Downside of regulation

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There are many things wrong with British banks, but contrary to the Cruickshank Report, the fact that they make profits is not one of them.

Don Cruickshank’s recent review of the banking sector concluded that British consumers overpay between £3bn and £5bn per year for their banking services. This startling figure is arrived at in the following way: take the return on capital or profits ratio of a group of banks and compare it with their cost of capital. The latter is calculated by adding a premium to reflect the riskiness of equity investment to the return for completely safe assets, such as government bonds. The answer is about 12 per cent. The difference between the profit rate, which has averaged about twice that, and the cost of capital is a measure of the alleged rip-off.

Extending Cruickshank’s basis of calculation leads to the discovery that every main British industry is in a similar condition. The annual Financial Times list of the five hundred largest British companies by market capitalisation identifies forty-five sectors and calculates the average return on capital for each using broadly the Cruickshank methodology. Forty-one of the forty-five earn more than 12 per cent. Financial services, ranked nineteenth, is in the middle of the pack. Four sectors have returns below this 12 per cent figure: three are engaged in investment rather than operating activities and their returns will reflect the funds rather than the profits of the underlying businesses. The other low yielding sector – gas utilities – is regulated to keep its profits in line with its cost of capital.

It is possible that Cruickshank’s work has only just begun and the whole of British industry is a rip-off, gouging tens of billions from consumers through uncompetitive practices. Alternatively, there might be something his analysis has omitted. Before jumping to the first conclusion, it is worth considering the second.

The report measures the profitability of the banking sector by reference to the average rate of return of eleven British banks over a ten year period. This list includes all the well-known names. There are, however, some companies which are not in the sample. There is no mention of the fraudulent Bank of Credit and Commerce International, which went bust during the period. Or of the hapless Barings. Nor does the group Cruickshank examined include Citibank, the principal foreign bank to try repeatedly to enter British retail banking.

The procedure is biased in favour of large, profitable, successful and long established businesses, and away from failures, new entrants, and companies in liquidation. It is not surprising that the vast majority of established companies quoted on the London Stock Exchange earn more than the cost of capital.

The reality of this point is evident if you look at individual companies rather than the sector averages. From the information I have it seems likely that the lowest returns in his sample were earned by National Westminster and Midland. This is not because NatWest and Midland abstained from the great rip-off and offered customers a better deal – they did not – but because they were worse run. Their average rate of profit over the period is more or less in line with Cruickshank’s estimate of the cost of capital. By chance the publication of the Cruickshank report coincided almost to the day with the demise of NatWest as an independent company. Midland had of course disappeared into the arms of HSBC several years before.

The characteristic of a competitive market is not that all companies earn returns equal to the cost of capital. In a competitive market badly performing companies – like Midland and NatWest – struggle to earn the cost of capital, while strong companies earn superior returns by virtue of their competitive advantages. The highest return on capital in the banking sector over the period has been earned by Lloyds. It has consistently had the best focused and articulated business strategy and the most respected management in the sector. It has used its high return on capital and greater market capitalisation to expand its activities through growth and acquisition. This is how competitive markets really do work.

So are returns in excess of the cost of capital evidence of market power? In a sense, yes. The effective management of Lloyds TSB, the brand name of Coca-Cola, the innovative products of Sony, the drug portfolios of Merck and Glaxo-Wellcome: all these are sources of market power for the companies which have them, but they are not forms of market power that the regulation of competitive markets should do anything to prevent. The object of such regulation is not to prevent companies earning returns in excess of the cost of capital, but to ensure that they can only do so as a result of genuine competitive advantage.

Cruickshank does at times acknowledge that this is the real issue. Obsessed with ensuring that depositors cannot lose money, regulation has not sought to secure innovative products and innovative services for bank customers: but it has inhibited competition which might have given customers these advantages. There are many things wrong with British banks but the fact that they make profits is not one of them.

John Kay is a director of London Economics and of Halifax plc.

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