Small-business banking inquiry moves beyond the Big Four

In a slim, four-page statement, the Competition Commission will accuse the UK banking sector today of operating a "complex" monopoly in the small business market - an issue more simple than it sounds, but to which there is no apparent remedy.

In a slim, four-page statement, the Competition Commission will accuse the UK banking sector today of operating a "complex" monopoly in the small business market - an issue more simple than it sounds, but to which there is no apparent remedy.

The Commission's report had been expected only to focus on the "big four" banks - HSBC, Royal Bank of Scotland, Barclays and Lloyds TSB - which have more than 85 per cent of Britain's small business accounts. But its concerns are wider. The issue is not whether they operate a cartel to maximise profits at the expense of struggling entrepreneurs. It is that their stranglehold on the market has become self-perpetuating, and prevents an influx of new entrants who otherwise offer small businesses better deals. Deliberate or not, the four enjoy the trappings of monopoly power.

So what is deterring new entrants from joining battle? For starters, the more branches a bank has, the more competitive it will be in the small business market. Branches are essential - not just because small businesses work around cash. Setting up on one's own is such a hazardous enterprise, so face-to-face relationships with the staff at a local bank are vital for instilling the confidence needed to take the risks involved in growing a small firm.

And it is the inherent riskiness of small businesses that gives those banks with a big branch network the advantage over their apparently more sprightly peers. Small business credit risk is best spread over a large geographical area. As one analyst said yesterday: "You don't want to be a small business bank focused on the agricultural sector in the north-east of England. Small business banking needs diversity, and as such, that implies scale."

Likewise, the banks themselves argue that the risks are so great that they need to be spread over the business cycle too - so criticism of bumper profits when the economy is booming is unfair.

But the big banks' advantage doesn't stop there. The emergence of four dominant players in small business banking dates back to the consolidation wave that swept the UK banking sector in the 1960s. Since then, the incumbents have had plenty of time to build up a store of knowledge relating to small businesses' credit risk, and, equally important, their basic requirements. From a standing start, it is impossible for aspiring rivals, such as the demutualised mortgage banks, to replicate this skillset.

The main evidence that the business banking market suffers restricted competition is found in its higher average net interest margins of about 4.5 per cent - three times those found in retail banking. Compared to the European small business market - where services are provided by mutual organisations such as Crédit Agricole - fee income is much higher in the UK. Indeed, in a review of the industry unveiled in last year's Budget, Don Cruickshank, the chairman of the London Stock Exchange, found that up to £1.5bn in "excess profits" was being made from the small business banking in Britain.

Naturally, the big four argue that this is a peculiarity of this point in the business cycle, the peak of a long period of prosperity. "During the early 1990s, small business banking was a loss-making operation. No one criticised us then," said a source within one of the banks under scrutiny yesterday.

The Federation of Small Businesses says that there is plenty of anecdotal evidence to suggest that its members get a bad deal. "In one survey, we found that around 30 per cent of our members had appealed against what they perceived as unfair or excessive charges, and 90 per cent had their appeals upheld by the banks."

Likewise, rival banks eager for a slice of the market are critical of the present set-up. "Just because some small businesses are risky, it doesn't mean small business banking should have higher margins than retail banking. You don't see many dentists or doctors' surgeries going under," said one retail bank yesterday.

Said another: "Small businesses is a market where being able to bundle services really matters. If you're a business and you want a loan, you'll go to the bank you have a current account with, because you'll be thinking 'Things might go wrong one day, so I'd better stay with these guys'. There's a real fear factor."

And some banks admit that they feel handicapped. "We don't know this business, we just don't have the underwriting skill to gauge the risks," said one demutualised building society.

There is little doubt of the political will to address the problem. Last month, Stephen Byers, the Secretary of State for Trade and Industry, cited concerns about the small business market when he referred Lloyds' bid for Abbey National to the Competition Commission, despite Abbey having only a fractional presence in the market just now. Could it be that he wanted to encourage Abbey in its merger with the Bank of Scotland, to create a "fifth force" in the small business banking sector? BoS said yesterday: "Creating another force in small business banking was one of the key elements of our plans [to merge with Abbey]."

But with the Abbey-BoS talks off, it is hard to see an easy solution to the problem now. The Commission is believed to be especially concerned about regional monopolies. But forcing banks to offload regional franchises onto rivals is fraught with logistical difficulties.

The Commission is not proposing any remedies today but will do so later this month. One option it has is to propose making it easier for rival banks to learn about customer credit risk by obliging banks to disclose clients' full credit history to other lenders. Eager to be seen to be doing the right thing, the Royal Bank of Scotland has already started to move in this direction. The Commission may require that banks agree to set up an automated current account transfer system in small banking, similar to one that should be in place for the retail banking market by the autumn.