FCA: Interim competition report on investment and corporate banking - proposals to overhaul the IPO process

The FCA has published an interim report of its market study on investment and corporate banking, setting out interim findings in relation to choice, universal banking and cross-subsidies, as well as other market practices. The market study is its February 2015 Feedback Statement reviewing competition in the wholesale sector. This identified a number of concerns in relation to primary markets, centring on cross-subsidies, as well as specific market practices such as syndication and reciprocity. The FCA published its terms of reference for the market study on investment and corporate banking in May 2015 and analysed 10,000 transactions spanning a period of five years.

The report finds that, while many clients feel well served by primary capital market services, improvements are needed in some areas in order to encourage competition. The report notes the widespread use of contractual clauses that seek to limit clients' choice of providers on future transactions and calls for an end to the use of such clauses. The FCA also found evidence that some banks may seek to reward favoured investor clients when allocating shares in an IPO and is undertaking supervisory work with a number of banks to better understand how potential conflicts of interests are managed when shares in IPOs are allocated.

The interim report is published alongside an Occasional Paper focusing on allocation of shares to potential investors in IPOs and a Discussion Paper on proposed improvements to the way in which information is provided to potential investors during the IPO process.

Interim findings

Findings identified in the report include the following:

• There was no compelling evidence that any particular sector or category of clients faces a lack of available suppliers for corporate and investment banking services and large and frequent issuers, such as financial institutions are well served by banks and advisers.
• Presently, medium-sized corporate clients and small corporate clients have a reasonable choice of banks, but there is evidence that larger banks opt to reduce their engagement with smaller, newer and/or riskier clients in response to market conditions and regulatory change. Future regulatory developments or an economic downturn could, therefore, cause some banks to withdraw from these types of clients to focus on larger, more attractive clients. Banks may question what is wrong with such developments given the various economic and regulatory burdens they face.
• Investment banking is a relationship business with relationships strengthened both by cross-subsidised lending and corporate broking (including daily coverage) and by past primary market transactions. Banks may wonder why their previous expertise could be held against them.
• Many investment banks lend at a low rate of return or below cost on the basis that a sufficient overall return will be made through cross-selling primary market transactional services. Lending committees often consider the share of future transactional business that the bank expects to win over the lifetime of the loan.
• Concerns have been raised that clients may not always be free to award primary market mandates to the bank that best suits their needs, especially if there are barriers to using non-relationship banks. New entrants also find it difficult to break into primary market services without also offering lending and/or corporate broking.
• The link between lending/corporate broking and primary market roles awarded to banks is strongest in DCM and other ECM (convertible debt) transactions and advice on M&A acquisitions, with around two-thirds of roles awarded in these transactions given to those banks with whom the client had an existing relationship. The link is significantly weaker for IPOs.
• The majority of larger banks are using/seeking to use contractual clauses restricting a client's choice in future transaction, although such terms do not necessarily generate better terms on the initial service.
• Large corporate clients, who want access to cheap lending, establish lending panels with a wide range of participating banks who then compete against one another on primary market mandates. However, medium-sized and small corporate clients, who typically have fewer banking relationships than large corporate clients, may feel the need to "reward" a lending bank or corporate broker with transactional business even when that bank would not have won a mandate.
• Clients are less sensitive to fees on primary market mandates and place more emphasis on maximising transaction value and minimising the all-in cost of funds. Therefore, the higher returns on transactional business relative to lending/corporate broking reflect a combination of cross-subsidy and low fee sensitivity.
• Cross-subsidies influence the awarding of primary market mandates (particularly in DCM), affecting both ease of entry and expansion for those providers not offering the cross-subsidised services, in particular lending. The cross-subsidy appears to make it harder to offer ECM and DCM services on a stand-alone basis.
• The size and composition of syndicates is driven by the client and not by banks, although the lead bank(s) may be asked to make recommendations. The fees that clients pay on transactions of different sizes do not increase as the size of the syndicate increases. No evidence was found of material and direct detriment as a result of syndicate composition. This is in contrast to the ABI report of 2013 "Encouraging Equity Investment" which was not in favour of large syndicates.The size and composition of syndicates is driven by the client and not by banks, although the lead bank(s) may be asked to make recommendations. The fees that clients pay on transactions of different sizes do not increase as the size of the syndicate increases. No evidence was found of material and direct detriment as a result of syndicate composition. This is in contrast to the ABI report of 2013 "Encouraging Equity Investment" which was not in favour of large syndicates.
• Reciprocity, a practice whereby a bank issuing its own capital awards the business to another bank in exchange for a role on that bank's transactional business, is currently most prevalent in covered bonds. There is little evidence that reciprocal arrangements cause significant detriment to competing banks that do not or cannot reciprocate and reciprocity does not appear to be excluding non-reciprocal banks from competing because they can win mandates.
• League tables can promote competition when they help a client to compare the services banks offer and where this drives banks to compete on the parameters that matter to clients but certain practices distort league table rankings and reduce comparability.
• Concerns have been raised in relation to the potential for conflicts of interest in relation to the role of corporate finance advisers and to the lack of clarity in relation to the application of the FCA's rules and guidance in this area. The FCA found no evidence of corporate finance advisers giving advice which would be against the client's best interests or trying to unfairly influence the research on IPOs.
• The current market practice for UK IPOs includes a "blackout" period (the FCA says this is "usually 14 days between connected research and the circulation of the pathfinder prospectus" although in our expertise the length of the period varies). Both sources of information are made available too late in the process to be used by buy-side investors, non-syndicate banks' analysts and independent research providers. Such an approach reduces the diversity and independence of information available to investors. The FCA wants research to come out after the prospectus but before an investment decision is taken. There may be seen to be a risk in doing this in thereby linking more directly connected research and the investment decision. The FCA's approach ignores the reason why firms issue research in advance of the prospectus, to limit the chance of being sued on the basis the investor was influenced by the research. Quite how the FCA thinks it can tell firms when to issue research is not made clear.
• Allocation decisions reflect the interests of the bank but there is evidence that, despite allocation policies, these are skewed towards buy-side investors from whom banks derive greater revenues from other business lines (e.g. trading commission). Although these investors may be long-term holders and of benefit to issuing clients, there is also a risk that allocations do not align with issuing clients' best interests and may shut out other investors.

Potential remedies

The interim report identifies a number of potential remedies designed to remove "artificial incumbency" advantages. These include:

• Removing the practice of banks using contractual clauses that restrict client choice.
• Seeking views on whether there are ways in which the FCA can reduce barriers to entry and/or expansion for non-universal banks and other service providers without undermining the efficiency benefits of cross-selling.
• Improving the IPO process to ensure more diverse and independent information is available earlier. Three main models are set out in Discussion Paper 16/3 incorporating combinations of the following two measures: (i) re-sequencing the publication of a prospectus so that it precedes publication of connected research; and (ii) providing unconnected analysts with an opportunity to have access to the issuer's management so that they can also issue research prior to the investment decision. Each of the models contemplates the prospectus being split into constituent parts with the registration document being published much earlier in the process. The share securities note, including the price of the shares, would be published at the latest at the start of trading in the shares. Comments on the Discussion Paper should be received by 13 July 2016, with the possibility of a consultation paper at a later stage.
• Investigating further with individual banks where analysis raises questions about conflicts management in IPO allocations. The FCA considers that provisions in MiFID II should also help to reduce the potential impact of conflicts of interest in allocations and of any harm to investors that are less important in revenue terms to a bank.
• Improving the credibility of league tables by exploring ways in which they could be better presented so that they are more meaningful for clients and remove incentives for conducting trades carried out at a loss purely for the purpose of gaining league table credit.

The FCA expects to publish its final report, setting out its findings and conclusions, in the summer of 2016. It will also consult on any proposed actions.