Docstoc

BANKING SERVICES AND EXTERNAL FINANCE FOR SMES

Document Sample
BANKING SERVICES AND EXTERNAL FINANCE FOR SMES Powered By Docstoc
					5            BANKING
             FINANCE FOR
                                  SERVICES AND EXTERNAL
                                          SMES


    I N T RO D U C T I O N

    5.1      A central aim in setting up the Review was to examine whether small to medium
    sized enterprises (SMEs) have access to the finance they need to grow and prosper. Not all
    of this finance will come from banks. Equally, SMEs make contracts with banking
    suppliers for a range of other services unconnected with external finance. Both types of
    service are important.

    5.2      The Review therefore considered two distinct groups of issues in relation to
    SMEs:
             • whether SMEs have access to appropriate external finance; and
             • whether there is effective competition in the provision of banking services to
               SMEs.

    5.3      The Review found no evidence that SMEs current have real difficulty in getting
    access to debt. Equally, the Review found no evidence to contradict the widely held view
    that there is a market failure in the provision of small scale risk capital to certain types of
    SMEs at critical points in their development. This lack of provision of relatively small
    amounts of equity is a well known phenomenon. It is discussed further in Chapter 6,
    which proposes appropriate policy interventions by Government.


    W h at i s a n S M E ?

    5.4       There are dozens of definitions of SMEs, based on thresholds for turnover, asset
    base, number of employees. The group of SMEs of interest to the Review is those firms
    which are no longer treated as personal customers by providers of money transmission
    services and credit, but are too small to have direct access to competitive capital markets.
    There are approximately 1.3 million such businesses in the UK. There are few, if any,
    statistics which relate exactly to this group. Inevitably, therefore, the Review has used data
    based on different definitions. Those relating to a turnover of up to £10 million, or
    employment of up to 250 people, are the closest to describing the group of interest.
    Producer data tends to use a definition of up to £1 million turnover. All the data sources
    include a proportion of sole traders, although the Enterprise Britain and the Review’s own
    data are both weighted towards larger SME businesses. The Review is satisfied that the use
    of different data sets does not materially affect the conclusions or recommendations.


    External finance

    5.5     The largest proportion of SME finance is internal. Overall demand for external
    finance has reduced as the macroeconomic climate has become more stable. Between

                                                                                              141
5     BANKING     SERVICES AND EXTERNAL FINANCE FOR                                                  SMES


         1995 and 97, only 39 per cent of SMEs sought new external finance, down from 63 per cent
         in 1991-31. Demand varies across SMEs, with the greatest demand coming from firms that
         are larger, faster growing or more innovative.


                                               Chart 5.1. Percentage of firms seeking finance, 1995 - 97

                                    60
                       % of firms




                                    40


                                    20


                                     0
                                         All


                                                  Manufacturing


                                                                  Services


                                                                             Older


                                                                                     Newer


                                                                                             Micro


                                                                                                      Small


                                                                                                              Medium


                                                                                                                       Stable/Declining


                                                                                                                                          Medium Growth


                                                                                                                                                          Fast Growth


                                                                                                                                                                        Non-Innovators


                                                                                                                                                                                         Innovators
         Source: Enterprise Britain 1994-1997, ESRC




         5.6      SMEs have access to a wide range of external financing instruments: overdraft,
         bank debt, factoring and invoice discounting, asset finance (including commercial
         mortgages), and equity (both business angel and formal venture capital). For some
         financing needs these different forms of finance are potential substitutes. But for the most
         part either the requirements of the providers of the finance, or the impact on business of
         taking such finance (including differences in price), mean that there is little effective
         substitution between many of them. In addition, there are economic efficiency gains to be
         made from matching the characteristics of the finance with that of the activity being
         financed, which limits the degree to which different external finance products can be
         substituted one for another.


         I s t h e m a r ke t f o r d e b t f i n a n c e wo r k i n g e f f e c t i ve l y ?

         5.7      The Review found little evidence of unmet demand for debt finance. A sample of
         firms reported an average rejection rate of 5 per cent for all forms of finance. The lowest
         rejection rates were for credit cards, asset finance and factoring (2 to 4 per cent); the
         highest for term loans (13 percent). This is in line with previous studies, which have found
         rejection rates for bank debt varying from 10 to 20 per cent. But are these rejection rates
         reasonable, or are there viable projects which are suitable for debt finance and which are
         not being funded?

         5.8     The theory of credit rationing suggests that for a given interest rate, debt may not
         be provided to all borrowers who want it. In a perfectly competitive market, interest rates
         would rise with the degree of risk associated with a project. But there are always
         information problems in the debt market: the borrower may know more about the
         probability of success than the lender. And little information is publicly available about

         1
             Cosh and Hughes Enterprise Britain ESRC Centre for Business Research 1998


142
5   BANKING   SERVICES AND EXTERNAL FINANCE FOR         SMES


       SMEs to help lenders construct credit scoring models and hence partially reduce the
       information imbalance.

       5.9       As interest rates rise, some borrowers are discouraged from the markets. These
       borrowers tend to be those wanting to finance projects with a lower risk and reward
       profile, so leaving a pool of borrowers which is on average more risky. Lenders generally
       respond to this by demanding collateral. Even so, the incentives inherent in a debt
       contract make it rational to restrict risk taking. The lender’s return is restricted to principal
       plus interest. In practice, this limits the extent to which interest rates and the use of
       collateral can be used to offset risk. Most UK bank lending is in the range 1 to 4 per cent
       over base rate. A few loans have a higher rate but less than one in twenty is more than 6 per
       cent over base. The limit is about 6.5 per cent. Higher rates can be found in the US where
       prime plus 8 per cent is not unusual. This may reflect the generally higher loan prices
       there, which may in turn be a feature of the very different insolvency regimes which
       operate in the US and UK.

       5.10      The Review found that, of those firms whose application for a term loan had been
       rejected, about 40 per cent were on the grounds of a bad business plan or excessive
       outstanding debt, that is for apparently rational reasons. The remaining 60 per cent (ie 8
       per cent of the total sample) had insufficient collateral or were refused because they were
       just starting up and had no track record. Some of these firms may have had good projects,
       suitable for debt finance; others may not. It is not possible to draw a firm conclusion from
       these data: it may be that at the margin some viable projects do not get debt funds. But it is
       more likely that these are high risk activities which would be better funded by equity or
       hybrid products. Banks have tried introducing these products, either loan repayments
       linked to turnover, or equity options. Both have attracted very little take up.

       5.11     In conclusion, there is little evidence that demand for appropriate debt finance is
       not being met. This does not mean that SMEs are being well served by banks, merely that it
       is unlikely there is a deficit in the quantum of debt finance available.


       B A N K I N G S E RV I C E S F O R S M E S

       M a r ke t d e f i n i t i o n

       5.12    There are three broad economic banking services provided to SMEs: money
       transmission, debt and savings.


       M o n ey t r a n s m i s s i o n

       5.13      Money transmission services are provided by means of business current
       accounts which give SMEs instant access to their money and which offer a range of
       specific money transmission facilities (eg cash and cheque deposit, cheque writing
       facilities, access to BACs, CHAPS, direct debit, and standing order facilities). These are
       core products for which there are no substitutes. A handful of banks are the only
       significant suppliers, and they in turn together control the wholesale networks for many
       transaction services. Moreover, SMEs often need a current account transaction history in
       order to secure reasonably priced debt.

                                                                                                   143
5     BANKING   SERVICES AND EXTERNAL FINANCE FOR       SMES


         Debt

         5.14     While bank lending accounts for substantially the largest source of SME finance,
         there are several other debt based products which are becoming a more significant source
         of finance for SMEs as a whole. This begs the question, therefore, whether these products
         should be included within the relevant economic market.


         Demand-side interchangeability of debt products

         5.15     Some businesses - particularly those with low steady state profitability - use
         factoring or invoice discounting as an alternative for overdrafts for smoothing out cash
         flow. Hire purchase and leasing are used by an increasing minority of businesses to pay for
         fixed assets which they might previously have financed through a secured term loan from
         a bank. However, the Review found that in practice small businesses tend not to compare
         prices on asset finance products when taking out a bank loan. Moreover, only 29 per cent
         of firms had considered alternative financial products when taking out their main source
         of finance. The main alternative the firms had considered was the alternative banking
         product - either term loan or overdraft - to the one eventually chosen. This suggests a
         further separation of asset finance, factoring and invoicing from traditional bank debt
         (loans and overdrafts). Very few SMEs saw equity finance or credit card finance as
         potential substitutes for these debt-based products.

         5.16     The fact that factoring/discounting provides only very short term working
         capital severely limits its ability to substitute for longer term bank lending for investment.
         Similarly, the need for a readily valued physical asset (ideally one with an efficient second
         hand market) limits the scope for leasing and hire purchase to substitute for longer term
         SME bank lending which is not based around investment in such assets. In practice, only
         around 2 per cent of SMEs use factoring or invoice discounting, which together account
         for around 6 per cent of the value of SMEs’ total external finance. Asset finance2 is a much
         more significant source of SME finance (27 per cent by value) but, as discussed below, it
         does not have a major impact on the bank lending market.


         Supply of ‘non-bank’ debt products

         5.17     The key suppliers of banking services to SMEs are also major players in the supply
         of factoring/invoice discounting and of asset finance. Figures 5.2 and 5.3 show market
         shares in the two non-bank debt product markets.

         5.18    In summary, the six largest UK retail banks account for the majority of both
         product markets, with around 66 per cent of the SME factoring market and 52 per cent of
         the SME asset finance market. While these shares are less than their share of the SME bank
         lending market (over 90 per cent), they are nevertheless significant. Furthermore, none of
         the non bank suppliers to these markets have market shares as great as those of the larger
         banks. So even if SMEs did in practice readily move away from bank lending to other debt
         products, they would be substituting into markets which are similarly dominated by the
         major banks. Restricting the market analysis to SME bank lending - and the associated

         2
             Factors and Discounters Association


144
5   BANKING     SERVICES AND EXTERNAL FINANCE FOR                              SMES


       money transmission services - would not exclude significant suppliers in adjacent SME
       debt markets and this is the approach that has been used by this Review.



                                                 Chart 5.2. Market share by factored volume

                                                                                  RBS
                                  Other
                                                                                      8%
                                    34%                                                                  Lloyds TSB
                                                                                                                 16%




                                                                                                                HSBC

                            BoS                                                                                  14%
                                                        Natwest                            Barclays
                             5%
                                                              18%                              5%


       Source: Factoring in the UK 1999, Factors and Discounters Association




                                             Chart 5.3. SME asset finance UK market shares

                                                              Royal Bank of
                                                  HSBC          Scotland                     Natwest
                              Lloyds TSB           4%                4%                    (Lombard)
                                   5%                                                          23%




                                                                                                         Bank of Scotland
                                                                                                                  8%



                                                                                                   Barclays
                                                                                                 (Mercantile)
                                            Others
                                                                                                      8%
                                             48%

       Source: CRA fieldwork, City Research Associates 1999




       Pricing between bank lending and other debt products

       5.19     The characteristics of asset finance and factoring mean that a degree of
       independence is maintained between these products and bank lending. In the case of
       factoring/invoice discounting, prices vary only slightly within a narrow range (1.5 to 3.5
       per cent above base rates, with negotiable service charges). For asset finance, the terms
       are very specific to the type of asset securing the finance; and they tend to be driven more
       by the nature of the asset (for example, resale values) than by the characteristics of the
       borrower. Given these product characteristics and the much greater scale of bank lending
       compared with the other two products, it seems unlikely that prices in the factoring or

                                                                                                                            145
5     BANKING   SERVICES AND EXTERNAL FINANCE FOR      SMES


         asset finance markets will have, at present, a material influence on prices set by the major
         banks for their core overdraft and term lending products.

         5.20      In conclusion, bank debt (overdraft and term loan) can be considered as a
         separate market from other debt products. There are a number of underlying reasons.
         First, there is very little demand side substitution, except between overdraft and term
         loan. Second, on the supply side, non bank debt products have specialist features which
         make them only partial substitutes. Third, reducing prices in asset finance would be
         unlikely lead to a material price reduction in bank debt.

         5.21      The Review did not consider competition in adjacent debt markets. Although
         banks have a significant presence in these, particularly asset finance, they do not
         collectively have the same dominance as in the provision of money transmission and
         bank debt. SMEs therefore have a greater choice of the type of supplier for these products.
         Moreover, there are no obvious signs of problems in these adjacent markets. They are not
         particularly concentrated and prices tend to fall within narrow bands.


         S av i n g s

         5.22      The Review found no particular requirement on SMEs to deposit surplus cash
         with the supplier of their money transmission services. However, there may be a
         convenience factor and an enhanced ability to transfer funds quickly between savings
         and current accounts if SMEs get both services from the same firm. But in principle SMEs
         face the same conditions as retail customers in the savings market, with a free choice from
         a large number of suppliers, but a surprisingly wide price dispersion and limited evidence
         of shopping around. The remedies described in the previous chapter on personal
         customers are therefore equally applicable to SMEs, and this market is not considered
         further here.


         Geographical scope

         5.23     The market for providing current account services and bank debt exhibits strong
         local characteristics:

                  • for those firms with a high volume of cash and cheque transactions, access to
                    a local facility is considered essential;

                  • SMEs tend to use a local provider. The Review found that half of all businesses
                    used the closest provider of their main source of finance (which includes non
                    bank debt). The median travel time between the firms’ location and branch
                    used for money transmission was eight minutes. Over 80 per cent of SMEs
                    were less than 30 minutes travel time from their main provider of finance.
                    Firms were much more likely to be closer if their main source of finance was
                    bank debt;

                  • two thirds of SMEs believed their bank had local discretion over prices or
                    terms. The firms most likely to believe this were larger firms with a finance
                    director;

146
5   BANKING   SERVICES AND EXTERNAL FINANCE FOR       SMES


                • this was supported by evidence on prices, which varied between areas,
                  although not in a systematic way;

                • local knowledge of the SME business environment is important for lending
                  decisions. Lenders can reduce their risk by understanding local economic
                  conditions and the impact these are likely to have on the success or failure of
                  individual projects.



       Conclusion

       5.24      The Review has concluded that there are two relevant economic markets for the
       following competition analysis; local markets for money transmission services and bank
       debt to SMEs, where SME has the definition in paragraph 5.4. In respect of this latter
       market the Review has concluded that for the purposes of a competition analysis of supply
       of external finance to SMEs there is a relevant economic market that consists of the supply
       of bank overdrafts and term loans. Although other debt products are partial substitutes
       consumer behaviour means that they are likely to have a fairly weak price restraint on
       overdraft and term loan prices. In addition, any pricing restraint that these products do
       have will be mitigated by the fact that banks are also significant providers of these debt
       products. Equity, even when available, is not seen as a real substitute for debt finance, and
       its pricing restraint on traditional bank debt is likely to be non existent for SMEs.

       5.25      There is a separate market in money transmission services, and these are only
       supplied by banks. However, in practice in the UK, the supply of overdrafts and bank loans
       is tied to the supply of money transmission services. In the case of overdrafts, this comes
       with the current account. In the case of term loans, supply tends to be restricted to those
       who also get their money transmission services from the same supplier. Thus, for the
       purpose of analysis, the supply of current accounts can be taken with the supply of
       overdrafts and term loans.



       MARKET STRUCTURE

       5.26   In recent years, the pattern of bank finance for SMEs has shown a marked shift.
       Changes include:

                • a steady decline in net borrowing. The lending:deposit ratio now stands at 1.1,
                  down from 1.8 at end of 1992;

                • a shift away from overdraft lending towards term lending. The ratio now
                  stands at 30:70, down from 49:51 in early 1992;

                • a gradual increase since the mid 1990s of fixed rate loans in place of variable
                  rates. Fixed rate loans now account for 34 per cent of term lending, up from 28
                  per cent at end of 1996.

       Charts 5.4 and 5.5 illustrate these trends.

                                                                                               147
5     BANKING      SERVICES AND EXTERNAL FINANCE FOR                                     SMES




                                                                Chart 5.4. Bank lending to small firms

                                         50

                                                                                                                              Total
                                         40                                                                                   Lending


                                                                                                                              Total
                                         30                                                                                   Deposits
                           £ Billions




                                                                                                                              Lending on
                                                                                                                              Overdraft
                                         20
                                                                                                                              Term
                                                                                                                              Lending
                                         10


                                             0
                                                  Dec     Dec       Dec      Dec   Dec      Dec       Dec      Sep
                                                  92      93        94        95    96      97        98        99
         Source: Annual Abstract of Banking Statistics 1999, BBA




                                                            Chart 5.5. Term lending to small businesses
                                        20


                                        15
                   £ Billions




                                        10                                                                                               Fixed rate

                                                                                                                                         Variable rate


                                         5


                                         0

                                                 Dec 96    Jun 97         Dec 97   Jun 98    Dec 98         Jun 99   Sep 99

         Source: Annual Abstract of Banking Statistics 1999, BBA




         M a r ke t s h a re s

         5.27    Market share information is derived from returns to the Review from 16 UK banks
         involved in supplying banking services to SMEs, defined as firms with annual turnover up
         to £10 million, the grouping of SME closest to those in the relevant economic market. Over
         the two-year period up to December 1998, the banks recorded each loan or overdraft to
         SMEs by postal area. Each bank’s market share was then calculated for the 1.9 million
         loans or overdrafts advanced in total to SMEs over this period. The Review compared
         market shares - derived from information on loans and overdrafts only - against
         independent survey evidence, based on market share of current accounts3. The two are
         broadly consistent, reflecting the fact that the major banks hold a roughly similar profile

         3
             For example, Taylor Nelson Business Line


148
5   BANKING       SERVICES AND EXTERNAL FINANCE FOR            SMES


       of SME customers, with broadly similar proportions of overdraft and loan holders. Where
       discrepancies have arisen, these have been adjusted in consultation with those firms
       concerned.


       5.28    There were not sufficient data on Northern Ireland banks to derive reliable
       market shares, so the following analysis relates to Great Britain only.



                               Chart 5.6. GB market share based on March 1999 postcode returns
                                                  NAG       Other
                                          BoS
                                                   3%        3%                    Barclays
                                          5%
                                                                                     21%


                                                                                                 RBS
                          Natwest                                                                   6%
                            26%




                                                                                           Lloyds TSB
                                                    HSBC                                      20%
                                                     16%

           Source: Banking Review




       5.29     The main providers of banking services to SMEs in Great Britain are NatWest,
       Barclays, Lloyds/TSB, HSBC, Royal Bank of Scotland, Bank of Scotland and the National
       Australia Group (Clydesdale and Yorkshire Bank). Of these, the big four supply banking
       services to 83 per cent of SMEs in Great Britain. Barclays and Natwest alone account for 47
       per cent of the overall total. When the merged NatWest/RBS begins trading the combined
       figure for the largest two suppliers will rise to 53 per cent.



       C o n c e n t r at i o n

       5.30    At national level the Herfindahl-Hirschman index (HHI) is 1834 (2117 post
       NatWest/RBS merger). This is above the 1,800 regarded as very concentrated according to
       US Federal Trade Commission merger guidelines (1998). The Review concurs.


       5.31      Chart 5.7 sets out market shares at a regional level, using the DTI’s functional
       map of the Government Offices for the region, and market shares for a number of British
       cities4. The latter may still be larger than the size of the relevant economic market. The HHI
       is shown in each case. Figures are given for both pre and post merger. These combined
       figures are based on historical data, but as market shares change only slowly in these
       markets the degree of inaccuracy will be very small. The post merger HHIs are shown in
       brackets. All the markets are very concentrated; especially in the North West of England,
       following the NatWest/RBS merger.
       4
             DTI Functional Directory July 1999


                                                                                                         149
5     BANKING                SERVICES AND EXTERNAL FINANCE FOR                           SMES




                                                             Chart 5.7. Regional and city market shares


                                    London - Herfindahl: 2245 (2389)                                           South East - Herfindahl: 2283 (2402)
                            50                                                                            50
           Market share %




                                                                                         Market share %
                            40                                                                            40
                            30                                                                            30
                            20                                                                            20
                            10                                                                            10
                             0                                                                             0
                                   RBS &      Natwest   Barclays    Lloyds      HSBC                            RBS &      Natwest    Lloyds    Barclays   HSBC
                                   Natwest                           TSB                                        Natwest                TSB




                                  South West - Herfindahl: 2333 (2418)                                         East England - Herfindahl: 2398 (2467)
                            50                                                                            50
           Market share %




                                                                                         Market share %
                            40                                                                            40
                            30                                                                            30
                            20                                                                            20
                            10                                                                            10
                             0                                                                             0
                                   RBS &      Natwest    Lloyds    Barclays     HSBC                            Barclays   RBS &     Natwest    Lloyds     HSBC
                                   Natwest                TSB                                                              Natwest               TSB




                                 East Midlands - Herfindahl: 2240 (2437)                                    West Midlands - Herfindahl: 2097 (2249)
                            50                                                                            50
           Market share %




                                                                                         Market share %




                            40                                                                            40
                            30                                                                            30
                            20                                                                            20
                            10                                                                            10
                             0                                                                             0
                                   RBS &      Natwest   Barclays    Lloyds      HSBC                            RBS &       Lloyds   Natwest    Barclays   HSBC
                                   Natwest                           TSB                                        Natwest      TSB




                                     Wales - Herfindahl: 2442 (2484)                                            Yorkshire - Herfindahl: 1948 (2132)
                            50                                                                            50
           Market share %




                                                                                         Market share %




                            40                                                                            40
                            30                                                                            30
                            20                                                                            20
                            10                                                                            10
                             0                                                                             0
                                   Barclays    HSBC     RBS &       Natwest     Lloyds                          RBS &      Natwest   HSBC       Barclays   Lloyds
                                                        Natwest                  TSB                            Natwest                                     TSB




                                  North East - Herfindahl: 2086 (2158)                                         North West - Herfindahl: 2058 (2657)
                            50                                                                            50
           Market share %




                                                                                         Market share %




                            40                                                                            40
                            30                                                                            30
                            20                                                                            20
                            10                                                                            10
                             0                                                                             0
                                   Barclays    Lloyds   RBS &       Natwest     HSBC                            RBS &      Natwest   Barclays    HSBC      Lloyds
                                                TSB     Natwest                                                 Natwest                                     TSB




                                   Scotland - Herfindahl: 2609 (2781)                                            Birmingham - Herfindahl: 2059 (2257)
                            50                                                                            50
           Market share %




                                                                                         Market share %




                            40                                                                            40
                            30                                                                            30
                            20                                                                            20
                            10                                                                            10
                             0                                                                             0
                                    BoS       RBS &       RBS      Clydesdale   Lloyds                           Lloyds    RBS &     Natwest    Barclays   HSBC
                                              Natwest                            TSB                              TSB      Natwest




150
5   BANKING                SERVICES AND EXTERNAL FINANCE FOR                         SMES




                                                  Chart 5.7. Regional and city market shares (continued)


                                 Norwich - Herfindahl: 2447 (2495)                                          Coventry - Herfindahl: 2041 (2166)
                           50                                                                          50
          Market share %




                                                                                      Market share %
                           40                                                                          40
                           30                                                                          30
                           20                                                                          20
                           10                                                                          10
                            0                                                                           0
                                 Barclays   RBS &     Natwest    HSBC      Lloyds                            RBS &     Natwest    Lloyds     HSBC        Barclays
                                            Natwest                         TSB                              Natwest               TSB




                                Manchester - Herfindahl: 2208 (3102)                                          Leeds - Herfindahl: 1805 (1909)
                           50                                                                          50
          Market share %




                                                                                      Market share %
                           40                                                                          40
                           30                                                                          30
                           20                                                                          20
                           10                                                                          10
                            0                                                                           0
                                 RBS &      Natwest   Barclays   Lloyds    HSBC                              RBS &     Natwest   Barclays    Lloyds       HSBC
                                 Natwest                          TSB                                        Natwest                          TSB




                                Cardiff - Herfindahl: 2458 (2487)                                           Edinburgh - Herfindahl: 2607 (2812)
                           50                                                                          50
          Market share %




                                                                                      Market share %




                           40                                                                          40
                           30                                                                          30
                           20                                                                          20
                           10                                                                          10
                            0                                                                           0
                                 Barclays   HSBC       Lloyds    RBS &     Natwest                             BoS     RBS &       RBS      Clydesdale    Lloyds
                                                        TSB      Natwest                                               Natwest                             TSB


       Source: Banking Review




       P R I C E S A N D P RO F I TA B I L I T Y

       5.32      SME banking prices are structured to reflect very low rates of switching. Banking
       is often free for the first six months or year as banks compete to attract start up companies,
       knowing that they are subsequently unlikely to leave.


       M o n ey t r a n s m i s s i o n p r i c e s

       5.33     SMEs do not have ‘free’ current accounts. They typically pay an annual charge for
       holding a current account and are charged for individual transactions. SMEs are also not
       generally paid any significant interest when their current account balances are in credit.
       In 1998, there was between £13–£20 billion held in SME current accounts at the big four
       banks. Although SMEs may get some benefits from holding positive balances in current
       accounts - for example, receiving nominal interest to offset transaction charges - this still
       represents a large sum of potential interest not passed on to SMEs.

       5.34    The combination of charging SMEs for money transmission services and not paying
       them significant interest on their positive balances indicates that the provision of money

                                                                                                                                                                    151
5     BANKING             SERVICES AND EXTERNAL FINANCE FOR                SMES


         transmission services to these customers is highly profitable. The quality of the accounting
         data available to the Review is not sufficiently robust to conclude categorically that the main
         source of the excess profits identified at a customer class level - see Annex C for more details-
         derives from prices paid by these customers for running a current account. However, the
         current price of SME bank debt - usually in the range 1 per cent to 4 per cent over base - and the
         other fee income applicable to loans, is not sufficient to generate the profits necessary to take
         the pre-tax return on equity up to the current levels identified as the return on SME business as
         a whole. The other major services supplied to SMEs are money transmission services, and
         deposit (savings) accounts. By a process of elimination, these would appear to be the only
         possible locations for the source of the excess profits generated in 1998.

         5.35      This is somewhat surprising, as it implies that the excess profits in 1998 are being
         generated from services which would not be expected to have a particularly cyclical
         profitability. That is, the banks are not making much money from SME lending at the peak of
         the cycle. In neither the supply of money transmission services, nor the supply of savings,
         are costs going to increase significantly in a downturn as a result of an increased bad debt
         rate. This, in turn, implies that over the cycle there is a structural cross subsidy within the
         supply of services to SMEs from money transmission or deposits to debt products. If the
         source of excess profits and cross subsidy is money transmission, then this is consistent
         with the relative levels of market concentration. There are no non bank substitutes for
         money transmission, while there are at least some partial substitutes for debt products.

         Range of prices between banks

         5.36    Chart 5.8 shows standard tariffs for current accounts held by firms with a
         turnover of less than £5 million displaying an average pattern of account use. The prices
         are based on figures from Business MoneyFacts5 .


                         Chart 5.8. Estimated monthly current account costs for SME with turnover below £5 million
                          45
                          40
                          35
                          30
                          25
             costs (£)




                          20
                          15
                          10
                           5
                           0
                                    Cooperative




                                                  BoS




                                                         RBS




                                                                    HSBC




                                                                                  Barclays




                                                                                             Lloyds TSB




                                                                                                                      Alliance &



                                                                                                                                   Natwest
                                                                                                          Leicester




         Source: APACS, Business Moneyfacts




         5.37       This shows a wide range of prices for the same transactions. The published figures
         have some limitations as they assume that firms have not negotiated away from standard
         tariffs. In practice, a majority of SMEs are on standard tariffs. The Review found this to be the
         case for around 75 per cent of SMEs on average, although there is a wide variation between
         5
                 Auto transactions charged at auto debit transaction prices; non-auto transactions charged at non- auto
                 debit transaction prices.


152
5   BANKING                     SERVICES AND EXTERNAL FINANCE FOR                 SMES


       banks. Precisely how negotiations by the remaining 25 per cent affect price dispersion is not
       known but it can only be in one direction: to widen the range of prices available.

       5.38     The majority of lenders have frozen their fee structure for money transmission
       charges since 1992, implying a 17 per cent real reduction in charges for SMEs. But the
       extreme stickiness of nominal prices over time could indicate a lack of price competition
       in the market and raises the possibility that the major players may be concerned not to
       upset the status quo. The proportion of total bank income from small businesses
       attributable to fees and charges varies greatly between the banks, ranging from 20 to 50
       per cent in the first half of 19996.


       Relationship between prices

       5.39     Small business tariffs are compared in Chart 5.9 for the six largest suppliers. The
       figure shows that the banks with the largest market shares do not have the lowest
       transaction charges. This implies that small businesses do not shop around to find the
       cheapest deals.


                                                Chart 5.9. Bank market share and transaction charges

                                30                                                             80
                                                                                               70



                                                                                                    Money transactions prices
                                25
                                                                                               60
                                                                                                                                Market share
                                20
           SME market share %




                                                                                               50
                                                                                                                                Non-auto debit
                                15                                                             40            (pence)            Auto debit
                                                                                               30                               Non-auto credit
                                10
                                                                                               20                               Auto-credit
                                 5
                                                                                               10
                                 0                                                             0
                                      NatWest




                                                 Barclays




                                                                  Lloyds



                                                                           HSBC




                                                                                   RBS




                                                                                         BOS
                                                            TSB




       Source: Banking Review, Business Moneyfacts




       5.40     Many businesses may not know that their business tariffs are negotiable. As the
       negotiation of reduced charges are unlikely to bring corresponding cost savings to the
       bank, it seems likely that banks are able to sustain undue price discrimination within
       classes of SMEs that have the same economic characteristics.


       L o a n a n d ove rd r a f t p r i c e s

       5.41   Comparing prices of term loans and overdrafts on a like for like basis is difficult
       because the level of associated risk introduces a source of cost variation. Previous


       6
                Bank of England Finance for Small Firms: A Seventh Report January 2000.


                                                                                                                                                  153
5     BANKING   SERVICES AND EXTERNAL FINANCE FOR             SMES


         research suggests that larger banks with greater market share charge more for loans of
         equivalent risk, and demand more collateral7 8.


         Relationship between margins and concentration

         5.42     The Review found that margins differed between banks, with one of the big four
         earning significantly higher margins than other banks. There was no significant
         relationship between local market shares and margins.

         5.43     Using regional and local concentration measures as a proxy for competition, the
         Review tested whether there was a relationship between strength of competition and
         margins. No systematic relationship could be found, although there was an inverse
         relationship between SME turnover and margins. There were, however, significant
         differences between average margins in different regions and areas (with very wide
         standard deviation). These results might be thought to reflect different risk profiles.
         Alternatively they could show that in any particular area or region, different banks hold
         different mixes of customers in terms of risk.

         5.44     However, the banks themselves could only explain a relatively small amount of
         their price differences in terms of the risk evaluation grade they had given the loan. This
         points towards prices being genuinely diverse between banks, areas and firms.


         P ro f i t a b i l i t y
         5.45    It is not possible to measure directly the existence of excess profits in individual
         markets. (See Annex C for details.) In banking markets, the business and credit cycle, the
         nature of the products, and the wide scope of business of the firms concerned make it
         doubly difficult. However, the Review has concluded, that within a very wide margin of
         error:

                    • at institutional level, the firms principally concerned in SME banking markets
                      have together made cumulative returns for their shareholders in excess of
                      nearly all other sectors of the UK stock market. This finding holds true for a
                      number of periods of time, all including the economic downturn of the early
                      1990s;

                    • over the period 1987 to 1999 the weighted average internal rate of return (IRR)
                      for shareholders of the big four banks was around 5 per cent a year more than
                      an equivalent risk investment in the UK stock market;

                    • at least a proportionate amount of these abnormal returns was earned in UK
                      banking markets. Within UK banking markets, corporate markets display
                      effective competition and a return close to the firm’s cost of capital, leading to
                      the conclusion that UK personal and SME markets are the sources of
                      abnormal returns: the return on risk weighted equity required to support SME
                      banking been materially above the cost of that equity for a sustained period;
         7
             Clay & Cowling (1996) ‘Small Firms and Bank Relationships: A Study of Cultural Differences between
             English and Scottish Banks’, OMEGA Vol.24(1) February 1996
         8
             Binks & Ennew ‘The relationship between UK banks and their small business customers’, Small Business
             Economics Vol. 9 1997


154
5   BANKING   SERVICES AND EXTERNAL FINANCE FOR          SMES


                • notwithstanding the fact that the SME and retail sectors show significant
                  variations in bad debt rates through the cycle - and thus their profitability for
                  the banks is highly cyclical - the returns currently being earned on these
                  customers is excessive on most reasonable predictions of what the bad debt
                  rate is likely to be over the next few years;

                • in addition, the high levels of profit appear to be being earned on services that
                  would not be expected to have a high cyclical variation in profitability - money
                  transmission services or deposit services - rather than on debt products where
                  the cyclical increase in bad debt rates has, and will, arise;

                • unlike the retail market, there is no evidence that price pressure from
                  competition in these markets will in the foreseeable future be effective in
                  reducing prices to bring returns into line with costs. Hence the current high
                  returns are likely to continue.

       5.46      Three further observations are relevant. First, that the Review’s analysis confirms
       the old saw that ‘banks make more money than their small business customers’. Second,
       that this finding was confirmed early in the course of the Review by senior persons in three
       of the firms in question. Third, that the analysis is based on data provided since the focus
       of the Review became evident and that it is possible that the profitability of SME banking
       is in excess of that indicated above.


       Conclusion
       5.47      A small number of banks have significant market power in the provision of
       current account services and debt to SMEs. Concentration levels are very high, both
       nationally and in the relevant local geographic market. The incumbent firms currently
       make profits well in excess of their cost of capital; pricing is erratic in both money
       transmission services and debt and, in the latter products, apparently poorly related to
       risk; there appears to be some significant price discrimination. Finally, the products most
       subject to cyclical changes in costs (ie changes in bad debt rates) do not appear to be
       where the high profits are being generated at the top of the cycle. A not insignificant
       proportion of them appears to come from those markets - money transmission - where
       the market is most concentrated and least substitutable with other services.


       L E V E L S O F S E RV I C E : M A R K E T I N G , I N F O R M AT I O N A N D R E D R E S S

       M a r ke t i n g b e h av i o u r o f b a n k s

       5.48     This hard information on market structure is supported by softer evidence,
       which tends to confirm that SMEs are in general treated poorly by banks. Half of all start up
       companies open their first business account at the bank where they hold their personal
       account. Rival banks rarely attempt actively to persuade SMEs to switch by making
       targeted marketing approaches. The Review found that nearly half of SME owners had
       never been approached by rival providers of the type of finance they used. The one
       exception to this was credit cards, which were actively marketed. Potential competitors
       attributed their low levels of marketing to a lack of information that would help them
       decide which firms presented a good credit risk. As the existing bank holds more relevant
       information on an SME than any other institution, this makes it difficult for competitor

                                                                                               155
5     BANKING    SERVICES AND EXTERNAL FINANCE FOR           SMES


         banks to target SMEs which it might be economic to serve. This universal refrain from
         incumbent firms can be seen merely as a convenient post hoc rationalisation for the
         absence of a marketing effort of a scale and nature commonly associated with effective
         competition.


         P ro d u c t i n f o r m at i o n

         5.49      SMEs lack information about the range of alternative banking products available
         to them and the prices of those products. SMEs find it harder than personal consumers to
         compare the prices offered by alternative suppliers because the prices for money
         transmission services are often negotiable and loan prices depend on the riskiness of the
         activity for which the loan is sought. While MoneyFacts sets out firm prices for personal
         customers, Business MoneyFacts more usually sets out price ranges, or simply states that
         prices are negotiable.

         5.50    As SMEs engage in more complex transactions than personal customers, their
         banking arrangements are usually more complex. This implies they need clearer
         information about prices and terms but in practice they do not get it. The box below shows
         current practice of the big four banks in terms of the information they give to their SME
         customers. There is little standard practice; some banks perform better in certain respects
         but worse in others.

           Box 5.1. Relative clarity of SME bank statements issued by the big four
                                                           Barclays   Nat West   HSBC    Lloyds TSB
           Does the statement clearly identify
           the current base rate?                             ✘          ✔           ✘       ✘

           Does the statement summarise bank
           charges by type?                                   ✔          ✔           ✔       ✔

           Does the statement expressly total
           payment and receipts by column?                    ✔          ✔           ✘       ✔

           Does the statement clearly show the
           APR/annualised interest rate?                      ✘          ✔           ✘       ✘

           Is a cleared balance facility available?           ✘          ✘           ✘       ✔

           Does the statement explain the clearing cycle
           and/or offer advice on clearing?                   ✔          ✔           ✔       ✔



         5.51     Not all banks even give information on interest rates in a clear and comparable
         way. Lloyds TSB offers monthly managed rates which are difficult for customers to
         compare with the APR equivalent. An explanation is not provided with the statement,
         although the two can be seen side by side in branches, and rates are published in
         newspapers.

         5.52     Unclear statement information can make it difficult for SMEs to judge whether or
         not charges and interest rates have been correctly applied. In particular, cleared balances
         and uncleared balances can often diverge widely for SMEs. While interest rates are
         calculated on cleared balances, uncleared balances are shown on the bank statement. This
         makes it difficult for SMEs to calculate whether or not interest rates have been correctly
         applied.

156
5   BANKING   SERVICES AND EXTERNAL FINANCE FOR       SMES


       Mistakes and Overcharging

       5.53      There is anecdotal evidence which suggests that overcharging by banks is a
       problem for business customers. Instances are reported of interest margins being
       incorrectly calculated on overdrawn accounts, or of increased overdraft limits being agreed
       over the telephone without clarity about the rate being charged on the increased limit.
       Moreover, there are a number of bank audit businesses in the UK, a phenomenon the Review
       did not find on anything like the same scale in any other country. One such business reported
       to the Review that it had a turnover of £300,000 a year, based on examining the bank
       statements of around 50 businesses and taking 30 per cent of any compensation for error
       awarded by the banks. This firm generally operated on a ‘no win, no fee’ basis for smaller
       businesses, but made a small charge to larger firms.

       5.54    Unfortunately, this information has to remain anecdotal as the bank audit
       agencies were unwilling or unable to give the Review any information on which to judge:

                • whether overcharging is balanced by an equal amount of undercharging,
                  implying that simple bank errors were the cause; or

                • the scale of the discovered part of the overcharging problem.

       5.55    Nevertheless, the fact that the UK can sustain a number of viable businesses
       which rely on bank errors for their livelihood suggests that there is a problem of some scale.


       We a k n e s s e s i n s y s t e m s o f re d re s s

       5.56     SME loans and current accounts, like most financial products, are held for
       substantial periods of time. Unforeseen eventualities may arise during the life of the
       product, not all of which can be included in the contract between bank and SME. This
       means that the contractual arrangements between banks and SME consumers cannot be
       fully specified in all circumstances. To make sure this does not operate unfairly against
       SMEs’ interests, they need a strong system of redress when things go wrong. The main
       elements to the current system are the banks’ internal complaints systems and the
       Banking Ombudsman Scheme. Currently, SMEs with an annual turnover of up to £1
       million are eligible for the Ombudsman scheme.

       5.57     In the aftermath of bad publicity and high levels of SME customer dissatisfaction
       in the early 1990s, banks made some efforts to improve their complaints procedures. All
       banks now operate internal complaints procedures on a two or three tier basis.
       Complaints which cannot be solved at a local level are passed up to a regional or head
       office level. But systems for handling customer complaints still appear to be relatively
       undeveloped. For example, not all of the four largest suppliers to SMEs collect
       information centrally on the number of complaints received by the bank.

       5.58    The Statement of Principles of Business Banking - last revised in 1998 - is set out
       in the box below. All SMEs receive a copy of the Statement when they open business
       accounts and it is taken into account by the Banking Ombudsman in reaching his
       decisions. The wording of the Statement’s commitments is disappointingly weak,
       however. While all statements are fine as far as they go, none is easily and independently

                                                                                                157
5     BANKING     SERVICES AND EXTERNAL FINANCE FOR                      SMES


         verifiable. This may reflect the way the Statement is currently agreed. As a voluntary industry
         agreement, the Statement is agreed within the BBA after negotiation between all banks
         providing banking services to SMEs. Each major bank effectively has a veto over the text.

            Box 5.2. Statement of principles of business banking
            1.      The bank will confirm the terms of any facility (borrowing, guarantees, bonds etc) in writing.
            2.      The bank will remind the customer to seek independent advice.
            3.      The bank will co-operate with those advising a customer to explain the nature of any facility and to clarify any-
                    thing during the relationship.
            4.      The bank will agree with the customer at the outset of the facility what sort of monitoring information the cus-
                    tomer should supply and how frequently. If circumstances change, the bank will agree any new monitoring infor-
                    mation with the customer.
            5.      The bank will alert the customer in writing when it has concerns about the business and/or the banks relation-
                    ship with the customer.
            6.      If the customer is unable to solve the underlying problems, the bank may ask for additional financial information
                    and/or seek an independent review of the business.
            7.      If the bank asks for an independent review, it will explain its requirements to the customer and discuss the terms
                    of reference, who should conduct the review and the nature of the costs the customer is likely to incur.
            8.      Where the bank has requested an independent review of a business to help the customer solve the underlying
                    problems, the bank will seek to discuss the information provided with the customer (and should the customer
                    request, their advisers) before taking any legal action.
            9.      The bank will add its support to a rescue proposition which it believes will succeed.
            10.     If the customer acts in good faith; keeps the bank informed about developments; keeps to agreements with the
                    bank; heeds what their own and independent advisers say; and are prepared to make the changes needed early
                    enough to preserve the underlying business, the bank will not normally seek the immediate appointment of a
                    receiver or start other recovery proceedings.
            11.     The bank has procedures to help resolve complaints and disagreements. The bank will act fairly and reasonably
                    and seek to resolve problems quickly, dealing in plain language.
            12.     The customer can appeal to the Ombudsman if he/she feels the bank has not kept to these procedures.




         Conclusion
         5.59      SMEs receive almost no information that would help them shop around for
         banking services. Other than start ups, banks do not target SME customers. The
         information on the products SMEs hold is obfuscated and it is difficult to find and use
         information on rival products. Although anecdotal, the evidence suggests that banks
         make more errors on SME accounts than in the personal or large corporate sectors. SMEs
         are also poorly served by systems of redress.


         M A R K E T DY N A M I C S

         5.60      Banks, and others, argue that these features of a lack of competition are transient
         in the face of new entry and technological change. The Review rejects these arguments for
         the markets under consideration here.


         Entry
         5.61    In contrast to personal retail markets, there is almost no entry in the markets for
         supplying banking services to SMEs. Some foreign banks have entered English markets

158
5   BANKING                   SERVICES AND EXTERNAL FINANCE FOR                                                                                                           SMES


       (eg Bank of Ireland, Bank of Cyprus). Others have withdrawn after making losses (for
       example, Citibank in the 1980s). Both Bank of Ireland and Bank of Cyprus have expanded
       beyond their original customer bases of Irish and Cypriot nationals and are successful
       niche players, but neither has made a significant impact on the market position of the big
       four.

       5.62     The overall position shows no sign of improving. Because switching is so rare -
       about 3 - 4 per cent of SMEs change their current account provider each year - overall
       market shares are strongly influenced by the proportion of start ups each bank can attract.
       The aggregate market shares of start up current accounts are shown below. The big four
       share of new customers has been around 80 per cent to 85 per cent over the last five years
       or so, with the higher proportion in the last few years. This is similar to their share of the
       total SME market. Thus this market shows no sign of becoming any less concentrated - if
       anything, it has become slightly more concentrated in the last few years.



                                                                                                                        Chart 5.10. Bank SME market shares

                                                     35

                                                     30
                                SME market share %




                                                     25

                                                     20

                                                     15

                                                     10

                                                       5

                                                       0
                                                              Jan-92

                                                                            Jul-92

                                                                                              Jan-93

                                                                                                            Jul-93

                                                                                                                         Jan-94

                                                                                                                                    Jul-94

                                                                                                                                             Jan-95

                                                                                                                                                      Jul-95

                                                                                                                                                               Jan-96

                                                                                                                                                                          Jul-96

                                                                                                                                                                                      Jan-97

                                                                                                                                                                                                    Jul-97

                                                                                                                                                                                                                      Jan-98

                                                                                                                                                                                                                                   Jul-98

                                                                                                                                                                                                                                               Jan-99

                                                                                                                                                                                                                                                         Jul-99




                                                                                                                     Chart 5.11. Market share of SME start ups

                               35

                               30
          share of market %




                               25

                               20
                                                                                                                                                                                                                                                                           Nat West
                               15                                                                                                                                                                                                                                          Barclays
                                                                                                                                                                                                                                                                           Lloyds/(TSB)
                               10                                                                                                                                                                                                                                          HSBC

                                5

                                0
                                                     Mar-94

                                                                   Jul-94

                                                                                     Nov-94

                                                                                                       Mar-95

                                                                                                                      Jul-95

                                                                                                                                  Nov-95

                                                                                                                                             Mar-96

                                                                                                                                                      Jul-96

                                                                                                                                                                 Nov-96

                                                                                                                                                                             Mar-97

                                                                                                                                                                                           Jul-97

                                                                                                                                                                                                             Nov-97

                                                                                                                                                                                                                               Mar-98

                                                                                                                                                                                                                                            Jul-98

                                                                                                                                                                                                                                                        Nov-98

                                                                                                                                                                                                                                                                  Mar-99




        Source: NOP




                                                                                                                                                                                                                                                                                      159
5     BANKING   SERVICES AND EXTERNAL FINANCE FOR              SMES


         Barriers to entry

         5.63    The continued dominance of the major players can be explained by the very high,
         and sustainable, barriers to entry in these markets:
                   • the costs of establishing a branch network. Suppliers need a sufficiently
                     widespread, but dense, network to attract enough ‘good’ firms switching away
                     from their existing banks;

                   • a lack of detailed information about past performance among the SME
                     sector. Such information would help new entrants build up credit scoring
                     systems. The difficulty of obtaining credit scoring information in the UK
                     compares unfavourably with the US or France. In the US, banks can buy into
                     the ‘Fair-Isaacs’ credit scoring system, established with information pooled by
                     several major banks. In France, much more financial information about SMEs
                     is available through the public sector Banque de France system;

                   • the costs of accessing information about the financial characteristics of local
                     small firms. This is particularly important, as the main reason SMEs give for
                     switching their current account supplier is being refused credit. The pool of
                     switchers is therefore, at least initially, likely to be on average riskier than the
                     SME population as a whole;

                   • high levels of joint supply. A current account gives a bank valuable
                     information about an SME’s transaction and credit history, allowing it to price
                     a term loan more accurately than a rival bank. This considerably increases the
                     potential riskiness and costs of monoline (such as loan only) supply.


         C o n s u m e r B e h av i o u r

         5.64     Price differences between different suppliers should give SMEs an incentive to
         save money by shopping around and switching to different financial providers. Despite
         this, consumer behaviour demonstrates four central characteristics:

                   • SMEs review their funding arrangements infrequently: over half conduct a
                     review annually or less frequently;

                   • SMEs generally do not compare the products of different providers;

                   • once they have chosen a product, SMEs generally do not switch between the
                     products of different providers;

                   • when SMEs wish to buy additional financial services, they are likely to
                     purchase them from their existing provider.


         Switching

         5.65    Only about 3 - 4 per cent of UK SMEs switch the provider of their current account
         each year9. Switching tends to be triggered by either the departure of their existing lending
         manager, or by the refusal of a credit application. Concerns about levels of interest
         9
             Bank of England Finance for Small Businesses: Seventh report January 2000


160
5   BANKING    SERVICES AND EXTERNAL FINANCE FOR             SMES


       margins or transaction costs do not appear to prompt a switch, although previous studies
       have found charges to be the main reason why SMEs consider switching . Value for money
       also does not appear to be a consideration: half of SMEs rate the value for money of their
       existing provider as ‘poor’ or ‘very poor’. The low propensity to switch is common across all
       the countries studied by the Review. It matters more in the UK than elsewhere because UK
       SMEs tend to focus on a single banking relationship rather than diversifying across two or
       more competing banks.

       5.66    There are relative advantages to an SME staying with the same supplier. Research
       suggests that longer relationships are associated with lower financing costs and a reduced
       probability of the lender requiring collateral10. This is because the lender has gained useful
       information about the SME’s performance over the course of the relationship.

       5.67      SMEs may also be tied in to a particular supplier because the main lender has a
       floating charge over assets. This inhibits the business from switching lender or from taking
       out a loan with a different supplier. The second bank may also take a floating charge, but
       only with the main lender’s permission.

       5.68      There are also costs to switching. Apart from the time taken to find a new
       supplier, there is a risk that complex transactions may not be transferred smoothly from
       one bank to another. If standing orders or direct debits go wrong, the goodwill of
       customers may be permanently lost. This can create the perception of business risk (as
       well as finance risk) for an SME considering whether or not to switch bank.


       Te c h n o l og i c a l c h a n g e

       5.69     By facilitating distance banking, technological change could in theory allow new
       entry into SME banking markets. Distance banking is commonly held to be well
       established in the US, for example by Wells Fargo. But the Wells Fargo approach generally
       relies on credit scoring the owner-manager rather than the business, and is only used to
       advance relatively small sums of money, typically up to $60,000. There are few signs of
       even this limited approach in the UK. The closest analogue is the use of unsecured
       personal credit - which can easily be bought at a distance - for sums up to about £20,000.
       This is not really relevant to the group of SMEs under consideration here, which by
       definition are beyond the size where personal credit is an appropriate source of external
       finance.

       5.70     Notwithstanding technological advance, the traditional branch is likely to
       remain the primary access channel of choice for most SMEs. Although many are using
       alternative delivery channels - and up to a quarter would like to use internet banking in
       the future - the proportion of those intending to carry on using a branch is virtually the
       same as the proportion actually visiting a branch today.

       5.71   Technology will equally have little or no impact on the other barriers to entry in
       these markets, predominantly the costs of acquiring local information and the relative
       advantages to SMEs who do not switch.
       10
            M Cowling ‘The Incidence of Loan Collateralisation in Small Business Lending Contracts: Evidence from
            the UK’ Applied Economics Letters Vol.6 1999


                                                                                                            161
5     BANKING   SERVICES AND EXTERNAL FINANCE FOR       SMES


         5.72     The Review concludes that the supply of SME banking services in the UK is likely
         to be characterised for the foreseeable future by high levels of concentration, centred on
         the incumbent suppliers’ existing networks of branches.


         C O N C L U S I O N S A N D R E C O M M E N DAT I O N S

         5.73     There is powerful evidence that a small number of banks have significant market
         power in the local markets for providing current account services and other banking
         services to SMEs:

                  • concentration levels are very high, both at aggregate national level and in
                    relevant local geographic markets;

                  • the incumbent providers currently make substantial excess profits from
                    services provided to SMEs. Some of this relates to the effect of the cycle - bad
                    debt rates are currently low and are likely to increase at some time in the future
                    - but discounting some special features of the early 90s default rates, and on
                    reasonable assumptions about the future the current excess profit is much
                    higher than is necessary. Moreover, much of the source of the excess profit
                    appears to arise from services that are not subject to any severe cyclical effect;

                  • price variation also suggests prices cannot reflect costs. Prices vary between
                    suppliers and in different locations in a way that cannot be explained by the
                    risk profile of consumers.

         5.74      Banks are able to continue to exercise market power because current account
         services and term loans are generally sold in a bundle. There are good reasons for doing
         this. The bank is able to price the risk of a loan more accurately when it has a long
         transaction history. Empirical evidence suggests that this advantage is real: SMEs tend to
         get relatively better loan rates the longer they remain with a bank. The overall effect of
         bundling therefore may give some individual SMEs a relative advantage, but it also means
         that a small number of banks can collectively exercise market power over the SME
         population as a whole.

         5.75    The relative advantage means that SMEs tend to switch current accounts rarely.
         When they do, it is usually because their loan manager has moved, or because they have
         been refused an application for a loan.

         5.76     This exacerbates entry barriers. These markets have strong local characteristics
         and require local knowledge and physical presence. The pool of switchers is also likely to
         be riskier on average than the generality of SMEs, imposing additional costs on the
         potential new entrant. The information advantages of bundling also act as a barrier to
         monoline entry from non bank providers of term loans.


         M a r ke t s t r u c t u re

         5.77    These market conditions look set to continue for the foreseeable future. The big
         four banks have a similar share of the current account market for start ups as they do for

162
5   BANKING   SERVICES AND EXTERNAL FINANCE FOR       SMES


       established SMEs. Given the low incentives to switch, this implies that their overall market
       shares are likely to remain stable. New technology will have little or no impact as most
       SMEs prefer their finance provider to be local, even when a local money transmission
       facility is not required. For these reasons, the overarching recommendations in chapters 2
       and 3 will not have a material impact on competitive conditions.

       5.78      The Review concludes that these problems are sufficiently intractable to warrant
       an investigation by the competition authorities. There is no evidence of a breach of the
       1998 Competition Act prohibitions. No firm can be said to be dominant, although there is
       a risk this may change in some markets under the NatWest/RBS merger. And without legal
       powers, it was not possible for the Review to gather evidence on whether anticompetitive
       agreements exist.

       5.79   The Review considers, however, there is a substantial case for a reference to the
       Competition Commission under Section 51 of the 1973 Fair Trading Act, on three counts:

                • first, a small number of firms may be operating a complex monopoly in the
                  provision of current account and other banking services to SMEs;

                • second, it is in the public interest for competition in this market to be
                  improved. SMEs are vital to employment and growth in the economy;

                • third, any structural or significant behavioural solutions need to be capable of
                  being imposed, and not agreed through negotiation with those that would be
                  adversely affected.

       5.80     The Review recommends that the Secretary of State should exercise his powers
       under section 51(1)(b) of the Fair Trading Act 1973 to refer the matter of the existence, or
       possible existence, of a complex monopoly situation in relation to the supply of money
       transmission services and other related banking services (including the provision of debt
       and savings services) to small and medium sized business in the UK.

       5.81     It is to be expected that a complex monopoly investigation would have a range of
       outcomes. At a minimum, an investigation would provide a framework for the
       consideration of merger proposals between firms active in the provisions of banking
       services to SMEs. This could be in the form of firm conclusions on the definition of the
       relevant economic market and problematic degrees of concentration.

       5.82     An investigation could also recommend a range of behavioural remedies, such
       as:

                • restrictions on firms extending the scope or the density of their activities in
                  specified geographic markets;

                • obliging a firm to offer money transmission services to competitor’s
                  customers on a non discriminatory basis, so that it would be charged the same
                  prices for access to the services of a branch as an existing customer of the firm;

                • price disclosure in the form of actual prices charged to discrete classes of
                  SMEs in the relevant geographic market;

                                                                                               163
5     BANKING   SERVICES AND EXTERNAL FINANCE FOR      SMES


                  • elimination of any restrictive covenants on the disposal or closure of branches
                    and the release or transfer of skilled staff.

         5.83   An investigation would also consider structural remedies in the form of
         divestment. These could require that in the problematic local markets:

                  • the one or two firms contributing most to the concentration problem should
                     divest a viable SME money transmission and lending business; or

                  • that all the SME business of a firm should be divested, (but ensuring a ‘shared
                     pain’ quota across the UK as a whole).

         5.84      There are likely to be a significant number of buyers for such assets. It could be
         that, in certain markets, firms contributing to over concentration elsewhere would qualify
         as purchasers, since there is a distinct historical regional bias to their activities. Both
         divestment options would result in more firms being active in SME banking across the UK,
         carrying the threat of contestability to contiguous markets, even where the divestment
         programme had not changed market shares in any one geographic market.

         5.85     In divestment of viable businesses, the problems of shared premises and
         common costs are not as serious as might be expected. Very few SME business decisions
         are taken in traditional retail branches and key staff, of whom there are surprisingly few,
         are increasingly not located in a branch. Taken along with the behavioural remedies on
         access to money transmission services, divestment would also inconvenience customers
         much less than might be expected. Certainly in the US where there are limits on
         concentration and, therefore, divestment is frequently a condition for merger approval,
         the costs are seen as a price worth paying for choice and effective competition. Whether
         such divestment is a proportionate and necessary remedy to the competition problems
         identified here would be the question at the heart of the investigation.

         5.86     In the meantime, the Government can introduce measures to improve
         competition at the margin. In addition to the recommendations contained in Chapters 2
         and 3, the following initiatives concerning entry, transparency and redress would all help.


         Reducing barriers to entry

         5.87     Two significant barriers to entry are the need for a local presence and the absence
         of high quality financial information on SME customers.

         5.88    Demand for a local presence is driven in part by the need of some SMEs for
         frequent cash and cheque transactions. In the US, where there is far less concentration in
         SME banking markets, agency arrangements for money transmission facilities are
         commonplace. These are beginning to feature in personal retail markets in the UK. For
         example, Barclays is running a pilot scheme with 270 Post Offices in Cornwall. Other
         potential agents for SMEs’ money transmission include any institution with large cash-
         handling facilities, such as competitor banks and supermarkets.

         5.89    New entrants need access to comprehensive information on small businesses so
         that they can construct credit scoring models. The Comprehensive Business Register

164
5   BANKING   SERVICES AND EXTERNAL FINANCE FOR      SMES


       currently under consideration will provide a useful platform for this. To address the
       problems directly, the Review recommends that the Government should publish the
       Comprehensive Business Register as soon as possible and it should include: location of
       business, sector, date the business began trading, turnover and VAT record. This level of
       detail would make a significant improvement to the information available to potential
       suppliers and would strike an effective balance between transparency and confidentiality.



       S t re n g t h e n i n g re d re s s

       5.90      Given the problems in the market, SMEs need to have access to strong avenues of
       redress. However, the Review has concerns about the FSA’s proposals on access to the
       Financial Services Ombudsman Scheme by small businesses. The FSA is currently
       proposing to limit access to the Scheme to those businesses with a turnover of £1 million
       or less and which have less than 5 employees.


       5.91     The introduction of a test on the number of employees would be a departure
       from the current provisions of the Banking Ombudsman Scheme. While the Review
       understands the FSA’s desire to introduce a more sensitive definition of a ‘small business’,
       the definition does not need to be identical for all financial services. The purpose of the
       scheme is to countervail the market power of financial firms and if firms have higher levels
       of market power in one financial services sector than another then it is appropriate for the
       terms of the scheme to be different in that sector. As the Review has highlighted earlier,
       regulatory solutions must be tailored to the specifics of the problem. The FSA’s
       consultation paper itself acknowledges that the banking sector is different in its
       comments that ‘in practice, it is only in the banking sector that anything approaching a
       significant number of complaints is received from small businesses’.


       5.92     The Review believes the introduction of an ‘employee test’ will exclude a
       significant number of SMEs from access to the scheme. At present, there are a significant
       number of SMEs with a turnover of less than £1 million which employ more than 5 people.
       A turnover limit would penalise labour intensive SMEs. The Review believes there is no
       sensible rationale for the introduction of an ‘employee’ test. Having more employees does
       not make a firm better able to commence legal proceedings against its bank . The Review
       therefore recommends that the Government should ensure that small business access to
       the Financial Services Ombudsman Scheme is not restricted by imposing a limit on the
       number of staff employed by the business.


       5.93     The Review also has concerns about the turnover limit. The purpose of the
       scheme is to give consumers, including small businesses, a cheap and efficient means of
       adjudicating unresolved complaints against banks. Businesses with a turnover above £1
       million are not necessarily able to afford the cost of legally challenging their banks. The
       Review recommends the Government should ensure that the turnover limit for
       determining small business access to the Financial Services Ombudsman Scheme is at
       least £5 million. The logic here is to give all the class of disadvantaged SMEs the same
       routes and rights of redress. This would encompass almost all the 1.3 million businesses
       that are of concern and bring some 200,000 more under the scheme than the FSA’s
       proposed limit of fewer than five employees.

                                                                                               165
5     BANKING   SERVICES AND EXTERNAL FINANCE FOR      SMES


         5.94     Currently, the Ombudsman takes account of any relevant industry codes of
         practice in determining complaints. In the case of SMEs, these are the BBA’s 12 Principles
         of Business Banking agreed in March 1997. Chapter 4 highlighted the Review’s concerns
         that such industry codes could be used to determine what is ‘fair and reasonable’ under
         the new statutory scheme and that it was entirely inappropriate for the banks to
         determine the standards against which complaints will be judged. The Review therefore
         recommends that the Government should ensure that the rules of the new Financial
         Services Ombudsman Scheme specify that the Ombudsman will draw up SME guidelines
         after consultation with interested parties, including small businesses, the OFT, the FSA,
         and the industry. The Ombudsman should then use these guidelines to determine
         whether a banking supplier’s actions are ‘fair and reasonable’.

         5.95    The purpose of the guidelines, as for personal consumers, would be to enable the
         Ombudsman to set out, where necessary, what small businesses should be able to expect
         from the suppliers of banking products. The Review expects the guidelines would
         concentrate on ensuring small businesses were provided with timely, accurate and
         relevant information from their suppliers. It should only need to set out specific
         requirements where banks failed to supply such information voluntarily. The Review
         recommends that the small business guidelines should, where necessary, include
         disclosure requirements for banking services.Given the particular information problems
         the Review has identified, the Review recommends that the requirements for disclosure
         should include:

                   • agreed margins and the basis on which interest payments are calculated in
                     all bank statements. This should make explicit the average cleared balance;
                     and APRs should always be stated so that rates are comparable;

                   • standards of service for switching current account supplier.


         I n c re a s i n g t r a n s p a re n c y

         5.96     For SMEs collectively to exert greater competitive pressure on banks, they need
         to have more information about the services they receive and to be able to compare prices
         and service levels across the market. This is in many ways a greater problem for SMEs than
         personal customers because their finances are often more complex and information
         more opaque and harder to come by.

         5.97    The Review recommends that the FSA should rebalance the resources it devotes
         on consumer awareness,to give more attention to the information problems experienced
         by SMEs.

         5.98    Chapter 4 recommends that the FSA should have robust legal powers to acquire
         information from suppliers of non regulated retail financial services products and to
         publish comparative information. The Review recommends that the FSA should publish
         comparative tables for small businesses which,among other things:

                   • rank SME current account services (at standard tariff and a range of
                     negotiated prices) according to price;

166
5   BANKING    SERVICES AND EXTERNAL FINANCE FOR    SMES


                 • show prices and terms for relevant geographic markets and not just on a UK
                   wide basis.

       5.99     The Ombudsman also holds information relating to particular firms which
       would provide very helpful guidance to small businesses. The Review recommends that
       the FSA compiles and publishes comparative tables of, among other things, the number
       of complaints:

                 • received from small businesses by individual firms;

                 • received by the Ombudsman from small businesses about individual firms;

                 • upheld by the Ombudsman against individual firms including the total
                   value of settlements made against each firm.

       5.100   To the extent that the information to deliver these recommendations cannot be
       obtained by voluntary means, it underlines the need for the FSA to have robust legal
       powers to compel firms to disclose information which is of value to consumers.




                                                                                         167

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:3
posted:4/22/2012
language:
pages:27