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.
The profitability problem - Coppola Comment