Competition Commission

SUPPLY OF BANKING SERVICES BY CLEARING BANKS TO SMEs INQUIRY

Notes of an Open Meeting held at Congress Hall, Gt. Russell Street, London WC1 on Friday, 3rd November, 2000.

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PRESENT

FOR THE COMMISSION

Dr D Morris - Chairman

Prof C Graham

Mr D Hammond

Dr E Monck

Mr R Munson

FOR THE STAFF

Mr J Banfield - Team Leader

Mrs J Wheeldon

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Transcript of the Shorthand Notes of Harry Counsell & Co.,

Cliffords Inn, Fetter Lane, London EC4A.1LD

Telephone: 0171-242 9346

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10.05 am

THE CHAIRMAN: Good morning ladies and gentlemen. I am Derek Morris, Chairman of the Competition Commission, and Chairman of the Commission's Inquiry into the supply of banking services by clearing banks to small and medium sized enterprises, and to get the terminology straight from the beginning, we refer to those, in short, as SMEs.

In that capacity may I welcome you all to that open meeting being held as part of that inquiry. There are four other members of the Commission on this Inquiry sat at the front here - Professor Cosmo Graham, David Hammond, Dr Elizabeth Monck, and Roger Munson. Your information pack contains short biographies of all of us, but relevant backgrounds and expertise lie in industrial economics, competition law, industry accounting and representation of customer and consumer interests, and I think that all of those are relevant to this particular inquiry.

I should also like to introduce to my immediate left, John Banfield, who is the Commission Staff Member responsible for this inquiry and there are members of his staff in the various fields of expertise in the main body of the report.

The terms of reference for our inquiry were sent to us jointly by the Secretary of State for Trade and Industry, and the Chancellor of the Exchequer on 23rd March under the monopoly provisions of the Fair Trading Act and we are required to complete our investigation and submit our report to the Ministers next year by 19th June.

We have included a progress report, including an outline of the timetable fro the remainder of our inquiry in the information pack, and you will see that we have already received a great deal of written evidence from the main parties and a range of other interested organisations and individuals as well.

We have already held quite a number of private hearings with a number of third parties such as SME representative organisations, building societies - or in some cases ex-building societies, and some of the smaller banks.

A word about public meetings such as this. They have increasingly become a regular element in the Commission's inquiry processes. This stems originally from detailed survey evidence indicating that while the Commission, I am pleased to say, was perceived to be thorough, fair, independent and authoritative, it was I am afraid regarded as far too opaque both by those directly involved in the process and seeking to understand fully the nature of the issues involved, and by the wider public. We have responded to that in various ways, publishing far more information than we did in the past, holding joint meetings and, of course, holding open meetings such as today.

My standing guidance to inquiry groups, a copy of which is available on our website, states that where appropriate meetings such as this should be held in each inquiry. The guidance also sets out the conditions or criteria for decided whether such a meeting is appropriate or not.

Today's meeting is quite simply intended to provide an opportunity for the main topics to be discussed so that all the interested parties are fully aware of the issues involved and, at least in broad terms, are aware of the position of the other main parties.

It is already clear to us that the provision of banking services to SME's is an extremely complex area of business activity involving, it appears, several million small businesses, and we believe that today's hearing should help to provide that wider understanding that we are seeking and I guess to ensure that the Commission's investigation is properly focused. I do invite all those participating today to make good use of the day and to place on public record, at least in broad terms, their position and their views.

Shortly after the meeting - almost certainly next week - we plan to send a so-called Issues Letter to the main parties and to publish a summary of that in Issue Statements, so that all parties may consider whether they wish to send us any fresh evidence, particularly on matters that we have identified for investigation, and those Issues Letters will, of course, reflect anything further that emerges from today's meeting.

We are also taking a verbatim note of today's proceedings to ensure that a correct record is available, and a copy of the transcript will subsequently appear on our website and hard copies will be available to anyone who wants them on request.

So anyone wishing to send us information in the light of this meeting is most welcome to do so.

To take part in the hearing we have invited those who have already provided us with written evidence to date - that includes obviously the banks, building societies, other financial institutions large and small, industry regulatory bodies, trade associations, chambers of commerce, business links and, of course, SME representative groups and advisory bodies. We have invited all of those to provide us with evidence and, if they wish, to take part in today's meeting.

The main participants are, in fact, seated towards the left and right of the hall, and then there is the public and media representatives who are invited today as observers in the central block.

You will see from the agenda that we have identified three broad areas for discussion and for each of these topics a spokesman or woman from one of the main participants will make an initial presentation. Other speakers will then give responses from the rostrum here.

To the extent that time allows, there will be an opportunity for other participants to make observations on the presentations. If anyone wishes to do that, could they just raise their hand, we have a roving mic. that will come around to you to enable you to be heard throughout the hall. Please would you remember at all times to speak only into the microphone, and to introduce yourself each time you speak. That will help the Shorthand Writer. Commission Members may also wish to raise points on the presentations.

Let me stress that while the presenters will not, in any sense, be debarred from responding to points raised, if they so wish, it is not the Commission's intention that this meeting will become a formal question and answer session. In particular this meeting, I must stress, is not a forum for participants to raise specific cases, or to make particular complaints that they feel they may have, to quiz or cross-examine individual organisations or their representatives directly.

Clearly, if people have concerns that fall into that category then they should be writing to us and we would be taking that up later in the inquiry, and indeed, some people already have written in those terms to us.

So any such intervention of that nature today I am afraid will be regarded as out of order and ruled as such. Questions of course may be raised, but they should be of a more general nature, for example, to the banks as a whole, perhaps to SME representative bodies as a whole.

If members of the public are burning to ask questions then please note them down on the forms that are provided in the information pack, let us have them at the coffee break or at lunchtime, and to the extent there is time, and we think it appropriate we can raise those questions later in the morning.

I should add, though I guess this would be obvious, there is absolutely no question of anyone being pressed to disclose any confidential information in this public forum.

There are a number of issues involved in this inquiry which can only, I am afraid fully be examined by the Commission with the use of commercially sensitive, confidential information. That will, of course, happen, but it is clearly not appropriate for today.

Two final points. First, the media have full access to today's proceedings, however there will be no recording - sound or vision - of the proceedings other than, of course, for the purposes of the official transcript. May I add that the Commission, as always, has gone to considerable lengths to try to ensure fair and equal treatment for all the parties concerned. Apart from the members of the public here today, or those who obtain a copy of the transcript, the public's knowledge of the issues will be obtained only from the media, so I do look to the press, radio and television to reflect in their coverage, whether it is brief or lengthy, a balance and a full range of views represented.

For the avoidance of any doubt whatsoever, the Commission has yet to form any view of the likely outcome of this inquiry. It will not even move into that phase of its inquiry until next year after the completion in particular of the main hearings with all the main clearing banks involved. That was the first point.

The second is, I hope, more prosaic, I have been asked to draw your attention to the emergency fire instructions which you will find in your pack. Please take a few minutes to read those if you have not already done so.

THE CHAIRMAN: I am now going to invite Fod Barnes to make the first presentation. He was a member of the Banking Review Team led by Don Cruickshank which reported. in the so-called Cruickshank report, to the Chancellor of the Exchequer earlier this year, and which was the occasion for the reference of this inquiry to the Commission.

He will be introducing our first topic, being some of the main points that were in the Cruickshank Report as they relate to SMEs.

I should just like to make it clear before he starts, that within the terms of the Fair Trading Act under which this Reference is made, the Cruickshank Report cannot carry any special status as far as the Competition Commission is concerned. We are required to establish and justify our own findings on the basis of our evidence which we are satisfied is robust.

The Cruickshank Report is one such input, along with many other submissions, along with survey material and the like. It does, of course, constitute one clearly relevant input amongst the large volume we have received, and therefore along with these other inputs, is a useful starting point for one of today's sessions, but I do feel that I should stress that that is the status of the Cruickshank Report in this inquiry.

So, with that preamble I should now like Mr Barnes to introduce the first topic.

MR FOD BARNES: Thank you for inviting me to give this presentation and I hope to keep it quite brief. Before I start I would like to continue very briefly the Chairman's remarks about both the Cruickshank review and indeed my own position. I am here as a former member of the Review Team. I have not been involved post the publication of the Review with the Competition Commission. I have not looked at any data or any analysis which refers to activities which have taken place post the publication of the Review. So this presentation is purely about the Cruickshank Review, and it is about a small part of the Cruickshank Review, and the focus is on SMEs as is the remit of the Competition Commission here.

However, I have to stress that the analysis and the conclusions in relation to the services provided to SMEs cannot be understood outside the framework of the provision of banking services to other customer classes. So some reference to other customer classes and other activities undertaken by the banks is necessary although this presentation is particularly focused on the provision of services to SMEs.

(Slide 1 shown)

The structure of my presentation is as follows: I am briefly going to run through the background to the problems that the Review found in relation to SMEs; briefly look at what we thought the impact on the provision of service from SMEs would happen from the other recommendations made by the Cruickshank Review, and then the bulk of the presentation is a much more detailed analysis of what we did in relation to measuring the profitability of the provision of services to SMEs.

The concerns of the review in relation to the services provided to SMEs was primarily the same as that for personal customers, namely, lack of effective competition in the provision of money transmission services, and in the provision of bank debt, and to a lesser extent in the provision of savings products.

In the personal sector there was some evidence that the problems identified were being, or would be likely to be solved through the technical change and normal competitive processes, especially if the other recommendations of the review were implemented.

But for the SME sector, the problems appeared to be worse and the prospect for self-correction much worse. The reasons for this were many, but in particular many of the technical changes that were making the personal sector more dynamic were less relevant to the SME sector. The differential needs to have access to a branch network, or at least a means of depositing cash and cheques meant that things like internet banks were unlikely to have such an impact in the short term.

Debt products also posed more difficulties. There is considerably more difficulty in risk assessment at a distance in relation to a valuation of SME type activities, as opposed to lending money in the personal sector.

Finally, there is a very different relationship between an SME and a bank in respect of things like insurance policy. SMEs at least appear to be much more concerned about what might happen in the future if, for example, they suddenly run into a cash flow crisis. That necessary insurance relationship with the bank is much less, and indeed may not exist in the personal sector.

(Slide 2 shown)

The main sources of evidence that we used in order to come to these conclusions were many. There is no single piece of evidence which says "Here is the problem, you can conclude that there is a problem".

The sources of evidence are many and the evaluation of those sources has to be taken in the round and not one piece of evidence at the time. It clearly includes the level of profitability and I will come back to that in a minute. But it also includes much softer sorts of evidence like the attitude demonstrated by the banks to their customers. It was surprisingly uniform across the banks that we looked at and so there seems to be some truth in the perception that all banks are the same.

The observable behaviour of the banks was also consistent with the assumption that existing customers would not move. This does not mean that no customers will move, it just means that the dynamic of the market place is not driven by customers switching suppliers.

There was also softer evidence, the language used by the banks in order to describe what they were doing was highly producer focused and not consumer focused. There was some hard evidence in that department as well. There was very little information around which would appear to allow the banks to actually make sensible decisions from a consumer focused perspective. There was much more information around about how they could make decisions with a producer perspective.

This was in quite sharp contrast to some of the experiences we had looking at banks in other countries, and in particular in the USA where there were much better developed information systems which had, at least as part of their potential output, much greater consumer focus.

In addition the market dynamics, the historical record suggests that there was not a lot of consumer switching between banks, market shares were surprisingly stable. This suggests again there is a stable set of customers out there, and that the banks can work on the assumption that most customers will not shift suppliers.

None of these bits of information on their own are indicative of a problem - they all have alternative explanations, some of which are benign, some of which are not. For example, the fact that customers are stable could be a reflection of the fact that the suppliers meet the consumers' needs very effectively and that there is no reason to switch suppliers. Or, it could be that there are other problems in relation to this market, and that even when the banks fail to meet the legitimate expectations of their customers, they do not move.

(Slide 3 shown)

In relation to what the Government has done other than this particular Reference, most of the other recommendations which have been accepted by the Government are specifically designed to make things like switching suppliers much easier, to make new entry for banks easier, to give some improved means of reddress in terms of the contractual imbalances that were observed, and to give customers, and indeed SMEs, some more powers in relation to dispute resolution.

For the personal sector the conclusion of the review was that this would probably be enough combined with the changes which were observed, or which were predicted to occur. However, in relation to the SME sector the conclusion was that these proposals were, on their own, insufficient to bring about the more competitive dynamic in the provision of banking services to SMEs, hence the need for a reference to the Competition Commission.

(Slide 4 shown)

I am now going to look at one element of the analysis in much more detail and that is the profitability analysis. There are a number of fundamental requirements for a profitability analysis to be useful in terms of an investigation of market power. In particular a test is required which allows a performance of the market to be compared against an expected result, what you would expect to see if that market was normally competitive.

So the question, "what would be expected if there was effective competition?" is a vital part of any profitability analysis, and unless that result can be specified in a robust way the analysis is unlikely to be particularly useful. It is the comparison between the observed result and the expected result which gives you indications of problems. It is not just the observed result on its own.

This has some quite serious implications for the analysis and it led to some of the misunderstandings, and led to an expectation on the part of the banks that we were going to do some things that we did not actually do.

(Slide 5 shown)

What we are looking at here is an activity based measure. We want to know about the profitability of the set of activities, not about the profitability of an individual bank.

Individual banks - individual producers - would be expected to have higher and lower results than any norm that we would specify in a normally competitive market. So it is not about comparing one bank with another, and it is not about concluding that a particular bank, a particular institution, is making excessive, or non-excessive profits.

(Slide 6 shown)

We came up with two tests - or two and a half tests depending on how you want to define them - effectively two fundamentally different tests.

One was to look at the returns to shareholders, those holding banking stock, and compare that to the returns they would have earned if they had held the Stock Market as a whole - in this case the FT all share index.

The second methodology was to compare the accounting return on shareholders' funds, return on equity, and compare that to a theoretical model called the "Capital Asset Pricing Model". Both of those types of comparison are done with a Beta adjustment, which is essentially a correction for the comparative risks that the banking sector has compared to the Stock Market as a whole, and it is a rather specialised use of the word "risk", it is about the co-variants of the Stock Market, and the shares of the sector.

One of the reasons for using this kind of analysis is that it produces norms. There is a return of the Stock Market as a whole, and on various assumptions about the UK economy being normally competitive overall, that produces a robust comparator.

(Slide 7 shown)

We looked at a number of other tests which we rejected. For example, we looked at the return on total assets - whether that would be a good measure to use. It is one of the measures the banks use. However, there are a number of problems with it. One is that the return as measured should vary with the default risk on the loan book, and in order to correct for that you would need to know more about the default risk on the loan book. Perhaps more importantly there was no "normal" benchmark. There is no way of comparing very easily the results that you would get from return on total assets with some expectation of what you would find in a normally competitive market.

You might be able to construct a normally competitive banking market, perhaps, by looking around the world, but the issues there would become even more complicated because there are very good reasons why you would expect this particular number to vary between different banking markets, other than difference in how competitive they were.

We could also look at the cost to incomes ratio, and again this was another measure suggested by the banks. Again, this should vary with the activities being undertaken, and again there is no very good "normal" benchmark.

One could also look at things like return on economic capital or return on regulatory capital. Again, the problem here is that you are trying to construct a norm using only bank data, because other sections of industry tend not to have concepts like economic capital, or regulatory capital.

There are some other implications from using this kind of test. The fact that we were looking at returns on equity does not imply that competition is only about price.

Within any framework of a competitive market and within any framework of a normal return on capital there will be large variations in the price of what are apparently similar kinds of products. We would expect a price differential if there is a quality differential. Nobody expects the price of a Jaguar to be the same as a price of Lada. They are both in the car market, and notwithstanding the good work that the Competition Commission has done here, the fact that a Jaguar and a Lada have a different price is not an indication that the market for cars is not competitive.

The fact that we are using a profitability analysis, a return on equity or a return for shareholders’ funds does not imply the banking sector should have a single price quality trade-off point in relation to prices, and that therefore, somehow or other, we have overlooked the fact that competition between banks operates in aspects of the service other than price.

(Slide 8 shown)

The question that we wanted to answer was: "What is the profitability of a particular activity?" When we came to the analysis it turns out that high quality data necessary to do this analysis was only available to the review at the institutional level. Therefore, both the measure and the test had to be carried out in the first stage of this exercise at the institutional level. We experienced very serious data availability problems when we tried to disaggregate the analysis in order to answer questions like "What is the profitability of the SME sector?".

In relation to the tests we found excess profitability on both tests. So both in terms of return to shareholders investing in the Stock Market, and on the accounting measures of profitability using a CAPM based norm, high levels of excess profitability were revealed for 1998 and similar years.

(Slide 9 shown)

There are, however, alternative explanations for the results that came out of the analysis. One of the more serious is that the analysis that was undertaken by the Cruickshank review used an incomplete business cycle. The average profitability over time would be lower than that measured for the later years in the late 1990s. Therefore, the problem, if it existed at all, was transitory. If the measures had been done using the correct time period the review would have discovered that the profitability of the banks was, indeed, normal.

In order for this to be the explanation it requires the future profitability - post 1998 - to be significantly lower than the current profitability. That is always a possibility.

There was, however, very little evidence that could be produced that this was the expected result. When we looked to see whether the industry, or the analysts in the industry, expected very significant reductions in the level of profit, and the level of profitability, than the existing UK banks we did not find any, or found very, very little.

(Slide 10 shown)

There is a second explanation which is that banks do not conform to the norm, that there is a fundamental problem with the methodology, that the comparisons are incorrect; that the "norm" - return on equity, risk adjusted CAPM and the stock market returns, do not produce the expected normal results of banks.

It is unclear why this should be the case. It is not clear why investors in banks should require a significantly higher return on average than investors in the stock market as a whole, given that we have already made the Beta adjustment for the co-variance of bank stock with the market as a whole. There may be some reason why this is the case, but no convincing argument was put forward that this was indeed the case.

Another piece of evidence was that the banks themselves seemed to use the CAPM methodology to estimate at least their marginal cost of equity. If there was a fundamental reason why CAPM methodology was unsuitable for banks you would expect this to happen both at the average level and at the marginal level.

There is another possibility in accounting rates of return which is that there are large amounts of intangibles in the balance sheet. In that particular instance returns to stock markets, as opposed to CAPM methodology, does not have that problem, so if that really was the case we would expect to see an error in only one of the two methods.

It is also not clear why banks in particular should have this problem more than the generality of the economy as a whole.

In addition, if one was to apply such a correction to the analysis it would result, in some years at least, in increased profitability to the banking sector as a whole, so the correction to that methodology is not unambiguously in one direction.

Crucially, for that particular problem, the level of intangibles cannot be assumed to be the difference between the market capitalisation and the accounting measures of equity, which was one piece of evidence which was put forward. The reason for that is that the stock market valuation is essentially the capitalisation of the expected forward looking cash flow. If there are monopoly profits in the system that future monopoly profit is capitalised in the market valuation, so all you are measuring is the expected monopoly profit, not the level of intangibles in the balance sheet.

(Slide 11 shown)

Another type of explanation is the late 1990s are idiosyncratic, we just happen to look in the late 1990s, and returns will return to normal quite soon as a result of market pressure.

There is indeed some evidence that this is the case, or was likely to be the case and indeed, underlying the conclusion that the personal sector did not require a monopoly reference was an assumption that this would happen; that indeed levels of profitability in the personal sector would drop as a result of competitive pressure and technical change.

Competition is a dynamic process and the underlying conclusion is that the dynamics of the personal sector were indeed sufficient to correct what we had observed.

The secondary conclusion though was that the underlying dynamics were not sufficient to correct what we had observed in the SME sector.

However, this particular alternative explanation cannot be dismissed out of hand. The review could clearly get its predictions about what would happen wrong, and I suspect that the Competition Commission will thoroughly investigate whether indeed this explanation is likely to be valid for the SME sector.

(Slide 12 shown)

One of the problems we had with all these alternative explanations is that to a certain extent they are mutually exclusive. So for example if the current levels of profitability are right in some way because of all the intangibles in the balance sheet, for example, then over the cycle the level of profitability is too low. So there is a problem in the cycle explanation also being used at the same time as the intangibles explanation.

If, however, the problem is failure to take proper account of the cycle the current levels of profitability are not going to be sustained in the future, and profitability will drop, so that they will come down naturally. If that is the case there are not intangibles in the balance sheet.

Throughout the review different people explained the results that we were presenting to them in different ways. This we had between different institutions, so one bank would say "The answer is X", and another bank would say "The answer is Y", and indeed, in a number of cases it was the same individuals under different circumstances providing us with different explanations, some of which were mutually exclusive.

(Slide 13 shown)

As I said, the question we wished to answer is there excess profitability at the level of the activity? What we concluded was that there was excess profitability at the level of the institution. There is a significant implication for that, which is if there is excess profitability found at the institutional level then at least one of the activities undertaken by those institutions must exhibit excess profitability. It is possible that it is not one activity on its own, that this finding of excess profitability can only be concluded in relation to a group of activities, but whatever happens there is something to be explained at the level of one or more activities contained within these institutional results.

This is a very important part of the methodology. It is also a sufficient condition, although it is in fact not a necessary condition, for there to be excess profitability in one or more activity. It would be possible to find no excess profitability at the institutional level and still find it at an activity level. It is not possible to find excess profitability at the institutional level and not find it at a lower level.

(Slide 14 shown)

The next question we had to address was: which activity or activities does exhibit the excess profitability found at the institutional level?

(Slide 15 shown)

As I have already indicated, we came up against a number of problems. One was the basic availability of information. The second was how does one allocate equity within a company, and the third, which is a great problem for economists, is what do we do about real joint costs. I just want to go through some of these briefly.

(Slide 16 shown)

The basic lack of cost information is contrasted rather highly with the information available to the supermarkets who were also under investigation at the time. The lack of high quality disaggregated data actually raises questions about what market pressures these suppliers are under. If they can operate successfully without this information base one might legitimately ask the question: "If you cannot measure the profitability of individual customer classes, how do you know whether you are giving them a good deal or not?" If you do not need to know whether you are giving a good deal or not I suggest that the market is not particularly competitive.

In any case, the lack of basic cost information at a disaggregated level, as I have stressed, cannot make the problem of excess profits disappear. It can only result in them being linked to the wrong set of activities. It is therefore crucial only to the distribution of profits and not the quantum of profits.

(Slide 17 shown)

The allocation of equity is a problem for which there is no perfect solution. From a theoretical standpoint what one would wish to do is to allocate equity on the basis of what it is used for, and it is essentially used for covering losses, to ensure that the business does not go out of business because some shock happens to it and they make an unexpected loss.

So the relative risk of default in banking is one of the determinants of whether you need equity or not, and in activities other than banking, the market looks at gearing ratios in order to discipline firms from having too little equity relative to having too much debt.

Different methods of allocating equity have the same effect as errors in the disaggregated data. They basically move excess profits around rather than create or destroy it.

In the end we used the ratio of regulatory requirements to allocate equity between different activities, and it is quite important that it is the ratio of regulatory requirements not the amount of regulatory capital required. What we are talking about here is allocating the total equity of the firm, whatever that happens to be, in the ratio of the regulatory requirements of capital.

We could have done it on some other base. We could have done it on economic capital, we could have done it on the total assets used. Although these have very different numbers, very different quantum, they do not particularly change the ratios involved, although they do a bit.

(Slide 18 shown)

There are some errors in the methodology that we used. There are some significant errors. In particular, it significantly underestimates the equity required for non-banking activities. The result of that is that it over estimates non-banking profitability and it underestimates banking profitability. The results of this process are that we will underestimate the profitability of banking activities that are the focus of the report.

In addition, at a slightly different level, it probably underestimates the equity required for SME lending and overestimates the equity required for personal customers.

(Slide 19 shown)

The results of our analysis, which we published in the report, are as follows for 1998:

The return on equity for SMEs was 36 per cent, 30 per cent. for personal customers, 24 per cent. for corporate customers, and for other activities was 29 per cent., and the total firm base, i.e. the aggregation of all the firms, was 30 per cent – these results are for the Big Four banks because that was the only reliable information base we could use.

(Slide 20 shown)

That produces an SME sector having the highest levels of profitability in 1998 of all the activity undertaken by those banks. It is possible, as I say, that we have underestimated the amount of equity the SME sector requires, and therefore if we were done properly the relative profitability of SMEs would fall.

However, the profitability in some other sector would have to rise as a consequence, because this error, if you like, is only an error in distribution and not an error in quantum. Which ones would it be? Would it be the personal sector? Would it be the corporate sector? Would it be the other activities?

If we are to raise the profitability of these other sectors, what is the explanation for their high returns?

(Slide 21 shown)

There is a second possible explanation of why those results I have presented are wrong - or at least meaningless. If it turns out that there are real joint costs in the provision of two or more of those sectors, then although it is an accounting convention to allocate costs between sectors in economic terms the allocation does not make any sense. In which case the excess profitability will arise at a combined level - SMEs plus something else. It could be SMEs plus personal, it could be SMEs plus corporate, depending on where the joint costs reside.

Again, the result would be that the excess profits, or the excess profitability, would have to rise in relation to one of the other sectors.

There was indeed some evidence of joint costs between the SME and the personal sector, but very little evidence of any joint costs with the SME and any other sector. I have to say when we were looking at this type of level of disaggregation the firms were unable to provide us with particularly robust data on which to base this conclusion.

(Slide 22 shown)

There is a third explanation which is to do with the effects of the cycle. The effects of the cycle are much more acute on the SME sector, and therefore one would expect to see much higher relative rates of profit in the SME sector compared to the other sectors in the good times, and much worse results in the bad times.

Unfortunately we did not have robust data for the relative profitability of different sectors in the last downturn in the economy. This evidence did not appear to exist.

However, looking forward, if this is likely to be the case we would expect to see an anticipation that default costs on SME lending are about to rise very rapidly and again, there was no real evidence of anticipated behaviour by the lenders.

Furthermore, to the extent that we could tell, there was very little evidence that it is the debt charges that are contributing to the excess profits in the SME sector. If this explanation was the true explanation, one would expect to see the variation of profitability match the activity that was causing those costs to vary you would expect to see excess profitability on debt in good times, and excess losses in bad times. There was very little evidence of that taking place, and as far as we could tell the excess profits were being generated by the money transmission services and possibly also in savings services.

(Slide 23 shown)

The final alternative explanation is that there was a systematic bias in the cost allocation models. A similar sort of error happens here. If we under estimate the cost of supplying services to SMEs we must have overestimated the cost of supplying services to somebody else. So the same sort of adjustment happens, you adjust down the profitability of SMEs and you adjust up the profitability of some other sectors. Which sectors is it going to be? Given that the firms knew what our focus was by the time they were providing the evidence, if there is an incentive on the firms to bias the data in any particular way, it is the incentive to do the reverse of this particular explanation.

It is, of course, possible that randomly, by chance, across the four banks the system of bias goes in the direction of under estimating the cost of serving SMEs, but one would find that on a statistical basis even with only four banks that was unlikely.

(Slide 24 shown)

So what conclusion did we come to? Well, what we were looking for was a consistent explanation of the overall results, both at the aggregated and disaggregated level and taking account of the other non-accounting data, and non-financial return data that we looked at.

(Slide 25 shown)

So the simplest explanation was that the concentrated market structure and barriers to new entry in the SME sector allows UK banks to make excess profits in that sector, and these excess profits are indeed located in the markets which exhibit the most concentration - services to SMEs and services to personal customers.

(Slide 26 shown)

Within the SME sector money transmission services are essentially a monopoly of the banks and a few other financial institutions, seem to be the least competitive, and the most profitable and the least subject to the default cycle business.

Looking to the future, we concluded there is little prospect of new entry into the SME sector as long as SMEs require local access to branches in order to deal with cash and cheques.

(Slide 27 shown)

Other explanations are still clearly possible, but to remain consistent they require more complexity: for example, if the bad debt rates are to increase significantly for SMEs then this is an explanation of why the SME sector is so profitable now. But one would also then need an explanation about why the bad debt rate is not going to rise for corporate customers, because corporate customers' profitability is not that high now.

One would need to run some differential explanations of the likely impact of a downturn on the different sectors.

One might also argue that the reason why rates of return in the late 90s were so high was actually due to a fault in the CAPM model. But then it is necessary to explain why they were not so high in earlier periods when presumably the fault did not exist. So one would need an explanation that says CAPM might have been a good methodology earlier but for some reason has now become less relevant.

One would also need to explain why it is that there appears to be high profit relative to costs in market with lots of competitors, and low profits in markets where there are fewer.

As I say, the simplest explanation is that the rate of profitability has gone with market concentration.

(Slide 28 shown)

Our overall conclusion in relation to SMEs was that the problems we had identified were not going to be solved by imminent technical change, or imminent market developments and that something else was needed. We were not entirely sure what that was, but it clearly might include things like structural changes to the industry,and on that basis there was a recommendation for a need for a complex monopoly reference which, as the Chairman has indicated, arrived on, I think, 24th March.

Thank you.

THE CHAIRMAN: Thank you very much for that presentation. Could I now invite a representative of Lloyds Bank to make a presentation. Could I just say that our deadline of 11.30 is flexible to the extent of ten minutes or so, if you should feel you need that time, partly because we have heard that the representatives of the Mid-Yorkshire Chamber of Commerce, who were due to talk in our second session, after the coffee break, are unfortunately unable to get here due to floods and transport problems. They have sent us a note of some of the main points they would like to make and if we get an opportunity we can feed those in. We will have, as you will see, other representatives of SMEs speaking, but it does mean that the second session will probably be a little shorter and therefore, if you need the time this one can be a little longer.

Thank you.

MR PRITCHARD: Thank you, Chairman, and good morning, ladies and gentlemen. My name is David Pritchard, I am Group Director, wholesale markets and International Banking at Lloyds TSB, where my responsibilities include our business with all sizes of company - small, medium and large. So I have been asked to reply on behalf of Lloyds TSB to the points raised in the Cruickshank Report.

As requested I will focus on the supply of banking services to SMEs and specifically on the issue of profitability. Although, for shorthand convenience, I am using the term SMEs, it is not one we use in our business. The sector is very diverse, ranging from sole traders to quite large, professionally managed companies, so we do not treat it as being homogenous.

In my allotted 20 minutes, I will be fairly brief in dealing with each of the issues.

First of all, I want to say that we agree with many of the recommendations in the Cruickshank report, particularly those relating to full and open competition, enhanced transparency of pricing and improvements to the regulatory regime governing banks.

Summary of conclusions.

I will start by summarising our key conclusions which I will then go on to demonstrate.

(Slide 1 shown)

We believe that there is real and effective competition in the provision of banking services to SMEs. Existing suppliers compete fiercely against each other in the knowledge that, if they do not provide good service, they will lose customers and potential customers.

There are no substantive barriers to entry in the SME market, other providers have and will continue to enter.

Products and prices are varied, which reflects the diversity of customers and the diversity of the services which they use.

The SME market is high risk, and banks should be able to make a profit, otherwise there is no incentive to stay in business.

Profits over the cycle are not excessive - as I will explain in a moment.

First, the Cruickshank inquiry

(Slide 2 shown)

Mr Cruickshank and his team had an unenviable task, with a broad remit that was not simply limited to SMEs. They did not provide definitive answers to all the questions which were identified. The most they could do was to identify issues which would merit further investigation - that is what they did in this assessment of the SME market.

Let me recap on the report's principal concerns:

(Slide 3 shown)

First, as Mr Barnes has described, it expressed a general concern, not really limited to the SME sector abut banks' profitability in recent years as measured by their return on capital.

Secondly, it concluded, there was a concentration in this market, in favour of only a small number of suppliers: it saw only 4 or so large banks serving the SME sector.

Thirdly, it found pricing hard to explain, and therefore called it "erratic". Effectively, it said that pricing was not consistent with competition.

The report also raised general concerns about money transmission services. This affects all customers, not just SMEs and is presently under review by the Treasury, with a view to setting up a specialist regulator - Paycom and we are co-operating fully in this.

I will now turn to how we address the key issues.

(Slide 4 shown)

The key issue is whether there is a competition problem, and if so, how it manifests itself.

Measuring profitability is only one important piece of evidence when assessing a market. The main question is whether the SME banking sector is competitive and to look at this we need to identify how the buyers of products behave, which products do customers treat as being substitutes? This assessment of substitutability should form the basis for the definition of the relevant markets.

Then, having defined the markets, an assessment can be made of how concentrated they are, and then understand whether there are barriers to entry. This in turn will help to explain why we think the existing suppliers are competing so effectively already.

(Slide 5 shown)

To measure profitability, we need to determine first, the capital employed b y the SME component of the banks' business and what return banks have earned on that capital over the cycle.

We also need to look at all suppliers in the market, to see whether suppliers in general have earned over the odds. Clearly, it is not sufficient to look juste at the most successful suppliers, since we would expect them to earn more than the average. The review team only looked at an unrepresentative sample and ignored the less successful ones - for example, Citibank, which entered the SME sector and then withdrew, or BCCI and Barings, which failed altogether.

We also need to know what we would consider to be a "normal" level of profit, against which to measure the average profits and whether these have been excessive.

I have emphasised each of these elements, since each needs to be measured with some precision, if we are to come up with an accurate assessment of profitability, and to compare that to some supposed "norm".

Each element raises its own difficulties. For example, there are real variabilities in measuring the capital employed in, say, Lloyds TSB. Our accounting capital provides a starting point, but it is not nearly enough. For example, it would be several billion pounds higher if we were governed under US accounting principles. Even then, it would not show our investment in intangible assets, such as our brands, our software, the trained workforce, all of which are key elements in our competitive armoury, and contribute to the value of the services we provide to our customers.

Even if we can measure the full capital employed, there is a high degree of arbitrariness in allocating that capital, and costs, to particular lines of business, to enable us to calculate the profits of the "SME business" on its own.

We are not talking about minor differences, or "fine-tuning" here. Depending on the basis of the calculation, the difference in the returns can be a factor of 4 or 5. For example, that is the difference between a return on investment of 36 per cent. and, say, 8 per cent. just by changing the definitions in the calculation.

There is also the issue of deciding what constitutes the full economic cycle, so as to measure profits over the cycle as a whole, rather than just looking at an unrepresentative snapshot.

(Slide 6 shown)

This chart shows the level of our bad debt provisions for SMEs over recent years, and demonstrates just how volatile this market is over the cycle. In any economic downturn, our income will decline. There is lower demand for our products, and our credit losses will rise, whilst our costs will remain largely fixed. IN an average year, bad debt provisions absorbed more than 60 per cent. of trading profits of our SME business. In the worst year, bad debt provisions were nearly 200 per cent. of our trading profits.

This of course begs the question of whether the past is a guide to the future? The profitability and economic survival of our customers is exposed to the full range of unpredictable economic pressures, whether through the impact of macro-economic policy, exchange rates, petrol prices, the impact of the internet, the level of economic activity or the rate of inflation. Although we try to avoid repeating the mistakes of the past, we cannot insulate ourselves from these effects.

(Slide 7 shown)

If we take account of all these factors, we contend that the figures quoted in the Cruickshank report should be taken to represent the top of a range of possible calculations.

Even using his extreme figures, Cruickshank accepted that the banks did not appear to have earned excessive profits over the cycle as a whole; it was only if the present level of profits continued that there would be evidence of excessive profits. But, of course, there is no reason to think they will continue. If we look at other figures in the range, there is no real sign of excess profits at all.

My point here, ladies and gentlemen, is that the evidence based on returns on capital is inconclusive, and it therefore makes sense to look for supplementary ways to assess the state of competition in the market.

(Slide 8 shown)

In particular, we consider there are four steps that should be taken:

* Define relevant markets

* Determine competition among existing players

* Assess barriers to entry

* Review pricing.

(Slide 9 shown)

First then let us look at the relevant markets. I will explain how we have arrived at these markets by rehearsing the following arguments.

What alternatives does an SME have, when looking for a particular kind of banking service? What range of options are available. If we can answer that then we can see who is competing to meet those needs, and whether, as the report suggests, the market is concentrated in the hands of only a few suppliers.

When it comes to raising finance, SMEs naturally have different needs and options - some may be able to use lease finance, or invoice discounting, whilst others may have no fixed assets suitable for lease finance, or no book debts capable of being discounted. But, just because there are SMEs who cannot use lease finance, that does not mean it cannot be regarded as a form of finance which competes with a bank loan or overdraft.

The questions to be answered are these: Are there sufficient SMEs who could use lease finance instead of a term loan, such that banks have to take account of the availability of lease finance and the price at which it is offered, when they price their term loans?

Would bank lenders find that, if they raised the price of their term loans they would lose business to leasing companies making the price rise unprofitable?If so, then we can properly regard leasing finance as being in the same product market.

In our evidence to the Commission we have had to look at these questions.

Our analysis shows that there are three relevant product markets to be examined, each comprising a range of services to meet a particular kind of need. They are as follows:

1. Savings/deposit accounts. SMEs want to save money, and suppliers compete to offer them attractive terms on which to set aside their funds for future use.

2. General credit products. I include in this term loans (both secured and unsecured) lease finance, factoring and invoice discounting, and all the other kinds of credit products with which you are familiar. However, I exclude the "core overdraft", which falls into the third category.

3. Current accounts with temporary overdrafts. More about this one in a moment.

(Slide 10 shown)

In the deposit account market there are some 80 providers and in the general credit products market over 190 providers.

In this slide we have listed just some of those companies - sufficient in number to illustrate beyond any doubt that these are competitive markets.

(Slide 11 shown)

The last product market is what we have called "current accounts with overdraft".

This is an informal package of components which, taken together, are well-suited to meet a particular kind of banking requirement. The four most important parts are: first, the SME wants a provider who takes delivery of and provides short term storage of cash generated by their business. This cash might be spent again in the short term, or set aside for future use.

Secondly, they want the means to draw on that cash to discharge their liabilities to pay cheques, or transfer money to a supplier's bank account.

Thirdly, they want to know that if they need to borrow money to make a routine payment, such as to suppliers, or wages, then they will have someone to make sure those payments are made, even if they have insufficient cash to hand. Even if an SME does not expect to use this overdraft facility, the option of having it available is widely valued.

Fourthly, the SME wants a relationship banker. Whether the customer chooses to have a complex relationship is optional. However, every day the bank has to make decisions based on our knowledge of the customer.

All of these are separable services and SME could look to one provider to pay his cheques;; another to handle his cash collection; and a third to make electronic transfers to bank accounts. But, in practice, the vast majority of customers find it more convenient and efficient to obtain all these services from one bank. This is customer choice.

This packaging of services into "current accounts with overdraft" is driven by customer behaviour and it typically covers money transmission services, relationship advisory services (to the extent that the customer needs or wants them) and overdraft facilities.

While it is clear that the savings and credit markets are widely competitive, the major high street banks do have a stronger position in the current account market. To give a sense of perspective here though, it is worth noting that overdrafts have fallen in the last ten years from 20 per cent. of the funding market to 10 per cent. and therefore play a much smaller role.

(Slide 12 shown)

The existing suppliers compete vigorously with each other in a number of ways. First, there is price competition. Our charges to small businesses are set out in a published tariff. SMEs can compare prices, and new SMEs genuinely shop around. Magazines like "Business Money Facts" regularly compare different suppliers' charges, and make it easy for SMEs to choose the best offer.

Secondly, banks compete to offer differentiated products. We are constantly working to improve our products and services and to ensure that they are designed to provide what the customers want. The latest development is our new relationship offer, which gives customers more choice. Another example is our "Essential Business Advice Service" which is a package dealing with employment, health and safety regulation and tax planning. Features of this service are a helpline, legal insurance and discounts on training consultancy.

Thirdly, we compete as to the quality and variety of our services, including the convenience and efficiency of our branch locations, the willingness of relationship managers to visit customers at their premises at their convenience, hours of opening, speed of delivery and so on.

We also compete to be willing to lend money when our customers want it. We aim to understand our customers' businesses will enough to be able to make quick lending decisions when the customer needs that. Every day, one in five of our SME customers, which is over 100,000 businesses, go over their limits without agreement. Each occasion requires a judgment call by the bank. This compares with less than one in fifty customers in the personal market.

Contrary to Mr Barnes's assertion of a stable universe of customers, this market is highly dynamic. Last year the banks competed for the business of 400,000 start-ups and 100,000 switchers from one bank to another, while losing about 350,000 businesses which ceased trading, some due to insolvency, and others for a variety of reasons. Because of this constantly changing composition of customers, the churn in this market drives the banks to compete vigorously just to stand still.

We therefore compete aggressively on price, products, service and lending in an effort to retain and recruit customers. This includes having managers whose only role is to target our competitors' customers with a view to poaching business.

(Slide 13 shown)

Next we should look at barriers to entry. If there are no barriers then it does not matter if there are only a few suppliers in the market. Each of the current players will be forced to compete effectively, not only in the face of competition from current players, but also because of the threat of new entry.

The question here is not whether it is difficult in some abstract sense to set up a bank offering current account services to SMEs. You or I would find it very difficult to do so, starting from scratch. The question is whether there is any obstacle to entry for those who are otherwise well placed to enter. In our view, the prerequisites for entry are:

* Access to a branch network, where customers can deposit and withdraw cash conveniently;

* A trusted reputation, encouraging confidence in the supplier's competence and reliability.

* A skilled body of relationship managers, who can understand the business needs of SME customers, and make well-informed credit decisions, as and when required.

* Need to have adequate resources and capital.

It is clear that there are several companies who are well-placed to enter. They include the ex-building societies who have the networks, adequate capital, trusted brands, and who can recruit relationship managers to provide sector-specific expertise.

It is also clear that the insurance companies can extend their brand reputations into banking. Look, for example, at Standard Life Bank, or Egg Bank, which has traded on its association with the Prudential, and potential entrants with no branch network of their own have shown interest in using the Post Office network.

The report also raised the question of access by new entrants to information on customers. We do not agree that this is an issue as customers are free to give information to anyone.

Subsequent to the publication of the report, several new entrants have announced their intention to cover the SME market, such as Abbey National, Alliance & Leicester, and Halifax.

So, ladies and gentlemen, it seems to us that the Cruickshank Report under-estimated the possibility of market entry, and ignored the fact that the threat of entry imposes a competitive constraint on existing players.

(Slide 14 shown)

If we take account of all these dimensions of competition, it is hardly surprising that different SMEs end up paying different prices for their current account services.

Price is just one aspect of competition.

Some SMEs use different services from others. Some represent a higher credit risk than others. Some use more of the bank's resources than others.

Pricing therefore reflects the diversity of the customers, the diversity of the services which they buy,and their diverse risk profiles.

The report regarded "erratic pricing" as an issue. Evidence was sought that banks were exploiting either different categories of customers or high local market shares through higher prices. No evidence was found. The report also concluded that UK businesses are not disadvantaged relative to SMEs in other countries.

Unfortunately, however, the report under-estimated the intangible services that the banks offer to SME customers - what we call "relationship banking". Whilst pricing is, of course, important, what businesses place at the top of their list of banking priorities is a bank which understands its needs, and that is the role of the relationship manager.

But what about the absolute levels of prices, and the level of profit that banks are making?

The report reflected that if banks were making excessive profits, then that was symptomatic of a lack of effective competition. We accept, of course, that it is sensible to try and work out the level of profit in the SME sector but, as we have argued, this could fall in a wide range of possible figures. Mr Cruickshank's error was to take an extreme figure from the range and to treat it as being the unique correct answer. We disagree.

(Slide 15 shown)

So to conclude: we agree with many of the recommendations in the Cruickshank report, but we do not agree on a number of points. In particular we contend there is no single conclusive measure of profitability. Competition should therefore be judged by looking also at structural factors in the market, and they show that:

* There is real and effective competition in the provision of banking services to SMEs.

* That competition between the major banks who provide current account services to SMEs is fierce.

* There are no substantive barriers to entry, as demonstrated most recently by the number of new entrants.

* Products and prices are varied rather than "erratic". This reflects the diversity of customers, and the diversity of the services, which they buy.

* Profits are not excessive when viewed over the cycle.

Lloyds TSB is working hard to develop and maintain relationships with our SME customers and to provide a high quality service consistent with value for money. We are not a "fair weather" bank, so we need to make a return over the cycle.

Chairman, that concludes my presentation.

THE CHAIRMAN: Thank you very much. We now have five or ten minutes in which we could take other observations or points from participants. Members of the Commission may have questions, but of course we do have other, quite extensive, opportunities, to put those questions to the parties concerned. So I would invite any comments from anyone who is involved. I have been sent a note saying that a representative of the Bank of Scotland would be interested to make one or two observations. Would you like to come up to the podium. Thank you.

If others of you would like to make any points please catch the eye of the person with the roving microphone and we will take those in a moment.

MR REILLY: Thank you, Mr Chairman. Good morning, ladies and gentlemen. My name is Austin Reilly. I am a Managing Director of Business Banking in Bank of Scotland. My responsibilities have generally been for the Business Banking Centres we operate in the English market. Clearly, I work very closely with my colleagues North of the Border in determining policy and how we go about our business.

I would like to start by saying that I fully agree with all the comments that you have heard in the previous presentation from Lloyds TSB, and also to state the objective of banks in dealing with SMEs.

I think there are probably two or three main objectives that we all have. Clearly, we want to be successful in our own right, but clearly our main intention must be to make sure that SME customers, indeed all customers, are successful themselves, and they grow their business, create employment, and wealth for themselves and the country, and lead to an ever growing and successful economy. When that happens then we all benefit.

The Scottish banks generally, and if I could perhaps take the liberty of speaking for all of them, and indeed including Lloyds TSB operating in Scotland, I think we have a good reputation of stability and participation in the life of Scotland. However, from Bank of Scotland we were facing a situation many years ago where, as a primarily Scottish bank working in a smaller market, we had to look at ways of growing our own business, and looking South of the Border at the English market, clearly much larger, we decided to tackle it in two ways, and we have established a relatively small number of business centres and branches, but also tackled the market on a direct banking basis.

Most recently - just to show that we are serious about competing with our much larger competitors in England - we have launched a direct business banking service which has the capability, or certainly the potential, for businesses to incur no bank charges at all at any time during their existence. There are clearly some conditions attached to that, but the take up of that service has been very gratifying.

In the Scottish market itself, we estimate SMEs in the region of 300/350,000 and of those the market is split broadly between ourselves and Royal Bank of Scotland who have broadly similar market shares in the low 30 per cents, and the Clydesdale Bank and Lloyds TSB who share the rest.

There is about 12,000 start-ups a year in Scotland, obviously much lower than generally in the UK, but I think Bank of Scotland in particular is extremely active in working with the Enterprise Councils, with the Local Authorities, and with others - consultants and representatives of business areas - to promote this, and to help establishing business, and to help them grow.

There is a good example of that happening in Edinburgh at the moment, and indeed it is replicated around other parts of the country.

Some very recent research that we have just received shows that there is switching that goes on. Lloyds TSB mentioned the number of 100,000 a year that switch. We reckon it is about 10 per cent. of SMEs generally do switch banks around each year. Before they do so there is probably about another 15 per cent. of them who think about it.

I think they think about it for various reasons. they look at price comparisons between banks, they look at service comparisons, they look at product mix. I suggest the main reason eventually why a switch does take place comes down to the relationship having broken down.

Bank of Scotland, like all the other banks, is exceptionally keen to establish strong relationships with its customers. It is through these customers that we can grow our business more successfully and hopefully they recommend us to others as well.

But now and again the relationship does break down for many reasons, whether that be that we are unable to support them financially, or on odd occasions the service quality has not made it, but the point I make is that these are all very competitive matters, and if we do not provide the service or the product mix at a price that is acceptable then customers do switch. I for one welcome that very healthy level of competition.

Talking of other entrants to the market, and indeed there are many now who are talking of entering - mention has been made of Abbey National, Alliance & Leicester, Halifax and indeed some insurance companies - I would raise the question of whether they are interested in providing all banking services to SMEs however. I suspect that some of them might be wanting to cherry pick products that they think they will make most profits from, whereas the clearing banks have (and will continue to do so) provided a full range, particularly in money transmission, lending products and in very, very competitive deposit products.

I agree too with Lloyds that there are no real barriers to entry here. I think as we see the internet banks starting to gain market share they clearly do not have branch networks of customers to lodge cash, but they are using other facilities, and it is much easier now, I think, for new organisations to enter these markets and focus on particular product areas as I have mentioned - perhaps cherry picking on the deposit products, or perhaps very, very simple financing products, commercial mortgages, leasing and so forth, and be very competitive. Again, I would stress that we, as an organisation, very much welcome that.

Perhaps to close I would say that there is a very healthy culture of competition amongst all the providers of banking services to SMEs. I do not believe there are any substantive barriers to entry. I think the fact that in the past it may not have appeared to be the case that others do enter the market is perhaps that they simply did not want to. They did not want to because they did not believe that they could effectively make money out of it, and perhaps they are changing their views, and we welcome the competition.

Finally, certainly speaking in Scotland, SMEs are very well satisfied with their banking relationships. I think all the banks work hard to build that relationship. It is about the banks understanding the business they are operating, and if I could also say it is about the SME understanding what the banks do, understanding how the banks deliver their service, and what their business objectives are.

That is all I want to say. Thank you very much.

THE CHAIRMAN: Thank you. I am aware many of the people here will be having an opportunity to talk and present in the other sessions, but are there any observations on what has been covered in this first session that anyone would like to make at the moment?

MR PELL: Good morning, ladies and gentlemen. My name is Gordon Pell. I am an executive director of the Royal Bank of Scotland, and I would just like to comment on a couple of issues which have come out from the Lloyds' presentation and just expand on them further.

Obviously we are broadly in agreement with most of the points raised by Lloyds which were obviously aired at the time the original Cruickshank proposals came out, but I would just like to touch on some areas.

First, UK banking is a deregulated operation, and open by comparison with both most of the European Community and particularly the US. Unlike some European countries the regulatory authorities have actually taken an enlightened attitude that sought to promote competition and new entry, rather than consolidation and the creation of national champions.

The FSA is obliged to pay regard to the competition consequences of its regulations while the Bank of England has for some years exercised special over-sight on the market for banking services to SMEs. This is the world in which we operate, it is actually an open market.

The industry itself, as you will hear later, has organised representative groups - well organised and vocal - with whom we are in regular dialogue, and that dialogue, particularly since the early years of the 90s, has resulted in a significant improvement in transparency and clarity in the way we deal with small business customers. There is inevitably a moving agenda with these organisations. We welcome that, and in three years' time there will still be items on the agenda and we will welcome continuing the discussions with them. In this open market it is quite difficult to see how retail banking can actually generate excess profits.

I would just like to comment on an authoritative article published by John Kay in the "Financial Times" on 5th April, 2000, where Mr Kay looked at the rates of return on capital across the whole FTSE 500 over the business cycle. Financial Services actually came 19th out of 45 sectors that he referred to in terms of returns. This, to echo the point made by David Pritchard, included the fact that a number of companies had actually disappeared from that list through failure. In other words, it was only the survivors that were left.

In a competitive market, very rightly a point made by Mr Barnes, most efficient banks earn more than the cost of capital and the less efficient earn less, and Mr Kay was right to point out that, unlike in a monopolised market where you could argue that those who dropped off the value cycle could actually sit on their laurels, in this market those banks that had been earning less over their cycle paid the ultimate penalty and both lost their independence. In one case of a highly contested bid the standard of customer service to small businesses featured in both the offer documents - a very open, transparent market, with clear penalties for failure.

There are really no significant barriers to entry that I can see by anyone who has the will, the energy and the capital to take it on, and I will be expanding on that later this afternoon when I talk about how the Royal Bank of Scotland has broken into the English market over a number of years. Building Societies clearly have branch networks, do operate in that business and have expressed interest in the future.

Supermarkets actually have more branches in England and Wales than, for example, the Royal Bank of Scotland. They already engage in banking activities. I know from my own experience they have looked at business banking; they have the capability to do it. A very apposite example at the moment: there are organisations in the UK that own thousands of locations, they are easily situated on ring roads, they handle cash every day, they are connected to the electronic payments systems, they are sophisticated, they run treasuries, and in some cases they even have banking licences - they are called petrol stations. In the US it is quite usual to find petrol station banks.

If there were excess profits in the industry I find it quite difficult to imagine that powerful organisations like the world petrol companies would not wish to have a share in it; they have the infrastructure. The question of whether they have the will is no doubt something which you will wish to explore during your discussions.

Thank you.

THE CHAIRMAN: Thank you. Are there any more points at this stage? If not I suggest that we break for about 15 minutes. There are some refreshments available, and we will reconvene here at 11.50. Thank you.

(Short break)

THE CHAIRMAN: Welcome back everyone. The second session is designed to focus more specifically on the relationship between banks and SMEs - an issue that of course emerged in the first session. As you will see from the programme we have a number of presentations. First, by the Forum of Private Business, and I would invite their representative to come forward, and introduce himself.

As I mentioned earlier, Mid-Yorkshire Chamber of Commerce cannot make it, which is a great pity because we had approached a number of Chambers of Commerce for views and information and they had put in quite a detailed presentation to us, and have clearly worked in this area prior to this inquiry, but unfortunately will not be with us. Then on to the Federation of Small Businesses.

We also have one other presentation from a group called "Global Consulting" which has been involved to some extent in issues relating to ethnic minorities and their banking needs.

After that a presentation by Barclays Bank. So without more ado could I invite the Forum For Private Business to come forward. Thank you.

I should say we are running about 15 minutes late so we may go through to 1.15 if we need that time.

MR REDMAN: Thank you, Chairman, ladies and gentlemen. My name is James Redman. I am head of research of the Forum of Private Business.

(Slide 1 shown)

I would like to talk briefly about the regular Forum of Private Business Survey, of the private business bank relationship that we conduct every two years. The last survey in 1998 was based on about 10,000 responses.

A vital element of this ongoing and regular forum research that we have conducted now since 1986 is the measurement of the perceived importance by small business owners of the essential issues in that relationship. For these issues two areas have been assessed.

First of all, the importance to the business and the perceived ranking of the quality of delivery by the banks of each characteristic. Initially we used 11 issues, which were determined from the ranking by business owners themselves, and these have been expanded to 18 in the latter surveys which you see here.

These are analysed in each survey.

(Slide 2 shown)

The measurement of the importance of the issues, and the ranking of the quality of delivery has been by indication on a five point scale. Our work has therefore been substantially focused around those issues that rank highly in the perception of business owners, particularly where there appears to be a significant differential in scoring between the required demand by businesses and their perceived supply by banks.

(Slide 3 shown)

In this presentation I would like to briefly cover six points, namely, transparency, charges, contracts, collateral, advice from the bank and service.

(Slide 3a shown)

To illustrate the ranking system, this table from the 1998 report shows the analysis of the scores or perceived importance of the 18 characteristics, cross-tabulated by four measures of participation. This is where both parties participate well, where neither participates particularly well, where the bank participates well, or where the firm participates well. You can see that from this analysis we have been able to arrive at a series of differential scores indicating how the relationship can be developed by the two parties working together effectively.

(Slide 3b shown)

This slide shows the patterns of quality by perception of the business and, although obviously you will not be able to see the immediate differences, we can see that there are quite big variables in some cases.

(Slide 4 shown)

Looking at transparency first of all. When we look at the negative measurements of those high ranking issues that are relevant to the perceived transparency, as well as a very substantial body of anecdotal evidence which, of course, we do have, it is quite clear that some of the bank processes are unclear or misunderstood by some business owners.

The first suggestion of this concern actually did come in the FBB Bank Report that we did originally back in 1986 which highlighted the fact that banks deducted charges without notification. This, of course, has been substantially addressed by the banks in the pre-notification of charges, and publication of tariffs.

It has to be said, however, that even now the complexity of some tariffs, and the uncertainty of the applicability still do make it a concern. A move to pro-active invoicing for example could be a desirable next step. Other bank actions, which are decisions on lending, margins, on availability of finance are still less than transparent to many small business owners.

We need to look at the necessity of both parties to be certain of the terms of any lending, and the need for a structure of a legal contract. Again, our anecdotal evidence suggests that too many arrangements are misunderstood, and certainly, action by the banks that they may consider fully justified is quite often seen as overbearing and impersonal.

So understanding by both sides from the start of the relationship is absolutely imperative.

(Slide 5 shown)

Charges still continue to be the major concern in the latest FPB research, and we believe that this is probably a combination of circumstances. First of all, the complexity of the tariffs, as I have already mentioned, the moves by banks away from personal relationships to more technological processes, the belief that centralisation has weakened the rapport between local branches and small businesses, and of course the reported increase in bank profits, and the perception that technology has not increased the speed of money transmission.

An element of this perception of the charging regime must be the relationship of charging to published or agreed tariffs, and much anecdotal evidence is concerned with the apparent imposition of additional costs in excess of those which were understood to have been agreed, and whilst these costs may again be justified as far as the bank is concerned, and very often are mentioned in the small print they are very often not expected by the business and frequently are felt to be unjustified - for example, charging for correspondence, or bank visits, or the increasing costs for changing circumstances which are not always immediately apparent to the business owners.

FPB is currently questioning business owners in our regular quarterly survey, and whilst the results I am quoting now are only an initial snapshot because the full analysis will not be available until the end of this quarter, it may help to expand on the reasons for the focus of bank charges as a concern for small businesses.

A majority of respondents still suggest that charges are a concern, but when asked to explain their reason, given four options, they rank the options as follows.

First, we already pay enough for other bank services.

Secondly, the bank uses my money and so should not charge for other services.

Thirdly, transaction charges are excessive compared to other fees; and

Fourthly in order of ranking, I just object to the principle of paying transaction charges.

We can therefore suggest that transaction charges, per se, are not really the reason for objection, but that in comparison with the range of charging they do not seem justified.

(Slide 6 shown)

The Forum of Private Business has for sometime advocated the introduction of a formal contract. That should be the basis of any bank lending, and I have copies of this contract available at the meeting if anybody should want them.

The contract document would define the obligation of both business and bank in a borrowing/lending situation. It has been a continuing paradox for us that a full contract is considered necessary, for example, when borrowing 1000 on a credit card, but only a letter of intent, which may not even define conditions of breach or termination, is seen to be required for borrowing by a business of 10,000 or more.

So the Forum of Private Business laid out a detail, a series of checks and guidance for business owners int he borrowing application process, and this has been contained in the Forum of Private Business Bank finance review which we have spent a great deal of time compiling. In this review is what we call a "risk assessment form" which provides understanding of the risk assessment procedure that the bank will initiate as a means to determine levels and margins appropriate to the loan so that the business owners themselves can appreciate the process that the bank goes through.

(Slide 7 shown)

Collateral plays an important part, and again there is often a significant lack of understanding by the borrower as to how the calculation is made, of the level of private and business security required or, indeed, if there is a mix of both how that ratio has been decided.

The perception of UK businesses in the FPB survey has generally been that UK banks have traditionally sought much higher guarantees than, for example, their North American counterparts.

The development of a contract would allow greater understanding of the liability attached to the provision of security and in the FPB model would allow for change in trading circumstances to safeguard both parties. It would allow for collateral and security to be more directly related to risk in a way that could be understood, and improved by the business so that borrowing margins could be reduced appropriately.

Improvement in technology, particularly in the supply of information and speed of access to account details has, in our view, taken some activity away from the banks - for example, account summaries and placed them more in the hands of businesses themselves. A new business culture is developing where decisions are needed far more quickly in response to, for example, instantaneous information on the internet, and which relates directly to banking advice.

(Slide 8 shown)

Illustrating this on this chart, what this means is that the period for consideration of management strategy that follows the provision of information is being shortened by the speeding up of the information process itself. So the reaction time for the bank to deliver quality service becomes less and the business bank relationship no longer enjoys a significant consultation period between the receipt of the information and the management decision.

The speed of technology is constantly increasing, and unless business perception of the quality of service and advice from the bank is maintained at the good level a decision deficit will develop where fast information overtakes poor quality of service. The small business need is therefore even more dependent on the high quality of service from the bank.

(Slide 9 shown)

We have seen the restructuring of bank services, particularly the role of the branches may well have contributed to a los of confidence in the quality of that advice. We have seen the concern of banks not to take on the role of shadow director, and greater equivocation in the provision of advice.

We have seen greater reluctance to offer solutions to short term cash flow problems, and the change in borrowing patterns with less flexibility on overdraft facilities.

(Slide 10 shown)

So in relation to service, the current FPB quarterly survey is indicating that 51 per cent. of respondents have perceived an increased threat to the withdrawal of their overdraft. For many small businesses the flexibility that has been their strength has been based on the ability to vary borrowing levels relative to market conditions.

Our evidence in the 1996 and 1998 bank surveys suggested that meeting short term cash flow problems successfully was a function of the quality of the business bank relationship, and a substantial part of this relationship is dependent on businesses own perceived quality of the service they get.

However, the pattern of this relationship appears to have been fundamentally changed in recent years, both by the greater use of technology and by bank restructuring.

Bank branches have lost much of their traditional role and are perceived by local small businesses to have distanced themselves from their involvement in the local culture that holds the pulse of local trading.

The last FPB report presented evidence from ethnic respondents, for example, that suggested a variation in bank services to ethnic businesses, and this again might be a result of that distancing process.

Complaints' procedures have been more difficult to access and the FPB member information service which, as an intermediary, does deal with complaints against the banks from our own members, has in the past two years seen an increase in the number and complexity of those complaints. Redress has become a more lengthy and complicated process.

It is our view, for example, that the role of the Ombudsman must be larger and wider if it is to retain the confidence of private business owners.

Finally, there continues to be a fundamental lack of understanding in the private business community as to why, in the age of electronic transfer, the clearing process still takes three days. Indeed, one recent electronic transfer we made from Northern Ireland to Canada took five days, and yet Canadian and Swedish banks can achieve it in one day.

So there are still very many question marks in the minds of UK private business owners over the speed and quality of bank services, now that we are being urged to move into the 21st century.

They seek to know that the special culture of private business, the small business ethos - whatever that encompasses - will at least be recognised and understood by the banks as they progress into this new age.

Thank you very much, Chairman.

THE CHAIRMAN: Could I now invite the representative of the Federation of Small Businesses to make their presentation? Thank you.

MR MARTIN: My name is Donald Martin. I am the United Kingdom Policy Chairman for the Federation of Small Businesses. My apologies that I do not have a prepared script and slides since the short period from when I was giving evidence to the Competition Commission my programme has been such that it has not been possible.

However, I would like to mention that the Federation of Small Businesses is the largest organisation representing solely SMEs with over 155,000 members.

I am here I would mention as a volunteer. I run my own business, so I know what it is like at the coalface. I am one of those few small businesses who actually has no debt. Therefore, under those circumstances I understand that it is easier to switch, but if you have debt then it is not so easy.

I am supported here today by my colleague, Derek French, who is also an FSB member and he is also director of the Campaign for Community Banking Services and the FSB has been a member of that steering committee from the beginning, and I would just mention that the Federation has sponsored the latest edition of the Case for Community Banking, the author of which is Derek French, which deals with this question of bank closures, and its effects, amongst other things, on small businesses. It is available and is published by the New Economics Foundation, but we are happy to make it available because the Federation sponsored the latest edition.

As far as the Community Banking is concerned, our concerns here are bank branch closures, the question of a community bank after the last bank moves out, and also the particular problems that bank closures create for SMEs, particularly the local retailers. Derek French will be making some remarks later, I understand, Mr Chairman, when we get to the comments section.

I would like to mention that whilst our remarks are complementary to the Forum for Private Business we have, as an organisation, enjoyed a very good dialogue with the banks and it is an ongoing dialogue, and we will maintain it, even of course if we do not always agree with one another.

Beyond bank closures and the availability of local bank counter services, our main concerns are in two overall areas. The question of the bank relationships and charges and secondly, the banks' virtual monopoly in the money creation process.

Turning therefore, first of all, to the relationships and charges and here I would agree with the Forum that that there was a great improvement since the 1980s and early 1990s, particularly with the prior notification of charges and interest. This overcame a major area of problems and concern, concerning going over limits as far as SMEs are concerned, but there are associated concerns still and I will come to that shortly.

The banks, of course, claim, that the majority of their SME customers are happy. But I think if we look at the surveys that we have, if small businesses had the number of dissatisfied customers that the banks have we would be out of business.

Here I would like to say that part of this happiness is associated with the acceptance of the status quo which, as I have mentioned, is not entirely satisfactory.

Our latest survey, which is Barriers to Survival and Growth in UK Small Businesses, a large survey which only has one particular reference to the question of banking services, this survey had a lot of research put into the questions and I have to say that we had a very good response in that 22,000 businesses responded making it a very large survey.

I just want to take a sample from this survey - the full survey is available, and it has been made available to the Commission. This is on the subject of satisfaction with banking services. I take just two items from this.

First of all, on the question of interest rates as a borrower. Those who were dissatisfied or very dissatisfied totalled 55 per cent. of the respondents. Those who were neutral 33 per cent., 12 per cent. being satisfied.

On the question of bank charges, satisfied or very satisfied was 11 per cent., neutral 15 per cent., dissatisfied or very dissatisfied 73 per cent.

Let us now contrast this with an earlier survey which did have a major number of questions dealing with the relationships of banks, and also the question of charges.

This also has been submitted in evidence to the Commission and this is the size of the report so you will see there was a lot of evidence there. It was like the first survey which was done independently on our part by Strathclyde University, these results were also done independently for us by the Electoral Reform Ballot Services.

Allow me, from this 16,000 returns survey in October, 1998, to give you a sample of some of the important points which came out of it, because it points to some of the relationship matters.

First of all, the survey shows that there were a number of businesses, but a small number of businesses who applied for a refund. 35 per cent. of those who responded had applied for a refund, but then when you look at the results of applying for refund how many actually got a refund and there we find that 96 per cent. obtained a refund.

If we look at this in relation to the banking ombudsman we find that those who had contacted the banking Ombudsman, let alone followed through on it, was only 2 per cent. So we find here that in dealing with this question there quite clearly needs to be an improvement, or greater access, and certainly perception of the Ombudsman's scheme.

Let us now relate this to a question in another area and that is of those who had a term loan, 32 per cent. had a term loan in this survey of 16,000. Of the 32 per cent. who had a term loan 80 per cent. of those also had an overdraft. Now, what does this mean? It is important from the small business point of view, and also from the perception that we understand that. It means, and it is contrary to the statistics I might say, before I mention this, from the Bank of England compiled in their annual report which shows the majority of funding on long term loans as distinct from on overdraft and why the difference between these figures, and it is important we should understand them.

The difference, I have ascertained, is because the figures which are presented, and the movement in the long term loan is on the volume of money being borrowed, as distinct from the number of businesses actually in the particular categories.

It is important here to understand this when you are dealing with the question of competition and also perception is that it means 80 per cent. of those businesses therefore with the long term loans are still vulnerable to the repayment on demand, and the macro-economic circumstances that are involved, and indeed, a number of cases that we have had when they are asked to go elsewhere.

Let us now deal with the other area which comes into this first survey, and that is those businesses who actually tried to negotiate with their bank when they were applying for facilities. Only 47 per cent. of them tried to negotiate.

When you look at the success rate of those when they negotiated in having their fees or rates changed, 72 per cent. achieved it. You might say 'Buyer Beware' that is their fault.I think you have therefore got to look at this in the context of the relationship between the small business and the bank. Most SMEs have a perception of little real competition between the banks. Their tendency is to accept what is on offer.

Unlike the bigger business they do not have the financial department which can exercise all the skills. Indeed, there was some reference earlier by Lloyds TSB on the movement between banks and I could not help but recall an incident that I raised at the Bank of England some time ago, and that is when there were a number of our members who were actually being asked to take their accounts elsewhere, and I discovered one of the problems was that they had been too hard in the negotiating. So I am not quite sure how the banks would cope if that 47 per cent went up a little higher, let alone down the line.

The small print is seldom read and understood as has been mentioned earlier. Indeed, I would ask you all in this room to reflect for a moment how many of you have read all of the credit card terms which you accept down to all of the detail. I think we would immediately recognise the point that needs to be made on that, and there does need to be some redress in this area, because the banks have all the clever lawyers, they have all the facilities. They have, as one would expect, those facilities, and the balance does, therefore need to be redressed.

One of the things, therefore, from the flow of these questions we need to have a look at, and in particular I refer to the question of interest rates. Whilst we have had the prior notification of charges there does need to be greater transparency in the capacity of the small business to be able to check their interest rates against those charges which are given to them. I have not found any competition between the banks at all in providing the facilities in this respect for the small business to be able to check, and I have raised this question.

Let us now move on to the question of charges beyond the overdraft, or term loan interest rates. Here we do have a high level of concern. A high level of concern which was heightened recently by having evidence of some degree of deliberate overcharging, evidence of which we have given to the Commission. But again, our survey results give an indication of some of the points I have mentioned, but I also refer in particular to three organisations which have done a lot of work in this area, that is Anglia Business Associates, Audit UK, and also Acquiring Solutions who operate mainly from Northern Ireland.

One would expect a higher percentage of businesses who approach these organisations to discover that they do have a measure of over charging but when you discover that the statistics are that it is somewhere between 75 and 85 per cent. results, then this is cause for concern. Indeed, when we look at the evidence, when these organisations to which I have referred are challenged, and they have been taken by the media as we know, and just selected at random, a sample of small business, and said "Right, test it on these", again the result has come up at 75 per cent.

This is, of course, some direct evidence, and largely a lot of anecdotal. But it does tend to suggest that there is an area which needs to be looked at.

Let us now look at the question of the clearance times on cheques. When we look at this we come into the sophistication of the system, that there is the problem, if the small business goes overdrawn, which is not shown on their statement at all because they have credited the cheques which were immediately shown on their bank statement, but they then run into the unauthorised overdraft charges, and are not clear again in checking their records as to whether they had applied the unauthorised charges.

Our view, with respect to this, particularly in this modern technological age is that if there was genuine competition between the banks on this particular point, there should be instant value on cheques deposited, subject of course to the recall on the famous bounced cheques. Indeed, we have seen a small chink of this in the private customers' market with Barclays Bank offering us up to 1000, again subject to recall, but no hint of this in the SME market.

The other question which is asked relative to this clearing period is since it immediately goes on to the credit of the small business on their account and therefore into the bank's books accordingly, who is making the profit after the credit has been made when it is available to that bank? I think there is a lot of questions where we have not got the answers, and as I understood it others are still having difficulties as well.

Let us now look at this question of switching, and I was interested that some figures were quoted concerning those accounts which were switched.

SMEs have great difficulty in switching if they have a loan or overdraft, and that is why I made my own personal opening remarks.

They also have difficulties if they have a large number of automatic debits or credits.

Whilst we were given the overall figure of switching it would be useful to have a breakdown of the figures. How m any are told to switch? How many, amongst those who switch, are that smaller percentage who are in credit - including myself I might say in that respect.

Moving into another important area when businesses run into problems, there appears to be a lack of competition concerning the liquidation of assets, particularly property. Here we find that a great concern of businesses is that the liquidation costs are on the basis of forced sales, and the assets, particularly when it comes to auction of other assets of the business, are sold to such a degree that they are a long way below market pressure, but where is the competition, in fact, to make sure that market value, the best value for creditors is, in fact, obtained.

Lastly and very briefly, I refer now to the question of the virtual monopoly over the money creation process that the banks enjoy, and particularly when we look at the position of the major banks..

The result of this is an increase in the level of debts which we know from statistics, both personally, SMEs in particular, and Government of course of all levels. Without opening this particular question, which is a huge subject in itself, I would however like to refer to the House of Lords Hansard where some very interesting statistics and the background of this was put on record and debated. I refer firstly to the late Lord Beswick, Hansard 27th November, 1985 volume 468, columns 935 to 939. A later one by Lord Caithness, Hansard of 5th March, 1997, volume 578, Number 68, columns 1869 to 1871.

What it means in summary, without developing this area, is the problem with the overall growing debt is that it limits others entering the lending market other than banks.

Thank you.

THE CHAIRMAN: Thank you very much. I now invite the representative of Global Consulting UK Ltd.

MR MISTRY: Mr Chairman, thank you very much for your invitation to this event. First, can I say that my colleague who was supposed to have been speaking here, Mr Uday K Dholakia, he is not able to be here, simply because he is with the Minister, Patricia Hewitt, in India with a mission on the IT sector. Hence, you have to put up with me instead of him.

I have been involved with Global Consulting UK Ltd in my capacity as Diversity Manager for Business Link in Hertfordshire, and we have been working closely, and hence we feel that our joint working relationship would be useful in this context.

Global Consulting's and Business Link's long term vision has been a platform of understanding and support for ethnic minority businesses in the UK and the rest of Europe to empower them to play an active and equitable part in shaping a common prosperous economy.

We have constantly sought to shape the facilities and environment for minority businesses in the UK, through the Business Link National Conference on Ethnic Minority Businesses in 1996, whose recommendations were launched in the House of Commons in the presence of all political parties and the national consultation which led to the establishment of the new, small business surveys, based on the small business centre in the US.

We recently took a delegation, and I was one of them of 12 minority business advocates, to visit members of the congress, the small business administration and the minority business development agency at a national conference in Washington.

We are therefore grateful for your invitation to contribute and the following are our views. Whilst the banks have gone along in understanding the needs of the ethnic minorities, communities, our own research, working with business support agencies, and minority business associations, suggest lack of following amongst the major high street banks.

One, low level of transparency. Disproportionately high level of charges, contracts - mainly short term - borrowing for long term needs. Unusually high levels of security, often the family homes for equity geared lending. Quality of advice is often mis-matched due to lack of understanding and customer needs.

Penalising the needs for small term cash flow needs, and not reflecting the short term nature of the many product cycles; lack of face to face banking in urban areas where there is a demographic majority of ethnic businesses community, and of course, the lack of non-executive directors from the ethnic minority communities.

The growth of minority businesses and the demographic changes will critically impact the demand for capital, by minority business enterprises.

However, for the minority businesses to grow and develop the economic infrastructure necessary to support the UK economy, new capital channels must be directed to this market sector.

Foremost among these channels must be those that increase the equity investment available to the minority business enterprise. The answer by the banks to advocacy by minority communities has been to conduct more research. Businesses run and owned by minorities have been researched for two decades.

However, consecutive researches carried out by the banks themselves have not yielded any new solutions. The old problems are regurgitated as one research project follows another, which buys time to ignore the actual needs of the minority communities. As a result the entrepreneurial base of our cities is being lost to the detriment of our economy in the long run.

There is a strong argument to create an environment to attract foreign banks to actively engage in lending to the SMEs in this country. Genuine competition for an existing entrepreneur to shop with High Street banks does not exist. This is not a case of arguing that there is a broad level of competition nor is this the time to recognise the challenges facing the SMEs and address them by creating a fiscal and monetary framework for competition.

The best practices in minority banking already exists in the United States. It is a question of whether there is a political will to address this issue and a bureaucratic commitment to enshrine services to minorities in monitoring the banks.

It is not a question of putting money in unbankable propositions. It is a question of taking the commitment of ethnic businesses services as essential economic parameters for UK Plc.

Finally, Chairman, I would like to offer a suggestion to the banks, namely, to meet with six or seven individuals like ourselves from across the country around the table to develop solutions for this particular sector, and not to conduct more research.

Thank you.

THE CHAIRMAN: Thank you.

MR ROBERTS: Good afternoon ladies and gentlemen. I am David Roberts, the newly appointed chief executive of Barclays Business Banking. Barclays Business Banking brings together all our business operations in the UK and Europe. I have a direct mandate from the board and from the Barclays Group Chief Executive to transform Barclays’ operations in business banking for all our stakeholders, particularly for our customers, my colleagues, for the communities in which we operate and also for our shareholders.

A number of people thought that I was quite frankly mad to take on the task of responding for the banks in terms of their relationships with their business customers, but there is nothing more important to me and to all the people in Barclays Business Banking. Why is that?

I have spent the last 12 years working in this sector, from being a relationship manager with customers to driving through the changes that we have made throughout the 1990s to improve our offering and now I have responsibility for a fabulous business and a great customer franchise.

Amongst my immediate family I have a doctors' practice and a tyre and exhaust business in Liverpool - where I come from - and I hear every day the problems of small businesses, access to people, competition, red tape and, yes, banks. So I hear it, I feel it, I know it, and we in Barclays are committed to working together with our small business customers to resolve the issues.

I would, at this stage, like to talk about what Barclays is here to do. We are here to change radically our offering, to be able to provide greater understanding and improved delivery to help our customers achieve their ambitions, to make them successful.

I would like to talk today about what I term "the perception gap", the gap between the reality as we would see it and the reality as indeed we have heard put forward powerfully and very well this morning. Let me say at this stage neither is right or wrong. We have to work together to bridge the gap or, rather than to bridge the gap, to close the gap, for the good of our customers, for the good of our economy and yes, of course, the good of Barclays.

When we are thinking about perception I guess the traditional perception is that the bank manager is "Captain Mainwaring - that loveable character. But I pose the question: Is Captain Mainwaring the right person to deliver the services rightly demanded by our small business customers in the age of a new economy? I would suggest not.

So maybe we have to put aside the perceptions and the rose tinted spectacles, and I would like us to consider the recession.

The advent of the recession is critical here. I remember only too well from the customers that I served in Manchester, the feeling of the invincibility of the economy: the Thatcher/Lawson boom coupled with the encouragement of the banks, in fact the pressure on the banks to go out and lend. Everyone believed there would never, ever, be a problem - we were entering a new economic paradigm. But, I am afraid, we fell off a cliff, did we not? What happened? Well, I can only speak for Barclays - we had relationships with customers that were, quite frankly, awful.

There was fear on both sides. We did not know what was happening, nor did our customers. There were surprises, both sides did things that were a complete surprise and were unacceptable to each other. Quite frankly, there was a lack of trust on both sides. We in Barclays - and again I can only speak for Barclays - determined at that stage that we would never, ever, ever, get ourselves into that position again.

I had the privilege of being asked to lead Barclays in rebuilding of its business banking operations during the mid-90s, so I would like to talk you through some of the things that we did and to address some of the perceptions.

I guess the first perception is that business bankers live in ivory towers, that we are people in suits, we are remote and we do not understand what our customers want. Nothing could be further from the truth.

(Slide 1 shown)

In Barclays we set about asking our customers to design the business that they wanted, their ideal bank. We went around the world looking at banking best practice, and we sought ideas from other industries.

(Slide 2 shown)

So what did we do? The first thing we did, and the first thing that our customers demanded, was a better understanding of their business, and so we did a number of things. We introduced relationship managers focused on specific sectors; we tried to develop experts, and provided more training. Did we do the training? No, we asked small business customers to deliver the training to our managers so they understood how it felt to run a small business. We introduced an industry-leading lending advisor system that allowed us to aggregate information, benchmark and provide value back to the customer as well as improving the underlying information that we were using.

Our customers also demanded continuity of relationships and in 1996 Barclays introduced the concept of continuity of relationships managers.

(Slide 3 shown)

Our customers quite rightly asked for convenient, easy access. So rather than having the customer come to the bank we set out on a crusade to take the bank to the customer. So we have undertaken major investments in internet and on-line banking. We have had for some years equipped relationship managers, to be able to go to the customer, and deal with the customer where they want to deal with us, not where we want to deal with them.

(Slide 4 shown)

Our customers asked for clarity and transparency of charging, and if I may, I would just like to focus for a minute on this.

As we have heard, we introduced pre-notification of charges, and we were the first bank to do that. We also tell all our customers precisely what our charges are. Some time ago we abolished charges for management time, for customer visits or for correspondence.

We also have clear, plain English legal agreements and only this year we have introduced a customer agreement that actually sets out the rights and obligations of both parties in the overall relationship. Our customers quite rightly expect that and I will return to it later.

(Slide 5 shown)

Our customers also asked for a fast, no surprises approach to lending, so we have a policy of moving away from overdraft to committed term lending.

In 1993/4 some 30 per cent. of exposure was by term loan in the SME sector, now it is over 60 per cent. 70 per cent. of decisions are within the relationship manager's discretion. Moving away from this nameless, faceless individual who seemed to take all the decisions, and we have a fast track approval process which means that 60 per cent. of all decisions for SMEs are taken within 15 minutes, and all other decisions are taken within 24 hours.

Our customers asked for this, and we re-designed the bank to deliver it. But there is a perception gap, is there not? Even though we had done this, why does this perception remain? We have to know, we have to understand and we have to resolve it.

I guess another concern was the fact that we have complacent, arrogant bankers, sitting in their ivory towers who do not actually innovate or bring new services.

Again, what has happened? I would like to talk in terms of Barclays about some of the major things that we have done in the last three years, not all of them - we would be here a long time otherwise.

As I said, our central tenet is to help our customers achieve their ambitions to be successful. If they are successful we are successful.

(Slide 6 shown)

So what about supporting start-ups? I am not going to deal with everything here, but we at Barclays are committed to supporting start-ups - not just in the products and the packages that we offer generally, but through the start-right campaign. 10,000 would-be entrepreneurs are being trained by Barclays and the National Federation of Enterprise Agencies this year. Why? Because management education skills and issues are the single biggest barrier to the success of businesses including start-ups.

(Slide 7 shown)

What about supporting growth? As indeed Mr Cruickshank said some 95 per cent. of all lending demands are met. In addition to that, we have helped to develop innovation centres, providing specific support from Barclays. We were the first bank to introduce cross-border specific skills in terms of our inward investment unit, using our capabilities to negotiate low cost funding from the European Investment Bank - some 250 million was available this year, for all SMEs to help them be successful. Only this week we finalised a deal with the Objective One Alliance, the alliance of the four areas who have "Objective One" status, ie deprived areas where there has been a drive to bring specific funding and skills and a combination of venture capital and debt to help our customers in those areas be successful.

(Slide 8 shown)

What about the critical, major issues facing small businesses at the moment which we have not really touched on today. How do you feel about the new economy? How do you take advantage in the new economy? Here again Barclays, and I can only speak for Barclays, has set out to help our customers to really make a difference. So we have the award winning brochure "E-Commerce made easy", again, education support, delivered free of charge. We have Barclays on-line banking, the first internet capable small business banking system. We have attracted over 150,000 customers in less than 12 months.

We have introduced Barclays B2B.com, Europe's first secure purchase to payment system bringing the power of the web to the benefit of our small business customers; and our joint venture with Freeserve - "ClearlyBusiness.com" - to bring all the information a small business needs, and to help cut through the red tape that is the single biggest issue affecting our small business customers.

(Slide 9 shown)

What about coping with major change? We have run 200 seminars for our customers to help them understand the issues associated with the implementation of the Euro all around the UK. Y2K questionnaires were circulated to help raise the awareness of all businesses to the risks that people were running.

Only last week we announced our stakeholder pension product. Not only is it low cost, which has attracted the attention - it is free - but also more importantly it brings with it real advice, help and support for the fundamental issues that all businesses and all SME businesses with more than 5 employees have to sort out between now and October next year. We bring help, support and advice as well as product.

(Slide 10 shown)

So with all these changes why is it that there is still this perception, and perception in my world by the way is reality, why is it still there? What is going on? We need to know. We have to sort it.

Maybe I can deal with another big issue. The perception that when it starts to rain the banks take the umbrellas away. We are particularly proud of our record in Barclays, particularly proud. We have redesigned the whole approach to turn around and support, to deliver corporate business support, and I would just like to show you some of the statistics.

(Slide 11 shown)

We return nine out of ten businesses in difficulties to financial health. We lend 200 million - remember we are talking about businesses in financial difficulty. These are businesses where we have identified with the customer that there are real concerns. We lend 200 million of new money every year. This, if you like, is the equivalent of the Barclays intensive care bed - skilled, trained people in specific units around the country to help nurse our customers back to health so that they are able to continue. This is good for our customers, it is good for the economy and, of course, it is good for us as well.

What has happened? 85 per cent. of those customers want to continue to bank with Barclays. 70 per cent. are confident we will continue to support them. Remember, these are customers who were in real difficulty.

90 per cent. are still banking with us six months later.

So, rather than take the umbrella away, we are actually looking to put the umbrella up, to identify difficulties early with our customers and help them through, because it is good for us, it is good for the economy and, of course, it is good most importantly for our customers.

What about costs in all of this? The perception has to be, is it not, that bank charges have gone up.

(Slide 12 shown)

This is independent research from the Bank of England that shows the fall in the real prices of certain industries across the country over the last six/seven years. As you can see telephony is down 30 per cent., electricity has fallen 25 per cent., gas down 20 per cent., and food down nearly 10 per cent.

Where do we think the banks are? What would be the perception?

(Slide 13 shown)

Independent research, from the Bank of England, shows that in real terms bank charges have fallen by over 30 per cent. in the last seven years. Why is that? Because fundamentally the markets in which we are operating will not support any increase. So our tariffs for the last seven years have been flat.

In addition to that we have introduced new, much lower cost services to our customers, for example electronic access. But why is it then that there is still this constant perception of poor service - what is going on? It is clearly not good. It is not good for us and it is absolutely not good for our customers, and we have to resolve it.

What has happened here? We have gone from, if you like, the branch, the 9.30 till 3.30 access of the early 90s, even the mid-90s, and we have moved to a position where our customers can do their work at a time when they want to, in a location that they want to, through a massive investment in increasing convenience and ease of access.

We have taken our relationship managers and moved them out of the branch and moved them into the place where our customers want them to be - their premises.

Barclays still has 1700-plus branches, which is more than the total of Tesco, Sainsbury, Asda and Safeway put together.

But what is going on? Customer satisfaction, surely, with all of this has improved? Well, the perception we have heard today and the perception that I read, and the public perception is that customer satisfaction is not good.

(Slide 14 shown)

This is customer satisfaction from 1992 to 1999. It appears the chart has gone a bit wonky with the PC difficulties - apologies.

Basically, as you can see, customer satisfaction, rather than falling, has risen. These are not our statistics. Our statistics are actually better than this. This does not include customers who say that they are fairly satisfied, these are only customers who are satisfied or very satisfied.

For Barclays we have roughly 75 per cent - three-quarters - of our customers saying they are satisfied or very satisfied with the overall service - not just the price, because people do not look at just price do they? We all, when we are making decisions, look at price relative to service, and relative to overall value.

75 per cent. is not good enough, and I am determined to lift that higher, and we will. But please, a cautionary tale.

I could deliver 100 per cent satisfaction tomorrow - it is called "free money from Barclays". In the late 80s, early 90s, our customer satisfaction was superb and that was because we were lending profligately, not sensibly.

We have to be intelligent lenders. Of course for us, but most importantly we have to be intelligent lenders for our customers, because the worst thing that we can do for a customer is to lend more than that customer can repay. We will never, ever, get satisfaction ratios up to the 90s, 100s, when we have that fundamental dichotomy. We have to do things that are right for those customers and they are necessarily difficult conversations at times.

So why does this perception continue? I would like to tell you about the reality as we see it, from the hundreds of customers that I talk to face to face and I do not think they are trying to fob me off. What is happening? I think there may be four or five things here that I would like to propose as some thoughts - I do not pretend to have all the answers. If I did, I would solve it.

The first one is that the damage that was done in the recession takes a long time to heal. As a very wise Chinese man says "When the ears hear one thing, and the eyes see another you tend to believe your eyes not your ears". Therefore, the real proof of the pudding is undoubtedly in the actions that we will be taking, not just now, but when - not if - when the next downturn comes. I think it takes a long time to break the perceptions of the past.

The second observation I would make is that I think Barclays - and I cannot speak for the other banks - I think Barclays has not been good at all at setting out the things that we do overall, the overall package, the way in which we support customers more broadly. I think we have a lot to do.

So I guess you are saying "So, it is all about PR, is it?" Fundamentally it is not. There are much, much more important things going on here, the first of which is for all that we have done around complaints' handling, around redress, around the actions that we have taken in conjunction with things like the Ombudsman scheme, (and I agree with Donald Martin that that process is too difficult, it is too long and things like that). There are still concerns to be tackled.

Our evidence of complaints is that we resolve something like 96/97 per cent, of them to the satisfaction of our customers. But fundamentally there seems to me to be, on the one hand, a perception of the "Big Brother" bank, and on the other hand the feeling of the small business community that they have no right of redress.

So I guess either through the offices of the Competition Commission or alternatively directly with the representative interest groups, The Forum, The Federation, The Chambers of Commerce, etc., I would like to propose that we take the recently introduced customer agreement that we have put forward, that sets out all the terms and conditions for the relationship as a whole, and see if we cannot work together to find some ways in which that can be taken forward to meet the issues and demands and concerns that your members are quite rightly voicing. That is an offer I would like to make, I would like to see that taken up if I may.

I think there is also something more fundamental going on here, and I call this the era of value focus. I think increasingly customers across the world as a whole, across society as a whole, and certainly in financial services are looking to make many more choices and are much more willing to make choices than they were only two years' ago.

We have seen in our research - we question 96,000 customers a year - we have talked in depth to over 2000 customers very recently to look at the trade-offs that customers are willing to make between the various elements of service and cost.

I am not going to stand here, least of all in front of the Competition Commission and reveal Barclays' competitive strategy - certainly in front of my competitors. But let me give a couple of clues. I think fundamentally people generally and our business customers are now willing to look at different options in terms of the type of service, and the level of cost, to make decisions that are right for their individual circumstances and their individual needs, and we at Barclays are looking to react to that and indeed, to lead that.

We have been working for quite some time now on an idea that offers customers that choice, and indeed we will be talking more about that in the not too distant future. We will offer a different service for, yes, a lower price. But clearly it takes things away as well as puts things in. More to come. But choice is fundamental and I think the advent of the net and far greater reliance in terms of taking decisions yourself, being willing to do things yourself, fundamentally starts to change the whole nature of some of the relationships, and we are testing and piloting that and we will see.

I guess finally, my summing-up here is that on behalf of the Group Board and the Group Chairman, we welcome the Competition Commission investigation. We welcome competition. It is really good for us. It is absolutely superb for the economy and it is fundamentally the right thing for customers. But we do not welcome having one arm tied behind our back and that is undoubtedly the debate that we will have going forward.

You have heard a lot from me today - some views. That is the reality as I see it. It is the reality as we in Barclays see it, but I would like, please, to emphasise where I started, namely, that there is this perception gap. We have to work together to close it. I do not say we are right. Can we do better? Of course we can do better. Is there more to do? Absolutely. Are we committed to doing it? You bet.

But I would like to end, please, not in my words, but in the words of a customer. I see all Barclays' complaints, in terms of the major ones that come into head office. I also see the letters of commendation and, yes, we do get some.

This letter is from a customer, sent to me in August of this year, and it is a good way to sum-up what I think we are striving to deliver and what we are delivering.

"Of course banks are there to make difficult decisions at difficult times, but we have found they have also been there to act pro-actively on behalf of clients like ourselves to make us become a more efficient company.

"So - unfashionable though it may be - I will put my head above the parapet and say "we are delighted with our bank!" Yours sincerely, chief executive."

Not my words, the words of a customer - not untypical. We have to work together to solve this perception gap for the good of our customers, for the good of the economy and the good of Barclays.

Mr Chairman, thank you.

THE CHAIRMAN: Thank you. We should break now for lunch. Can I just say clearly this morning we have looked at some of the issues arising from the Cruickshank report, different views on profitability, and then in this session various perspectives on service charges and the quality of the relationship between SMEs and banks.

This afternoon we move on to the critical area of competition. That has been touched on this morning, but I am sure there is much more to be said on that issue, and I hope there will be time for some more general discussion as well of the topics that we have covered both this morning and this afternoon, and I would hope to include Mr French, from the Federation of Small Businesses in those comments.

So I think we should now break for lunch.

(Adjourned for a short time)

THE CHAIRMAN: Welcome back everybody. Just before we start this afternoon, as you may imagine the members of the Commission have been discussing the various issues that came up this morning and we would like to pose two fairly general questions at this stage. If those about to present feel disposed to address them in their presentations that is fine, but they should not feel in any sense obligated to and the questions could, as it were, lay on the table until after the presentations and form the basis of some further discussion towards the end of the session.

The two questions we would like to place on the table are these.

We have heard that there are a number of complaints on the part of some SMEs about the services they receive. We have also heard evidence of rising levels of satisfaction in various surveys of SMEs. Obviously one question that we are going to have to address is the truth of the matter. How do we reconcile those.

There are two possibilities. Obviously one is that it could be that there are complaints, that complaints by their nature do tend to get disproportionate attention, and that when one does more thorough surveying of larger numbers, one gets a more typical or representative picture and that that is of rising levels of satisfaction.

An alternative explanation might be that there are relatively low expectations on the part of SMEs, that 'yes, the service is in some sense satisfactory but that that is because one would not expect much different from any other bank, would one', that kind of interpretation. As I say, clearly the Commission is going to have to investigate these sorts of explanations, but if there are any observations on those or if there are any ways of distinguishing between those two ways of reconciling these rather different views of the service provided, that would be helpful.

The second, not unrelated, is the evidence of rising levels of satisfaction with the overall service provided by banks to SMEs. We have heard of concerns, in particular, about charges, be those fees, commissions or interest rate charges. Again one can see two ready explanations. One was hinted at this morning: frankly no-one likes paying for anything and lower charges would infinitely be preferable to higher ones, and that one should see the concerns about charging in that light.

The alternative might be that the emphasis of the banks has been on improving service. That obviously has costs. It may have led to higher costs, perhaps higher prices. Conceivably, obviously a debate is still to be pursued, to higher profits. But a concern therefore that maybe competition has been focused more on providing service, perhaps in response to what the banks perceive to be the main concerns of SMEs, but less competition on price. That might be another way of reconciling the rising levels of satisfaction overall, concern about charges and if substantiated concerns about the level of profitability.

Those are just some of the thoughts that we would put on the table for this afternoon.

Could we now move on to the first of this afternoon's presentations, which will be from a representative of HSBC.

MR PICKEN: Thank you Chairman. Good afternoon, ladies and gentlemen.

My name is Graham Picken. I am General Manager for Business Banking in HSBC. I am responsible for business banking to customers, large and small, on behalf of HSBC.

I am not going to attempt to directly answer the questions on the concerns that the Chairman has just posed, but I think you will find in my presentation I certainly go some way towards providing an indication of where those issues are and how they might be resolved.

Thank you to the Commission for giving me the opportunity to talk about HSBC services to small businesses. I will describe how we believe the market operates and I shall address some of the misconceptions that we believe exist. My hope is that, as a result of today's hearings and of the Inquiry as a whole, it will be concluded that competition works well and that small businesses in the UK are well served by the banking and financial services industry, albeit there are always opportunities to improve.

There are five main messages that I would like to convey to you today.

My first observation is that it is wrong to talk about small businesses as if they are some homogenous group. All business customers, in my experience, are different. They want different things. They are attracted to different suppliers for different reasons. We should not assume that there is an average or typical small business customer.

My second point is that because of these differences between customers, it is misleading to talk about the market for banking services to small businesses. There are in fact three principal markets: debt, current account and deposits, within which there are a wide number of different products and services.

Also within these three markets, my third point, a large number of varied and alternative suppliers compete at a number of levels, of which price is only one. Price is important, but in fact most customers value quality of service and dependability more highly.

My fourth message is that HSBC is different in several crucial ways from other banks. On the one hand we are a global bank and we offer a full range of products and services over traditional and emerging distribution channels. On the other hand, we are committed to the principle of community banking, having the bank's people working alongside their customers in local business communities.

My final point is about the future. New technology, new competitors, alternative delivery channels, changing customer preferences and regulation all have a massive impact on the ways in which banks operate. The evolutionary process, which has taken place over a number of years in the personal markets for financial services, are occurring in the business markets at a faster rate. This will have significant consequences for all involved.

Let me start by talking about customers, because that is where, in HSBC, we like to start.

It is only possible to understand the sector if you understand the needs and demands of small businesses. Consciously I prefer not to use the phrase SME. Such a diverse group of customers is not so neatly categorised. We look at businesses individually. We can understand why the Commission needs to simplify the Inquiry to make it manageable. However, this slide highlights the diversity of business customers by size, industry sector, region, legal status and indeed how owner-managers approach debt and technology. Many customers negotiate overdraft facilities but then do not draw on them.

The Commission has chosen to define SMEs as those businesses with a turnover of less than 25 million per annum. Not only is this definition arbitrary, we believe, but it covers many different sorts of business, most of which will have very different financial and service needs. Business customers have different needs according to their legal constitution. For example, as we know, sole traders are different to limited companies, the age of the business, the number of employees, sales turnover, are all considerations and many more.

One particular aspect of customer behaviour is very important to this Inquiry. Our smallest business customers, who make up the majority of this customer base, very often use personal products as opposed to specialist business products. Indeed we estimate that about a quarter of small businesses may be using personal current accounts for business purposes. Many small businesses also use personal facilities for debt and deposit products, sometimes substituting, sometimes in addition to business accounts. We must not ignore the significant overlap that exists between the personal and business markets. It also means that many banks and financial institutions which claim not to serve the small business customer in fact do so. The building societies, new and old, would be included in this group.

Because customers are so different, there are a great many financial products on offer. We have grouped these into three separate markets: the market for current accounts or money transmission services, the market for debt products and the market for deposit products. There are other markets in addition, such as insurance and investments. Most business customers are quite willing and able to take different products from different providers. Whilst some suppliers, and I include HSBC in this, offer a full range of products and services, customers do have a choice. They tend not to buy from you unless you are competitive at individual product level.

For example, independent market research shows that small businesses buy between four and five financial products in addition to their current account, but over 60 per cent of these products are purchased from another supplier, other than the current account provider. Obviously a full service bank will seek to satisfy as large a proportion of the customer's needs as possible.

These many different products and the three main markets into which they fall makes it misleading to talk about overall market shares, as the Cruickshank Report attempted to do. Each market must be considered separately and, as I have said, the overlap with the personal market must also feature in this assessment.

I now wish to talk about how the suppliers of financial products compete against each other.

The first point I wish to make, and I wish to put special emphasis on this, is that none of these markets are controlled by the so-called 'big four group of banks'. The following numbers are not from HSBC but from independent research, Business Money Magazine and Business Money Facts. There are currently circa 28 providers of business current accounts. When one adds to this the fact that 25 per cent of small businesses use their personal accounts, you gain a more accurate impression of the choice available.

The debt and deposit markets are even better served. There are currently around 148 providers of debt products to small businesses and 72 suppliers of deposit products. Each of these players may compete for a wide or a narrow part of the market. Some serve more than one market. Others do not. Some are national. Others are regional. Some offer all delivery channels. Others specialize. There are differences, but all compete vigorously.

This brings me to the nature of competition. I am conscious that the Commissioners asked lots of questions during the process to date about price.

Price is important but it is by no means the only important factor. We know from what our customers tell us and our own research that customers care about many different things. Again the responses and behaviours depend on the market segment being considered. However, in all markets customer service and dependability are really important.

In the market for current accounts it is also important to form good relationships with customers and to offer them a delivery channel which most suits their needs. This may be branch based but it could also be over the telephone, the internet or PC based.

In debt markets the ability to tailor a product around the customer's cashflow is important, as is the price.

Deposit markets also tend to be more price orientated, but product choice is also important in the buying decision.

To respond to the different needs of customers, different banks focus on different products or services, different delivery channels, or different types of customer. HSBC aims to offer business customers a full range of products and services on a national basis with a full choice of delivery channels. We also offer banking experience based on our global network of branches and international reach.

It may make us sound like a big bank for a big world. Ironically our approach to customers is precisely the opposite. We call it community banking. We decided some years ago to create a decentralised organisation to focus our efforts through branch staff and to ensure that our customers had nominated relationship managers. The vast majority of decisions affecting customers are taken locally, which increases our speed of response and ensures that our customers know the decision makers. We have not undertaken major branch closures. We employ specialist teams where they are needed by particular industries or customer groups. For example, we have twelve of our branches nationally with business banking managers devoted entirely to servicing the needs of South Asian banking customers. We also have product specialists for invoice finance, equipment finance, vehicle finance, trade services and a whole raft of other specialist products. We constantly monitor how we are performing in customer satisfaction surveys. We listen. We try to understand what the customers are saying to us and we act upon those messages.

Our market position is illustrated by this slide. Our share of business current accounts, for example, was about 14 per cent in the late 1980s. It fell to about 12 per cent in the early 1990s. This downturn occurred during a period when we adopted a strategy of establishing offices dedicated to business customers. This approach was not right for us and obviously not right for our customers.

We learnt from this mistake. We listened to our customers. As a consequence we developed and implemented our community banking strategy. Our share of the business current account market has subsequently increased from 12 per cent to about 16 per cent. We have smaller shares of the debt and deposit markets. All of this, I believe, illustrates that competitive forces are in action.

These shifts in market share bring me to another point. Customer turnover. There is a misconception that business customers are reluctant to switch banks, even if they think that their bank does not provide value for money. It is claimed that customer inertia makes it easy for banks to earn higher returns. This is not true. Each year just short of 400,000 small businesses leave the market in the UK and another 400,000 or just over enter it. You can see the implication. To stand still in these markets, in market share terms, we need to attract a lot of new customers. In the business current account market, for example, HSBC loses some customers but we gain more than 70,000 new ones each year. This is how we have increased our market share.

The reasons for this customer churn are varied. Sometimes it is due to switching, sometimes because businesses cease to trade, and sometimes where businesses with more than one banking relationship - and there are a lot of them - decide to move their main account. The market is dynamic, not only for business current accounts but also for other products, debt and deposit products, and nobody in this industry can afford to take their eye off the ball. These large movements in the customer base ensure that banks must offer competitive terms in the markets in which they operate. If not, the customers will simply switch to another supplier. Again I know that this is not the most commonly held perception.

Independent research also shows that one third of small businesses claim to review their banking arrangements annually. This means that they have the knowledge and the opportunity to switch suppliers. Independent research also shows that nearly all small business customers switch banks at some point for one or all of the products they buy.

Precisely how much switching takes place is difficult to measure. We have had some statistics this morning. We know that many of our customers buy products and services from our rivals, but we do not know precisely how many products or which services. We would like to. We, too, are also constantly trying to sell our products and services to the customers of other banks to encourage them to switch. We also know that many small businesses hold more than one account or use a personal account for business purposes. This does make it very difficult to track switching decisions and means the numbers we have are likely to understate the true position. We do know though that, whatever the reality of switching, some customers continue to believe that it is difficult to switch banks. This is a problem for HSBC because we are trying to attract new customers.

To counter this perception we work hard to minimise the time taken to switch accounts. We offer all new customers compensation if we make any mistakes. But it is not just customers who switch towards us that we are concerned about. Our business banking charter, which is our commitment to our customers, states that we will not inhibit or delay any customer who decides to switch away from HSBC to another bank.

One reason competition is intense is because new suppliers are entering these markets all the time and because smaller companies get bigger and need more products and services.

There are lots of anecdotes about barriers to entry, but less by way of firm evidence. We discussed this this morning.

HSBC has grown its market share by changing strategy and focusing on customers, so what are the presumed barriers to entry?

The lack of a retail branch network. But is this really a barrier to entry? Notwithstanding the drift of product and service delivery to electronic channels, it is clear to me that there are many organisations out there - some were described this morning - in possession of extensive branch networks.

The riskiness of the debt market. Is this a barrier? If it is, it should not apply to the current account or deposit markets. But let us think about this some more.

Business debts, maybe secured, maybe unsecured. Why should these loans be any more difficult to risk assessment than a personal mortgage or a personal loan? We assert that you use the same risk assessment techniques. We use credit scoring as well as judgemental decisions in both personal and business markets.

But, of course, all types of loan can be affected by a change in economic circumstances. The current environment of low inflation is good for personal and good for business customers and should encourage new entrants to the debt market.

Another perceived barrier to entry is information about customers. When it comes to debt, particularly unsecured, it is necessary to know your customer. It has been claimed that getting information represents a barrier to entry. Again I must disagree. The vast majority of information we use to assess lending propositions comes from the customers themselves. That is who we ask and any debt provider should do the same. The other information we use is publicly available, like company accounts from Companies House, credit ratings from agencies like Dunn & Bradstreet, and general information in the local press of government statistics.

Our view that entry and expansion barriers are not prohibitive is supported by competitor announcements. Many of the mortgage banks have expanded their services to include the small business market. As mentioned, I suspect they have always served small business customers, knowingly or not, through personal accounts. But now Alliance & Leicester and Abbey National and others are overtly marketing business current account facilities. According to their own claims, Abbey National and Alliance & Leicester now have between them almost half as many business accounts as HSBC. We expect to see more mortgage banks enter the business market.

But the growing interest of mortgage banks is not the only form of change that we will see in the future. The transportability of European banking licences could encourage many large banks with established business banking presences in countries such as Germany, France and Spain to enter the UK market. Electronic transactions will grow as the use of cash and cheques continues to decline.

These changes will have a significant impact on the cost and operational structures of banks going forward. We believe the competitive forces in personal banking are also impacting the business banking markets. This is partly because business customers are personal customers. But the speed of change is also driven by competition and market sophistication. We are constantly learning about how to use new forms of technology, about what our customers want and how to serve them better. We are looking at new ways to get products to market faster to speed up decision times on loans and to move money around the financial system more efficiently.

In conclusion my messages are these.

(1) All business customers are different. They want different things and go to different suppliers for different reasons. It is misleading to talk about the average or typical SME.

(2) There is not one market for banking services to small businesses. There are several, of which debt, current account and deposits are the principal ones. Within each market there are a wide number of different products and services and personal products also serve the business market.

(3) Within these different markets there are many alternative suppliers competing not just on price but on quality of service and dependability, which customers value.

(4) HSBC is different from the other banks. We are a global bank with a full range of services and distribution channels but we are also committed to community banking, having bank people empowered to make decisions operating in their local business communities.

Finally the future will bring even greater benefits for small customers. We believe there is a lot of change happening as I speak and this will continue.

Thank you very much indeed.

THE CHAIRMAN: As a final formal presentation I would like to invite the Royal Bank of Scotland Group's representative to offer their comments. Then we will open the issues up to a wider discussion.

MR PELL: Thank you very much.

Good afternoon, ladies and gentlemen. My name is Gordon Pell. I am an Executive Director of the Royal Bank of Scotland and have responsibility for our retail businesses in the UK under both the Royal Bank of Scotland and NatWest brands.

Before I start however, what I would like to do is put on my other hat, which is as a director of Race for Opportunity, a "Business in the Community" initiative designed to make a case for exploiting the rich talent of wealth in our ethnic minorities in this country. An invitation was given from the podium early today and if Ulay Delucia from Global Consulting would like to come and have that discussion with me, I would be very happy to pick that up. All the banks have made major strides in this area over recent years and I am conscious from my own experience, as a bank manager in the East End of London dealing with the Bangladeshi community for many years, that this is a particularly difficult area and I am sure that we would welcome the chance to resume that dialogue.

If I can put my bank hat back on and move forward, what I would like to do is give you a vignette based on how the issue of barriers is more in the mind than in reality. If you follow competition theory through, if there is this rich honey pot of excess profits sitting in any sector, logic would suggest that the bees will buzz round and over time those profits will be eroded and profits will move back nearer to costs. We do not accept the concept that there are excess profits, but I could quite see a natural suspicion which says that if there are, there must be some artificial barriers that are stopping other people coming in to compete. You only have to look at "Business Moneyacts", which has been mentioned today several times. There are literally pages of competitors in this business and even on current accounts there is nearly a page and a half. And set across the page (at the princely price of 20p) you can read the detailed tariffs of at least 20 suppliers in this industry. There are competitors there. But why are there not more? That is what I would really like to touch on.

I would like to give you an example of a small Scottish Bank which fought its way into the English market, looked at those barriers, if they were there and found ways around them innovatively. The only question I would like the Commission to address is, if there is an issue then why are not other people addressing it that way?

The issue of the Royal Bank of Scotland's success in attacking the English small business market is a matter of public record. It has appeared in various documents during the bid for NatWest and therefore I do not need to comment on it. But if I just give you two figures. Since 1996 we have enlarged our share of small start-ups in the UK by nearly 33 per cent and over the last 12 months our share of the small business market has increased by 25 per cent. These are impressive figures but we are looking at a base of 4 per cent to 5 per cent of the UK market, built up with virtually no infrastructure, very few people and no large English and Welsh customer base. How has it been done and how can we achieve these apparent miracles in the face of the huge barriers that have apparently been put in our way?

Let us look at physical infrastructure first. We see no real evidence that you need a large branch network to build a business in the small business sector. There are clearly areas such as products, liabilities, savings balances and lending, but quite frankly there are literally 160 to 180 suppliers for whom clearly physical presence does not matter. So what we come down to is clearing, the handling of money transmission.

On average the Royal Bank of Scotland has one branch in every major conurbation in this country. Not five, not ten, not fifteen, but one. In that same conurbation someone like Boots has probably half a dozen, Tesco has two or three, there is a British Rail station. You can go on and on and on. There are endless suppliers of physical infrastructure in far greater depth than the Royal Bank of Scotland has ever been able to lay its hands on. We have not found that a problem and I will touch later on why.

Let us look at the other issue which is often raised, which is clearing. Entry to the clearing system is some sort of mystical right of passage, without which you cannot become a real bank. It is complete nonsense. In fact, in our case we regard clearing as of such little relevance that we have out-sourced the whole thing to EDS. You can buy clearing these days as a modular product and you can bolt it onto any other offering that you would like. That is our strategy with almost everything.

But in addition to that, we also offer clearing services to any other institution that wants to do business with us at a sensible price, and by "sensible price" I mean competitive tender, because it is quite a hard fought market. We provide this mythical clearing service to over 50 other financial institutions, many of which compete with us.

In addition we also provide clearing services to Tesco Personal Finance and Virgin Financial Services. In fact we even own 50 per cent stakes in those businesses to help them compete with our other brands. The reason for that is that competition keeps us healthy and tests all the time our customer proposition. The idea of competition within our group, let alone outside our group, is part of our fundamental market position.

Let me touch on the other major barrier, which is the supply of credit information. In other words, the development of a relationship with a clearing bank somehow provides the clearing bank with a monopoly of information that precludes the movement to another institution.

I have spent 14 years managing branches and I have to say that the customer walks around with the best form of credit information provided to him by his bank every month that any analyst could want to get his hands on. It is called his bank statement.

If you take a typical customer's bank statements, from that, in the course of about an hour with a 14p calculator, you can actually work out his debit turnover. You can roughly work out the time he takes to settle his debts. You can take out the information as to whether he is settling all his bills or merely keeping the ball in the air by paying around some payments. You can work out the interest rate that he is paying. You can work out his bank charges. You can work out whether he is observing the facilities agreed with his bank and, if not, what are the good reasons why not. In fact, it is such a powerful document that I am not sure why you would want to let it out of your possession if you are a customer. But the fact of life is, it is the best credit history you can possibly take to any bank, and bank managers over generations have been basing credit decisions on that information alone. Today if you bring that information to another bank, they can also draw on freely available information from credit agencies as well to help support that decision. It is almost impossible to believe why you could not make a sensible case with another bank, particularly if you have a reasonable track record of bank statements at another institution.

Let me touch on people. Perhaps banking people are some sort of rare commodity, that once you have bred them for 20 years they are not available in the market and therefore by definition they constitute a barrier.

On the Royal Bank of Scotland board there is not one executive director who comes from a traditional banking background and has spent his entire career with the Royal Bank of Scotland. Those institutions do not exist. We recruit in the market at all levels. We recruited over 2,000 people last year, many of them in England and Wales where we have very little infrastructure and very little history. The banking labour markets have proved to be remarkably efficient at supplying labour to any competitor. I am sure all the bankers in this room will be only too conscious that when someone like Tesco Personal Finance open up for business, the first thing that happens is that large numbers of your staff go there and work. It is a fact of life, that it is extremely easy to enter this market. There are plenty of skills available and they are very mobile.

Let me move on to the fallacy that you have to have a large personal customer base because that is the only real way you can develop a small banking business. We do not have a large personal customer base. That is just a historical fact. So how do we deal with this?

First of all, we focus on "hunter" teams of relationship managers, whose job is to build relationships with intermediaries and draw in business from the professional community itself. It is attracted by the service we provide to customers and is therefore prepared to pass us business. We are realists. We pay for these introductions. It is a competitive market.

In addition, our operating model is based on proactive management and incentivisation of our staff and our managers. It is not a cosy monopoly sitting there massaging yesterday's business. The fact of life is our managers are managed by activity by the day. Those targets are assessed by the week and by Monday of the next week they know where we have succeeded, where we have failed and where their activity is to be directed. It is impossible for them to earn their bonuses unless they attract a significant amount of new business. We do not have that sort of customer base in the past that we can rely on, even if we wanted to. Our managers are out there looking for new business. Each month we bring in about 3,000 new businesses and by and large we have to find them on the street, in the nicest sense of the word. Because we do not have them available to our customer base, we can make the case and these people come to us, and, being realistic, price is an issue. Businessmen are sensible. We sit down. We negotiate. We end up with a situation where they come to us on the grounds of service, price or a mixture of both.

Let me come back to the issue of entry. Clearing banking is not an easy business to come into, but then neither is brain surgery or moving into the steel industry. You have to have competence. You have to have capital. You have to have drive and you have to have commitment. But if you are setting up a national football team wanting to compete in the next World Cup, you need to invest in your coach, your managers and young players. But all of those are freely available in the market. You can buy them. The same thing as in banking. If you wish to come into this business, there are very few barriers that you have to overcome, they are largely in your own mind rather than in reality.

On the ground out there we have thousands of people competing at the moment to take business off the other banks. That is just a reality and my colleagues I am sure would reiterate the fact.

We have offered an invitation to the Competition Commission to visit one of our business centres and see our people on the ground, to see how they are paid, how they are driven and how they are measured. What the members would find, if, as I hope, they take up that invitation, is that there is no way that they can leave at the end of the day knowing that they have earned their bonuses unless they are out there on the street improving the satisfaction of customers and bringing in new business. Thank you very much.

THE CHAIRMAN: We now have some time available for some questions. I think we will kick off perhaps with one from amongst the Commission members. There may be others later. Then I would invite questions from other participants, in particular if representatives of the FPB or the FSB would like to come back on any of the points raised by the banks, and indeed if time whether the banks wish to respond to any of those points.

MR MUNSON: Chairman, if I may.

Two presentations, I think from Lloyds and HSBC, have both made the point in slightly different terms to each other but the same general point, that there are three relevant markets, not one. Savings and deposits accounts on the one hand, lending on the next and current accounts with overdraft is the third according to Lloyds. HSBC I think would put overdrafts in with the lending.

Is there an argument, does anyone think, that there are sufficient SMEs who actually want, need and demand a combination of those three services, or perhaps of two of them, perhaps SMEs with fluctuating excess funds who need deposit accounts with quick access back into their current accounts, so that there may be a separate market for the joint supply of two, or even all three, of those allegedly three separate markets?

THE CHAIRMAN: Would one of the banks like to respond to that? It will obviously be a key issue for the Commission to pursue.

MR PELL: Thank you. This obviously is a key question. The issue really is not whether we have a joint supply but whether in that product there is actually any bundling or commitment to use one product and not be able to pick and choose. That is clearly not the case and the Commission will see plenty of evidence of that when we enter into our discussions with them.

The reality of life is that while money transmissions can be used as a standalone, I think most small businesses would see the need to maintain some small amount of balance with it. But our best calculations are that in terms of an overall customer supply of credit balances, we are probably very lucky if we hold between 20 and 50 per cent. There is a massive market out there for savings balances. You only have to open any Sunday paper. So that market clearly operates in both dimensions. But the fact of life is that banks over time have managed to attract a relatively small amount of customers' liquid wealth. That is one of our problems.

If we move on to lending, there are ample suppliers of lending products that do not have any connection at all with one's current account in any shape or form. There is asset finance.

I refer back to "Business Moneyacts". In that area in particular there are literally pages of people who will lend to you without any form of customer relationship and we, on the other hand, will perfectly happily - in fact would be delighted to - conduct current accounts on a credit basis only if that is what the customer wishes.

I think the issue is not, are we happy to provide joint supply. Of course we are in the business of selling as many of our products as possible. The issue is, is there any conditionality? Certainly not. And, is there any requirement by the customer to actually use all our products? Certainly not. He can pick and choose.

Thank you.

THE CHAIRMAN: Thank you. Would the FPB or the FSB care to comment on the perception of their members as to whether there are three distinct areas of business here that might be regarded as three distinct markets, or not?

MR REDMOND: Yes. James Redmond, of the Forum of Private Business.

I think the biggest problem that we seem to encounter is not so much that the products are available separately, but that the products tend to come in packages. As far as the small business is concerned, some of the difficulties in unravelling these packages are formidable.

I am not quite so sure whether the comment on loyalty, that most small businesses have a loyalty to the bank, does not really reflect the problem with lack of time, in that it is not a positive attitude, it is rather one that has developed over a period.

Whilst I can accept that there may be three different products, the difficulty is that all those three products seem to come in one. It is probably easier for larger companies to take them separately but it is extremely difficult for a small business.

THE CHAIRMAN: Thank you.

MR MARTIN: Thank you. Donald Martin of the Federation of Small Businesses.

I think when you look at the point that you have raised, certainly if you are in a borrowing position with a term loan or with an overdraft, first of all the bank usually likes to know the total picture. It is not unreasonable that they need to know the total picture, particularly if you are running close to your limits and particularly with an overdraft on a continuous basis. That is number one.

Number two is the question of convenience and that is particularly for the small business, who has not necessarily got the opportunity to go to different banks, particularly if it is a matter of calling in or even dealing with them because of the limited time available with all the other things that they have to deal with, let alone government regulations as well as banks.

But on the question of bundling and availability, whilst the answer was given to us by the banks, there is sufficient evidence to look at this from a different angle, and that is that for the business applying, and when other products are on offer, unless it is made quite clear that they are free to go elsewhere, is the perception in their mind. We have talked a lot about that today. If they do not take other products, they may not get the main thing that they are after.

The question therefore back to the banks is, do they make that sufficiently clear that they are not obliged to take the other products, and is that quite clearly on the table so we can get rid of that perception? That would be helpful as a start.

MR PICKEN: Graham Picken of HSBC. As one of the instigators of this debate, perhaps I could have a word.

First of all, some customers may choose to bundle the products. Banks cannot stop them doing that. That does not make for a different market, we submit, in terms of that product.

I think it is also clear from our market shares that we have got a smaller share of the debt market than we have of the current account market. I can state categorically that there is no conditionality between the different products that we offer to business customers, so there should be no question of unravelling the packages.

I think also it is worth noting - I think it was on one of my slides - that 70 per cent of our small business customers do not have an overdraft. I know that is a somewhat different statistic to what my colleague was quoting earlier, but that is a fact for us.

THE CHAIRMAN: Thank you.

Could we move on to the question of branch closures, which came up in one or two of the presentations? Clearly that is another important area. I think we can quite understand that for businesses that are dealing with a lot of cash, most obviously retailers, that the ability to get good access to a nearby branch would obviously be important. We are less clear at the moment of the specific role of the branch for SME business where cash is not involved and we would quite like to hear something on that, but could I first invite on that topic Derek French of the Federation of Small Businesses to give us some views on that.

MR FRENCH: Thank you very much.

Derek French, Director of the Campaign for Community Banking Services, which is supported strongly by the Federation of Small Businesses and by 24 other national organisations dealing not only with small businesses but with the elderly, the disabled, the less well-off and so on, all of whom collectively have problems if there are not local branches.

Dealing, Chairman, specifically with your question, I think it is interesting to refer to the research that was undertaken by Bristol University for the British Bankers Association only in February of this year, where research across the whole country showed that 70 per cent of small businesses of all types visited a bank branch at least once a week and 8 per cent of them did so every day. Obviously if you looked within that and looked at retail small businesses, catering businesses and so on, you would see a much higher percentage of the daily visits. But it is interesting that the figure is as high as 70 per cent across the whole spectrum of small businesses, and they are not all dealing in cash, they are not all dealing in notes and coins. But this in fact is very similar to the individuals' market, that when people have cash to pay in, they want to pay it in across the counter and have it properly checked and receipted. They will go quite a long distance and suffer a considerable amount of personal inconvenience to achieve that. It is not only cash, it is cheques as well, and I think that very much has to be borne in mind when we see the withdrawal of all local banking by the big four, five or six, however many there now are, from something like 1,000 communities, urban and rural, over the last decade.

I could say a lot more, Chairman, but I think that will perhaps open up the discussion for you.

THE CHAIRMAN: Thank you.

Are there any other points on branch business?

MR ROBERTS: Thank you. I am David Roberts from Barclays.

It is probably invidious for us not to talk on branch closures, given some of the issues we have had to face this year.

I think the first thing is, what is the role of a branch, which is the question that you have posed. There is the fundamental role from a business customers perspective firstly the exchange of cash and the deposit and collection of cheques and documents. Aside from that, the key thing is the need for a locational base for our business bankers. We have business bankers in 900 locations serving the SME business sector, so we also have a community focus.

Secondly, branches are also a base for some of our relationship managers and servicing teams (who actually visit the customers) ie for our business bankers and also some of our corporate managers and relationship managers. I think there needs to be a clear distinction between, the cash handling function and the physical location for our relationship teams.

In terms of cash handling, we have something like 1720 physical branches. Those are present in pretty much all major communities. Roughly the average distance from a small business customer to the branch is of the order of about three miles, and we have provided you with information on that in our submission.

The physical demands, in terms of what the branch is now used for, are such that a lot of the services that were provided in the branch a few years ago, are now delivered by completely different means. I think both ourselves and a number of the other banks today have talked about on-line banking, PC banking and the information provision that is now provided by direct channels.

The issue, I think, is around how easy is it for small business customers to get there? I think the Federation of Small Businesses did a survey that said that less than 1 in 10 respondents to their survey indicated that they had suffered inconvenience as a result of having to change their banking routine in the last three years because of the closure of a bank branch. I think it has been very high profile. We have put in place the Post Office solution for our personal customers where the impact is bigger to provide services for all of them. No doubt we will spend more time on this issue in the private hearings.

THE CHAIRMAN: Would anyone else like to comment on that particular point?

MR PICKEN: It is Graham Picken of HSBC.

We did some research on our customers and we established that over 90 per cent of our customers have at least three business current account providers within six miles of them, so there is quite a lot of choice out there. Although branches are very important and we are very committed to our network, I do not think you can look at branches without looking at other delivery channels and the growing use of the internet and telephone delivery.

Thank you.

MR FRENCH: Could I come back on a couple of those points?

I think the crux of it is that we would not disagree that there is a huge migration of personal and business customers to these other delivery channels. What I think is important is that some businesses, and a lot of people, still need to use branches, but not enough customers of any one particular bank need to use it in a community of less than, say, 6,000 - 7,000 - 8,000 population. I think a solution has to be found to provide for these markets. That is very important, I think.

When we are talking about branches closing - and the people from Barclays talked about the communities that they left high and dry in April of this year when nearly 90 of the 171 branches that they closed were in fact the last, or the only, bank in a community, and if we had some of those customers here today I think they might have something different to say - I think it is interesting that of the nearly 1,000 communities that have been left bankless over the last decade, there have been hardly any cases where a competitor bank has gone in and sought to replace or fill the void. In fact, there are a couple of them within the last five years. They are both HSBC, but two cases against many hundreds of communities vacated does not amount to any sort of competitive approach. I think some of the banks tend to say, and HSBC has been mentioned here, 'we will stay where we are', but they make very little competitive effort, either to go into places where their competitors have closed, or indeed where the size of the community has grown and would normally justify a banking presence. They all look at it and say 'none of us will go'.

I think there are issues there to be considered. As I say, one could say a lot more on the branch closure issue, but I think that is probably enough response now. Thank you.

THE CHAIRMAN: Perhaps one further response on this topic and then we will move on.

MR ROBERTS: Thank you.

I think some good points have been made. The first is, we do have the deal with the Post Office for all our personal customers, which I think was recognised by the vast majority as the sector where the issues arise. We do therefore have some alternative arrangements in place.

The second point which I would like to make is about how we have handled the branch closure issues, from which we have learnt. I think there has been a focus on those. There is not, however, a focus on the massive investment that is being made in the infrastructure, the real estate, the systems and everything else for the remaining branches, which in Barclays terms amount to over 1700, more than most of the supermarkets put together for example.

We do not mean in any way to be arrogant or dismissive of these concerns because they are real concerns, and indeed we have had, and continue to have, conversations with the BBA on this subject.

But there is another concern, which is to reconcile the individual actions of each bank with the competitive actions of potentially all four of them, all six of them or however many of them are working on these issues. That, I think, is the dilemma that we face.

The final point is that we do have to recognise that our customers are accessing us in fundamentally different ways. At the end of the day, the branches we closed were closed because not many people were using them and they were relatively uneconomic. On the one hand we hear the call for competition; on the other hand it has to be recognised that those competitors without a branch network overhead are competing with a fundamentally different cost base. This implies that we have to meet the call for pricing competitiveness as well. We are faced with a dilemma here and it is one that we wrestle with every day.

THE CHAIRMAN: Could I at this point bring in Professor Graham on a distinct, but nonetheless related point.

                          PROFESSOR GRAHAM: We have heard quite a lot about the

importance of relationship managers, both from the banks and the representatives of small businesses. One issue which came out is that there seems to be some concern about whether or not relationship managers have rather less discretion than they did in the past, given the perception perhaps of the importance of more centralised procedures in some of the banks. I would be interested in getting responses, both from the banks and from others on this.

THE CHAIRMAN: Would someone volunteer to respond to that?

                           MR PELL: Thank you very much.

I think this is a difficult issue. The reality of life is, having been a Captain Mainwaring myself, I had far less power than many of my customers might have suspected in those days. Therefore I think there is a bit of perception as to what used to happen in the past compared to what actually happened. The reality of life is that bank managers confine their activities to the largest customers in their branch and most of the customers we are talking about in this sort of debate were actually handled several points down the ladder.

What has happened in the meantime is that we treat this as a national market. Our local managers are expected to deliver with huge flair and enthusiasm central policies against central price and against central credit criteria, because on balance we have found that that is the best way of raising the average performance and average customer satisfaction across the country. But I emphasize the local flair, the local satisfaction.

At the end of the day one of our managers in a small town is not allowed to blame central policy for the fact that he has not met his target of taking businesses off new banks. He has to convince the customers. Obviously if our managers feel that the central policies are not set properly, I can guarantee they are extremely vocal in passing their views back to the centre. There is an active debate all the time between the sales force and those of us in the centre. We are trying to manage the stability of this business, growing it at the right rate and growing it at the right levels of asset quality, so we do not take too much lending hit when things go wrong, and growing it in line with growing customer satisfaction.

In the old days I am afraid you were only as good as your local Captain Mainwaring. If you drove five miles away you found a very different one who might have preferred to play golf all afternoon. Today we can guarantee a relatively standardised level of service, because I know within a few inches what every one of my managers is doing every day and I can provide that service quality in a way that any industrial company or any retailer would regard as absolutely normal. The banks could not have made that claim 10 or 14 years ago.

MR PICKEN: Graham Picken of HSBC. I hope in my presentation I conveyed the fact that we at HSBC do believe in empowering people in the branch network to make the decisions necessary to satisfy the needs of the customer. We certainly attempt to do that. I hope those Commission members that visited our area branch in Leicester saw that in action. But clearly we have got delegated authority out into the branches with relationship managers and it is their job to deliver decisions for customers. Whether they are lending decisions, whether they are resolving issues on accounts, making refunds or otherwise, they have got the authority to do that. We believe in that. It is very much part of our community banking approach to business.

THE CHAIRMAN: There is time for two further replies. First, the gentleman at the back.

MR PRITCHARD: Thank you, Chairman. David Pritchard from

Lloyds TSB.

Our experience is similar to that of the other banks. Currently 90 per cent of decisions are taken locally and that has not changed over time. I think some of the confusion may arise because the relationship manager may now be based in a business centre, but nevertheless he is still responsible for covering a local community and still has the responsibility for taking the decisions.

MR ROBERTS: David Roberts again, from Barclays.

I think again there is a philosophical issue here, which I think Gordon touched upon.

Our philosophy is very clear. The person who is best able to make the decisions in terms of what products to offer and how to meet the needs of the customer base is the relationship manager. They have, within bounds, discretion around price. They have complete freedom about the way in which they deliver that service.

In terms of lending, we have invested heavily in Lending Advisor. It is a decision support tool, not a decision taking tool. As I have said, we have driven a strong policy that said that the lending decision is, over 70 per cent of the time, in the hands of the relationship manager. In days of yore it was about 30 per cent, because the manager's discretion was limited. It was then passed either to the famed Captain Mainwaring, or it was passed on to a local, regional or central area. We have been trying to change that by equipping our managers to make those decisions locally.

I think the other aspect, which probably has not been covered, is around some of the servicing undertaken. Again we invested heavily for our larger SME customers, recognising the points that have been made that there is not one homogenous group here in terms of local service. This has paid off "big time" in terms of attracting new customers.

But there is also a fundamental dichotomy here about creating time to allow the relationship manager to spend time out with customers, rather than bogging him or her down in the detail and in routine administration. So one of the other shifts which has happened a lot during this time has been a shift from the absolutely multi-faceted 'doing it all' type of approach, to one that is more specialist and more about serving and understanding the needs of our customers.

I know some of you are coming to spend some time with us. We will be delighted to let you talk to our relationship managers and, if necessary, spend a day with them to see what they do. There are things there that I think would help to resolve that dilemma.

THE CHAIRMAN: Thank you.

Another issue that we will be looking at quite closely is just how wide the relevant market for these banking services should be drawn.

We have here a representative of the FLA (The Finance and Leasing Association) and I would like to invite him to come to the podium and make a few points from your rather distinct perspective.

                           MARTIN HALL, Director General, FLA: Thank you Chairman.

Sometimes I think I am in a dream. I find myself agreeing with quite a lot of what some very senior bankers have been saying today.

FLA represents asset finance, which is essentially leasing and hire purchase. Our Asset Finance Division has 55 members. They include all the main clearers, the demutualised building societies, quite a lot of companies which are captive, linked to manufacturing companies who are an important force in this area, and a number of independent companies too.

There are two questions that I want to try to address: (1) Does asset finance actually compete with corporate lending; and (2) How competitive is asset finance itself?

On the first point, is there substitutability between asset finance and corporate lending? I think the answer is, 'yes, up to a point'. There is a certain amount of fungibility at the margin.

A bit over 50 per cent of all SMEs, as far as we can tell, use asset finance. I think undoubtedly there is scope for more sophistication, more understanding of the products, more understanding of the concept of horses for courses and that you need a cocktail of different kinds of finance as an SME. But I think the pricing of the products is likely to be close. If one gets out of line, at the margin competition will bring them together, both driven by the general level of interest rates as the main feature, but also affected by the degree of service which is attached to the finance which is being provided. As speakers have said, the whole package of what is being offered is developing and changing very quickly, as operating leasing in particular becomes available.

On the second issue, how competitive is the asset finance sector? To give you a sense of how big it is, it is about 20 billion of new business a year. It is a relatively flat, mature market. It has not changed much from year to year. Of that, about 3 billion are very large deals. Say 17 billion to corporates of various sizes.

Our members do not really differentiate SMEs as a separate homogeneous group. I think the lack of really good data is something that handicaps your inquiries quite genuinely. It is not a matter of it being hidden, but it is like asking what is the creditworthiness of people under 5 feet tall? It is not something that is automatically collected by institutions.

About half of asset finance is provided by the five largest banks, or subsidiaries of the five largest banks, which (I am not a competition expert) I would think was not an especially concentrated market. That 50 odd per cent applies to all companies. Cruickshank had a figure very close for SMEs. There is no obvious reason why SMEs should be particularly different in their choice of different sorts of finance from other companies, so I think 50 to 54 per cent is probably about right. The rest of the market really is very competitive.

The word 'cherrypicking' was used this morning, which led me to ask to come to the rostrum. I see it more as specialisation, that there are specialised players out there. There are large generalised providers, the banking groups. There are niche players, the specialists. Some of them are linked to particular manufacturers, some of which are very large. Some of those companies evolve into more general finance companies. But they are niche players. They are doing business. Not many of them need branches. I think the local branch, if we are just in this business, would be pretty unimportant, increasingly commoditised. As Graham Picken says: e-commerce, the telephone, increased sophistication in credit scoring and greater availability of information, all of these are cutting the costs of distribution. They have to. It is something like 100th of the cost to do a deal through e-commerce than through a branch and these economies are bound to come to business banking as well, with benefits not just to the providers but also to the customers.

We felt, and we have had the opportunity for giving private evidence from a range of members, that this is a competitive market. The jury is out. You [the Commission] are it, in fact, as we know, which is why we are here. I would hope that the conclusion is not that the jury should stay out, but that it should stand ready to reconvene, depending on the answers to two questions, which I will have to leave because I do not know the answers. One is, will people at the end of the day go for putting all their eggs in one basket for a package? In other words, is cross-selling going to be a successful strategy for the large banking groups, or not? The SME customers will decide that.

The other question is one that has been voiced (the more serious question I think) by SME representatives. When the going gets tough, when you absolutely need that liquidity, when you need your overdraft, are they going to be as free as they are now? We have some very reassuring statements from the banks today, but will they feel free to choose? I think that will be the point at which the spotlight may return if they are not. I think those are the issues for the future, but the present market in that narrow area appears to be a highly competitive one.

Thank you.

THE CHAIRMAN: Thank you. Having once had two children under five feet, their credit worthiness was appalling, but as they went through that height barrier it got substantially worse, I have to say!

Would anyone like to comment on the points raised by the FLA? These are difficult areas.

MR MARTIN: Donald Martin, Federation of Small Businesses.

There is just one point that I would like to come back on. There has been quite a bit of emphasis on internet banking and of course I think that was where the 'cherrypicking' aspect came in.

I think the British Bankers Association, the Bristol Study, looked into this question and came up with the answer only on personal customers. That is that, whilst there was a lot of take up, there was only 2 per cent usage.

The banks have been making lots of comment about alternative methods. Can they give us any research figures on take up and usage, as far as businesses, and in particular small businesses, are concerned?

A SPEAKER: I am happy to provide that, given that we have the largest statistical sample. Well over 50 per cent of people who are registered are active users.

MR PEGG: Steven Pegg from Lloyds TSB Business Banking.

We have a similar proportion of over 50 per cent who are actively using it, and we are now registering 1,000 businesses a week for internet banking.

THE CHAIRMAN: I would like to move on in the last few minutes to one or two other areas that some of my colleagues would quite like to ask about.

Perhaps first David Hammond. This is rather tracking back to some of the material that was discussed this morning, to do with profitability, which is obviously going to be a thorny area for the Inquiry.

MR HAMMOND: My question refers to the two people this morning who talked about intangibles, a determination of total assets and consequently capital employed.

I think we are all aware of the difficulties regarding recognition of pure acquisition goodwill. My point is more about other forms of intangibles. To what extent do the interested parties have a view on those other intangibles, whether or not they have appeared in the published financial statements?

MR PRITCHARD: Thank you. David Pritchard, Lloyds TSB.

Since I started by raising the subject of intangibles, perhaps I should go first on this.

You may recall that in my presentation this morning I was saying that there was a wide degree of variability in the capital figures and I suggested that the range may be something of 4 or 5 to 1, depending on where one struck the balance. Intangibles were one of the things that I mentioned, but actually you can get to a degree of variability of that sort of order of magnitude without even beginning to consider the intangibles. The Cruickshank report based its figures on regulatory capital. If we take our small businesses and look at the economic capital that is required to support them, as compared with the regulatory capital, you get a factor of more than 2-1. If you drew our accounting figures on the basis of US standards rather than UK standards, you would again get a factor in the order of 2-1, so you can get to more than 4-1 simply by excluding the intangibles. Then on top of that, we would of course argue that there is a substantial investment that we have all made in intangibles in the nature of training, for example, for our staff.

MR BARNES: I am an ex-member of the Banking Review.

As can be imagined, we did look at this problem in some detail. I would like to pick up the last point made by Lloyds on the use of things like economic capital, or indeed total assets. In making assumptions about what this does to the measured rate of return, one has also to look at whether it has an impact on the number that you would expect in a normally competitive market. You have to vary both if you are going to make a different set of comparisons. We chose equity because that happened to be a return number which is reasonably well grounded in competitive literature, about how the capital market works, and therefore reasonably easy to construct a norm.

The use of regulatory capital was only to establish the ratios of the allocation of shareholders' funds. We did not use regulatory capital as the basis for calculating rates of return. Similarly, if one was to use economic capital as the ratio, again one would allocate the equity on the basis of the ratio of the use of economic capital, not on the absolute numbers of the economic capital employed. To the extent that economic capital represents a better measure of relative risk, I think as we said in the report somewhere, it might have been a better basis for calculating the ratios of the use of equity in the different segments.

There are issues about distortions which arise because expenditure, which is essentially a capital good, is recorded in the accounts as operational expenditure. The impact on profit is rather complicated and the impact on what that does to measurements of norms is rather complicated as well. In the event there was not enough data available to us to make sophisticated calculations of what these impacts were and the likelihood that that particular problem would have led us to a different conclusion, given the results that we obtained, meant that we did not go to the ends of the earth to try and solve the problem.

Thank you.

THE CHAIRMAN: I think there is one further response to that, which is probably as far as we can take it before we get into the private hearing.

A SPEAKER: Thank you very much, Chairman. I would just add that in looking at the equity performance, the Cruickshank Commission based its period at a time which started when the bank share price was particularly depressed as a consequence of the third world debt period. It is those judgemental issues over the timing of the appropriate starting point which led us to our conclusion and recommendation that one needs to look beyond the simple profitability issues.

THE CHAIRMAN: Just one final comment on that point.

MR PELL: Thank you. There are obviously a lot of technical issues like this that we will welcome the opportunity to discuss with you. But often a common sense test gives us a clearer answer sometimes than actually delving too far down in the detail.

If you look at the performance of UK banks in 1998 and their return on equity of about 30 per cent, if you look at the FTSE generally that meant we were the 13th sector out of 38 in terms of the return on equity we actually turned in. We were not in the top one or two, which the concept of excess profits would perhaps imply. You could argue: is the UK therefore somewhat strange? But if you look across Europe generally, European commercial banks in the European 500 were actually the 16th sector out of 45. So again banking generally does not appear to be up in the top half dozen of sectors by return on equity and yet apparently we appear to be, at least de facto, enjoying excess profits. That is an interesting conundrum that we look forward to discussing with you over the coming months.

THE CHAIRMAN: Dr Monck?

DR MONCK: We have been told that roughly 40 per cent of SMEs still require cash handling facilities and within reasonable distance obviously, since it is a cash handling facility.

That does seem to us to be likely to be concentrated at the smaller end of the SME market that we are looking at, but it does lead us to wonder whether cash handling does in itself represent a significant barrier to entry. If anybody had any thoughts on that, it would be useful to us.

MR PELL: I would merely reiterate the comment I made earlier, that there are a huge number of institutions in this country that handle vast amounts of cash every day and actually pay for security vans to truck it away. Virtually every major retailer does so, and by far and away the biggest by all means is the post office which has something like 20,000 locations in the country. Through its alliance with GiroBank, retailers can pay in cash if they are operating at that simple level. So there are plenty of competitors in this market. But perhaps more importantly there are plenty of potential competitors if they actually wish to come into it. They already have the infrastructure. They are often connected to bank systems. They will have made a judgment presumably that this is not high on their list of priorities. If there are excess profits, you would think they would perhaps wish to think again.

THE CHAIRMAN: We have just about run out of time. Are there any last burning questions that anyone would like to raise in this public forum?

MR REDMOND: Jim Redmond from the Forum of Private Business.

I would like to emphasize the fact that there sometimes seems to be a significant lack of understanding about the small business ethos, the difference in thinking between large and small organisations.

The impact of new technology does limit time for small business owners to evaluate their opportunities and quite often they get a baffling range of new products from their own bank. Small business owners are generalists. They are not specialists. Very often they have to rely on the expert advice which is provided by the banks, but if that expert advice was to the effect that some other bank might provide a better service, would it be given?

Banks are confident in their technology. Small businesses are less so. I think this perception gap that was mentioned by David Roberts is extremely important. We do need to overcome that gap in perception between business owners themselves and what the banks are seeing as their level of delivery and quality of service.

THE CHAIRMAN: Thank you. I think we should draw the proceedings to a close now.

I would like to thank everyone who has been involved in this. I know, as we all know from this side of the table, that it takes quite a lot of time, effort and resource to prepare for an occasion like this, so I am grateful to you all for that.

I think we have aired most of the main issues. I am already aware of some people who have said that in the light of what they have heard they would like perhaps to write in to us with some further comments and that is welcome, but I would urge them to do it very rapidly because the second point that I would like to make is where we go from here, and to reiterate that next week, hopefully as early as possible next week as we can, we will be issuing our so-called Issues Letter to the main parties, with a view to having the main private hearings with them. Some are scheduled for December and the others for January. We will obviously in those be seeking to sort out the difficulties and issues that we have heard today concerning profitability and what the appropriate benchmark should be, the nature and extent of competition, which we have heard quite a lot about today, and the resulting performance that is delivered by the banks in terms of price but also more widely in terms of service.

I think the third and final point is to say that every day as I go to work, I pass a wall on which there is some graffiti which says in very large letters: "God is alive and well", and someone has added rather insultingly in small letters at the bottom, "and working on a much easier project now". I sense some empathy with the writer of that.

Thank you very much.

(The hearing concluded)

 
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