FCA investment and corporate banking market study: interim report

On 13 April 2016, the Financial Conduct Authority (the FCA) published its interim report of the findings from its investment and corporate banking market study (see Investment and corporate banking market study: the scope for a background of the study).

The report noted that “many clients feel well served by primary market services” and highlighted that a competitive market exists for investment and corporate banking services, as the FCA did not identify “compelling evidence that any particular sector or category of clients faces a lack of available suppliers for corporate and investment banking services”.

The FCA’s interim findings report did, however, identify a number of practices for which the FCA wants to propose remedies in order to encourage more competition. For example, the FCA found that banks tended to offer lending and corporate broking services at low or below cost to clients, in exchange for a more profitable flow of transactional business (known as universal services). Typically higher returns were made on transactional business which would subsidise the lending/corporate broking businesses, with the expectation that a client would provide enough transactional business to warrant continuing the relationship.

The FCA considered that this cross-selling/cross-subsidisation approach has an impact on competition, namely in creating barriers for new players to enter the transactional or relationship services market and discouraging clients from using its non-relationship banks for transactional work (even where those non-relationship banks might better suit their needs).

How does this impact consumers?

For large corporate clients, the FCA found that cross-subsidisation worked as they have a wide range of banks or institutions competing for their transactional mandates and this provides the client with choice for transactional business.

However, for smaller companies, the FCA found that they might feel pressure to "reward" a lending bank or corporate broker with transactional business, even in circumstances when they may not have otherwise won a mandate. The FCA found that the effect of this on the market was increased due to “the widespread use of contractual clauses in client engagement letters restricting future choice of supplier”. Clients were therefore not always free to award primary market mandates to banks that best suit their needs.

The importance of consumer choice was a key theme in a recent speech by Deb Jones, the Director of Competition for the FCA (see here). Ms Jones explained that, in accordance with its statutory objective, the FCA considers that a key part of promoting competition in the interests of consumers is ensuring that consumers have the confidence to exercise choice - and it is this consumer confidence which will drive healthy competition through factors other than price such as quality, range or innovation.

How does this impact market participants?

The FCA found that cross-subsidisation not only impacted the consumer’s ability to choose, but could also make it more difficult for banks who provide only transactional services to compete in the market, particularly as “investment banking is very much a relationship business with relationships strengthened by both…lending and…broking…and by past primary market transactions”. Client mandates may be less likely to be awarded to a bank offering only transactional services, where there is pressure to direct the business to its lender bank or corporate broker.

Other market practices

The FCA also looked at a range of other market practices to assess whether they restrict or distort competition to the detriment of consumers. They identified concerns relating to:

• the IPO process, both with regard to the “black out” period and because allocations of shares are skewed towards buy-side investors from whom banks derive greater revenues (eg trading commission), and
• league tables that rank banks by transaction activity can be misleading where banks carry out loss-making transactions just to improve their ranking.

The FCA’s potential remedies and consultation process

Despite the potential detriment arising from universal banking and the cross-subsidisation approach, the FCA considers that highly interventionist measures, such as separating lending activities from transactional services, are not warranted.

The FCA will seek to address its specific concerns in the universal services market through a number of potential remedies. The report also outlines concerns with loan and transaction syndication and reciprocity, however, the FCA found that these issues do not pose competition risks at this time.

The FCA remedies are focussed on lowering the barriers to entry and expansion for banks that do not provide universal services. The potential remedies the FCA has proposed focus on ensuring that consumers are able to choose their advisers freely, however it is not yet clear what the specific remedies would look like in practice. The FCA is consulting on the following issues:

• Are there any benefits to contractual clauses that restrict choice that the FCA needs to consider in assessing potential remedies? If such clauses are prohibited, what practical issues might arise?
• Are there other proportionate ways in which barriers to competition for non-universal banks can be reduced?
• Are there any other steps the FCA should take to allow more innovative approaches in primary market services to emerge?
• Improving the IPO process to ensure more diverse and independent information is available earlier. The possible improvements to the IPO process under consideration are set out in Discussion Paper 16/3. The FCA is considering three main models incorporating various combinations of the following two measures:
  • re-sequencing the publication of an approved prospectus and connected research, which is intended to make the approved prospectus the primary source of information available to investors
  • providing unconnected analysts with an opportunity to have access to the issuer’s management
• Investigating further with individual banks where the FCA’s analysis raises questions about conflicts management in IPO allocations. The FCA has published a separate occasional paper on allocations (See here).
• Improving the credibility of league tables by exploring ways in which they could be better presented so that they are more meaningful for clients and remove incentives for conducting trades carried out at a loss purely for the purpose of gaining league table credit.

The FCA is accepting comments and feedback on the report and potential remedies. This stage of the consultation process closes on 25 May 2016. A final report from the FCA is expected in summer 2016.

Our view

After the extensive deep dive by the FCA into the investment and corporate banking market, with market participants producing extensive amounts of transaction data for the FCA, the FCA does not appear to have found any fundamental problems with the market. Instead the FCA is examining a number of specific, targeted measures in order to further improve competition in the market.

Of the potential remedies, the two focusing on IPOs are arguably more about improving the IPO process rather than competition issues per se. Any changes to the order in which investment research and prospectuses are published would represent a fundamental change to UK IPO market practice and we will be writing a separate elexica article about that (as well as the paper on allocations in IPOs).

Of the three other potential remedies, (league tables, contractual terms and further measures to reduce barriers to entry), the last of these seems to be the most significant to us.

What can we expect next from the FCA?

In addition to the market studies being conducted by the FCA across a number of areas of the financial services industry (for example the Asset Management Market Study, in respect of which an interim report is expected in summer 2016) the FCA continues to develop its wider competition agenda by:

• Embedding competition within the FCA’s regulatory activities - the FCA continues to review its own internal processes and regulatory rules to ensure that they do not stifle competition, including through Project Innovate and the Regulatory Sandbox, an FCA programme which offers support to firms to bring innovative financial products and services to market. In addition the FCA has clarified the Principle 11 obligations (relations with regulators) to specifically include an obligation on firms to report significant infringements of any applicable competition law to the FCA (SUP 15.3.32R).
• Demonstrating its increasing appetite for intervention on competition issues - the FCA is gaining increased confidence to intervene, provide feedback and direction to firms on competition issues:
  • “On notice” letters - two “on notice” letters issued (similar to CMA warning letters) which put firms on notice of a potential competition infringement and sought confirmation of action the firm would take to address the FCA’s concerns. Both these actions arose from the Retirement Income Market Study.
  • Advisory letters - three advisory letters issued which are educational in nature and seek to increase awareness of competition issues.
  • Competition law enforcement [referral] - the FCA has publicly confirmed that it is has opened its first competition enforcement investigation pursuant to its powers under the Competition Act 1998
• Securing continued cooperation with the CMA - on 31 January 2016 the FCA and CMA published a new Memorandum of Understanding in relation to the exercise of their consumer protection powers.

If you would look further information or advice in respect of the FCA’s competition agenda and the ongoing consultation process, please contact your regular regulatory contact at Simmons & Simmons.

Update: The FCA has now published its final report. See our analysis of the final report.