25 Apr 2013

[by Bruce Lyons] It has just been announced that the sale of 632 Lloyds branches to the Cooperative Bank has . Some people thought this would have created a competitive market structure in UK retail banking. The lessons from research on divestitures by the US FTC, EU DG Competition and suggest otherwise. In particular, necessary conditions for a divestiture package to restore competition include that the package must not be carved out of an existing business, it must have sufficient scale and scope, and it should not be sold to a weak buyer. The proposed sale of branches to the Co-op met none of these basic requirements. Why not? And is there a way forward from here?

I begin by recalling how we got into this mess, drawing on published last year. Lloyds and TSB merged in 1995 and retained a reputation for prudent management going into the financial crisis. HBOS had been created by a 2001 merger of the Bank of Scotland and Halifax, which had been the UK’s biggest building society before demutualising. Their business model became aggressive including very large loans to certain favoured businessmen. Much went into commercial property development. A reckless lending policy resulted in a £7.4b loss. At the height of the immediate post-Lehman crisis (September 2008), HBOS was in severe funding difficulty and a rescue merger with Lloyds was announced. This was apparently initiated by a private conversation between the then Chancellor of the Exchequer, Gordon Brown, and LloydsTSB chairman Sir Victor Blank.

The merger was completed in January 2009 despite objections from the OFT (the agency responsible for first phase merger decisions). The OFT was quite reasonably concerned that, for example, in the personal current account market, the merger would combine shares of 19 % and 14 %, and in the Scottish market for SME business it would combine shares of around 10 % and 35 % (to create a balanced duopoly with the equally crippled RBS). The government response, with the support of the Bank of England, Treasury and Financial Services Agency, was to change the law so the merger could take place without a second phase merger investigation. This was the first case of such an intervention since the reforming Enterprise Act of 2002 was meant to take mergers out of political decision making. It soon became clear that HBOS assets were more toxic than Lloyds had expected. It required massive state aid and the government took a controlling 40% stake. Notice that none of the story so far has mentioned divestiture of branches.

Enter the European Commission and its investigation of state aid. It required ‘compensatory measures’ as a disincentive to future reckless behaviour. Note this justification for intervention – under the state aid rules, it was not charged with restoring competition, which it would have been if it had been investigating the merger itself. The compensatory measures included (as a punishment) the requirement to sell 632 branches. This divestiture, known as Project Verde, would bring a 4.6% share of personal current accounts which were attached to the branches. Current accounts are important for (the absence of) competition because consumers are very reluctant to switch. Banks can then lever profits by cross-selling insurance, savings products, loans and mortgages. Pause for a moment to recall that Lloyds had just acquired 14% with HBOS, and they were required to sell only 4.6%. They would still be left with a ten point higher market share than their next biggest rival, RBS.

There were also restrictions on who could buy the divested assets, including no bank with at least a 14% market share. This left few potential strong buyers, especially as foreign banks were busy rebuilding balance sheets and consolidating in their home markets. Look a little closer at the branches which had those current accounts attached. Lloyds has no incentive to create a strong rival. A quarter of the branches are currently branded with the former building society name of Cheltenham & Gloucester (acquired by Lloyds in 1997), with the remainder being Lloyds-TSB (largely ex-TSB). These are not the star branches in the Lloyds-HBOS empire. They are not a ‘stand alone’ business, but are being carved out of existing businesses to meet technical market share requirements.

As part of its response to the financial crisis, the UK government set up an Independent Commission on Banking headed by Sir John Vickers. The ICB found strong evidence that smaller challengers to the Big Four banks have to fight to overcome switching costs by providing both higher deposit rates and lower borrowing rates (i.e. achieving lower margins). Challengers need at least a 6% share of personal current accounts and there were other problems (e.g. a high loan to deposit ratio making funding difficult). Vickers recommended that a much larger divestiture was necessary to create a credible competitor. Despite its 40% ownership stake, the UK government said that it would not press Lloyds to enhance the divestiture required by the EC.

There was little serious interest in acquiring Verde, leaving bids from the Cooperative Bank and NBNK. The Co-op would have created a bank with 7–8 % share, but there were always doubts about its effectiveness, leadership and governance systems. NBNK was an investment vehicle with plans for a consumer-oriented bank. It is interesting to note that the Co-op was Lloyds’s choice as preferred bidder—it had superficially attractive market share characteristics but would in practice have been a weak competitor. Lloyds’s reserve position is to float Verde as a separate entity through an initial public offering under the faded TSB brand. I fail to see how this improves on the unworkable Co-op plan. It is highly unlikely to create a serious competitor.

This saga provides yet another lesson from the banking crisis. Short term panic fixes that create an anticompetitive market structure are not a good idea. Is there a positive way forward from here? Remember the lesson from merger remedy research: we need a credible, stand-alone business – not a mix-and-match bundle of assets. I suspect that the only way a serious challenger bank could be established on a reasonable time scale would be to unwind the latest merger; that is, to float HBOS once the bad loans have been stripped out to follow its reckless management. Unfortunately, the legal opportunity to enforce this sensible competition policy solution was missed in 2008. The government could still use its controlling equity stake to achieve this, but it failed to adopt the much more modest ICB recommendation so it is unlikely to have a major change of heart now.

Postscript: This history of mergers and failed divestiture can sometimes get confusing, so I finish with a postscript on RBS. For the same state aid control reasons as discussed above, RBS was required to sell 316 branches (i.e. about half the size of the Lloyds requirement). A very credible buyer in Santander was found but that too fell through, showing how difficult it is to integrate banking businesses. Santander realised there were severe IT incompatibility problems and it would have taken until to integrate. Finally, the Governor of the Bank of England, , has called for RBS to be split into a ‘good bank’ and a ‘bad bank’ but that has more to do with getting the bank to start lending again than it does with retail competition.