End free in credit banking?

In the last six months we have seen two salvos at free in credit banking. In June, Brian Hartzer, as outgoing head of RBS Retail Banking, said that a package of measures might be needed to end to the “unfairness” where some customers (ie those who stayed in credit) were cross-subsidized by others (who use overdraft, and especially unauthorised overdraft, facilities). As well as dealing with “unfairness” it would also remove the claimed opaque nature of current account charges.

Perhaps Brian Hartzer was emboldened in this attack not only by his departure to Australia but also by the comments from Andrew Bailey, the head of the Bank of England’s Prudential Business Unit (the forerunner of the Prudential Regulation Authority). Undeterred by some of the furore he had stirred up by earlier remarks about the “distortions” arising from free in-credit banking, he returned to the charge in a speech to the Westminster Business Forum at the end of May:

“In the same speech last November, I managed to attract some notoriety also for stating that free in-credit banking in this country is a dangerous myth. It is a myth because nothing in life is free; rather, it means that we pay for our banking services in ways that are hard to link to the costs of the products we receive. This can distort the supply of banking services. The dangers include that the pricing of banking to consumers varies too much depending on the services they use. I also worry that the banks may not properly understand the costs of products and services they supply. And I worry also that this unclear picture may have encouraged the mis-selling of products that is now causing so much trouble.”

So we seem to have a series of arguments against free in credit banking, alleging it:

• distorts competition
• is unfair
• confuses banks on the costs to serve
• leads to product misselling

Distorting competition?

Free in credit banking was introduced originally by Midland Bank (now part of HSBC) in 1984 – “free banking for as long as you stay in credit” – and within four months all the UK banks had followed Midland’s lead.Interestingly, Midland had a reputation at the time as a banking innovator, having introduced a series of innovative services, including personal loans (1958), personal cheque accounts (1958) and cheque cards (1966), so the evidence would seem to indicate that this was a competitive move by Midland to gain market share.

We can see similar market dynamics operating today, with Santander (as a relatively new challenger to the “Big 4” in the UK via its acquisitions of Abbey National, Alliance & Leicester) offering its 1-2-3 account. While there is a £2 a month fee, plus a requirement to fund the account with £500 a month, the 1%, 2%, 3% off utility, (Santander) mortgage and paid for TV packages should easily save the average family £5 to £10 a month. So this is not free in credit banking – it’s the next stage, we pay you to bank with us.

Of course, the banks are not offering it merely as a goodwill gesture – they believe ownership of the current account is the key to the sale of other, more profitable products – loans, savings accounts, credit cards or whatever. But this pricing is not unlike what we see in other markets – for example, personal printers – where the price of the initial goods are discounted (printers) and the margin is recovered on parts sales (print cartridges). How “competitive” the outcomes are in these markets depends on whether consumers can accurately price the whole bundle of services they might need from competing providers (unlikely) or  can unbundle and get out of particularly overpriced items of the bundle of services. For financial services, the latter is much more likely to be the case, and we know that the switching rates for mortgages, credit cards etc are much higher than for current accounts. So a savvy consumer might exploit “free plus” banking but opt out of the overpriced loans and credit cards needed to cross-subsidise it.

So “free plus” banking looks more like the result of competitive rivalry than a “distortion” of competition.

“Unfair”

Well, very possibly. If we pursue the line of argument above, “savvy” customers will be cross-subsidised by their more dozy brethren. Or those in credit by those who need to borrow.

But whoever expected a competitive outcome to be “fair”? Of course, sometimes it is – so for rail travel, the rich commuter cross-subsidises the poorer off-peak traveller, and we applaud. But that is the result of the nature of demand in that industry, where the price-insensitive customers pick up a higher share of the fixed costs. In banking, it’s different – the price insensitive people are those who urgently need an unsecured overdraft – and they get stung. Again, this is market dynamics – it is no use expecting the banking system to redistribute the income and wealth arising from a competitive system when the elected politicians have failed to do so.

There is a similar confusion in the Andrew Bailey piece, which refers to the dangers of the pricing of banking to consumers “varying too much depending on the services they use”. What an extraordinary statement! Surely all pricing of services should depend, somehow, on their use? Or is banking supposed to be exempt from the normal laws of supply and demand?

“Confuses banks on the costs to serve”

If this is true, it would be helpful to see the evidence. And it is true that, where there are joint costs involved (eg the costs of the branch network required for the sales and servicing of multiple products) costs to serve for a specific product can be difficult to determine. But the charge is at best unproven.

“Leads to product misselling”

So the argument here is that, because “free plus” banking is unprofitable, banks have to find other products to sell to meet their profitability targets, and therefore get pushed into selling unsuitable ones (for example, PPI).

Again, there are a number of steps in the argument. The first is that “free plus” banking is “unprofitable”. While we know this is true for some customer segments – for example, basic bank accounts cost some £50 a year to run, and presumably many of those holding them would not meet the criteria for loan products – it is not clear that it holds for all segments or in aggregate. For example, account would need to be taken of interest not paid and of the cross-selling of other, margin and fee-earning, products.

Then there is the linkage argument from “one product (potentially) makes a loss so I must sell other products that make a profit”. But banks will do the latter irrespective of whether there is a profit or loss on the first product.

In fact, the causes of product misselling are not hard to find – an examination of the incentive structures for branch and call centre staff, and the balance between the rewards for “good” advice, customer service, and securing additional product sales should identify the problem pretty quickly.

So what do we do now?

So if I’ve convinced you that there are more pressing (banking) problems than free in credit banking – nothing.

If not – well, Andrew Bailey thinks we may need a policy intervention:

“But in truth this is not something that will happen spontaneously. It is hard for a single bank to break out of the existing situation without appearing to raise the price of its service to customers (even though it may not actually be raising the price as a whole). And, it is hard for the industry as a whole to break out without appearing to collude. So, it may require intervention in the public interest, not least because it is a way to encourage greater competition.”

• viz, we force banks to “charge” for banking services.

I hope we don’t do that. If we do, it will be interesting to see how Santander’s 1-2-3 account fares. It does charge a monthly fee – but then rebates it. So does this mean it should be banned?

There is a long history of regulatory interventions making outcomes less, rather than more competitive. It is to be hoped that ending free in credit banking isn’t added to that list.