Wednesday, 6 July 2011

EU and ICB 20th Century thinking hampering LBG disposal programme

The intent of both the EU and the Independent Commission on Banking by forcing Lloyds Banking Group to sell branches was to create greater competition in the UK banking market, however their 20th century thinking has made the possibility of this happening highly unlikely.

Both the EU and the ICB have defined the disposals in terms of market share and branches. By not understanding or not recognising the impact of treating the reductions in market share in deposits and mortgages as separate and unrelated topics they have given any new entrant an almost impossible task. They have made this task even harder by tying it to a large number of physical branches, whilst not recognising that increasingly branches are becoming irrelevant and a high capital burden for any organisation to take on.

Indeed, for example, indications are that NAB whilst interested in acquiring the customers sees the deal as far less attractive if they have to acquire the branches as well. A similar argument could almost certainly be made by Tesco.

To get an understanding of the impact of the mismatch between the deposits and the loans - it is estimated that there will be an initial £35bn cash shortfall between the deposits and the loans that the acquirer will have to deal with. Bidders will have to find a way to fund this. This £35bn makes the asking price of £2.5bn look like loose change. Whilst the Information Memorandum shows how the funding gap will reduce to between £14 and £17bn over time, that is still a significant amout of money. Building that into the business case for a new entrant means that the time to get to breakeven for any new entrant is going to be a long time, maybe too long for investors.

Add to this that the audit firms are warning that any bidder who puts in a bid  for the assets could lead to the auditors not being able to sign off on their accounts.

The FSA is also not helping to get this deal away by warning about the operational risk associated with migrating off the Lloyds systems. Even the CEO of Lloyds Banking Group, Antonio Horta-Osorio, agrees that what is being sold is not a good as it could be. In his strategy announcement at the end of June he laid out the need to significantly improve the efficiency of the Group's IT systems, the same IT systems that the buyer would be acquiring. Inheriting inefficient systems will hardly put the acquirer in a strong competitive position, let alone the costs, risks and complexity of migrating onto a new set of systems.

The combination of the funding gap and the operational risk could result in the buyer being required to hold a Tier 1 capital ratio  of almost 20%, double the level of the Big 5 banks. This would put the new entrant at a significant competitve disadvantage to the existing incumbants; hardly a way to increase competition!

Had the EU and the ICB understood the UK Retail Banking market in the 21st century they would have proposed a disposal based on matching deposits and loans and based on numbers of customers, and had branches as optional, giving a new entrant a far better chance of competing with the Big 5. However they didn't and the process is being forced through at pace for good reason on the part of LBG. By ensuring that  the bidding process is well underway before the ICB reports in September, it makes it far more difficult for the ICB to make the case to add further branches as their interim report suggested.

By the end of the second week of July first round bids need to be submitted. By the end of July the second round bids will need to be in. It will be extremely interesting to see how many, if any bidders, remain at that stage.

The reality is that the most likely outcome will be a floatation, a floatation of a cloned mini-Lloyds Banking Group. Given that it will be led by senior executives from Lloyds Banking Group, using the processes and systems of that Group, but hampered with more expensive funding and without the level of investment that Antonio Horta-Osorio has indicated in his strategy review, it is unlikely that this new player will do much for competition in the UK banking market.

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