(by Bruce Lyons) It seems that the European Commission has reached agreement with the British Government and bailed out banks about the ‘compensatory measures’ required as a quid pro quo for receiving state aid. It looks like opportunities have been missed.

[see , OJ C 244, 01.10.2004, p. 2]

The UK government, often in conjunction with the Bank of England, has invested vast sums of money to prop up the financial system over the last couple of years. In addition to setting a general framework for financial support, the role of DG Comp has been mainly in adjudicating on individual banks that had the most untenable business models and which required direct funding resulting in large ownership stakes. The State Aid rules allow the Commission to ensure that such banks gain no competitive advantage. Of course, the national government could, if it wished, use its ownership stake to go further and promote a more competitive banking system. I very much doubt that it has done so.

The three UK banks in question and what has been required of them:

[see: (3 November 2009) BBC News]:

• Northern Rock: the smallest of the three and the only fully nationalised bank. This has been split into a ‘good bank’ and a ‘bad bank’ with the worst performing loans. The bad bank will take the toxic assets leaving the good bank unencumbered to lend. This looks good for consumers wanting mortgages but it promotes a moral hazard. Other mortgage lenders, including the remaining mutual building societies, who have been more cautious in the past, still find themselves with bad loans after house prices dropped. They may feel it is worth the risk of adopting a less cautious strategy in future.

• RBS: the gay abandon of CEO Fred Goodwin’s unbridled macho acquisitions and failure to focus on the fundamentals of banking created the biggest bank in the world (measured by its balance sheet) out of a successful regional bank. It also created the largest ever UK losses and has overtaken Citibank as the costliest bailout in the world. It is now 70% owned by the taxpayer but this will rise to 84% with a promised cash injection. In UK retail banking, its brands include NatWest which is strong in England and weak in Scotland, and the RBS brand which is strong in Scotland and weak in England. So, what has been required of it in restructuring? It must sell NatWest in Scotland and its RBS branches in England. This is 14% of its branch network but RBS itself claims that this and other modest divestitures will cut its UK market share by only 2%. Research on divestitures in mergers suggests this sort of mix-and-match of weak assets is prone to failure.

• Lloyds: includes some of the biggest brands in UK banking including Lloyds, TSB, Halifax and Bank of Scotland. The latter two were acquired at the height of the crisis promoted by an unholy alliance of the Chancellor, Bank of England and FSA. It even required special legislation through parliament to avoid antitrust scrutiny overriding the view of the OFT. It appears that mortgage broker Cheltenham & Gloucester and Lloyds TSB branches in Scotland will be sold off. Needless to say, this is another combination of the weaker assets in Scotland and England, although it is over 600 branches and reportedly 4.6% of UK current accounts. This still leaves Lloyds with a bigger market share than they had before the ill-fated, steamrollered acquisition of HBOS.

We do not yet know who will buy these divested assets and whether they will be effective owners with diverse and effective business plans. The Chancellor has also said that it will take time to implement the divestitures. What we do know is that great care is needed to devise effectively competitive banks. For example, firms have an incentive to damage the assets they are required to divest so they create a less effective competitor. They can also withhold business-critical information or systems. As is clear from the recent announcements, they also carve out the weakest chunks of business to sell.

So I am sceptical that a new and competitive structure of banks has been created in the UK by the above changes. The restructuring is timid, not radical. It will be even more important to encourage entry and particularly to facilitate exit. The real problem with bank competition is that large complex banks are too big and interconnected to fail. Until we create a framework in which bad banks can exit through a non-catastrophic market process (or early nationalisation), there will be moral hazard creating distorted incentives and future crises. Stable competition will require more focused and smaller banks.

[see my article on ]