Garry Smith looks at the upsides and downsides of free banking and asks whether it really does provide fair value and transparency for customers
Milton Friedman's 1975 book There's No Such Thing as a Free Lunch laid bare the economics behind bar owners in the US providing free food to patrons (as long as they wet their whistle while enjoying it), proving the book's title. So why on earth does the UK bank customer remain wedded to the notion of free in-credit current account banking?
We all know that free banking in aggregate is a myth. Maybe we can convince ourselves that it is always someone else, less financially astute than us, who pays fees for going into unauthorised overdrafts or having direct debits returned 'insufficient funds'. Except, this stuff happens to most people - a straw poll around the office suggests quite a lot of us have succumbed, and that was only those prepared to admit to their personal financial mismanagement. Some charges are unavoidable - using an ATM abroad, for example.
Regulators are concerned by the free banking model. It's generally seen as a barrier to competition, and a major hurdle for challenger banks to overcome. The old Midland Bank started the ball rolling in 1984 with its fee-free current account, followed by the rest of the banks who needed to staunch the flow of customers moving to the Midland. However, once in place, the free banking model has proven almost impossible to dislodge.
A more insidious side to an apparently free service is that it becomes valued that way by the customer. If there's no explicit charge, there's a tendency to underappreciate the service and potentially be profligate with it.
You get some subtle behavioural aspects coming through depending on whether there's a per-use charge applied to a service. Even if it's a relatively trivial amount, it's the principle that matters. I personally became aware of this when I moved to Canada in the late '90s. I was initially appalled at the thought of actually having to pay for my banking (I was unaware that free banking is a peculiarly British phenomenon). I was given the option of paying $5 per month for unlimited use of the usual services, which seems to be the model that some UK banks have implemented or are currently considering. However, I could also opt to get a small number of transactions of each type at no charge per month. I could use my own bank's ATMs five times per month, but each further transaction incurred a 25c fee.
Seeing the other side
Ever the parsimonious Scot, I decided to 'do the math' as they say on the other side of the Atlantic, and figured a per-transaction charging basis would be cheaper for me. But the subtle thing I discovered is by paying for transactions, I started to appreciate their true value. Rather than withdrawing 10 or 20 bucks every day or two, I started drawing down a hundred on a weekly basis. I went from making 20-odd ATM withdrawals per month (this was in the days before debit cards), to making one per week.
So, there may be unexpected upsides for banks to institute a per-transaction fee model - they might just find their overall operational costs decline as customers become a bit more thoughtful about how they use the bank's service. In comparison, the monthly-fixed-fee-for-unlimited-usage model looks a bit like the scenario where some people happily view the 'eat as much as you like buffet' offer as a challenge to 'eat as much as you can'.
Getting the balance right
The question of fees is usually considered separately from the question of the interest rates paid, or not, on our deposits. You can argue that they are two sides of the same coin and should be considered together. Why? Well, our deposits provide the bank with a large pool of stable funding that can be lent out, earning the bank a turn for taking on credit and other risks. But, in most cases, the bank pays no interest on those deposits - they are known in the industry as NIBLs - non-interest-bearing liabilities. So, to an extent, there is a fair but rather opaque mechanism for paying for our free banking - we provide the bank with a source of free funds, and in return the bank provides us with a range of free services - subject to remaining within the rules.
The degree of fairness in this system is limited, due to the cross-subsidies among customers it creates. Customers with large, stable balances and who make few transactions provide valuable funding to the bank, without the bank incurring much expense in servicing the account. On the other hand, customers with small, erratic balances who make lots of small transactions cost much more to service than the value of the funding they bring. The former unwittingly cross-subsidise the latter.
A model that awards interest on credit balances coupled to a per-transaction fee basis would be more transparent. Given the prevailing low interest rate environment, it would be difficult to offer much interest on deposits until the Bank of England raises interest rates.
In economics, and free markets in particular, you often get the optimum outcomes when interests are aligned, and transparent and equitable allocations of costs vs benefits occur. It's not clear that introducing a fixed monthly fee while still awarding no interest on current account deposits, as some banks are either considering or have actually implemented, meets these criteria.
On the other hand, a model that awards credit interest while charging a per-transaction fee basis reduces cross-subsidies and is demonstrably fairer. It might just be a step in the right direction in restoring transparency and, dare I say, trust between banks and their customers.
Charging up the hill...
Let's do a little thought experiment on how this might play out in practice. Jack has an average balance of £5,000 on which he receives interest of £25 p.a. (which will be tax-free next year due to the abolition of tax on interest income). He makes five transactions per month which may cost him £12 per year. Net-net, Jack will receive £13 p.a. credit from the bank and is better off over the free banking model. Rather than cross-subsidising others, he gets credited for the value he brings the bank.
On the other hand, Jill has an average balance of £600 on which she receives £3 p.a. of interest. She makes 10 transactions per month and incurs fees of £24 and incurs a net cost of £21 p.a. Jill loses compared to the free banking model, but in a way that lays bare the myth of free banking. She starts paying for services used rather than benefiting from a hidden subsidy across the customer base. She might not like it, but can't really argue that it's less fair in a wider sense than the current set-up.
This is fine in theory, but what would motivate a bank to adopt this model given the prevailing view that abandoning free banking is committing commercial suicide as it bids farewell to its customer base? Well, all banks like to attract customers like Jack and are less keen on customers like Jill. The proposed model plays well to this narrative - you generate a win-win with a 'selection' effect. The quality of the bank's customer base improves as customers like Jack are drawn to the bank, and the less valuable customers like Jill leave to avoid paying for their banking, taking advantage of free banking offered elsewhere. The bank's competitors, on the other hand, experience 'anti-selection' as they absorb customers like Jill coming to them.
This is the mechanism by which the first mover of this proposed charging model actually steers the whole marketplace to adopt this pattern, finally dislodging the free banking model. This is not to neglect the undoubted social consequences for poorer customers who pay for their banking, although other providers of banking-type services, such as credit unions, might be a better option for them in any case.
DR GARRY SMITH is a risk management actuary at Hymans Robertson LLP and a member of the IFoA's Banking Member Interest Group