Small and medium-sized businesses in Scotland and people with current accounts and mortgages could all suffer from a reduction in competition arising from Lloyds TSB's rescue takeover of HBOS, the Office of Fair Trading believes.

Small and medium-sized businesses in Scotland and people with current accounts and mortgages could all suffer from a reduction in competition arising from Lloyds TSB's rescue takeover of HBOS, the Office of Fair Trading believes.

However, the OFT's report on the deal highlights HBOS and Lloyds TSB's own submission that the Government would have had to step in to rescue HBOS had the deal not been agreed, "most likely by nationalising HBOS".

Seemingly underlining just how precarious a position HBOS had been in, the OFT report also cites the assertion from the two banks that "it is inconceivable that government would have stood by and allowed HBOS actually to fail, because this would have given rise to unacceptable systemic risk, jeopardising the stability of the entire UK financial system".

Highlighting Lloyds TSB and HBOS's view that HBOS could not have continued under its own steam without the deal, with a Government rescue the only alternative, the OFT report states: "The parties argue that a more realistic counterfactual to HBOS remaining independent is that Government would have intervened with some form of HBOS specific rescue package', and further that such intervention would probably have led to structural limitations on the ability of HBOS to compete effectively."

"Counterfactuals" are the alternative scenarios used by the OFT to assess the com-petition impact of a particular transaction.

The OFT, declaring it considers it realistic that any specific government support for HBOS would have involved recapitalisation, says: "It is too speculative, however, to try to predict with any certainty the precise level of any such recapitalisation - that is, whether Government would have taken HBOS into temporary public ownership, as was the case for Northern Rock, or whether it would have taken some lower level of shareholding in the bank."

Separately, the OFT report contains statistics from the Financial Services Authority showing HBOS's funding gap in June this year was much greater than that of any other UK bank at nearly £198bn. This underlines HBOS's reliance on wholesale funding markets, which seized up after Lehman Brothers' collapse on September 15 and sent HBOS rushing into the arms of Lloyds TSB.

The OFT report was published yesterday as Business Secretary Lord Peter Mandelson cleared the transaction on the basis that public interest in UK financial system stability outweighs competition concerns.

The government said when the deal was first announced on September 18 that it would waive the normal competition considerations.

The OFT makes it plain that, in normal circumstances, the conditions for referral of the Lloyds TSB-HBOS deal for an in-depth investigation by the Competition Com- mission would have been met.

It concludes there is a "realistic prospect" that Lloyds TSB's effective takeover of HBOS would result in a "substantial lessening of competition" in the UK personal current account and mortgage markets and in the provision of SME banking in Scotland.

The OFT highlights the fact that HBOS and Lloyds TSB's total market share in small and medium-sized business banking north of the border is between 40% and 50%.

It notes Royal Bank of Scotland is the next closest competitor, with a share of between 30% and 40%, and that a combined Lloyds TSB-HBOS would be way ahead of the 10% to 20% share of the third-largest player in this market north of the border, Clydesdale Bank parent National Australia.

The OFT concludes: "The merger would make the market more duopolistic in the competition for start-ups, and consolidate the merged entity and RBSG (Royal Bank) as the clear market leaders in the Scottish SMEs banking market in terms of stock."

Highlighting the relatively low tendency of small firms to switch banks, the OFT says: "Since a merged Lloyds/HBOS will have a still larger base of inert customers in Scotland, its incentive to offer attractive terms might be expected to be reduced."

It highlights the fact that Lloyds TSB and HBOS's combined share of the personal current account (PCA) market in Scotland is between 40% and 50%. Throughout the UK, their combined share of at least 30% of this market is roughly double the individual positions of Royal Bank of Scotland, HSBC and Barclays.

The report states: "In relation to PCAs, the OFT has concerns at the national - Great Britain - and local levels. The merger will remove a firm, HBOS, that was, at least until less than two months ago, a major driver of competition in the market, and strengthen the current market leader, Lloyds.

"In addition, the merger will significantly increase Lloyds' share of the market," it added.

"As a consequence of its increased market share, coupled with characteristics of the market such as high levels of customer inertia and a limited degree of price discrimination, it is expected that its incentives to compete for new customers, and those of the other major banks in the market, will be diminished - in essence, the increase in Lloyds' customer base will encourage it to attach more weight to enhancing margins on current customers than to customer acquisition."

Turning to business banking, the OFT adds: "In relation to SME banking, the OFT's concerns are focused on Scotland and are similar to those in relation to PCAs - the increased incentive on Lloyds to enhance its margins on current customers."

The OFT describes its concerns around Lloyds TSB and HBOS's combined share of the UK mortgage market, put by FSA data at about 30%, as "more marginal".

However, the OFT declares: "Evidence suggests that the mortgages market may be tighter than it was prior to the credit crunch' so that barriers to entry may be higher and customer switching is more difficult.

"Under these market conditions, the combination of the largest (HBOS) and third-largest mortgage providers is significant enough to cause concern. In this regard, the OFT is mindful of the fact that the mortgage business is of enormous importance to the UK economy, such that the cost of a wrongful clearance would be very high."

The OFT says that it did "not receive sufficiently compelling evidence to conclude confidently" that the efficiencies of the deal claimed by Lloyds TSB and HBOS and consequent pass-through to customers would occur "such as to offset the competition concerns identified in relation to PCAs, SME banking and mortgages".

The OFT says Lloyds TSB did not offer any structural or behavioural undertakings in lieu of reference to the Competition Commission, given the circumstances of the deal.

It adds: "The OFT does not rule out entirely the possibility that, with more time and more willing engagement by the parties, it might have been possible to develop structural remedies, although it accepts that - given the competition concerns - this would cer- tainly have been challenging."

The OFT report has been edited ("redacted") heavily to produce the "non-confidential version" for public consumption but, reading between the missing parts, it highlights HBOS's troubles.

Lloyds TSB and HBOS's own submission on the public interest consideration states: "A redacted HBOS which was becoming redacted in mid September would have been or would be traumatic in terms of: l counterparty exposure: it is common knowledge that HBOS has significant wholesale market exposure l depositor exposure (since HBOS was the market leader in savings and has a large number of current account customers) l investor confidence, and l general confidence: redacted.

Redacted would have been potentially disastrous in terms of financial stability and therefore not tenable."

Earlier, the OFT report says: "Lloyds submits that the transaction was negotiated and announced over a very short period of time. The deal was negotiated and agreed in the context of the sharp worsening of the global financial markets in mid-September, when HBOS's position in terms of share price and funding became increasingly vulnerable...

"For HBOS, the trans-action was seen as a means to minimise the risks of further erosion to its position and the continuation of its activities in view of its otherwise uncertain future."

The report also states: "In these circumstances, HBOS argues there was no realistic prospect of reorganising its business. It submits that it would have been required to take steps redacted. A similar picture, it says, would have emerged in SME lending. While it would have been possible, in theory, to sell off assets redacted asset disposals would need to have been on an extraordinary scale to make any meaningful contribution redacted. Moreover, as a distressed seller of assets, HBOS would undoubtedly have incurred substantial losses even if buyers could be found."

Lloyds TSB revealed on Thursday that nine of the top 11 jobs in the combined entity to be created by its takeover of HBOS, would be filled by its people.

It is offering 0.605 of its shares for every one in HBOS. This offer was worth nearly 120p last night, and the discount at which HBOS shares are trading to the bid value has narrowed to 17%.

Shares in HBOS rose 5.3p, or 5.6%, to 99.3p yesterday. Lloyds TSB shares edged up 0.3p to 197.8p.