After the confidence crisis caused by the failures of Silicon Valley Bank (SVB) and then, stunningly, Credit Suisse this month, one key change for UK banking may have flown somewhat under the radar. At the very end of February, the Prudential Regulatory Authority (PRA) announced a new consultation paper: CP5/23 – Remuneration: Enhancing proportionality for small firms.[1]

The aim? To reduce restrictions on smaller non-systematic domestic banks, increasing competition by removing red tape around malus, clawback, and buyouts for firms, thereby promoting the PRA’s competitiveness mandate and ‘Strong and Simple Framework’.

Following events in March, responses to the consultation paper may be rather stronger than the PRA initially predicted. However, it’s worth noting that the ‘Strong and Simple Framework’ intends to reduce regulatory red tape for only domestically-focused UK banks with assets of under £20bn. In comparison, the US rollback of banking regulation under the Trump administration, which many analysts are arguing compounded SVB’s issues, applied to institutions with under $250bn in assets, an order of magnitude different.

The crisis of confidence in the banking sector should not mean that proportionality for small challenger banks is thrown out with the bathwater; rather, it is time to consider the dual task placed on regulators to create a safe resilient banking system that is still competitive for smaller entrants and provides customer choice.

David vs Goliath

Firstly, the facts. The PRA’s proposed proportionality measures intend to reduce the compliance and regulatory demands placed on smaller banks, which currently face the same regulatory burden as systemically important institutions despite having far less capital to implement necessary measures and posing far, far less of a risk to UK banking as a whole.

Proportionality is an issue we certainly need to address as, without improvements, the UK’s banking sector is set to squeeze out the challengers that we so badly need.

Despite the best efforts of the wider banking sector, over the course of the past 20 years competition levels in the UK banking sector has declined. The combination of a series of consolidations following the global financial crisis in 2008 and new digital banks struggling to deliver positive returns for investors has led to fewer options for consumers and businesses, and less motivation for innovation amongst the large incumbents.

This is damaging to the sector, as smaller, challenger banks have been successful in confronting the status quo. They have very successfully identified high-margin niches and challenged the incumbents to deliver an improved customer outcome at a more affordable price. This has raised the hygiene levels within the industry and allowed challengers to build market share in their specific niche.

However, for smaller challenger banks increased market share has not necessarily translated into increased profitability. This is due to the increased costs they face from complex regulation which are proportionally far less burdensome for larger incumbents simply owing to economies of scale. Without proportionality in how these smaller institutions can approach regulation, they simply will not have the capital to compete.

Identifying the balance

However, reducing regulatory burden on smaller banks naturally must be weighed against the risk of reducing the regulatory safeguards for that bank’s customers. There is a fine balance between facilitating the market development and avoiding having a system with dual standards.

One standard is one thing, but ‘one-size-fits-all’ is another. International bodies have in the past developed new regulatory initiatives for larger international banks in this fashion – applying the same rules to all, regardless of assets. This has unfairly penalised the smaller banks, harmed innovation, damaged competition and prevented development. Not quite the intention.

 Proportionality within the wider banking and financial services sector is needed if the PRA and other regulators are serious when it comes to increasing the level of competition in the market. And competition – when in tandem with regulation – is necessary to prevent oligopoly.

The PRA’s recent announcement is the first step on the long and bumpy road to a more balanced UK banking sector, with smaller challenger banks and established financial institutions on a level playing field.

[1] https://www.bankofengland.co.uk/prudential-regulation/publication/2023/february/remuneration-enhancing-proportionality-for-small-firms