GREAT FIRE - TOO CONVENIENT!

Economic and financial recovery is like the film Restoration (1995) from the book by Rose Tremain has drama just like our present recession. The story begins with young doctor, Robert Merivel (Robert Downey), in service of King Charles II (Sam Neill) after saving the King's spaniel. Merivel enjoys a life of hubris and careless pleasure at court, until the King orders Merivel to wed Celia, the King's mistress, basically to get the assets off balance sheet and fool other mistresses. The film opened as world bond markets went into meltdown. At the pre-screenings, the test audiences (Califormian muesli types) the written comments complained that The Great Fire of London seemed like an all too convenient plot device for resolving the story. Harv' Weinstein, a genius producer, furiously dipping into his jelly babies and diet cokes, foresaw a solution and this is why the final film is the first to open with a credits crunching sex scene (that was shot and edited by my brother Laurence - a brilliant cinematographer by the way).
What makes me think of this on the day of the HBOS shareholders' general meeting and vote on the Lloyds TSB takeover (a vote that looks like a totally foregone conclusion) is that I just hope they too have the insight to say hang on, something's just too convenient here, we're being tricked into selling out far too cheap!? The answer stands or falls on how unavoidably and all-destructive the Great Fire or Credit Crunch recession really is for these banks?
This morning, I also get an insightful email from Melvyn Bragg about the Great Fire: "Here are some observations and excerpts from the two great London diarists of the time, Samuel Pepys and John Evelyn. It seemed that people looked first and foremost to saving their own goods and getting out of the path of the flames, rather than considering what might be the best way to act in order to stop the fire outright. Pepys described in his diary entry [a dossier by a Government official that remained secret for 200 years] on 2nd September how he observed “Everybody endeavouring to remove their goods, and flinging into the river or bringing them into lighters that lay off; poor people staying in their houses as long as till the very fire touched them, and then running into boats, or clambering from one pair of stairs by the water-side to another…Having staid, and in an hour's time seen the fire rage every way, and nobody, to my sight, endeavouring to quench it, but to remove their goods, and leave all to the fire…” Pepys described the voracity of the fire in great detail and wrote how,as he walked along with his wife “all over the Thames, with one's face in the wind, you were almost burned with a shower of firedrops. This is very true; so as houses were burned by these drops and flakes of fire, three or four, nay, five or six houses, one from another. When we could endure no more upon the water; we to a little ale-house on the Bankside, over against the Three Cranes, and there staid till it
was dark almost, and saw the fire grow; and, as it grew darker, appeared more and more, and in corners and upon steeples, and between churches and houses, as far as we could see up the hill of the City, in a most horrid malicious bloody flame, not like the fine flame of an ordinary fire…We staid till, it being darkish, we saw the
fire as only one entire arch of fire from this to the other side of the bridge, and in a bow up the hill for an arch of above a mile long: it made me weep to see it. The churches, houses, and all on fire and flaming at once; and a horrid noise the flames made, and the cracking of houses at their ruins. So home with a sad heart…” (entry for 2nd September)
The diarist and town-planner, John Evelyn, described in his diary of 2nd September how the fire “continued all this night, which was as light as day for ten miles round, in a dreadful manner, I went on foot to the same place. The conflagration was so universal, and the people so astonished, that from the beginning they hardly stirred to quench it, so that there was nothing heard or seen but crying out and
lamentation, running about like distracted creatures, without attempting to save even their goods. It leapt after a prodigious manner from house to house, and street to street, at great distances one from the other. Here we saw the Thames covered with goods floating, all the barges and boats laden with what some had time and courage to save. And the fields for many miles were strewn with movables of all sorts, and tents erecting to shelter both people and what goods they could get away. Oh, the miserable and calamitous spectacle! London was, but is no more!”
For London then read Edinburgh and Scotland today!

WHEN BANKS MERGE?

The merger of Lloyds TSB and HBOS is at risk of becoming a nightmare for both banks at a time when there are nightmares a plenty in the markets and the economy. This is a time for J. Shumpeter's 'creative destruction' (see comment below). It will be two steps back for one step forward. Why?
Lloyds TSB expects to integrate HBOS and achieve 'synergies'. At the same time the whole of both banks have to be shrink-washed, assets run-down and a new economic capital model created as condition of redeeming the Government's 43+% shareholding. Lloyds is already planning what to writedown and sell-off including talking with potential buyers for this or that even before the deal is finally certain. HBOS has moved half a £billion of PFI assets off balance sheet and sold some non-banking holdings as well as Westpac Bank (for a fraction of its book value). In the merger process 20,000 jobs are expected to be cut. HBOS staff can expect to bear the brunt of this and they are all distinctly queasy, angry, and unhappy. What is the risk-value of merging with a distressed bank and uncooperative, or let's say less than enthusiastic, staff? Lloyds will use as its template how Royal Bank of Scotland integrated the operations and systems of NatWest a decade ago. That time the cost (external not internal) was somewhere in the region of £3 billions. Cost savings, called 'synergies', are expected to be worth £1.5bn a year. But it will take several years to get to that. HBOS's internal systems are probably much supperior to Lloyds, but Lloyds has the whip hand in this merger. Lloyds general ledger core accounting is reputedly a 30 year old model long past its replacement date. A 4 year old project to modernise financial reporting within the bank has been cancelled half way through? HBOS had problems in integrating with Halifax. But this was a merger of equals (financially) and much effort was expended to choose and keep the best, and anyway the two bamks had so many complementarities that integrating into a single contiguous system at all levels and across all business units was thankfully not worth doing.
Deloittes, the audit and consulting firm, emailed me recently about bank mergers to say, "...All those dreams of capturing synergies through higher revenues and lower costs may turn to dust if you don’t incorporate information technology (IT) into the integration process from start to finish. By failing to invite IT to the party, companies may overpay for an acquisition and suffer buyer’s remorse down the road. And once the transaction is completed, IT still has a crucial role to play in whether the expected synergies actually deliver on the promise of the deal. Here’s the bottom line: Integration without IT is no integration at all". Synergies, if narrowly cost-ratio determined, are illusory anyway in my extensive experience - they are demanded by stock market analysts as a fig-leaf wanting to be told the values-added of "why buy?", when the real why buy is simply for bigger market share. But, when two big players merge in markets where players trade directly with each other, the merger wipes out a large slice of the markets' in depth liquidity. And this also happens in domestic traditional banking. A lot of assets are borrowings by households and businesses merely to re-cycle other loans with other lenders. So when LTSB and HBOS merge they make UK domestic banking volume smaller. The 'velocity of capital' in the UK economy will fall significantly, and do so when it is alreday falling too much anyway (credit crunch + recession). This is not good for anyone. Mergers in such conditions will find that expected gains prove largely illusory, a mirage in a fast desertifying landscape.
M&A projects all too readily assume integration is worthwhile and forgets that one or more company cultures (internal brand value, procedures & processes - very delicate) is destroyed and a new culture has to be created. This is why it is two steps back for one step forward. It is like taking two different very fine highly elaborate swiss watches, taking them to bits and trying to build a new watch with a mix of bits from both the originals. It doesn't work. So what happens - a whole new bank infrastructure and IT systems need to be bought in, tailored, legacy data populated into new gone live systems, tested and tested again many times, rolled out operationally, training and more training, bug fixing and more bugs - an endless cycle of improvements and replacement that should take normally no more than 18 months but will take a full 5 years, by which time half of everything is outdated and needs replacing again!
Far better is to maintain the banks as separately operating entities under a holding company and only judiciously integrate beginning at the top and moving down layer by layer and business unit by unit only as and when business cases are convincing and change necessary. Cultural changes take time. Banks are not standard machines; they are people businesses with quirky and highly-elaborated unique systems that are very complicated to intergrate. There is no way that everything can be changed at the same time. This would overwhelm management resources as well as intellectual and technical skills available to the bank and available in the marketplace. Some people use the analogy of merging two railways with different gauge size of tracks. It is not like that. My advice: forget root and branch integration synergies and stick to what really matters especially at this time which are economic risk management and financial risk accounting.

MAG v. Secretary of State (Lloyds TSB takeover of HBOS)

In this case before the Competition Appeal Tribunal Merger Action Group (www.mergeractiongroup.org.uk) challenges the Secretary of State's assertion (a Government discretionary decision, 18 & 31 September) that the takeover of HBoS by LTSB not be referred to the Competition Commission (CC) because the public interest of Financial Stability is greater than competition issues. In effect, Government (and the two banks) either know and accept that competition in UK domestic banking will suffer and/or they have good grounds for believing this merger is so urgently vital in the interest of the stability of the UK financial system that there is no time for a referral, and/or the Government has good grounds for believing this merger would not be against the public interest to have competitiveness among UK banks maintained.
The two banks will enjoy roughly 30-40% of UK domestic banking, which is twice the level considered a 'dominant' position. To be in a position of dominance, a business must have the ability to act independently of its customers, competitors and consumers. Establishing if a company is dominant requires a complex assessment of a number of elements but, as a general rule, if a business has a 50% market share there is a presumption that it is dominant. However, dominance has been found to exist where market share is as low as 40% and even 15%. To be a major player in a market only requires 5% market share. Under EU law, Article 82 requires dominance in a substantial part of the European Union, but there is no requirement under Chapter II that a dominant position must be held in a substantial part of the UK, meaning that, in theory at least, dominance could be considered to exist in a fairly small area of the UK e.g. Scotland or North of England or even a sub-region.
Having a dominant position does not in itself breach competition law. It is the abuse of that position (or the potential for likely abuse in the absence of safeguards) that is prohibited. Examples of behaviour that could amount to an abuse by a business of its dominant position include:
- imposing unfair trading terms, such as exclusivity e.g. in factoring by banks;
- excessive, predatory or discriminatory pricing e.g. in mortgages;
- refusal to supply or provide access to essential facilities e.g. SME overdrafts;
- tying e.g. stipulating a customer for one loan product must also purchase all or some of a second product such as insurance.
In this context it is a powerful statement by the OFT that competition will be damaged according to the conclusions of its report, which is why MAG wants the merger referred to the CC. Exceptions may be sought if some other larger benefit of the merger is sufficient to substantially outweigh a loss of market competitiveness. And this benefit should be long term, not just a short term benefit! But, as Sir Ian Burt and Sir George Mathewson reasonably stated (two senior bankers who should know intimately about these things) in their published letter, financial market conditions have changed since 18 September such that financial stability should not be an issue following the Government's intervention (£56bn) to supplement the reserve capital of UK banks of systemic importance. Therefore, they say that the benefit of financial sector stability is no longer served by this merger and no longer relevent as a reason for not referring the merger to the CC. The Government based its decision on the views of the FSA, which MAG asserts are irrelevent and/or has failed to respect section 46(2) of the Competition Act (1998) and is seeking an order quashing the Secretary of State's decision pursuant to the power conferred by section 120(5) of the Act.
Clearly, stability is a short term concern while market competitiveness is a longer term concern. But, the latter appears to be of substantially less importance to Government (deciding on behalf of the general public interest). The Government's reliance on advice from the FSA is odd insofar as it is the Bank of England, not the FSA, that is responsible for UK financial sector stability. The FSA is responsible for UK financial sector resilience. If the Government's decision had been based on 'resilience' not 'stability' its argument might appear more valid. There is absolutely nothing in the Bank of England's many reports, especially in any of its Stability Reports/Reviews that indicate bank mergers as a factor of interest or concern in this context? The FSA states on its website merely, "The announcement of the proposed merger with Lloyds TSB is a welcome move as it is likely to enhance stability within financial markets and improve confidence among customers and investors in the UK financial sector." There is no basis offered for this claim? The FSA adds that "The merger will be subject to shareholder approval and approval by the FSA, OFT and some overseas regulators." But, the OFT does not approve. On 24th October it recommended referring the merger to the CC, advice overriden at the discretion of the Secretary of State on 31st October. The report, which the OFT submitted to the Secretary of State on 24 October 2008, contains the following advice and decisions: there is a realistic prospect that the anticipated merger will result in a substantial lessening of competition in relation to personal current accounts (PCAs), banking services for small and medium sized enterprises (SMEs) and mortgages . The OFT's concerns on PCAs and mortgages are at the national (Great Britain) level, while its concerns on SME banking services are focused on Scotland. In addition, the OFT cannot exclude competition concerns arising at the local level in relation to PCAs and SME banking services. No further competition concerns are considered to arise in relation to the other identified overlaps between the parties in retail banking (savings, wealth management, personal loans, credit cards and pensions), corporate banking (banking services to large corporations, asset finance/fleet car hire) and insurance (PPI, life, general), and in the absence of any offer of remedies from the parties, it would not be appropriate to deal with the competition concerns arising from the merger by way of undertakings in lieu of reference to the Competition Commission. The OFT finds that the combined market share of HBoS & LTSB would be 30-40%! The challenge by the Merger Action Group (MAG) should be allowed to challenge the basis for the Government's belief i.e. whatever technical advice it received whereby it considered it could anticipate or make unnecessary a full enquiry by the CC. Information required from the two banks on this question are determined to be business-confidential and therefore can be delivered in summary only to MAG and the Tribunal?

NOTES
Details of Competition Appeal Tribunal procedures are at www.catribunal.org.uk
Merger Action Group (“the Applicant”), is an unincorporated association of persons and businesses established in Scotland, challenging a decision by the Secretary of State for Business, Enterprise & Regulatory Reform (contained in a document entitled “Decision by Lord Mandelson, the Secretary of State for Business) not to refer to the Competition Commission the merger between Lloyds TSB Group plc and HBOS plc under Section 45 of the Enterprise Act 2002 dated 31 October 2008” (“the Decision”). On 18 September 2008, the former Secretary of State, the Rt. Hon. John Hutton, issued a notice to the Office of Fair Trading (“OFT”) pursuant to section 42 of the Act (“the intervention notice”) stating that the stability
of the financial system in the United Kingdom ought to be specified as a public interest consideration in section 58 of the Act. The Secretary of State further stated that the stability of the UK financial system may be relevant to a consideration by the OFT of the merger situation arising out of the proposed merger
announced by Lloyds TSB Group plc (“Lloyds TSB”) and HBOS plc (“HBOS”) on 18 September 2008 (“the Merger”).
The intervention notice required the OFT to investigate and provide a report to the Secretary of State in accordance with section 44 of the Act within the period ending on 24 October 2008. The intervention notice also indicated that the Secretary of State would lay before Parliament for its approval an affirmative resolution to specify the new public interest consideration under section 58 of the Act. The relevant order completed Parliamentary scrutiny on 23 October 2008 and came into force on 24 October. The new public interest consideration has been added to the Act as section 58(2D). The OFT produced a report under section 44 of the Act dated 24 October 2008 entitled “Anticipated acquisition by Lloyds TSB plc of HBOS plc” (“the Report”)2. The Report includes decisions to the effect that it is or may be the case that arrangements are in progress or in contemplation which, if carried into
effect, will result in the creation of a relevant merger situation and the creation of that merger situation may be expected to result in a substantial lessening of competition (“SLC”) within a market or markets in the United Kingdom for goods or services, including personal current accounts, banking services to small and
medium enterprises and mortgages such that further inquiry by the Competition Commission (“the CC”) is warranted. The Report also provides that any relevant consumer benefits did not outweigh the SLC and it would not be appropriate to deal with the matter by way of undertakings under paragraph 3 of Schedule 7 to the Act. In deciding whether to make a reference to the CC under section 45 of the Act, the Secretary of State is required, under section 46(2) of the Act, to accept the decisions of the OFT as to the creation of a relevant merger situation which may be expected to result in SLC.The Decision states that the new public interest consideration contained in section 58(2D) of the Act, the stability of the UK financial system, is relevant to this case and that taking account only of the SLC and the public interest consideration, the Secretary of State believes that the creation of the relevant merger situation is not expected to operate against the public interest. The Secretary of State considers that the Merger will result in significant benefits to the public interest as it relates to ensuring the stability of the UK financial system and that these benefits outweigh the potential for the Merger to result in the anti-competitive outcomes identified by the OFT. The Decision (www.berr.gov.uk/files/file48745.pdf) states that no reference will be made to the CC (Competition Commission).

REFERENCES
1998 Competition Act - http://www.statutelaw.gov.uk/legResults.aspx?LegType=All+Primary&PageNumber=18&NavFrom=2&activeTextDocId=1455848
Case Name: Merger Action Group v Secretary of State for Business, Enterprise and Regulatory Reform
Case Number: 1107/4/10/08 Date Registered: 28 November 2008
Status: Summary of application published on 1 December 2008. By an Order of the President, made on 1 December 2008, the time for making a request for permission to intervene was abridged until 5.00pm on 2 December 2008. A case management conference took place on 3 December 2008 when HBOS plc and Lloyds TSB Group plc were granted permission to intervene. A hearing has been fixed for 12pm on 8 December 2008 with a time estimate of one day.
Tribunal: President - Sir Gerald Barling, Michael Blair QC, Professor Peter Grinyer
Documents: Order of the Tribunal (Confidentiality ring) - (17Kb) 03 December 2008
Order of the Tribunal - (17Kb) 03 December 2008 (http://www.catribunal.org.uk/documents/Order_proceedings_1107_Merger_031208.pdf)
Order of the President (abridging time for requests for permission to intervene) - (14Kb) 01 December 2008 (http://www.catribunal.org.uk/documents/Order_confidentiality_1107_Merger_031208.pdf)
Summary of application - (42Kb) 01 December 2008
http://www.catribunal.org.uk/documents/Summary_1107_MergerActionGroup_011208.pdf