FCA announces its intention to launch a market study to assess competition in investment banking and corporate servicesPrint publication
On 19 February 2015, the Financial Conduct Authority (FCA) announced plans to launch a wholesale market study into investment and corporate banking in the UK to assess whether competition in the sector is working properly.
The FCA uses market studies as an important tool for examining how well competition works in financial markets and to help it assess whether it should intervene in the interests of users.
The market study is the first to result from the FCA’s review of competition in the wholesale sector, which was launched in July 2014 to gather views on areas that might benefit from further investigation through a market study. The review was an exploratory exercise that aimed to identify areas where competition may be weak or not working properly.
The review focused primarily on competition in wholesale securities and investment markets, and related activities such as corporate banking. In particular, the FCA considered:
- markets and market infrastructure
- investment banking
- asset management
- corporate banking.
On 19 February 2015, the FCA published its findings in a feedback statement and identified potential competition concerns in all of the areas above. However, the FCA has chosen to focus on investment and corporate banking services for the time being because it considers that this area has the greatest potential to benefit from improvements in competition, given the size of the market and the reach and impact of the market players.
Focus of the market study into investment and corporate banking
The FCA’s market study will broadly focus on competition concerns in relation to the following areas.
The FCA is concerned about the limited amount of transparency over both price and quality, which may hinder corporate clients’ ability to assess value for money and to monitor whether they are getting “best execution” (this obligation requires investment firms to take all reasonable steps to obtain the best possible result when executing orders on behalf of retail and professional clients) and whether the issuing clients are able to monitor effectively whether the allocations being provided are consistent with their wishes.
Bundling and cross-selling of services
The FCA recognises that investment and corporate banking services often benefit from economies of scope, whereby the cost of providing additional services for an existing client are likely to be lower than the stand-alone cost of providing these services. This is because the provider of the services has already invested in the client relationship, and in understanding the client’s business model. This can be beneficial for the client, who may value having advisers who understand the needs of its business.
However, the FCA is concerned that bundling (i.e. where two or more services are sold as part of a package and these services are available separately (pure bundling), or where two or more services are sold together in a package, although each service can be purchased separately (mixed bundling)) may have detrimental effects for some clients:
- it could be used by a firm with significant market power in one aspect of the bundle to exclude competitors and therefore decrease the intensity of competition. For example, where below market price lending is provided on the assumption that the firm receiving the lending will purchase additional, more profitable services over time, this can reduce the intensity of competition for the additional services
- it may distort the market for the service being provided below cost, which means alternative service providers cannot compete with existing providers and may reduce innovation and lead to reduced quality in the service provided for free/below cost. For example, where corporate broking is provided for free it is likely to be difficult for new entrants (who cannot subsidise the costs of corporate broking services) to compete effectively. Therefore, bundling and cross-selling may act as a barrier to entry and expansion where competitors must offer the whole bundle of services to compete
- a lack of transparency may arise from firms bundling or tying services together over time, especially when some services are explicitly charged for and others are not. The client is unlikely to know exactly what they are paying for or may be unable to estimate the stand-alone cost of the products and services. The client would then be unable to evaluate whether the cost is appropriate for the level of service provided. This may mean that the client is less able to negotiate a better deal, or to switch to an alternative provider
- larger firms may be able to buy services unbundled because they have greater power in negotiations due to the size of transactions they undertake, whereas smaller corporate clients may have an exclusive banking-brokerage relationship with one provider which may affect their ability to compare providers or switch to alternative providers.
Principal agent issues
In some circumstances, an investment bank acts as an agent for a client, transacting on their behalf. Where this is the case, it may be difficult for clients to monitor whether the service that they are getting is the right quality (for example, where a client would need a significant amount of data to evaluate the service given, it may be costly, time consuming or complex). If the incentives of the principal (the client) and the agent (the provider of the investment banking services) are not aligned, and the principal is not able to monitor the actions of the agent sufficiently, there is a risk that the agent will not act in the best interests of the client.
This may, particularly, be an issue in relation to equity and debt issuance. It is possible that investment banks may have incentives to allocate shares to investors in a way that would not be optimal for the issuer, without the issuer fully realising it (for example, to reward institutional investors for their business). Where investment banks have incentives to allocate equity and/or debt to institutional clients based on commissions received, the allocation given may not be in the issuing client’s interest.
Furthermore, the FCA notes that, even with the rules relating to “best execution” in place, brokers may still execute orders to maximise gains, rather than act in the interests of their clients. This is because it is costly to achieve high levels of execution quality, orders that are not executed at the best possible price are valuable to brokers and clients may face difficulties in monitoring best execution from their broker.
The FCA states that the full scope of this market study will be set out in a “terms of reference”, which will be published upon launch of the market study in spring 2015. The terms of reference will be informed by views from industry, trade bodies and clients.
After the launch of the market study, the FCA will have six months to investigate and publish a notice for consultation setting out whether it proposes to refer the markets for a detailed 18-24 month market investigation by the Competition and Markets Authority (CMA). The FCA will then have a further six months to decide whether to make that reference. It may decide to accept undertakings from the market participants in lieu of making a reference, or to exercise its regulatory powers to address any concerns.
Other forthcoming market studies
The FCA also identified various potential concerns in the areas of markets and market infrastructure and asset management.
In relation to markets and market infrastructure, the FCA states that it recognises there are potential aspects of this market in which competition issues may exist and it may consider a market study in the future. For now, the FCA has decided to wait and see how current regulatory reforms – such as MiFID I/MiFIR (the Directive on markets in financial instruments and the Regulation on markets in financial instruments) and EMIR (the European Markets Infrastructure Regulation) – impact on the relevant markets.
In relation to asset management services, the FCA said that it will consider a market study later in the year, once it has a better indication of how the industry will evolve to accommodate new regulations such as MiFID II/MiFIR and AIFMD (the Alternative Investment Fund Managers Directive).
The FCA’s plans to launch a market study into investment and corporate banking in the UK may have far-reaching implications for this sector. It will highlight the need for more clarity around greater price transparency and bundling of services and in all likelihood will accelerate changes to existing practices. This market study comes alongside the FCA’s market study into credit cards as well as the CMA’s market investigation into the personal current account and SME retail banking sectors, which is due to report provisional findings in September 2015. As the FCA will exercise concurrent competition powers alongside the CMA as of 1 April 2015, we are clearly entering a new phase of regulation for the FCA where competition issues are given centre stage. We are only now beginning to find out just how significant this could be for parts of the financial services sector.
Should you require further information or assistance regarding this market study, please contact Trudy Feaster-Gee Partner (Barrister) and Head of Competition.