gleedsaling

So there I was, working away in H M Treasury in the last Great Recession (1980-84 from memory), when one of my colleagues piped up – “so I suppose evidence of seasonality in stock market prices would be prima facie evidence against them being efficient?”

It was a rhetorical question, as the answer was obviously yes – if stock prices exhibited seasonality, say rising in the spring and falling in winter, you could trade to beat the market. So markets were not, in some sense, “efficient” – they did not price in all of the available information (in this case, the seasons). And if you had information they did not appear to have (in this case, whether it was spring or winter) you could do what Margaret Thatcher advised you could never do – buck the market.

“Oh come on”, I can hear you say, “can’t you find a better and less trivial example?” Well, how about this? As David Schwartz pointed out in an FT article on 30th November, in 19 of the previous 21 years since 1989, the stock market had risen in December. 2012 proved no exception, with a rise in the FT 100 (and FT All Share) – but by only 0.5%. However, the end of December was mired by worries about the US fiscal cliff, so had you hung on till the markets opened on the second of January, you would have done much better – a gain of over 2.5%. Hence the argument about Santa being delayed.

Evidence that perhaps markets are not as efficient as all that also comes from a more academic source, where Pontiff & McLean have published a paper on whether published academic research destroys stock return predictability – a paper also picked up by the FT. “Not completely” appears to be the short answer, although publication of a “profitable” trading strategy (ie buy before December) does then reduce the returns you can expect significantly – especially for large, easy to trade stocks.

Bit of a mystery, though, we still see the Santa effect in stock markets – after all, it must now count as a published strategy. Transactions costs? End of year trading constraints? Or are the arbitrageurs too busy at their Christmas parties?

A surprise was in store when I (digitally) opened the latest HBR – a contribution from Ronald Coase on “Saving Economics from the Economists”. A surprise because I had assumed that the author of the seminal 1937 paper on “the Nature of the Firm” was no longer with us (Wikipedia tells me he’s in fact going strong at 101). Nice to see his article returns to this subject, with a plea that economics has strayed too far into theory to be useful to “business”. Although I’m not sure the article’s main thesis is right. I seem to recall that the latest Nobel prize in economics went to to professors Alvin Roth and Lloyd Shapley for their work on the best possible way to allocate non-priced resources (for example, scarce places in popular schools). That seems pretty practical to me. And of course, whilst economics may have become more rigorous, the whole field of business school education and research has opened up in ways that (I would assume) a younger Ronald Coase could not possibly have imagined.

To be sure, much of the business school writing lacks definitive guidance for businessmen – but isn’t that just a reflection of what I vaguely recall as “the oligopoly problem” – the appropriate model for many markets today?

But whatever the gripes it’s worth a read.

As I am at present “resting” between assignments, I have had the chance to sort out some of our personal financial affairs. This has led me to dealings with banks & building societies other than HSBC, to whom I switched my main banking relationship 4/5 years ago.

For example, I have had dealings recently with “a major UK building society”. They are currently advertising on TV that, while you do need a bank account, you don’t need a bank. True enough, but there are certain basics you have to get right. In my case, I need to transfer my online account to joint names – so I take a form into a branch (well, OK) and then check a week later online to see if it is, indeed, in joint names. Problem: the internet banking site doesn’t show me if it’s single or joint names – indeed, it shows no name at all. Not a good start given that I want to transfer funds to an e-savings product with them. However – it gets worse. I phone the contact centre. They want to “take me through security.” Only problem – their questions were different from those used to set up internet banking, and ones I didn’t know the answers to (e.g.”what is the overdraft limit on your account” – “don’t know, I never use it”). So I failed security clearance, which always makes me mad. Can it get worse? – yes it can! OK, I said – get someone to phone me back. “Oh I’m sorry sir, we can’t do that, we are an inbound call centre only”. Time to start chewing the carpet. In fact I emailed my query in & they answered – but in the process they had gone down the snake to the bottom of the pyramid (see the graphic below from an IBM White Paper on rebuilding customer trust in retail banking – http://goo.gl/Kvm7B)

The trust pyramid in retail banking – see the IBM White Paper

Contrast HSBC. “Would you like to talk to one of our Premier advisers?” Well, I suppose I ought. Fill in the form, 90 minute slot booked (yawn) – but in fact a sensible 20 minute conversation with one or two good ideas. And they had helpfully suggested I do it before, following the Retail Distribution Review, they introduce charging (a topic which will need another blog entry). So they secure a place at the top of the graphic  – acting in my best interests even with no immediate benefit.

The problem with retail banking is that it generates too many customer experiences that push people down the snakes to the bottom of the pyramid, and not enough that provide a ladder to the top. The good are very good – and are ready to go mobile, exploit social networking etc. But the rest better fix the basics!

In the last couple of days I’ve come across two good graphics on the growing ubiquity of mobile – even in a pre-4G world. Pinned to a new board on Pinterest – see the link on the right hand side.

My copy arrived, courtesy of Amazon during the week. On first look, it maintains the high quality of the original, and is a more detailed think piece than his “Branch Today, Gone Tomorrow” polemic. Of course, in the couple of years since Bank 2.0 was published (May 2010), his ideas have become more mainstream, and social media/mobile/digital relationships can no longer be ignored. The investment required is less the cash (£13.99 on Amazon) than the time to properly read & think through his analysis. Let’s hope Sir David Walker has bought a stack & is giving them out to his new Barclays board nominees.

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.

So the FT last Friday (sorry, bit behind) had an interesting article on the use of NFC and apps (for iPhones etc) that allow customers to be identified as they walk in to a store by an app sitting on a cash register – worth a read.

Interesting that the examples are of coffee shops and the morning caffeine intake run. It’s a low value transaction, and I’m sure all of us who have stood in a queue while someone fumbles for their credit card & tries to remember their PIN for a £2 cappuccino will welcome the new technology (even if we are still paying cash).

Is abandoning the Euro the way out for the southern states?

For countries retaining their own currency, the classic way out of this situation is a one-off devaluation, imposing a one-time capital loss on the holders of (say) lira debt, and imposing a one-off adjustment in the living standards of the country devaluing. Of course in practice the situation is much more complex than this, as the UK experience in 1967 showed, and there is a particular problem in ensuring that the entire adjustment remains a one-off and does not trigger an inflationary spiral. But such a mechanism is at least a possibility.

The southern states have no such option. Each would have to introduce their own currency, and declare a conversion rate to the euro. We can safely assume that, if each country reverted to its pre-euro currency, the offered conversion rate would represent a significant mark-down to its going-in rate. The governments concerned would then have to offer a conversion programme to holders of Euro-denominated government debt to induce them to switch to a domestically-denominated substitute. “Offer” may of course be putting it politely – a more likely scenario would be a forced conversion or default. And the resulting domestic debt would no doubt need to offer a higher yield than equivalent Euro area debt.

But by this time the banking sector in the country concerned would be in meltdown. It would be facing losses of 50% or more on its government bond portfolio and CDS payments would probably have been triggered. On the liabilities side of its balance sheet – as the Euro area has no capital controls- it would probably have seen a massive flight of deposits to non-domestic Euro area banks, which it would be financing by discounting any bill out loan on its books with its central bank. But even with this, a significant contraction of credit would be likely by the domestic banking sector, while the Euro area recipients of the “hot money” would often lack the distribution capacity to recycle the funds.

It is less clear what would happen to the Euro as a medium of exchange in the country concerned.The government would presumably declare the “lira”  the legal currency, pay state benefits & salaries in lira, & request tax payments in lira. But a dual currency solution is surely more likely, with corporates & the entire tradeables sector continuing to use the euro. The status of contracts would also be interesting -would the government pass a law requiring all “domestic” contracts to be redenominated to lira? And how would you determine the difference between domestic and non-domestic contracts?

Other solutions

So faced with these difficulties it is not surprising that even socialist countries like Greece have sought more or less any alternative to leaving the euro. But adjustment will still be required – and if that is not to come via devaluation, then similar changes will be needed by other means. The fundamental needs are to make the economies competitive and the debt burden serviceable.