An Analysis of the Proposed Merger Between Lloyds TSB Group Plc and Abbey National Plc.
An Analysis of the Proposed Merger Between Lloyds TSB Group Plc and Abbey National Plc
In 2001 the secretary of state referred the proposed acquisition of Abbey National Plc by Lloyds TSB Group Competition Commission for investigation to decide whether the merger was deemed to act for or against the public interest.
Lloyds TSB has for many years been one of the four leading clearing banks in the UK along with Barclays PLC, HSBC plc and Royal Bank of Scotland plc/National Westminster Bank plc, which make up the 'big four'. Lloyds has substantially increased in size and diversity of activities in the last six years as a result of other mergers, including that of TSB. Abbey National was the first building society to convert from mutual to public company limited company (plc) status. It has since developed into a full service retail and wholesale bank with 15 million customers in 2000, and is now the fifth largest banking group incorporated in the UK in terms of total assets.
The proposed horizontal merger between Lloyds and Abbey National qualified for investigation by the CC as it satisfied the Assets Test. Abbey National had total gross assets at 31 December 2000 of £204 billion, which exceeds the £70 million threshold set for the assets test. The share of supply test was excluded from consideration. The main markets to be investigated were; (i) markets for financial products sold to personal customers, in particular personal current accounts (PCA's) and (ii) markets for financial products sold to small and medium sized enterprises (SME's). The possible effects this proposed merger would have on these markets, as well as the overall effects of the merger on the public shall be considered.
The merger's largest effects are likely to be seen in the PCA market. This market is of particular importance as PCA's are also 'gateways' through which suppliers can sell other financial products. The market share of Lloyds TSB, already the market leader, would rise from 22 to 27% if the merger went ahead, widening the gap between its share and its nearest competitors. This marker power could be exploited by Lloyds at the expense of the public in terms of higher prices.
The theoretical reasoning behind this is that a more imperfect market could lead to a dead-weight loss to society, in which the consumer surplus is decreased and the price increased. The is because Lloyds will be the market leader and will produce where its marginal cost is equal to its marginal revenue, which will be at a lower output and higher price than in perfectly competitive market. As a result consumer surplus is converted into producer surplus, acting against the public interest (Sloman, 1991)
The significant market power that Lloyds would gain from the merger in the PCA market would lead to a lack of Pareto optimality, that is, the market would fail to equate marginal social benefit (MSB) and marginal social cost (MSC). The graph below shows the effect of a firm behaving monopolistically on society:
In an imperfect market, the firm will face a downward sloping demand curve, and therefore marginal revenue is below average revenue (or price). Profits will be maximised where marginal revenue equals marginal cost. Price is above marginal revenue and so is above marginal cost. If there are no externalities then P= MSB and MC= MSC, the firm will produce less than the Pareto optimal output, because if price is greater than MC, then MSB must be greater than MSC. The Pareto optimum would be achieved at a higher output where P= MC and so MSB=MSC. It can be seen above that the Pareto optimum is found at an output of Q2, however in an imperfect market the firm will produce at the output Q1, which is against the public interest. (Sloman 1991)
The combined share of the PCA market held by the big four banks would increase from 72 to 77%. In terms of The Herfindahl-Hierschman Index (HHI) for current accounts, a Lloyds TSB/Abbey National combination would see an increase of 318 to 1,849, a significant increase in an already concentrated market (CC, 2001). The merger would effectively consolidate the stranglehold which the big four currently have on the PCA market.
An increase in the concentration of market power among the big four could lead to a stronger oligopoly, with higher entry barriers, less competition and more collusive practise, which would act against the public interest.
As the market becomes more concentrated among the big four, they will be able to achieve greater economies of scale and will have the advantage of an established brand and network of branches and ATMs. Any potential new entrants would face high entry costs and difficulty in posing real competition to the big four.
There are a number of features of ...
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An increase in the concentration of market power among the big four could lead to a stronger oligopoly, with higher entry barriers, less competition and more collusive practise, which would act against the public interest.
As the market becomes more concentrated among the big four, they will be able to achieve greater economies of scale and will have the advantage of an established brand and network of branches and ATMs. Any potential new entrants would face high entry costs and difficulty in posing real competition to the big four.
There are a number of features of the PCA market, which make it particularly vulnerable to tacit collusion in pricing. These are; product homogeneity, many small customers lacking buyer power, transparent prices, stable demand and similarity of size and cost structure among suppliers. A habit of cooperation has also developed between banks in the operation of payment networks and there is little evidence to suggest that the big four compete keenly on price for the bulk of their customers (CC, 2001). The merger's effect on increasing the concentration of market share among the big four would increase the likelihood of tacit collusion and other forms of anti-competitive behaviour. The industry may experience dominant firm price leadership, in which the market leader, Lloyds, sets its price where its marginal cost is equal to its marginal revenue in order to maximise profits, a price which the other firms follow.
Increasing the market concentration for PCAs could also potentially lead to greater price inelasticity of demand, acting against the public interest. If the combined share of the big four increased to 77% their grip on the banking network as a whole will be tightened. As a result, the public will become more dependent on these banks, giving them a more inelastic demand curve.
The merger could act against the public interest if it led to 'back-book' pricing whereby established customers are left with worse terms than those offered to customers when new products are introduced. For example the merged firm may introduce a new service which offers new customers some sort of preferential treatment for a limited period.
Research shows that the PCA market is characterised by customer inertia and so suppliers must compete on price to lure customers to change banks. Firms with low market share tend to grow (or sow) their share by competing aggressively through price, while those with high market share tend to exploit (or harvest) theirs by increasing margins on their existing customer base. One argument is that the merger would replace a firm in sowing phase (Abbey National), with one in harvesting phase (Lloyds TSB), to the detriment of consumers.
The likely effect the merger has on innovation must also be considered. A major concern of allowing the merger is that the newly formed company with high market share would have less incentive to innovate. If the merger did not go ahead, smaller companies like Abbey National would continue to innovate in order to differentiate themselves from the big four, passing on the benefits to the public, in the form of a better service. This may not be the case if the merger went ahead.
It could be argued that the merger would lead to greater profits made by Lloyds which would then be reinvested to fund innovation. This is illustrated below:
Assuming the merged company seeks to maximise profits, it will produce at an output Q1 where marginal cost equals marginal revenue, giving a price of P1. The supernormal profits are shown by the shaded rectangle. These supernormal profits can then be ploughed back into increasing the level of innovation. The merged firm will also benefit from the combined expertise of both Lloyds and Abbey National.
However, the removal of Abbey National, as one of the most significant independent competitors to the big four is a major argument against the merger. Abbey National offers a distinct alternative to the big four banks and is one of only two providers (along with Halifax) able to pose a sustainable challenge to the big four in the PCA market. The preservation of 'mould breaking' firms that are able to successfully challenge the big four is crucial as it ensures the public benefits from competition in terms of lower prices, higher levels of innovation and a better service. The removal of Abbey National would lead to a reduction in competition in the PCA market than would otherwise exist. This reduction in competition would have adverse effects in the form of higher prices (higher fees and overdraft rates, and lower interest on credit balances) and a loss of innovation.
Lloyds argued that Abbey National's role in the competitive process was not of great significance and that its removal would not act against the public interest. It was argued that Abbey National is not a 'maverick' player or a price leader and that it was concentrating on other markets and had lost focus on the PCA market. Halifax on the other hand could provide vigorous competition in the PCA market and could realistically prevent the merged firm from abusing their market power.
The view could be taken that changing conditions in the PCA market, such as advances in technology, new entry, the introduction of enhanced services and an increase rate of switching is facilitating the emergence of firms that could potentially pose a threat to the big four. For example, new online banks that have lower overhead costs can afford to offer better rates, which could win them a larger share of the market, leading to more price competition. However, at the moment it seems that customers prefer established banks, which offer Internet banking as part of a full range of services. Therefore this sort of competition may be insufficient to constrain the anti-competitive policies of the big four.
In terms of the savings and mortgage markets, the proposed merger would not act against the public interest. There are far more suppliers of savings products than of PCAs and growth and switching is much easier. The market is therefore perfectly competitive and would not face the same problems of concentrated market power if the merger went ahead. Under perfect competition, the firm will produce at the bottom of their average cost curves and the price is given where the demand equals the marginal cost, closer to the Pareto optimum. This is a greater quantity and lower price than is found in an imperfect market and results in a larger consumer surplus.
The loss of Abbey National as an independent competitor in the savings market would not act against the public interest as it would in the PCA market. Similarly, the mortgage market would not be adversely affected. The HHI would increase from around 860 to 1,110 and the four-firm concentration ratio would increase from 51 to 58% (CC, 2001). However, there are many suppliers (over 100) and entry is not difficult. There is now considerable competition in the market and so any supernormal profits made by a leading firm will be competed away in the long run by the entry of new competitors. The merger would not damage competition and the public will not lose out.
The effect that the merger has on the SME market and whether the resulting situation is against or in favour of the public interest is more debatable.
On the one hand, the merger could be seen to work against the public interest by removing Abbey National, in terms of reducing competition in an already highly concentrated market. Abbey National is a small player but has the necessary attributes to expand successfully such as an established brand name, a national network of branches and a presence in personal and some business banking markets. The merger would eliminate one of the very few players outside the big four which could potentially contest this market. The merger would therefore lead to higher prices for SME services and lower innovation than could be expected in the absence of the merger.
On the other hand, both Lloyds and Abbey National have a relatively small market share in the SME market and consequently the merger may have little effect on current concentration of supply in this market. The merger would not limit any potential competition in the SME market as there are several other firms equally able to enter the market. The merger would allow another competitor into the market, increasing competition further and benefiting the public.
The merger could potentially act against the public interest if it had harmful effects on cross-selling. If Lloyds achieves a higher level of cross-sales than Abbey National and the additional products sold were worse value for money than those which the customer would otherwise have bought, then the merger is not in the public interest.
The proposed merger would be expected to create synergy benefits for Lloyds TSB, however this may or may not be passed on to consumers. It could be argued that the merger will create significant cost savings, resulting in efficiency gains, which will be passed to customers in the form of price reductions, an improved service and an extended product range. There would also be benefits of the enlarged group's combined investment in telephone banking and Internet services.
However, it could be argued that the markets are competitive and so Lloyds would be obliged to compete on price regardless of the merger. The synergies it gained from the merger would simply put it in a better position to reduce prices without damaging profitability. However, Lloyd's has not reduced prices previously and so there is no guarantee that these synergy benefits will now be passed onto consumers in the form of lower prices.
In deciding whether to allow the merger, the commission must weigh up the relative benefits of the merger in terms of increased efficiency and increased market power. This is shown in Williamson's Naïve Tradeoff model below (O.E Williamson, 1968)
The horizontal, AC1 line represents the level of average costs of the two firms before the merger, while AC2 shows the level of costs after the merger. The price before the merger is given by P1 and is equal to AC1. The price after the merger is given by P2 and exceeds P1 caused by increased market power. This increase in price causes a dead-weight welfare loss to society, which is shown in the area A1. But since the average costs are reduced by the merger, the area that represents cost savings, A2, must also be taken into account. The net effect of the merger is the difference between A2 and A1. If this is positive, that is the cost savings exceeds the dead-weight loss, then the net allocative effect of the merger is positive (American Economic Review, 1968)
However, a positive net effect means there are economic gains from the merger, it does necessarily mean that the public benefits. Although the merger has led to greater efficiency, in terms of lower average costs, this is coupled by an increase in price that has resulted from greater market power. The graph illustrates that despite there being efficiency gains, due to the nature of imperfect markets the merger acts against the public interest in terms of higher prices.
The merger could also be seen to adversely effect the public in terms of choice and convenience. Lloyds may not choose to continue certain elements of Abbey National's product portfolio which have provided greater choice for consumers. Also, customers who chose Abbey National because its local branch was convenient may suffer some inconvenience if that branch closed as a result of the merger. It is estimated that Lloyds would close 600 branches which would inevitably cause a reduction in service quality for some customers.
The Commission came to the following conclusions:
* The merger would reduce competition in the PCA market and adverse consequences could be expected to result.
I would agree with this conclusion as the merger would increase the level of concentration the big four have in the market, making it very difficult for other independent competitors to pose a real threat to them. This will have adverse consequences on the public in the form of higher prices and less innovation.
* The merger will not dramatically affect competition in any other individual market for personal financial products in which both Lloyds TSB and Abbey National operate.
I would agree with this as other markets are not so highly concentrated. There are fewer barriers to entry and more suppliers, making it a competitive market, where the public benefits.
* In relation to the market for the supply of banking services to SMEs, the merger would reduce competition, with adverse consequences for the consumers of those services.
I agree with this conclusion as the loss of Abbey National as a potential independent competitor will reduce competition in this market, acting against the public interest.
* The merger would lead to efficiency gains but these would not be passed on to consumers in the form of reduced prices.
It is difficult to say whether efficiency gains will be passed on, however, due to their strong market position, I do not think that Lloyds have a great incentive to pass on the efficiency gains in lower prices.
* The merger would have an adverse effect on consumer choice and innovation.
I would agree with this as it is clear that certain products offered by Abbey National will not be available once the merger has taken place. Losing Abbey National as an independent competitor, would also be likely to lead to a decrease in innovation.
Recommendation
The Commission concluded that the merger between Lloyds TSB and Abbey National would act against the public interest. Prohibiting the merger is the only remedy capable of fully addressing the adverse effects associated with the merger.
I would agree with the Commissions recommendation as it seems that the merger would certainly lead to less competition in both the PCA and SME markets, resulting in adverse effects on the public.
However, subsequent changes to the banking market must also be taken into consideration when making a judgement on this decision taken in 2001. The most notable change is that Halifax has merged with bank of Scotland to form HBOS. The possibility of this merger taking place was considered in the Commissions report but its effect on the PCA market was expected to be small. It was not expected that synergies gained from the merger would be used to fund a more competitive stance in the PCA market.
I would argue that the Commission underestimated the impact that the HBOS merger would have on competition and market share, particularly in the PCA market. The HBOS merge has created a fifth force that has the necessary network and customer base to pose aggressive competition to the big four. In hindsight, allowing the Lloyds/Abbey National merger may not have acted against the public interest, given the heightened competition created by the HBOS merger. The merger could be re-assessed, taking these recent changes to the market into consideration.
Bibliography
Primary Source:
Competition Commission: Lloyds TSB Group Plc & Abbey National Plc, A Report on the Proposed Merger, July 2001, Part 1: Summary & Conclusions (www.CompetitionCommission.org.uk)
Secondary Sources:
Carlton & Perloff (2000) Chapter 2, pp.19-28, 'Mergers and Acquisitions' from Modern Industrial Organisation, 3rd Edition,
Carlton & Perloff (2000) Chapter 3, pp.56-86, 'Competition' from Modern Industrial Organisation, 3rd Edition,
Carlton & Perloff (2000) Chapter 19, pp.624-628, 'Antitrust laws and policy' from Modern Industrial Organisation, 3rd Edition,
Sloman, J. (1991) Chapter 6, pp.214-225, 'Profit Maximization Under Imperfect Competition ' from Economics, Prentice Hall
Sloman, J. (1991) Chapter 10, pp.362-384, 'Markets, Efficiency and the Public Interest' from Economics, Prentice Hall
O. E. Williamson (1968) 'Economies as an Antitrust Defence: The Welfare Trade-offs', American Economic Review, Vol 58, March 1968, pp. 18-36
Student ID: 322148
