Weak competitive position of smaller financial institutions

The Competition Authority published the report „Financial services at a crossroads“. The report sets out the Competition Authority's views on the financial market and its tasks in this area. The report focuses on three areas:

• Firstly, the size and structure of banks and companies over the past quarter-century, concentration, operating costs, mergers and partnerships are discussed.
• Secondly, the competitive restraint is addressed, i.e. the ability of both smaller and newly established financial institutions to compete with Arion Bank, Íslandsbanki and Landsbankinn.
• Thirdly, securities services and its individual markets, such as corporate advisory, asset management and brokerage, are discussed in particular. In this context, consideration is also given to the separation of commercial and investment banking activities.

Below are some points from the report:

Arion Bank, Íslandsbanki and Landsbankinn play a key role in business life.

Through their claims on the country's indebted and newly restructured companies, Arion Bank, Íslandsbanki and Landsbankinn play a key role in business life. At this stage, it does not appear that the banks' influence on companies has led to a circular structure, i.e. a network of companies with extensive cooperation. It must be ensured that the vacuum created in corporate ownership in the years following the collapse does not ultimately lead to the creation of large business conglomerates with extensive management and ownership ties that hamper competition.

High operating costs of banks

The constant-price operating costs of the banks have increased significantly each year since the crash. The operation of 14 lending institutions in 2011 cost 30% more at constant prices than the operation of 32 lending institutions a decade ago, and is equivalent to two National Hospitals today. According to the Competition Authority, this indicates that competition in banking services is lacking, as competition encourages companies to be more efficient. Bank customers pay for this operating cost dearly through unfavourable terms and conditions. A high interest rate spread in an international context places a heavy burden on households and businesses and reduces the competitiveness of the economy.

The way out of the problem is competition, not mergers.

The problem, reflected in the high operating costs of the banks and consequently the high interest costs for households and businesses, is significant and not easily resolved. One option often mentioned in this context is the merger of two of the major banks. The Competition Authority has spoken very clearly about the fact that mergers of larger banks are not a solution to this problem. The reduced competition that would likely accompany such mergers would, on the contrary, harm consumers and the competitiveness of business. The Competition Authority's position on increased cooperation between banks, with the aim of achieving efficiencies, has also been clear. Such cooperation is worthy of consideration, but only on the condition that it does not undermine the incentive for banks to compete with one another, as competition benefits consumers and customers. In this context, reference can be made to a settlement the Competition Authority reached with the Reiknistofan bankanna and its owners regarding the company's activities.

Increased competition is the key to efficiency and increased productivity in the Icelandic banking sector, according to the Competition Authority. Competition promotes the efficient use of production factors, encourages management to streamline operations, and leads to new ideas, innovation and technological advances.

There are considerable barriers to entry in the market.

There are considerable barriers to entry in the financial market. Tighter rules on the operations of financial firms and increased supervision make it more difficult for smaller companies to operate, as the general principle is that the same requirements are imposed on all firms, regardless of their size, scale and risk. High information technology costs also make it difficult for smaller financial firms, in addition to which the strong links between commercial banks and individual businesses and the wider economy give the commercial banks an advantage. Furthermore, access to the payment and payment card market has not always been straightforward. It is also costly and time-consuming for business customers to switch banks.

A significant mismatch could be seen in the financial market.

A significant power struggle may exist between the big banks and smaller financial firms. The big banks are in a strong position as they can offer customers a comprehensive range of services. They tower over other competitors in terms of balance sheet size and scale. By virtue of their size, they can offer a wider range of services, prices and terms that smaller firms find difficult to compete with.

Buyers of consultancy services connected to the big banks

A study of 90 advisory projects by financial firms reveals that in around 70% of the corporate advisory projects of the major banks, the clients are connected to the relevant bank, through ownership links, or the bank being the company's largest creditor or primary service provider. It is also noteworthy that relatively few of these 90 projects were put out to tender, and that price surveys and the process for selecting consultants appear to be inadequate. This situation has led to a great deal of suspicion, which is reflected in the many complaints and tips to the Competition Authority.

The banks must ensure they do not unreasonably restrict competition.

In these circumstances, the three large commercial banks must be particularly careful not to restrict competition unreasonably. In many cases, it may be reasonable to negotiate advisory services with a commercial bank that can offer a full range of services. However, bundling or cross-subsidising of services, or the subsidisation of specific services, can be contrary to competition law if companies are in a dominant market position.

Separation could increase competition

Competitive conditions and the state of the securities market should be taken into account when deciding on the structure of the financial system, including when determining the relationship between commercial and investment banking activities. From a competitive standpoint, there is a case for separating, at least operationally, the fee-based and lending divisions of banks, so that the relevant bank subsidiaries are independent in both name and in practice. This could, for example, apply to corporate advisory and brokerage. In this way, the capital for projects would still come from the banks, but there would be greater competition for advisory services and brokerage for investors. This would be an attempt to separate those who provide loans from those who provide advice, and would thus be conducive to better protecting the customer's interests. This argument must be weighed against other arguments concerning the efficiency and security of the financial market and a strong economy.

The report mentions numerous desirable actions due to insufficient competition, including:

• It is important to monitor management and ownership relationships in business life and to take action, where necessary, against a concentration of power that may limit competition.
• Progress must continue to prevent banks from creating networks of companies with interlinked business relationships. To this end, the Competition Authority imposes conditions on bank takeovers of companies. It must be decided how ongoing oversight will be structured once the banks' ownership of companies has ended.
• Ensure that information on the beneficial owners of companies can be obtained, for example through transparency in the registration of shares in holding companies or in annual accounts.

• It is of paramount importance that the three major commercial banks ensure their operations are in every respect compliant with competition law. The banks must ensure that any potential joint dominant market position is not abused or that competition is not otherwise impeded.
• The Minister for Industry and Innovation, the Minister of Finance and the Financial Supervisory Authority should consider the competitive position of smaller financial institutions. There appears to be a tendency to place all financial institutions under the same umbrella, regardless of their size and nature. Such increased requirements, where not required by the nature or impact of the activity on financial stability, can lead to increased costs for smaller financial institutions and reduce their competitive discipline.
• The Minister for Industry and Innovation, the Minister of Finance and the Minister of the Interior shall take steps to increase consumer protection in the financial market and reduce switching costs.
• It is important that that the major commercial banks can in each case demonstrate objective pricing for individual services, the traceability of fees, and that their involvement in the negotiation process is beyond reproach. Furthermore, it is important that their related counterparties can in each case demonstrate a sound choice of corporate advisory.
• Investors, such as pension funds, should consider making greater demands for the independence of individual divisions within the major banks, thereby reducing conflicts of interest and increasing credibility. This refers to the fact that there are examples of banks having „four hats“ in their dealings with a company; as a creditor, shareholder, potential investor in the company's project, and adviser on a sale. Chinese walls do not prevent the problems inherent in such an arrangement.
• Íslandsbanki should sell its stake in Íslensk verðbréf as soon as possible due to the conflicts of interest involved in the country's second-largest asset management company being the largest shareholder in the third-largest company.