Capco Blog

Virgin and Tesco shouldn’t bank on an easy ride

Clearly, the financial crisis is leading to major changes in the capital, liquidity, and accounting regimes for banks. But might the crisis also open up the sector to non-bank competitors on a scale not seen before? Is the distrust of mainstream banks now so deep that ambitious companies in other sectors have an unparalleled opportunity to become major providers of banking services?

Industry watchers should keep a close eye on the U.K., which is set to become a fascinating test case on the future of banking. In the wake of the crisis, both Sir Richard Branson’s multi-sector Virgin Group and retailing giant Tesco have announced plans to offer full-service retail banking. And both are ambitious to do banking differently. Virgin Money wants “to offer a new kind of bank in the U.K. - one where everyone benefits.” Tesco Bank says it will focus on “being simple, straightforward and rewarding loyalty.”

How likely are they to make an impact? Can they really bring a new approach to retail banking? We have recently completed a research study assessing the prospects for Virgin Money and Tesco Bank. For all the excitement around their plans, our research indicates it will not be easy.

Of course, the suggestion that ‘non-banks’ such as retailers might shake-up retail banking long pre-dates the crisis. A 1994 study for the American Bankers' Roundtable concluded that "banking is essential to a modern economy; banks are not." Indeed, both Virgin and Tesco first ventured into financial services as long ago as the mid-1990s. However, until the crisis, both were niche players, concentrating on a select range of products and operating through partnerships with existing banks. Tesco operated through a joint venture with RBS, only buying out its banking partner at the end of 2008. Virgin Money also partnered with RBS along with other financial services companies. It launched but then sold its stake in the innovative “One Account” mortgage joint venture with RBS, though for the moment it remains an introducer for the business.

Does the impact of the crisis justify a step up from niche players to full-service retail banks? Clearly, the post-crisis unpopularity of existing banks makes new entrants potentially more attractive. But set against this, banking is becoming less profitable, making the market less attractive. And despite the crisis, the established banks’ branch networks, infrastructure, and customer relationships remain remarkably well-entrenched.

In reality, for all the excitement, there are major hurdles that ‘non-banks’ like Virgin and Tesco face in building full-service banks:

  • Despite all the moves by regulators to facilitate account switching, U.K. consumers remain instinctively relucant to change their current (checking) account.
  • Further, U.K. banks are reliant on opaque means of generating revenue from their current accounts, namely high overdraft charges and little or no interest paid on credit balances. This is in return for notionally free banking. The recent failure of the U.K.‘s Office of Fair Trading legal challenge to unauthorised overdraft charges reduces the pressure for new pricing models and may hence be a further impediment to ‘new’ entrants.
  • If Virgin and Tesco rely on these same pricing models, will they lose their reputational advantage? But if they charge customers a fee for current accounts, will U.K. consumers be willing to drop their deep attachment to ‘free-in-credit’ banking?
  • With much reduced access to wholesale funding following the crisis, Virgin and Tesco will need to build large deposit bases in order to offer services such as mortgages. But they face intense competition for retail deposits from existing banks and building societies (mutual thrifts).
  • Like many banks, Virgin Money and Tesco Bank relied heavily on credit cards and consumer credit before the crisis to drive their own financial services businesses. However, in the wake of the crisis, prospects for credit cards are bleak. And no other banking segment offers an equivalent ’growth engine’ to support their push into full-service banking.

Further, despite both offering financial services for more than a decade, the current operations of Virgin Money and Tesco Bank are small relative to the established banks. The only way for Virgin or Tesco to achieve scale quickly would be through a major acquisition. The U.K. government’s planned sale of mortgage lender Northern Rock and divestments imposed on Lloyds and RBS by the European Commission may present opportunities. Virgin originally expressed an interest in acquiring Northern Rock back in the early days of the crisis. But acquisitions on this scale (Northern Rock’s retail savings balances are approximately four times those of Tesco Bank) would carry significant integration risks and require a significant capital investment.

From the perspective of competition and consumer choice, the banking ambitions of Virgin and Tesco are clearly welcome. And for all those that follow developments in banking, it will be fascinating to watch. This is an attempt to do banking without the banks on a scale not seen before. Virgin has already signalled it is prepared to challenge the ‘free-in-credit’ model that dominates personal banking in the UK. But even brands as strong as Tesco and Virgin may find it tough to shake-up as conservative a market as retail banking.

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