and banks from around the world choose to operate a good portion of their trading, investment and corporate banking from London. 

The retail side of the story is perhaps less apparent, but there is significant foreign ownership of UK banks – Abbey-Santander is just the most prominent example – and there is precedent for allowing foreign organisations to become British  – as HSBC amply demonstrates.  And there are scores of banks from other countries that provide banking services to UK consumers either via branches on the high street and/or over the internet.  Subject to banks meeting threshold conditions, entry into banking is free.

Entry into products that compete with the products offered by banks is also free.  Banks do not have a monopoly on credit or investments.  Loans provided by banks must compete with loans provided by non-bank lenders, and deposits must compete with other forms of investments, including unit trusts, bonds and shares.  This actual and potential competition serves to limit the ability of any one bank to build up, much less to abuse, a dominant position.

What about exit?  In a normal competitive market, firms that are unsuccessful fail.  They become insolvent, and they are liquidated or reorganised under the bankruptcy code.  Shareholders lose their money, creditors suffer losses and managers and employees seek new jobs.  This so-called "creative destruction" assures that capital and labour are always employed in their most efficient uses and that competition remains vibrant.

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Applying this process to banks runs the risk of creating severe collateral damage on the economy at large.  These systemic concerns are the reason why the Tripartite authorities in this country intervened to provide emergency liquidity assistance, then a government guarantee of all deposits and finally to take Northern Rock into government ownership.

As a result of this experience, the Tripartite authorities resolved to introduce legislation to improve their ability to handle failing banks – to allow for exit of unsuccessful banks from the marketplace whilst limiting collateral damage to depositors, to the public finances and to the economy at large.  This involves two principal measures:

• Introducing a special resolution regime for failing banks
• Strengthening the ability of the deposit guarantee system to pay out covered deposits promptly.

The trigger for entry into this new regime would be the failure of the bank to meet its threshold conditions.  Whether a bank does or does not meet its threshold conditions is a supervisory decision, and the FSA, as the bank's supervisor, will continue to take the decision – in consultation with the Treasury and the Bank of England -- as to whether the bank does or does not meet threshold conditions.

I should emphasise that threshold conditions differ from the standards for corporate insolvency.  In particular, the threshold condition for capital is the bank's capital requirement.  So the resolution regime for banks could be initiated when the bank still has significant positive net worth. 

This is in marked contrast to normal corporate insolvency procedures.  But the justification for this is that the banking license represents a privilege to take deposits from consumers and other market participants.  The bank can keep this license as long as it maintains adequate capital and meets the other threshold conditions.  If it does not meet threshold conditions, the authorities are justified in executing early intervention, in stepping in to resolve the bank so as to protect depositors, preserve financial stability and safeguard the public finances.

The choice of resolution tools will be up to the Bank of England, subject to consultation with the Treasury and the FSA, and subject to the approval of the Chancellor of the Exchequer if the tool involves the sue of public funds.  The range of tools includes

• a transfer of part or all of the failing bank to a private sector third party;
• a transfer of part or all of the failing bank to a publicly-controlled bridge bank;
• the power to take a bank into temporary public sector ownership; and
• a new bank insolvency procedure.  This would involve the payout of covered deposits to eligible depositors within a very short time frame, and for this purpose the legislation will also propose a number of measures to strengthen the ability of the FSCS to do so.

The intent of the legislation is to enable failing banks to be resolved in a manner that minimises the collateral damage that a bank failure could cause to depositors and to the financial system and economy at large.  It is intended to provide greater assurance that exit from banking can occur, and occur in an orderly fashion.  In this respect, the authorities are looking to put in place a regime for orderly exit from banking to go alongside the regime for orderly entry into banking which we already have.  This should, in our view, also promote competition in banking and financial services.

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