There has been much speculation about the prospect of Tesco competing strongly with the existing UK banks as it increases its finance footprint and starts to offer loans to its customers.  Tesco already has stores spread nationwide which could serve as a branch network to the millions of customers who already shop there each week. Last year Tesco also bought out RBS’ 50% stake in their Tesco Personal Finance joint venture which means TSCO now has roughly 6 million accounts and deposits of £4.5 bln.  Today Tesco announced a deal with Fortis whereby the latter will provide motor & household insurance underwriting and claims management with Tesco doing the retail pricing and marketing.

However if we follow the money then the prospect of Tesco crushing the existing UK banks by its entry into the banking market seems less fearsome.  The big question is where is Tesco going to get the money from which it would wish to lend out to its customers?  The Bank of England (which will once again resume its proper role as banking regulator if, as currently seems likely, the Conservatives win the next election) will not allow Tesco to fund its lending via the wholesale markets (this is the business model which got Northern Rock into trouble and the BoE will not allow it to happen again anytime soon), so TSCO is going to have to compete with the rest of the banks for its share of retail deposits.  These retail deposits are highly sought after at the moment as every bank (except HSBC with its loan-to-deposit ratio of 90%) is keenly trying to increase its retail deposits so as to shift their loan-to-deposit ratios down towards 100%.  This is the structural problem in the UK banking sector at the moment – there are not enough customer deposits to go around and so most banks will continue to shrink their loan books.

The implication is Tesco are going to struggle to quickly attract tens of billions of pounds sterling in retail deposits and therefore their capacity to extend loans to customers is going to be limited to how fast they can attract deposits.  As Tesco do not intend to run their banking subsidiary at a loss (and have little experience in assessing credit quality), they are going to grow their banking business relatively slowly.  Calm down dear, its only a supermarket trying its hand at banking.  This is nothing new as the Co-op has been in the banking business since 1872 and announced recently that its customer deposits increased 21% in the first half of 2009.

The other way for Tesco to fast-track its way into banking would be to buy Northern Rock off the UK Government.  However NRK holds deposits of £19.5 bln and has a mortgage book of £66.7 bln.  However although the TSCO-to-buy-NRK deal has been rumoured, Tesco would still face the same problem of how to attract sufficient deposits to pay off the billions which NRK still owes to the BoE.  Also NRK’s loan book is said to be of low quality and questions would arise as to whether Tesco is capable of assessing NRK’s outstanding loan book, as in order to get a deal done, a significant chunk of NRK’s mortgage book would remain with the Government.

The existing UK banks needn’t spend too much time worrying about serious competition from Tesco over the next decade.