Monday, 29 April 2013

Turning back the clock? The future of retail banking

In my last post, I commented that there is a fundamental problem with retail bank profitability about which regulators unwisely appear totally unconcerned. Various people have suggested that I am therefore calling for looser regulation. That is a misunderstanding. The issue runs far deeper. Really it calls into question the future of banking as we know it. 

Many people would like to return to a supposed “golden age” of banking, when banks were small and local and bank managers were respected pillars of the community with real power to make lending decisions. And I understand their nostalgia. In some ways they are right. We need to restore trust in banking. But should we - or could we - turn back the clock?

Retail banking began to change in the 1960s with the advent of non-bank lenders and development of money markets.  The UK’s banking cartel was ended in 1971 to level the playing field for banks and non-banks, encouraging competition to give a better deal for customers.  The lifting of exchange controls in 1979 forced banks to compete for deposits with the Eurodollar market. The breakup of the building societies’ cartel in 1983 and relaxation of restrictions on savings banks to allow them to offer a full range of banking services increased the competitive environment for retail banks and reduced their profitability.

In response to this, retail banks started to cross-sell products such as endowment mortgages and pensions early in the 1980s. After Big Bang this expanded considerably when they bought up non-banks that traditionally had provided these products. Despite this, retail banks’ profitability continued to decline, forcing them to seek better returns by gaining market share. They introduced free current account banking and other incentives to attract retail customers. Conversion of building societies into banks from 1988 onwards enabled retail banks to buy up their smaller competitors, and deregulation of merchant banking and the stock market enabled them to acquire ready-made investment banking arms. The age of universal banks had arrived.

Retail banking’s low profitability also forced change from within. The old retail banking model was popular with customers but expensive to run. And keeping back office processing in the branches prevented banks from benefiting from economies of scale and computer technology. So banks centralised their back–office processing in specialised centres with giant computers. Stripping out back-office processing from the branches allowed them to reduce staffing levels and give more focus to product sales.

A new view of retail banking was developing. As deregulation removed the boundaries between different types of financial product, banks saw themselves as “one-stop shops” where customers would come for ALL their financial needs. For retail banks this was a lifeline. Their core retail offering of deposits, payments and vanilla lending was only marginally profitable. But if they could use deposit and current account balances to fund more profitable activities, then it was worth attracting deposits and current accounts. And even more importantly, even if they couldn’t make any money out of core retail banking, they could cross-sell other products to their customer base. Suddenly retail customers became very desirable, particularly at the low- to middle- income level where people traditionally were paid in cash and had little borrowing. They represented an enormous sales opportunity, not just for retail banking products but for far more lucrative things such as endowment mortgages, pensions and insurance.

Bank staff didn’t understand these products, but they were given aggressive sales targets for them with penalties for under-performance.  Mis-selling started from the moment that banks diversified into added-value products. The scale of mis-selling across the range of added-value retail financial products has driven people away from banks: few people now would buy insurance from their high street bank. Even trust in core retail banking products has been eroded by what is seen as appalling behaviour by some commercial banks. Investment banking has borne the brunt of people’s anger, and it has suffered a severe contraction, with thousands of job losses. But the large universal banks are far from popular – hence the rise of movements such as Move Your Money, which encourage people to move deposits and current accounts to smaller banks and non-banks such as building societies and credit unions.

The overlay of profitable added-value activities is being stripped away from retail banking, leaving an increasingly unprofitable core. .Very low interest rates are destroying bank margins, while regulation forcing them to maintain higher levels of capital and liquid assets raises their costs. Branch use is declining as customers turn to automated payments and online and telephone banking. As the use of cash declines, transactions through payments systems are at an all-time high, which is a cost to the banks but not currently to their customers. There is growing competition from non-banks for traditional retail lending products, especially online where lending decisions based on credit scores can be made in a matter of minutes.  Legislation is planned to force banks to limit the use of deposit balances to supporting retail lending, not higher value investment banking activities.  And regulators are determined to limit the range of products that banks can sell. To me this does not look like a viable business model. Somehow, retail banks have to make some money.

I foresee a number of ways in which they might improve their profitability for the future.

Free current account banking will end.  Banks are already introducing accounts with monthly fees.  There may be fee-based current accounts similar to mobile phone contracts, setting limits on the volume and types of payments that can be made for a given monthly fee: perhaps there might be a “pay-as-you-go” option for low-volume payments users.

The mass market in banking is going online. Competition in the online marketplace is intense, but online banking does not have the overheads of high street branches, so for many banks, a move to the online market place may signal a return to profitability.

Branch banking is set to change radically. Some banks in Ireland have already closed all their branches, and in the UK hundreds of branches have already closed and many more closures are planned. It seems unlikely that there will continue to be “high street” branches as we know them. However, there will still be a need for local banking to support the elderly, the low-paid and small businesses. So the future for branch banking may be part-time cashier outlets in local shops, and small local banks offering fee-based personalised services.

More radically still, the big banks may find their dominance challenged. Large retailers are creating their own banks: Marks & Spencer is now offering current accounts, and other retailers are bound to follow suit. 

There can be no return to the banking of the past. Even the supermarket-style high street bank branches to which we have become accustomed are doomed. But diversity in finance is set to increase, and that is surely a good thing for both banks and customers. 

Related links: 

The profitability problem - Coppola Comment


  1. The problem is that runs into what is socially necessary.

    Everybody needs a bank account now that the ability to get paid in cash has gone.

    Remember that cash is printed by the state and is essentially usable for transactions free of charge.

    So you are right that the future of banking is pretty much as you describe it - unless the state intervenes to force it to become something different.

    1. I agree. In fact on twitter yesterday Sharon Bowles and I discussed the possibility of creating a state-funded utility bank.

    2. I think we'll see a combination of generic mobile payments and on-line transfers of land-based (local) and energy-based (generic) currencies. Neither of these forms of 'money messaging' - as Bitcoin demonstrated - need or will involve banks.

      Then I think we will see decentralised local credit creation and clearing:

      (a) People-based - essentially a community credit card; and

      (b) Asset-based - direct 'peer to asset' investment in 'prepay' units in future revenue streams from land (low risk); energy (medium risk) and IP (high risk).

      The role of local banks-as-capital-lite-service-providers will be to manage guarantee limits in respect of community credit

      and to advise in relation to peer-to-asset investments, eg in prepaid property rentals and heat loans funding carbon fuel savings.

  2. Question; How does this work; 'Very low interest rates are destroying bank margins'?

    Don't the banks borrow at 0.5% and lend at 5%?

    1. The problem is their existing lending, much of which is priced at base + margin. Base rate is 0.5%, yes, but their cost of funding is higher than that - it depends on the market view of their risks. And inflation is running higher than their marginal income. So an existing SVR mortgage with a margin guarantee may be paying only 2% interest or less (mine has been 1.5% for the last 4 years), which is quite possibly less than their funding cost and certainly less than inflation. In effect it is a negative rate - which is a cost.

    2. Thanks. Next question; When I use my credit card, doesn't the bank get 2.5% of every transaction? Even in store?

    3. Yes. They charge fees for credit card use. Card services are separate from retail banking though - Barclaycard for example is an independent division in Barclays. Contributes to overall profits but doesn't improve the unprofitability of branch-based retail banking, which is what I was talking about.

    4. Fair enough. But is my current account really free? I have to pay a minimum of £1500 into it every month, on which I get no interest. I also pay £25 a year to stop them taking a limb if I inadvertently go overdrawn. I have £8m in my zero bearing savings account, by the way, and they pay me next to nothing on my 26 cash ISAs. Is it really 'free'?

    5. You don't pay for any transactions in and out of your current account, do you? Having said that....actually you pay in other ways, of course. But the fewer opportunities there are for banks to make money in other ways, the more core retail banking will have to bear its own costs.

    6. Isn't M&S Bank just HSBC with a wrapper?

    7. Not really. 50:50 partnership. At some point I expect M&S will buy it out - as Tesco did with RBS.

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  5. Frances - I still don't follow why core retail banking is unprofitable (and has been since 1980). If the net interest margin is too thin, why can't this simply be addressed by banks sorting out their pricing models? Why aren't banks pricing their loans (or deposits) correctly? Why should retail banking see any greater competitive intensity than any other sector?

    For the banking system as a whole, loans should more or less = deposits (this seems roughly the case internationally, based on this graphic: I would guess that to the extent a bank has a very high loan/deposit ratio, it may indicate a large chunk of the loan book being overseas, where it is harder for it to attract deposits.)

    So considering a bank's domestic retail lending book, it ought to be possible to strive to fund this 100% with deposits, where the bank will have greater control over deposit rates (and, in future, charges!) and thus a good ability to protect its NIM.

    What am I missing?

    1. Anders,

      No. The domestic loan book can far exceed domestic deposits, and indeed did for most UK banks prior to the financial crisis. Wholesale funding was widely used to fund domestic retail lending. Since the financial crisis banks have been actively working to reduce their loan/deposit ratios. However, deposit funding itself is not "safe": you might wish to recall that Cyprus's banks were mainly funded with deposits....

      The problem really is customer expectations. People have come to expect cheap loans, free banking and high deposit rates. Add all of those up, remove the added-value products that were beefing up retail bank margins, and you have something that is fundamentally unprofitable at the prices customers expect to pay. Hence my remarks about free banking being unsustainable. I also think interest rates on most lending will have to rise significantly, and interest rates on deposits will have to remain low.

      Banks do not have complete control over deposit rates. Bank deposits and other liquid investments such as gilts are substitutes. If bank deposit rates are too low relative to the substitutes, money leaves. That's not a problem at the moment with gilt yields so depressed, but it would be if yields started to rise.

    2. Profitability is surely a function of supply and demand. The supply environment has become more benign since 1980 given the consolidation in retail banks (even taking account of entrants like Tesco Bank). So if there is systemic pressure on profitability in retail banking, this must be a function of demand (which must outweigh the supply effect). But it's not as if people have stopped wanting loans. Isn't a slowing in demand more likely to result from the fact that, after a long period of increasing credit intensity (increasing private indebtedness relative to GDP or other income metrics), credit intensity has now slowed and may even slightly revert towards the mean? In other words, pressure on profitability is largely a function of banks' having historically grown their retail lending books too fast?

      You say "prior to the financial crisis...wholesale funding was widely used to fund domestic retail lending". I was aware that UK banks en masse have LTDs > 100%, but assumed this was an international phenomenon. If LTDs have long been >100% even for the retail books, then where did the missing deposits go?

    3. LTDs were well over 100% for the retail books. I believe prior to the financial crisis the average LTD ratio in UK retail banks was 137% and in some banks it was much higher - Northern Rock reached 184%. Deposits don't have to remain in retail banks - they can be placed in investment funds for example. So even though loans create deposits, that doesn't necessarily mean matched funding.

      The core profitability problem is secular, not cyclical as you suggest - so not a recent problem. It was disguised by banks selling (and mis-selling) higher-value products such as insurance off the back of low-margin vanilla retail banking. Those are now being eliminated, either because people don't trust them, because of increased competition especially from online marketplaces, and because of regulatory tightening. This leaves the fundamental unprofitability of core retail banking as it has been done since the 1980s exposed. If retail banking is to survive as a commercial industry, then either products will have to be allowed that give higher returns (& are therefore higher risk), or people will have pay more for current account services and vanilla lending.

  6. I agree that if we get banks to stop ripping people off on add-on services, the core functions will have to become more expensive, though why should it be monthly fees? The marginal cost of a dormant account is practically nil (a few kilobytes of disk space) and objectively it would make more sense to charge on activity.

    ATM fees, for instance, would really make more sense (using cash is a net cost to both the banks and society, so it would be good that the public sees that costs rather than have heavy cash users enjoy a free ride) than monthly fees, at least if you could get the public to understand...

    1. I wasn't assuming monthly fees. I was thinking that banks might offer a range of fee packages rather as mobile phone operators do. Mobile phone operators offer both monthly fees and pay-as-you-go....similar choices might be good for bank accounts. Monthly fees better for ppl who do a lot of transactions, pay-per-transaction better for light users. It's all to do with transaction charges though.

  7. "to level the playing field for banks and non-banks, encouraging competition to give a better deal for customers"

    The NBs/SBs do not compete with the CBs. Money flowing through the non-banks never leaves the CB system. Savers never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries (non-banks).

    Shifts from time/savings deposits to demand deposits within the CBs & the transfer of the ownership of these deposits to the non-banks involves a shift in the form of bank liabilities (from TD to DD) & a shift in the ownership of (existing) DD (from savers to non-banks, et al). The utilization of these DDs by the non-banks has no effect on the volume of time/savings deposits held by the CBs, or the volume of their earnings assets. I.e., the non-banks are customers of the member, money creating, depository banks.

    In the context of their lending operations it is only possible to reduce bank assets, & deposits, by retiring bank-held loans, e.g., for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

    1. The sentence you quote refers to the lifting of credit controls and the ending of the banking cartel in the UK in 1971. I assume you don't know anything about this, since your comment has nothing whatsoever to do with it. The credit controls that were lifted in 1971 were on lending, not deposits.

      I would appreciate it if you did not use the acronym "CB" to mean a commercial bank. It is confusing for me and for my readers, as on my posts generally that acronym means "central bank" (Fed, BoE, ECB, BoJ etc.)