Profitability of UK Banks Essay Example Pdf - Free Essay Example

ASSESS THE PROFITABILITY OF UK BANKS INTRODUCTION The issue of the profitability of banks in the UK market has been the subject of controversy for sometime now. For the past twenty years there has been a substantial increase in the number of financial firms entering the banking sector in the UK. This has mainly been due to the fact that the financial industry in the UK is not as fiercely competitively fought, in comparison to other European banks and other banks around the world. This has made the UK market attractive with regard to foreign banks wanting to come and set up shop in the UK. In the UK alone there are about 500 banks that operate, but the big five namely, Barclays, Lloyds TSB, Royal Bank of Scotland, HSBC, and HBOS, dominate the UK’s retail commercial banking industry. It is argued that Britons get the banks and the levels of innovation they deserve. However the hypothesis is that because most people in the UK are not too bothered about the level of service provided by most financial banks, most banks exploit this consumer apathy and notably consumer’s reluctance to switch accounts to swell the profits of the major banks. Recent research has shown that most people in the UK change their bank account as infrequently as they change their spouse, i.e. they have low expectations of the services provided by banks. It is argued that the only reason most banks make such astronomical profit margins is because we as consumers allow them to g et away with it, Fraser (2005). Recent calculations show that if UK consumers were to switch to the bank offering the best rates and level of service on offer, they would be better off to the tune of  £15 billion per year. With this in mind, this paper goes on to address the issue of profitability generation within the UK banking sector. This will be done by using published material from articles, journals and already established theoretical concepts. The idea is to try and visually picture exactly what factors lead banks in the UK to be able to generate such huge profit margins in comparison to other banks around the world. Therefore, this paper will start of by carrying out a literature review, and then the use of already established theory namely monopoly would then be described. Following, one would look at any matches or mismatches with regard to the literature review and the established theory of monopoly and then a conclusion will be arrived at the end. LITERATURE REV IEW The Cruickshank Report (2004) on competition in UK banking, established that there was a ‘complex monopoly’ that existed between the big five UK high street banks and that this position has not been corrected by the government. Bank consumers have continued to be financially disadvantaged or in plain English worse off. Additionally, the banks have been allowed to enjoy a further five years of monopolistic profiteering in an area that affects every UK consumer in their daily life. He argues that nothing has been done to boost competition among banks and the profits should sound alarm bells. The headlines surrounding this report into the state of the UK banking industry have tended to concentrate on the accusation that the industry is making ‘supernormal profits’ of  £3 to  £5 billion a year. The question here is why given the recent excellent profits made by UK banks do completely new players not enter the market? The unwritten rules, he argues ma ke partnership with an existing bank a condition of market entry. The British Bankers Association (2005) argues that  £30 billion profits make UK banks jittery. Perhaps the banks think they will appear to be profiteering? After all, they’ve all been pretty successful, making huge profits over more than a decade. They also argue how cheap it is in the UK to bank and how much better off we are than those in the US who pay for checking accounts. In an article by the Money Observer (2005), banks were blasted for their billions in profit making. It was stated that Banks were resisting calls for a windfall tax despite record profits. In particular HSBC and Barclays record profits led to calls for a windfall tax to be imposed on the whole sector as Weatherill (2005) puts it, ‘banks treat their customers very shoddily while demanding sky-high charges for inferior products’. A windfall tax is the only way to make this industry sit up and take notice. The consumers assoc iation (2004) accused the main high street banks of exploiting their strangle hold over the high street to make excessive profits. In another article by the Daily Express (2005), it was argued that Banks in the UK were conning their most loyal customers out of millions of pounds a year by failing to offer them the best rates. Savers and borrowers who stick with their bank through thick and thin are likely to suffer huge financial penalties because they are not offered the competitive deals designed to attract new customers. A report, from savings account provider ING Direct, argues that HSBC had posted record profits of almost  £10billion. Weatherill (2004) states that the big banks have always made their money by penalizing those customers they considered captive. These people reasonably think the bank will be honourable towards them because they act honourably towards the bank. ING direct (2005) said 40 percent of individual customers who had left a financial institution in the past year did so because of their banks two tier approach to dealing with customers. This means that the many savings account providers will allow existing customers to advantage of new better rates. However, this relies on the customers finding out about the better rate themselves. Most lenders will not allow existing borrowers to take advantage of new deals unless they think the customer is about to go elsewhere. If people moved from their current bank and looked for a better deal, they will make savings and get better service, Daily Express (2005). In another article by the Guardian (2005), HSBC unveiled profits of more than  £9 billion but denied the record figure by a London based bank had been made at the expense of UK customers. The 37% rise in annual profits forms part of a  £30 billion industry-wide haul that has left UK banks facing calls for a windfall tax and accusations that the sector runs a complex monopoly structure. HSBC denied this and stated that its profits a re owed much to the growth and favourable conditions in the United States and China, as less than a quarter of its earnings came from the UK. In the Herald (2005), it was argued that it takes more than a week to be able to draw money from a single deposited cheque. Banks such as the Royal Bank of Scotland, Alliance and Leicester, and the Co-operative Bank took the longest to clear cheques in a survey conducted by the Herald of 12 of the major high street banks. Even an electronic money transfer in which there are an estimated 3.5 billion transactions a year by phone or the internet will take a minimum of three and a maximum of five working days to be credited to accounts. That time, as the adage goes, is money, as the bank can then use the uncleared amount to earn interest on it. Customers in Britain have to wait longer than almost all their western European counterparts for funds to pass through the clearing process. While 12 million cheques are written every day in the UK, it is o nly the ones paid in to Barclays that will benefit from instant withdrawals and interest, before the clearing cycle has barely had time to revolve. Consumer groups say banks are making millions every year from the limbo of uncleared funds. Finally, in the Financial Times (2005), UK focused banks such as HBOS and Lloyds TSB argue that most of their profits came from business banking and corporate lending rather than UK consumers. The banks argue that UK retail banking profitability is falling and they have cuts costs to compensate for falling profit margins and say that net interest margins, i.e. the profit made on lending has been falling for years. THE CONCEPT OF MONOPOLY A monopoly occurs when one firm, called a monopolist or a monopoly firm, produces an industry’s entire output. In contrast to perfectly competitive firms, which are price-takers, a monopolist sets the market price. Because the monopoly firm is the only firm in its industry, there is no distinction bet ween the market demand curve and the demand curve facing a single firm as there is in perfect competition. Thus, the monopoly firm faces a negatively sloping market demand curve and can set its own price. However, this negatively sloped market demand curve presents the monopoly firm with a trade-off; sales can be increased only if price is reduced, and price can be increased only if sales are reduced. One must note here that monopoly firms have U shaped short-run cost curves just as perfectly competitive firms do and this is a consequence of the law of diminishing marginal returns[1]. However, this negatively sloped market demand curve presents the monopoly firm with a trade-off; sales can be increased only if price is reduced, and price can be increased only if sales are reduced. When the monopoly firm charges the same price for all units sold, average revenue per unit is identical to price. Thus, the market demand curve is also the firm’s average revenue curve. But un like the firms in perfect competition, the monopoly firm’s demand curve is not its marginal revenue curve, which shows the change in total revenue resulting from the sale of an additional (or marginal) unit of production. Because its demand curve is negatively sloped, the monopoly firm must lower the price that it charges on all units in order to sell an extra unit. It does follow that the addition to its revenue resulting from the sale of an extra unit is less than the price that it receives for that unit (less by the amount that it loses as a result of cutting the price on all the units that it was selling already). The monopoly firm’s marginal revenue is less than the price at which it sells its output. Now to show the profit maximisation equilibrium of a monopoly firm, we bring together information about its revenues and its costs and then apply two rules. First, the firm should not produce at all unless there is some level of output for which price is at least equal to average variable cost. Secondly, if the firm does produce, its output should be set at the point where marginal cost equals marginal revenue. The following diagram illustrates this. Figure 1: The equilibrium of a monopoly When the monopoly firm equates marginal cost with marginal revenue, it reaches the equilibrium shown in figure 1. The profit-maximizing output is the level at which marginal cost equals marginal revenue. The point on the demand curve corresponding to that output determines the price at which that output can be sold. The monopoly produces the output Q0 for which marginal revenue equals marginal cost. At this output the price of P0, which is determined by the demand curve, exceeds the average variable cost. Total profits are the profits per unit of P0 – C0 multiplied by the output of Q0, which is the area marked X on the graph. When the monopoly firm is in profit-maximizing equilibrium, equating marginal revenue with marginal cost, both are l ess than the price it charges for its output. This is because the firm’s marginal revenue is always less than the price it charges. The fact that a monopoly firm produces the output that maximizes its profits tells us nothing about how large these profits will be, or even whether there will be any profits at all. Additionally, because the monopolist is the only producer in an industry, there is no need for separate analysis of the firm and industry, as is necessary with perfect competition. The monopoly firm is the industry. Thus, the short-run, profit-maximizing position of the firm, as shown in figure 1, is also the short-run equilibrium of the industry. Allocative inefficiency of a monopoly Output under monopoly is lower compared to perfect competition, and so must result in a smaller total of consumers’ and producers’ surpluses. When the monopoly chooses an output below the competitive level, market price is higher than it would be under perfect com petition. As a result, consumers’ surplus is diminished, and producers; surplus is increased. In this way, the monopoly firm gains at the expense of consumers. This is not however, the whole story. When output between the monopolistic and competitive levels is not produced, consumers give up more surplus than the monopolist gains. There is thus a net loss of surplus for society as a whole. This loss of surplus is called the ‘deadweight loss of monopoly’. It follows that there is a conflict between the private interest of the monopoly producer and the public interest of all the nation’s consumers. This creates a rational case for government intervention to prevent the formation of monopolies if possible or, if that is not possible, to control their behaviour. Entry Barriers In both monopolized and perfectly competitive industries, profits and losses provide incentives for entry and exit. If the monopoly firm is suffering losses in the short-run, it will continue to operate as long as it can cover its variable costs. In the long-run, however, it will leave the industry unless it can find a scale of operations at which its full opportunity costs can be covered. If the monopoly firm is making profits, other firms will wish to enter the industry in order to earn more than the opportunity cost of their capital. If such entry occurs, the equilibrium position shown in figure 1 will change and the firm will cease to be a monopolist. Entry barriers may be natural or firm-created. If a monopoly firm’s profits are to persist in the long-run, effective entry barriers must prevent the entry of new firms into the industry. Barriers determined by technology Natural barriers most commonly arise as a result of economies of scale. When the long-run average cost curve is negatively sloped over a large range of output, big firms have significantly lower average total costs than small firms. A natural monopoly occurs when, give n the industry’s current technology, the demand conditions allow no more than one fir to cover its costs while producing at the minimum point of its long-run cost curve. In a natural monopoly, there is no price at which two firms can both sell enough to cover their total costs. Another type of technologically determined barrier is set-up cost. If a firm could be catapulted fully grown into the market, it might be able to compete effectively with the existing monopolist. However, the cost to the new firm of entering the market, developing its products, and establishing such things as brand image and dealer net-work might be so large that entry would be unprofitable. Policy created barriers Many entry barriers are created by conscious government action and are, therefore, officially condoned. Patent laws, for instance, may prevent entry by conferring on the patent-holder the sole legal right to produce a particular product for a specific period of time. A firm may also be granted a charter or a franchise that prohibits competition by law. Regulation and licensing of firms, often in service industries, can restrict entry severely. For example, the 1979 Banking Act required all banks in the UK to be authorized by the Securities and Investment Board (sib) or some other recognized regulatory body. Regulation and authorization of all financial firms, including banks, was formally transferred to the financial services authority in December 2001. Other barriers can be created by the firm or firms already in the market. In extreme cases, the threat of force or sabotage can deter entry. Barriers such as set-up costs for a new market entrant might play a significant factor of a firm gaining entry into a market. For example, the threat of price-cutting, designed to impose unsustainable losses on a new entrant, and heavy brand-name advertising could act as a major stumbling block for new market entrants. Now, because there are no entry barriers in perfect competition, profits cannot persist in the long-run. Profits attract entry, and entry erodes profits. In monopoly, however, however, profits can persist in the long-run whenever there are effective barriers to entry. Entry barriers frustrate the adjustment mechanism that would otherwise push profits towards zero in the long-run. In the very long run technology changes. New ways of producing old products are invented, and new products are created to satisfy both familiar and new wants. This has important implications for entry. A monopoly that succeeds in preventing the entry of new firms capable of producing its current product will sooner or later find its barriers circumvented by innovations. A firm maybe able to use new processes that avoid some patent or other barrier that the monopolist relies on, to bar the entry of competing firms. Another firm may compete by producing a new product that, although somewhat different, still satisfies the firm might get around a natural mon opoly by inventing a technology that produces the good at a much lower cost than the existing monopoly firm’s technology. (The cost curve maybe lowered throughout this range, and the minimum level of costs may be reached at a lower output than previously thought). The new technology may subsequently allow several firms to enter the market and still cover costs. Matches and Mismatches with regard to the Literature review and the concept of Monopoly in Bank Profits. Most importantly, the Cruickshank report (2000), stipulates that there exists behaviour of a ‘Complex Monopoly’ between the big five UK high street banks in the banking industry and that this position has not been corrected by the government as at today. This tallies with the established theory of a monopoly, because the five high street banks are the dominant firms in the banking industry and so they have the market power to control the level of service that needs to be provided in the banking se ctor. Also, the fact that the banking industry is reported to be making supernormal profits of between  £3 to  £5 billion a year; why then do new players not enter the market? This tallies with the fact that there are serious technological barriers to entry and firm-created barriers to entry. Infact, most new entrants into the UK banking sector have tended to either merge or acquire a bank in the UK, so as to have a solid and useful foundation in order to gain entry into this sector. Additionally, the fact that banks treat their customers very shoddily while demanding sky-high charges for inferior products as stated in the literature review, tallies with the established theory of dead-weight loss. Due to monopoly power, the firm charges a high price, reduced output or poor quality products and services are provided to the consumer, which leads to an allocative inefficient market. This is very typical of the banking industry as mentioned in the literature review, with regar ds to the level of service and financial products provided by the major high street banks. This is why the Cruickshank report was commissioned by the government to investigate possible solutions to this very serious problem. One issue that doesn’t correlate with the literature review is the fact that under monopoly firm’s price discriminates, i.e. charging more than one price for the same product. However, it all boils down to the information that is provided to the customer. Now, it is not every banks business to inform a customer about what the other bank rates are of its major competitors. It is up to the customer to go and shop around for the best bank rates. SUMMARY AND CONCLUSION This paper has mentioned the five dominant banks in the UK banking industry, namely, HSBC, Royal Bank of Scotland, Barclays, HBOS, and Lloyds TSB. In the context of the literature review, the contending issues that relate to the profitability of banks in the UK, such as, poor le vel of service; innovation; not enough competition in the banking sector; the barriers to entry; proper information being provided with regards to what options customers have; and technological issues pertaining the clearance of cheques and withdrawals; are all scrutinized. Also one has used the concept of monopoly to explain the banking industry. Sub-issues under monopoly such as allocative inefficiency; entry barrier, such as barriers determined by technology and policy – created barriers are all mentioned. Finally, a look at any correlations or mismatches with regard to the literature review and the concept of monopoly is then put into play. As a whole it will be worthwhile to conclude that, as technology evolves and we humans evolve with technology, the barriers to entry within the banking sector will begin to breakdown. Why? Because it is more convenient, easier and cheaper, for customers to be able to carry-out transactions online, without a physical presence at a ba nk. Additionally, this will lead to reduced profits for banks; however, they will be able to tap into developing markets in order to revise methods for profit maximisation. Examples of which are HSBC’s acquisitions of small to big banking conglomerates around the world, which has more than tripled their profits. Thereby, in the long – run competition in these markets would become rife. REFERENCES AND BIBLIOGRAPHY British Bankers Association, (2005), Article,  £30 billion profits make UK banks ‘Jittery’. Bulletin in the Banking News and Comments. Lipsey, R.G., and Chrystal, K.A., (2004), Economics, Tenth Edition, Oxford University Printing Press. Financial Times, (2005), Article, UK Bank profits head for  £1,000 a second, 31/01/2005 Fraser, I., (2005), Their profit†¦Ã¢â‚¬ ¦. Whose Loss, Article in The Sunday Herald, 13/20/2005. The Financial Regulator, (2000), Re-writing the contract, Financial market trends, No. 75. The Herald , (2005), Article, Slow cash makes fast money. The Cruickshank Report, (2004), Competition in UK Banking. Consumers Association, (2004), Article, How can banks keep growing? The Evening Standard, February. Daily Express, (2005), Rip – off banks do loyal clients out of millions, in Your Money, March. ING Direct, (2005), Daily Express, Your Money, in article, Rip-off banks do loyal clients out of millions. The Guardian, (2005), in article, HSBC denies profits accusations, February. Weatherill, E., (2005), Independent Banking Advisory Service, in article, Banks blasted for their billions, Money Observer, April. Weatherill, E., (2004), Independent Banking Advisory Service, in article, Watch dog to quiz Bradford and Bingley on debt tactics, Sunday Express, June. 1 Footnotes [1] This law states that if one or more of the factors of production are fixed, e.g. land; increasing the inputs of the variable factors of production, i.e. labour, raw materials, etc are increased; will eventually lead to a diminishing marginal product.