Anticipated acquisition by Lloyds TSB plc of HBOS plc Report to the Secretary of State for Business Enterprise and Regulatory Reform 24 October 2008 Contents I OVERVIEW................................................................................................ 4 Conclusions............................................................................................... 4 Merger jurisdiction...................................................................................... 5 Substantive competition assessment............................................................. 5 Remedies................................................................................................... 7 Public interest consideration......................................................................... 7 II PROCEDURAL OVERVIEW ........................................................................... 8 III PARTIES AND TRANSACTION.....................................................................10 The parties................................................................................................10 Transaction rationale..................................................................................10 IV JURISDICTION AND LEGAL TEST................................................................11 V THE COUNTERFACTUAL............................................................................13 Introduction to the OFT's general approach to the counterfactual.....................13 The appropriate counterfactual in this case ...................................................14 Conclusion on the counterfactual.................................................................23 VI AREAS OF OVERLAP .................................................................................25 VII PERSONAL CURRENT ACCOUNTS...............................................................27 Market definition........................................................................................27 Horizontal assessment................................................................................29 Conclusion................................................................................................41 VIII BANKING FOR SMES .................................................................................44 Market definition........................................................................................44 Horizontal assessment................................................................................45 Conclusion................................................................................................52 IX MORTGAGES............................................................................................53 Market definition........................................................................................53 Horizontal assessment................................................................................53 Conclusion................................................................................................58 X AREAS IN WHICH COMPETITION CONCERNS DO NOT ARISE.........................60 Introduction..............................................................................................60 Savings....................................................................................................60 Personal loans...........................................................................................61 Credit cards..............................................................................................62 General insurance......................................................................................63 Payment protection insurance......................................................................64 Wealth management ..................................................................................68 Pensions...................................................................................................68 Banking services to large corporations..........................................................69 Treasury and capital markets.......................................................................69 Asset finance – fleet car hire.......................................................................70 Life insurance............................................................................................71 XI COORDINATED EFFECTS THEORIES CONSIDERED BY THE OFT......................73 Introduction..............................................................................................73 Financial products sold to larger firms and wholesale banking..........................74 Financial products sold to personal customers and SMEs ................................74 Conclusion................................................................................................79 XII NON-HORIZONTAL THEORIES CONSIDERED BY THE OFT..............................80 XIII EFFICIENCIES............................................................................................81 XIV SUMMARY OF VIEWS OF INTERESTED PARTIES ON THE IMPACT OF THE MERGER ON COMPETITION................................................................................84 Introduction..............................................................................................84 PCA.........................................................................................................84 SMEs.......................................................................................................85 Mortgages................................................................................................85 PPI...........................................................................................................87 Savings....................................................................................................88 Personal loans...........................................................................................89 Credit cards..............................................................................................89 General insurance......................................................................................90 XV SUMMARY OF VIEWS OF INTERESTED PARTIES ON THE PUBLIC INTEREST CONSIDERATION..............................................................................................91 Merging parties..........................................................................................91 Tripartite Authorities..................................................................................92 Third parties in the financial sector...............................................................92 Consumer interest groups...........................................................................93 Other representations.................................................................................94 XVI REMEDIES – UNDERTAKINGS IN LIEU..........................................................95 Relevant principles.....................................................................................95 Assessment..............................................................................................96 XVII ASSESSMENT AND REPORT.......................................................................97 Assessment..............................................................................................97 Advice......................................................................................................98 ANNEXE 1 – INTERVENTION NOTICE..................................................................99 ANNEXE 2 – COPIES AND EXTRACTS OF SUBMISSIONS ON THE PUBLIC INTEREST CONSIDERATION............................................................................................100 Lloyds and HBOS.....................................................................................100 Tripartite Authorities................................................................................106 Third parties active in the financial sector ...................................................140 Consumer interest groups and other responses............................................148 3 I OVERVIEW CONCLUSIONS 1. The Office of Fair Trading (OFT) hereby reports to the Secretary of State for Business Enterprise and Regulatory Reform (the Secretary of State) in relation to the anticipated acquisition by Lloyds TSB Group plc (Lloyds) of sole control of HBOS plc (HBOS) which was announced on 18 September 2008 (the transaction). On 18 September 2008 the Secretary of State, in exercise of his powers under section 42(2) of the Enterprise Act 2002 (the Act), gave a public interest intervention notice (the Notice) to the OFT and required it to investigate and report on the transaction in accordance with section 44 of the Act within the period ending on 24 October 2008 (see Annex 1 for the Notice). 2. As required by section 44(4) of the Act, the OFT's report contains four principal 'decisions'. These are that the OFT believes 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 • 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 (SMEs), and mortgages, such that further inquiry by the Competition Commission (CC) is warranted • any relevant customer benefits in relation to the creation of the relevant merger situation concerned do not outweigh the substantial lessening of competition and any adverse effects of the substantial lessening of competition, and • it would not be appropriate to deal with the matter by way of undertakings under paragraph 3 of Schedule 7 to the Act. 3. The OFT accordingly reports and advises in accordance with sections 44(3) and (4) of the Act that the test for reference to the CC on competition grounds contained in section 33 of the Act is met. MERGER JURISDICTION 4. The OFT believes 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 because as a result of this transaction Lloyds and HBOS will cease to be distinct, and given that HBOS's UK turnover is above £70 million the turnover test in section 23 of the Act is met. SUBSTANTIVE COMPETITION ASSESSMENT 5. The OFT's competition review in this case involves a predictive merger assessment of financial markets in the UK (and also globally) that are currently experiencing extraordinary turbulence and change. These uncertain conditions, as exogenous forces affecting the market being investigated, are a reason for caution. 6. The OFT assessed the merger against two counterfactuals that it considered to be the most realistic to occur in absence of the merger: • In the short-term, HBOS remaining in the market with some form of Government support (the 'Stage I counterfactual'), and • In the medium to long-term, following withdrawal of the Government's support, the sale of HBOS to a 'no overlap' third party (one that does not raise competition concerns) or an independent HBOS once again (the 'Stage II counterfactual'). 7. Against one or both counterfactuals, the OFT considers that there is a realistic prospect of an SLC in three areas: personal current accounts (PCAs), SME banking and mortgages. More specifically, the OFT has medium to long-term concerns (Stage II) in relation to all three product areas, and in addition short- term concerns (Stage I) in relation to PCAs and SME banking. 8. In relation to PCAs, the OFT has concerns at the national (Great Britain) and local levels. The merger will remove a firm, HBOS, that was (at least until less than two months ago) a major driver of competition in the market, and strengthen the current market leader, Lloyds. In addition, the merger will significantly increase Lloyds' share of the market. As a consequence of its increased market share, coupled with characteristics of the market such as high levels of customer inertia and a limited degree of price discrimination, it is expected that its incentives to compete for new customers (and those of the other major banks in the market) will be diminished – in essence, the increase in 5 Lloyds' customer base will encourage it to attach more weight to enhancing margins on current customers than to customer acquisition. 9. In relation to SME banking, the OFT's concerns are focussed on Scotland and are similar to those in relation to PCAs - the increased incentive on Lloyds to enhance its margins on current customers. The OFT also cannot exclude competition concerns arising at a local level across Great Britain. 10. In relation to both of these markets, the OFT's belief that the merger will result in an SLC is not formed on the balance of probabilities; rather, its belief is of a 'realistic prospect' of SLC under the 'may be the case' standard. The OFT therefore considers that it is by no means a foregone conclusion that the CC would reach an SLC finding on the balance of probabilities standard, at the end of a detailed 24 week inquiry. 11. In relation to mortgages, the OFT considers there is a realistic prospect of an SLC. However, the OFT's concerns are more marginal. Evidence suggests that the mortgages market may be tighter than it was prior to the 'credit crunch' so that barriers to entry may be higher and customer switching is more difficult. Under these market conditions, the combination of the largest and third largest mortgage providers is significant enough to cause concern. In this regard, the OFT is mindful of the fact that the mortgage business is of enormous importance to the UK economy, such that the cost of a wrongful clearance (false acquittal or type II error), even if the risk of such error is relatively low, would be very high. 12. The parties submitted that the transaction will lead to significant cost savings [REDACTED] of Lloyds and HBOS, while creating the largest and most effective retail franchise in the UK, enabling better access and service for customers. While plausible, the OFT did not receive sufficiently compelling evidence to conclude confidently at the Phase I stage of analysis that the claimed efficiencies and consequent customer pass-through would occur, and would occur such as to offset the competition concerns identified in relation to PCAs, SME banking and mortgages. 13. No further competition concerns were 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). 6 REMEDIES 14. Lloyds did not offer any structural or behavioural undertakings in lieu of reference to the CC. 15. The absence of any such offer of remedies makes it inherently difficult, particularly in light of time constraints, for the OFT to formulate a hypothetical set of undertakings and subsequently test whether they might be appropriate to deal with the competition concerns identified. 16. The OFT does not rule out entirely the possibility that, with more time and more willing engagement by the parties, it might have been possible to develop structural remedies, although it accepts that – given the competition concerns – this would certainly have been challenging in Phase I. 17. Accordingly, the OFT therefore advises that it would not be appropriate to deal with the competition concerns arising from the merger situation by way of undertakings under paragraph 3 of Schedule 7 to the Act. PUBLIC INTEREST CONSIDERATION 18. The OFT received representations on financial stability from a number of people, including the merging parties, the Tripartite Authorities (Financial Services Authority (FSA), Her Majesty's Treasury (HMT) and the Bank of England), third parties active in the financial services sector, consumer interest groups, and several interested individuals. 19. The majority of third parties considered that, in light of the extraordinary conditions in the financial markets, the merger would benefit financial stability, and was therefore in the public interest. However, some third parties expressed concerns about the impact of the merger on competition in the medium to long term. Concerns were also specifically expressed that the impact of the merger in Scotland would be against the public interest. 7 II PROCEDURAL OVERVIEW 20. On 18 September 2008, Lloyds and HBOS announced that they had reached agreement on the terms of a recommended acquisition by Lloyds of HBOS under which HBOS shareholders would receive 0.83 Lloyds shares for every one HBOS share. 21. The Secretary of State issued a public intervention notice on 18 September and requested the OFT to report by 24 October. 22. On 3 October, the OFT received an informal merger submission from the parties. 23. On 8 October, after consultation with the Bank of England and the FSA, HMT announced that it was bringing forward measures to ensure the stability of the financial system and to protect ordinary savers, depositors, businesses and borrowers. In summary, it was announced that Government's intention was to provide sufficient liquidity in the short term; make available new capital to UK banks and building societies to strengthen their resources permitting them to restructure their finances, while maintaining their support for the real economy; and ensure that the banking system has the funds necessary to maintain lending in the medium term. 24. On 9 October, the OFT sent an issues letter to the parties setting out the core arguments and evidence in favour of the reference test being met. On 13 October the parties attended an issues meeting with the OFT's case team. 25. On 13 October, in view of the exceptional instability in the global financial markets, HMT announced that it would be implementing the set of measures announced on 8 October to make commercial investments in UK banks and building societies to help stabilise their position and support the long-term strength of the economy. In particular, HMT announced that it was making capital investments in HBOS and Lloyds, conditional on completion of their proposed merger. As part of this investment, the banks supported by the recapitalisation scheme have agreed a range of commitments with Government. 26. On 13 October, Lloyds announced revised terms for the acquisition of HBOS and the raising of £5.5 billion of new capital. The revised terms agreed with HBOS are that HBOS shareholders will receive 0.605 Lloyds shares for every one HBOS share. At the same time, an offer will also be made for HMT to exchange HMT preference shares in HBOS for equivalent preference shares in Lloyds. 8 27. The specification of the stability of the UK financial system as a public interest consideration in section 58 of the Act was laid before Parliament on 7 October. It was subsequently approved by the House of Lords on 16 October and by the House of Commons on 22 October, and comes into force on 24 October.1 1 www.opsi.gov.uk/si/si2008/uksi_20082645_en_1 9 III PARTIES AND TRANSACTION THE PARTIES Lloyds 28. Lloyds is a UK-based financial services group that provides a wide range of banking and financial services to personal and corporate customers. Its main business activities are retail, commercial and corporate banking, general and life insurance, pensions and investment provision. Its services are offered through a number of brands, including Lloyds TSB, Cheltenham & Gloucester and Scottish Widows. Its UK turnover in 2007 was £18 billion. HBOS 29. HBOS is a financial services group that provides a range of banking, insurance, financial services and finance-related activities in the UK and abroad. Its UK turnover in 2007 was £4.25 billion. TRANSACTION RATIONALE 30. Lloyds submits that the transaction was negotiated and announced over a very short period of time. The deal was negotiated and agreed in the context of the sharp worsening of the global financial markets in mid-September, when HBOS's position in terms of share price and funding became increasingly vulnerable. 31. Lloyds submits that the merger will allow it to build the UK's leading financial services company with leading market positions and a platform to create a highly efficient group. 32. For HBOS, the transaction was seen as a means to minimise the risks of further erosion to its position and the continuation of its activities in view of its otherwise uncertain future. 10