Research critical of European regulation of mergers and state aid for banks

Their study, published in the Journal of Industry, Competition and Trade, says the commission should have been more concerned about the competitive effects of market concentration as a result of subsidised mergers, particularly that of Lloyds TSB and HBOS. Last month Co-op pulled out of buying 632 branches that Lloyds had been ordered to sell as a condition of receiving £20bn of state aid in 2009, following its merger with HBOS.

Prof Bruce Lyons and Dr Minyan Zhu, of the ESRC Centre for Competition Policy at UEA, found that the aid given out to banks was excessive in some cases and warn that the commission needs to pay more attention to the implications for competition when regulating bank restructuring in the current Euro debt crisis.

During the financial crisis of 2007-2010, 40 European banks across 22 member states needed specific and urgent rescue and others received huge amounts of assistance through general schemes. The commission issued guidance on the design and implementation of state aid for banks, imposing limits on the amount of aid each bank could receive and also requiring 'compensation' in the form of asset sales and price restraints on individual banks receiving specific aid.

Prof Lyons, a member of the commission's Economic Advisory Group for Competition Policy, and Dr Zhu examined in detail the cases of four banks: Northern Rock, which was nationalised before being sold to Virgin Money; WestLB, which after five years of restructuring and bailouts was wound-down; Fortis Bank, which was partially nationalised and partially sold off to BNP Paribus; and the merger of Lloyds and HBOS.

Prof Lyons said: "The commission has achieved much in dealing with a huge caseload of bank rescues and has almost certainly resulted in more systematic and less distortionary rescue and restructuring aid than would have been the case in its absence. However, we found that it would be better to focus rescue and restructuring aid control for banks exclusively on restoring balanced competition.

"A significant failure by the commission was that 'compensation' was offered to rivals in the form of measures to weaken the bailed out banks and this clearly suppressed competition. There were also lost opportunities. In the case of the Lloyds-HBOS merger, given the Office of Fair Trading's advice that there was a realistic prospect that it would substantially lessen competition, and the Independent Commission on Banking's later confirmation of the merger's anticompetitive effects, the European Commission could have been stronger in requiring a truly viable divestiture that would re-establish a strong competitor. Unfortunately it did not take on the UK government which had colluded with the Treasury, Bank of England and FSA to pushed through an anticompetitive merger.

"At the very least the commission should have required a competitively effective disposal of assets. Instead it took a blinkered approach, excluding viable competition concerns remaining after the unorthodox UK merger approval, and considered only punishment in its state aid approval. The Lloyds-HBOS merger was a panic response to the 2008 banking crisis and the lesson from this is that short term fixes that create an anticompetitive market structure are not a good idea. Mergers should not be excused a full and rigorous review process, or separated from state aid appraisal, even in the heat of a crisis."

Prof Lyons also questioned the decision to try and save some banks, suggesting the commission seemed too ready to consider every bank as being of systemic importance under the terms of its treaty for state aid. For example, it may have been that Fortis and Lloyds were systemic but Northern Rock and WestLB probably were not. Instead the presumption was that it was appropriate for the banks to survive.

"Excessively high amounts of aid were allowed in some cases and with Fortis, shareholders were able to use the courts to extract more aid for themselves. Even accepting the desirability of saving a particular bank, there was no serious attempt to judge the required amount of aid," said Prof Lyons.

While some asset reductions were imposed to improve the viability of a bank, they were also imposed purely for punishment, such as Lloyds' disposal of non-core businesses, the aim being to deter future risky behaviour.

"Our case studies show that viability has not always been achieved, but that was because of the inefficiency of the ban, not for lack of state aid," said Prof Lyons. "As illustrated by WestLB, an inefficient bank was allowed to come back for more aid. This undermines the principle of 'one time, last time' and also the incentive to take tough action so as not to get into future financial difficulty."

Prof Lyons said it remained unclear how effective the requirement to reduce assets would be in deterring banks from getting into difficulties again, adding: "Forced divestitures are unlikely to be competitively successful without very clear safeguards. Neither the Northern Rock sale to Virgin nor the Lloyds divestiture look set to establish strong competitors in the near future.

"There may be very little time for the commission to absorb these lessons from the 2007-10 financial crisis. The current Euro sovereign debt problems may result in many more banks requiring rescue and it is to be hoped that the commission will pay more careful attention to the implications of competition when it sets 'compensatory measures' as part of the regulation of bank restructurings."