The coming squeeze on free banking

Bankers like to talk about how much their industry has been transformed in recent years, be it by crisis, regulatory overhaul or technological change. But headlines from 1984 would sound strikingly familiar for any modern British executive.

The four large clearing banks that dominated the UK market were struggling to get to grips with rising costs and growing competition from smaller upstarts. Pressure on profit margins threatened to make their current account offerings unsustainable. 

“It does not take much imagination to see what happens when interest rates fall further,” warned the FT’s Lex column.

More than 35 years later, the same four banks dominate, despite a few changes in ownership and names. Regulation has driven up costs while competition has driven down profit margins, and many observers have suggested a further interest rate cut could spell the end of their current business models.

In the 80s, Lex suggested the logical response to the pressure would be for banks to “set more realistic charges on the services they provide”. Banks did the opposite: the industry is still paying for that decision today.

They slashed fees to avoid haemorrhaging customers, subsidising the new “free” accounts by lending out customers’ deposits at high rates and levying expensive penalties against those who made mistakes such as unexpectedly dipping into an overdraft. Andrew Bailey, now governor of the Bank of England, once said the idea that banking could be free was a “dangerous myth” that encouraged product mis-selling.

This time around, banks don’t have the same option. With interest rates at record lows, revenue from traditional lending is under pressure, while the Financial Conduct Authority has made clear that it disapproves of business models that rely on overcharging a minority of customers for example for unarranged overdrafts.

Even the smaller challengers are feeling the pinch and looking for new ways to raise revenue.

Approaches vary: some lenders are putting more effort into cross-selling other services such as insurance or wealth management, while others will try to — at least partially — reverse the reliance on free accounts that has dominated for the past three decades. Whoever you bank with, however, UK consumers will soon face growing pressure to start paying their way. 

The changes may be unpopular with those who are unused to paying for banking services — or at least not receiving a bill for them. Which?, the consumer group, warned last year that it would be a “huge and risky move” for one of the major banks to start charging for regular accounts. NatWest, Barclays and Lloyds lost hundreds of thousands of customers in the space of 12 months when they tried to resist the initial spread of free accounts in the 1980s.

However, some experts hope the pressure will create a fairer, more transparent market. “The UK industry has put about this impression that products are free,” says Paul Pester, chair of the Fairer Finance Consumer Advisory Board and former chief executive of Virgin Money and TSB. “It’s just not the case. Consumers don’t understand what they’re paying, and often it’s those least able to who end up paying more.” 

Low rates erode bank margins

Lloyds Banking Group, which also owns Bank of Scotland and Halifax, said in its annual report at the start of 2020 that a 25-basis-point reduction in the Bank of England’s base rate would wipe about £150m — 5 per cent — from its annual revenues. Within a month of publishing those figures, the base rate had fallen by 65 basis points to 0.1 per cent.

Amid much speculation about the potential impact of negative rates on the provision of services, Lloyds’ figures show why banks have already started looking for new ways to make money out of their customers.

“It’s already happening,” said the chief executive of one high street lender. “You’ve still got to offer a free basic account and we all do, but . . . every bank including neobanks are starting to bundle products or offer different combinations. Some fees are relatively small, but we will see more and more of this.”

With the exception of Barclays and HSBC, which have large investment banking units, the bulk of profits at British banks comes from their net interest income — the difference between the interest earned from lending, and the interest paid to savers and other sources of funding. 

Many loan rates are directly or indirectly tied to central bank rates, meaning that as interest rates fall, so do revenues from lending. However, with most savers already earning practically zero interest after a decade of cuts, banks have been unable to offset the reduction in income by lowering funding costs. As a result, their profit margins fall. Lloyds reported a net interest margin of 2.42 per cent in the third quarter of 2020, down from 2.88 per cent in the same period the previous year.

In the eurozone, where central bank rates have already been negative for several years, banks have only dared pass on the charges for holding cash to large companies or the very richest consumers, for fear that customers would simply withdraw their savings.

Alongside record low rates, regulators have clamped down on some of banks’ most lucrative alternative sources of income. Last year, for example, the Financial Conduct Authority banned banks from charging higher rates for falling into an unarranged overdraft, after finding that banks were generating a disproportionate amount of income from a tiny percentage of customers.

Banks responded by charging higher rates to those with pre-agreed overdrafts as well, with the largest lenders levying close to 40 per cent on all overdraft customers. But the increase will not be enough to offset the hundreds of millions of pounds previously generated each year from unarranged loans.

Other income sources, such as the interchange fees generated whenever customers pay with a debit or credit card, have also fallen substantially after European regulators introduced a cap — though a small part of this will be reversed as a result of Brexit.

A senior executive at another high street lender said: “It’s great news for customers, but that’s a commercial challenge for a bank trying to make money . . . the amount of money a bank can make from a current account has been significantly reduced through the combination of those factors.”

Ban on total end to free accounts

Despite recent commentary predicting an end to free banking, lenders cannot completely withdraw free accounts. Under the 2015 Payment Accounts Regulations, the UK’s nine largest traditional banks and building societies are legally required to offer fee-free basic accounts, and more than 7m consumers held such accounts as of June 2020.

The law provides an effective “floor” on how many features banks could remove from their free standard accounts. When a HSBC executive suggested last year that the bank might start charging for standard services in some markets, the bank quickly clarified that “whatever happens with negative interest rates, we’re committed to continuing to provide basic bank accounts”.

Basic customers may not be eligible for services such as an overdraft or cheque book, but are guaranteed access to payment networks and branch and Post Office counter services.

Still, Sarah Coles, personal finance analyst at Hargreaves Lansdown, says lenders have “an awful lot of wriggle room” to raise extra cash and encourage customers to switch to fee-paying accounts by removing free features and charging more for those that are only used occasionally. “The amount each bank charges differs enormously already, so they can increase fees without people particularly noticing,” she adds.

New charges for once-free services

In November, app-based bank Starling started charging £5 for replacement debit cards and £20 for CHAPS transfers, which tend to be used for occasional high-value payments like placing a house deposit. Its digital rival Monzo, meanwhile, introduced a similar replacement card charge along with a 3 per cent fee for ATM withdrawals after the first £250 per month.

TS Anil, Monzo chief executive, says the company’s approach is fairer than the traditional route of subsidising the majority of customers by punishing those who fail to shop around, make mistakes or run into unexpected problems.

“My general view is transparency trumps cross-subsidies. We make something available to customers, and give them the tools to make good decisions . . . Is it OK for us to make a reasonable amount of return providing services to customers? Absolutely yes. Giving it away for free and therefore not being sustainable and having to make up the money insidiously somewhere else feels less attractive.”

Revitalising premium accounts

Occasional fees such as charging for a replacement card will help to keep costs down, but are not enough to move the needle on a bank’s income statement — Monzo says only 10 per cent of customers have ever ordered a replacement card and only 1 per cent have ever ordered more than two. It is pinning more hopes on monthly subscription fees for premium accounts.

Premium or packaged accounts have been around for years, offering perks like higher interest rates or travel insurance and airport lounge access in exchange for a monthly fee, but have received renewed attention since low interest rates began to bite. 

Monzo has signed up more than 100,000 subscribers since relaunching its £5 a month and £15 a month premium accounts last year — still a small fraction of its total user base, but Mr Anil says he is confident more consumers will be willing to pay.

“Most customers are happy to pay for stuff they value [and] these are not static products, we will continue to improve them and make them more useful and relevant,” he says.

Start-ups such as Monzo and Revolut have been the most prominent recent exponents of premium accounts, attempting to lure subscribers with flashy metal cards as well as more standard features. However, high street lenders are also putting more effort into the once-neglected area.

NatWest is encouraging customers to sign up for its “Reward” accounts, while TSB and Virgin Money both plan to introduce premium accounts this year.

Ms Coles says packaged accounts tend to appeal to “people who aren’t all that excited about money”, who appreciate not having to shop around for products like travel insurance.

Risk of mis-selling scandals

However, packaged accounts have sometimes gone beyond charging slightly more for a convenient product, into territory that regulators considered mis-selling. Banks spent £1.6bn between 2014 and 2018 compensating customers for mis-sold packaged accounts, with many customers complaining that they had paid for features such as travel insurance that they were not actually eligible for. 

One executive said their bank would now offer subscribers features such as cashback on bills or discounts at certain shops, but was unwilling to bundle additional products such as travel insurance because of the risk of further mis-selling. 

Fairer Finance’s Mr Pester says: “If customers don’t realise they’re double insuring themselves, or they don’t really understand the true cost, that’s a conduct risk for the bank, and ultimately for investors.”

As well as being encouraged to pay for everyday banking, better-off customers should also expect more attempts to sell them long-term products such as investment advice.

NatWest already has “premier” services for customers who earn more than £100,000 per year or have the same amount in savings, which include access to a relationship manager. Premier banking is separating from NatWest’s main retail arm and will be integrated with the part of the group that runs Coutts, the private bank.

Similarly, Lloyds plans to make insurance and wealth management a core offering, a focus reflected in its choice of new chief executive. Charlie Nunn, who takes over later this year, was previously global head of wealth at HSBC.

Lloyds’ so-called “mass affluent” customers are being targeted by a new joint venture with Schroders, the wealth manager, and it will soon announce a new execution-only investment service.

Banks have also started raising prices in less visible areas. The average spread on mortgages reached its highest level for more than six years in September, according to Bank of England data, despite the fact competition has remained intense.

After years of mis-selling scandals over products such as packaged accounts and payment protection insurance, consumers may be sceptical of bankers who claim they are trying to make the market fairer when they raise fees. 

The irony is not lost on executives as they prepare to try out further revenue-generating experiments in the coming months.

“There’s a challenge in that area, balancing the value and reputation side of it,” admitted the high street executive who complained that current accounts were becoming unprofitable. “For [new fees or products] to be worth doing, it has to generate significant revenue. If it generates significant revenue, it’s a significant reputational risk. Every bank is going to have to play those off against each other.”