The trouble with ‘free’ banking for challenger lenders

No one likes us, we don’t care” sing the supporters of Millwall, the unfashionable south-east London football club. Across the river Thames in Canary Wharf, where many of the UK’s largest banks have their head offices, retail bankers have been quietly whistling the same tune for years.

Their profession consistently ranks among the least admired, least trusted in British consumer surveys yet only 3 per cent of retail customers and 4 per cent of business customers change bank in any given year. Despite low interest rates, underlying returns in retail banking remain high for the largest players and their market share is robust. If it looks like an oligopoly, moves like an oligopoly and speaks like an oligopoly, then it probably is an oligopoly. The failure of Co-op Bank, RBS’s problems in finding a buyer for Williams & Glyn and the slow progress of other challengers suggests that nothing can shake it.

There are some understandable economic reasons for this. The sunk costs of establishing a banking infrastructure present a huge barrier to entry. The payments system is owned and controlled by vested interests. The branch network, albeit less important in the age of digital banking, is a reassuring, visible presence on the high street. Customers buy a bundle of services from their bank and worry that something will go wrong if they move to a new supplier and find it difficult to disaggregate the true cost of individual products. Most new products and services are easy to replicate and often better delivered through a big branch network. Consequently, first-mover advantage rarely lasts long.

But the challengers have failed to find a compelling, distinctive customer offer and until they do the oligopoly will persist. In the modern history of British banking there has been only one such event, the introduction by Midland of free-if-in-credit current account banking in 1984. It was a disarmingly simple idea and the original 39 second advertisement was a chirpy little number with a catchy cartoon character, the occasional whoop for joy and a plain message. Nearly half a million customers promptly switched to Midland, eventually forcing the other big banks, which were still charging for handling cheques and issuing statements, to accept the challenge to their way of doing business and fall into line.

Ironically, given that it was forced on them by unwelcome competition, free-if-in-credit banking has served the banks well. Customers who stay in credit pay nothing, those who run up overdrafts on current accounts or cards pay heavily. It is opaque, complex and highly profitable. But charging the poor to pay the rich is not only banking’s dirty little secret, it is the most effective barrier to entry of them all, for it neutralises price competition.

Solving that problem is the true challenge for the challenger banks. Using technology to mine customer data, they need to find a new business model which could include charges for current accounts, less punitive rates on cards and overdrafts and tools to help customers understand their spending pattern. The retail banking market urgently needs such a differentiated product that restores customer satisfaction and breaks the oligopoly.

While we wait for this to happen, there will be some mild improvement in transparency from the reforms set up as a result of last year’s Competition and Markets Authority report on retail banking but the emphasis is on mild. This report promised much. The authority’s press release on launch day proclaimed: “CMA paves the way for open banking revolution.” But the CMA avoided radical reform, the banks breathed a sigh of relief and the stock market responded by marking their shares higher. It was a missed opportunity to accelerate change and yet again the banks had wriggled away. No wonder they still don’t care.

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