Financial Institutions in the UK

Retail Banks e.g. Barclays, Lloyds, abbey National

Wholesale banks: these deal primarily in receiving large deposits from and making large loans to industry and other financial institutions

- They help companies raise money on the stock market

- Merchant banks such as Rothschild’s and Hambros

- Increasingly provide mortgages for customers

- Foreign banks deal a lot with foreign exchange

Building societies: not public limited companies like banks. Primarily concerned with saving accounts and mortgages loans. Increasingly acting like Banks

Finance Houses: specialise in providing hire-purchase agreements for buying consumer durables, several finance houses are subsidiaries of banks

Discount Houses: These specialise in lending and borrowing money for very short periods of time. There are eight discount houses in the UK (e.g. King & Shaxson)

N.B. the distinction between these has been blurred in recent years due to changes in the financial system.

The Bank of England has a longstanding interest in the structure of the financial system. System structure can affect financial stability through influencing the cost and availability of the financial services on which households and businesses

depend. The basic services provided by the financial system are relatively timeless, but the structure of the system that provides them continues to evolve. While new products and players have emerged over the past 50 years, UK banks have become ever larger and more central to the provision of the full range of financial services.

Post-crisis, public-policy attention has been focused on the potential costs of this evolution. In particular, the emergence of large, highly interconnected universal banks has transformed the financial network, increasing the likelihood of system-w distress. To the extent that these banks are ‘too important to fail’, private incentives are distorted and resources misallocated (Haldane (2010)). Acknowledging this, efforts are under way both domestically and internationally to address the risks associated with too important to fail institutions. This article examines the structure of today’s banking system and explores the drivers of change over recent decades. It

begins with an overview of the services provided by the financial system and describes how the provision of these has changed over time. It goes on to identify key economic and regulatory drivers for change, before taking stock of the policy

challenges ahead.

The financial system provides a range of services that support then transformed into funding for households, companies for government.

The financial system provides three key services: payment services, intermediation between savers and borrowers, and insurance against risk. These services support the allocation of capital, and the production and exchange of goods and services, all of which are essential to a well-functioning economy. While the basic financial services are relatively timeless, the characteristics of the system providing them change continuously, in response to both economic and regulatory developments.

This article tracks the evolution of a core component of the financial system in the United Kingdom, the banking sector, describing how technology has transformed the economics of banking, and how deregulation in the 1970s and 1980s freed banks to take advantage of new opportunities through globalisation and financial innovation. The result has been the emergence of large, functionally and geographically diverse banking groups. Post-crisis, public-policy attention has been focused on the costs of a banking sector dominated by large and complex institutions that are seen as too important to fail.

Deposit accounts allow households and companies to insure themselves against liquidity shocks, while securitisation, derivatives and other insurance contracts facilitate the dispersion of other financial risks within the economy. For example, foreign exchange derivatives allow companies to protect their international revenues from fluctuations in foreign exchange rates; and securitisation markets package and disperse banks’ loan exposures.

Today, more than 300 banks and building societies are licensed to accept deposits in the United Kingdom. However, the provision of retail banking services is highly concentrated. Of the 16 clearing banks present in 1960, fifteen are now owned

by the four big UK banking groups: RBS, Barclays, HSBC and Lloyds Banking Group (LBG) . These banks, along with Nationwide and Santander, together account for almost 80% of the stock of UK customer lending and deposits. Collectively, smaller share of the market for these services than the banks from which they originated.

The building society sector, having continued to expand during the 1980s and 1990s, saw a sharp contraction in the mid-late 1990s, as many building societies demutualised and became banks. Over the past 50 years, the number of societies declined from over 700 in 1960 to just 52 today. As the clearing banks have grown and consolidated over recent decades, they have also taken on a broader range of functions. The largest banks have become truly ‘universal’ banks, their activities encompassing securities underwriting and trading, fund management, derivatives trading and general insurance. This expansion coincided with a period of significant growth in securities markets and the markets for foreign exchange and derivatives

The UK banks have established themselves as major global players in these markets . For instance, recent market surveys place three UK banks among the top ten worldwide in several markets, including bond underwriting, foreign exchange trading and interest rate swaps. The evolution to universal banking is reflected in an increase in the contribution of non-interest income to banks’ earnings. Today, non-interest income accounts for more than 60% of banks’ earnings, having been a minor share three decades ago.

Collectively, UK banks’ balance sheets are now more than 500% of annual UK GDP, with much of this growth having occurred over the past decade . Three of the for largest banks individually have assets in excess of annual UK GDP. Relative to the size of the national economy, the UK banking system is second only to Switzerland among G20 economies, and is an order of magnitude larger than the US system.(2) The expansion of the UK banking sector, particularly since the late 1990s, far exceeds that in other financial sectors .

The ‘universal’ banking model was already an established feature of some other

banking systems. For instance, in Germany, banks had an established role in

facilitating funding for long-term industrial investment projects (Gerschenkron

(1966)). The UK universal banking model is somewhat different to that in Germany

however, since UK banks’ lending to corporates remains typically relatively short term.

The steep decline in building societies’ assets relative to GDP in the mid-1990s was mainly driven by the conversion to bank status of a number of societies (following Abbey National’s lead in 1989): Halifax (in 1997), Alliance & Leicester (in 1997) and Northern Rock (in 1997) (British Bankers’ Association (2002)). This resulted in over half of building society assets, equivalent to 15% of GDP, being transferred out of the sector.

The data are a backwardly consistent sample of institutions providing banking services in the United Kingdom in 2009. The sample includes the following financial groups: Barclays, Bradford & Bingley, HSBC, Lloyds Banking Group, National Australia Bank, Nationwide, Northern Rock, RBS and Santander UK. Where data are consistently available for the UK component of the banking group, these have been used.

This section examines the factors that have influenced the evolution of the banking sector. It first examines the evidence on economies of scale and scope, before exploring how the economics of banking and the evolution of the market structure might have been influenced by changes in demand and regulation. It closes with some thoughts on the potentialrole of ‘too important to fail’ in the evolution of the bankingsystem.

One reason for the observed development of the banking sector may be banks’ pursuit of economies of scale and scope. These arise, respectively, when the unit cost of providing a given banking service declines as the scale of provision of that service increases, or when the unit cost of providing a mix of services jointly is lower than the sum of providing each separately. The presence of such efficiency gains would be

consistent with both consolidation in the banking industry and the expansion of banks’ roles beyond their traditional functions. The nature of these efficiency gains is likely to have changed over time, driven by technological advances, financial

innovation and the globalisation of markets. Furthermore, banks’ ability to take advantage of such economies has also evolved. In the past, institutional and regulatory restrictions on banks’ activities prevented banks from fully responding to

economic drivers. Financial deregulation in the 1970s and 1980s removed these constraints. At the same time, deregulation also introduced stronger competitive forces in the banking sector, encouraging banks to expand into new markets offering higher (albeit more volatile) margins. Recent banking industry studies have examined the potential cost efficiencies inherent in the universal banking model.

These studies emphasise efficiencies arising from: spreading fixed costs over a larger volume of output; and risk diversification through capital pooling.(1) For large banks, it is estimated that around 15%–20% of total costs are fixed. Of these, the largest components are technology costs and corporate centre costs (eg head-office functions), for which 50%–60% and 80%–90%, respectively, are estimated to be

fixed (JPMorgan (2010)). However, these industry studies rely primarily on case studies and anecdotal evidence to support their claims. The majority of academic studies, on the other hand, do not find positive evidence for economies of scale and scope beyond a relatively small size. For instance, Saunders (1996) surveys at least

20 empirical studies and finds little evidence of scale economies for banks with assets greater than $5 billion. Similarly, in a survey of more than 50 studies by Amel et al

(2004), the minimum efficient scale in retail commercial banking appears to be somewhere below $10 billion in assets, depending on the sample, country and time period.

Applying these findings to the global population of banks in 2008 would

suggest that several hundreds are above the threshold at which no positive evidence for economies of scale could be found. Beyond a certain size there may even be diseconomies of scale, possibly due to the complexity of managing large institutions

(Haldane (2010)). While some recent studies are more supportive of the existence of scale economies in banking, including a review of studies of mergers and acquisitions in banking by DeYoung et al (2009), taken together the bulk of the empirical literature to date has failed to identify material economies of scale in commercial banking beyond a relatively modest size.

The notion of risk diversification is consistent with anecdotal evidence in Frontier Economics (2009) that large global banks are more likely to continue to lend during an economic downturn.

The evidence on scope economies is mixed and inconclusive. Empirical research in this area is complicated by the low incidence of specialist companies against which to compare the outcomes of functionally diverse companies. Stiroh and Rumble (2006) fail to identify substantial economies of scope, and in a study of financial conglomerates, Laeven and Levine (2007) find evidence of a conglomerate discount,

rather than a premium (ie the market value of a conglomerate is less than the sum of the market values of the individual entities from which it is comprised). However,

other studies, such as Hughes et al (2001) do find in favour of scope economies.

Over time, technological advances have undoubtedly transformed the economics of banking. Automation in retail banking and innovation in both risk management practices and the design of financial products have all triggered changes in the provision of the three core financial services. But the net effect of these changes on economies of scale and scope is unclear. On the one hand, the unit cost of processing power continues to decline. But at the same time, banks have adopted new financial technologies and increased the breadth and quality of their services, requiring increased expenditure (Berger and Mester (2003)). Smaller banks may also have

been unable to keep up with the pace of technological change (Wheelock and Wilson (2010)).

One outcome of this is increased market-wide reliance on a limited number of large firms in the provision of technology-intensive services, such as trade-execution and post-trade infrastructure provision. For example, as execution services in foreign exchange have become more automated, the banks with the financial

capacity to make the largest up-front information technology investment have gained market share (Barker (2007)). Indeed, the ten largest institutions in foreign exchange (by turnover) have a combined market share of around 77%, and the 20 largest 93%.(1) And advances in information technology and telecommunications would seem to have accelerated the globalisation of finance towards the end of the 20th century. Another factor operating on economies of scale and scope is the value of specialist knowledge and private information. Traditionally, knowledge transfer (either within or across business lines) allows firms to respond quickly to new opportunities, eg as new products and new markets emerge.

Economies of scope may also arise from access to private information; for example, deposit-taking activity may generate information relevant for lending decisions. However,the importance of such private information may have declined over time, particularly as judgement-based credit assessments — especially in retail lending — have increasingly been replaced with credit-scoring models. Indeed, potential information loss arising from increased use of models as a bank grows in size, instead of basing decisions on judgements and relationships, could itself generate diseconomies of scale.

The functional expansion of UK banks may reflect the changing demands of the corporate sector. For instance, UK private non-financial corporates increasingly rely on bond and equity finance — currently comprising 65% of total liabilities — rather than bank finance, and therefore seek issuance, underwriting and market-making services. They also increasingly seek to hedge their financial risks via derivatives markets. Of the world’s 500 largest companies, 93% of non-financial businesses report using derivatives (ISDA (2009)).

There is evidence that large companies value the provision of investment banking services by their bankers. For example, bonds underwritten by commercial banks appear to outperform those underwritten by investment banks, due to the perceived ‘certification’ of the issue by a party with privileged information on the borrower (Puri (1996), Gande et al (1997) and Yasuda (2005)).

Multinational companies may also value being able to work with one bank present in a range of countries. Indeed, according to Frontier Economics (2009), banks often enter new markets purely on the basis of demand from their multinational clients. However, the Association of Corporate Treasurers noted that, while some very large companies will occasionally find it convenient to deal with one or two large banks, corporate customers generally ‘do not need very large banks’ (Association of Corporate Treasurers (2009)).

Big bang reforms

The abolition of exchange controls made subsequent financial liberalisation more likely, because businesses had an option to relocate to less tightly regulated jurisdictions. Such deregulation occurred over the course of the 1980s,

particularly in 1986. The phrase ‘Big Bang’ refers to a series of reforms that sought

to eliminate perceived anticompetitive practices at the London Stock Exchange and put London’s financial markets on an equal competitive footing with its international rivals, particularly the United States.(5) Among other things, the reforms sought to remove price rigidities in the provision of securities transactions and dismantle barriers to entry onto the Stock Exchange.(6) Two practices received particular

attention: fixed minimum commissions; and so-called ‘single capacity’, which prevented both brokers from trading on their own account and market makers (‘jobbers’) from acting for customers.

The abolition of minimum commissions changed the economics of brokerage and market-making, making joint-provision of these functions and foreign entry inevitable.(8) Although the total number of institutions did not increase, there was a marked rise in the number of individual members of the Stock Exchange . There was also a wave of consolidation in the broking and market-making industry.(9)

Indeed, one motivation for the lifting of exchange controls had been to facilitate the investment abroad of North Sea oil surpluses. For example, the United States lifted some exchange controls in 1974, Japan in 1980, Australia in 1983, and France and other European countries in 1986. Earlier, in 1979, the Stock Exchange rule book had been referred to the Restrictive

Freed from regulatory restrictions, banks began to diversify into new activities, using existing knowledge and infrastructure to cross-sell new products. This attempt to increase returns from existing assets ultimately led to the emergence of universal banking. Perhaps contributing to this, the managed funds industry saw a marked expansion in the years following these reforms, increasing competition for household savings and reducing margins on retail banking activities.

While the direction of travel in the 1980s was towards ending functional restrictions in the banking sector, this period also saw the beginnings of a shift towards internationally agreed prudential regulation, notably through the introduction of the

Basel Accord in 1988. This arguably also generated incentives for banks to grow, by introducing an additional fixed cost of meeting regulatory capital requirements and associated reporting and supervision.

Date: 2015-12-24; view: 1105