Is greed good?
May 19th 2005 From The Economist print edition
Sometimes banks can seem too profitable
IN A recent poll about the chief risks facing financial institutions, a senior British
clearing banker pointed to the public perception of “greedy banks”. Last year
Britain's four biggest banks between them made profits of ?23.3 billion ($43 billion),
a 16% return on equity. About ?6.7 billion of that came from their retail banking
operations in Britain. That means a profit of about ?126 per customer.
Not even customers would like their bank to make a loss. However, there are two
questions to be asked about such fat profits. First, do they point to a market
inefficiency, ie, is there some reason why competitors have failed to provide cheaper
services? Second, is the quality of these earnings good enough for the banks to rely
on them in future?
In Britain, competition from consumer-finance companies, mortgage brokers and
alternative deposit-takers is certainly growing, but bank customers are very reluctant
to switch their main account. The big British banks have generally been more
successful than banks elsewhere at selling their depositors additional products such
as unsecured loans, mortgages and insurance. The bulk of their recurrent earnings
comes from that legacy of captive business—the so-called “back book”. But their dominant position as deposit-takers of choice is slowly being eroded, so any
competitive inefficiency will not last.
As for the quality of earnings, it seems that the British banks are world leaders at
confusing their customers and extracting extra charges. One area of rich pickings is
overdrafts, particularly the unauthorised sort. Which?, a magazine published by the Consumers' Association in Britain, calculates that in 2003 banks made more than ?3
billion from charges for unauthorised overdrafts. In an article published last
September, Which? showed that customers pay anything from ?18 to ?30 for
stepping over the mark, and a lot more if the overdraft continues, usually ?5 per day,
up to a maximum of ?80 a month, with perhaps ?25 added for each extra
transaction. That does not include interest charges on the actual overdraft, which
can be as high as 34% at an annual rate. Nobody pretends that such fees bear any relation to costs. The banks say that they
have to charge high rates to cover the credit risk of defaulting customers, and that
this subsidises cheap banking for good payers. But they do not make it easy for
customers to compare and understand their scale of penalties. All British banks have
signed up to a voluntary banking code obliging them, among other things, to give 14
days' notice before applying charges for “standard account services”; whether that
includes unauthorised overdrafts is unclear. Banks and loan companies play the same game with late payments and with
repayment insurance on credit-card accounts, says Which?, noting that of 2,000 people interviewed, “a staggering one in four people were charged at least once for
paying late or exceeding their credit limits.” That netted the banks around ?427m. A
repayment-insurance premium added to a loan, sometimes without the borrower's
knowledge, can sneakily double the borrowing cost. Another, less tangible, problem is borrowers being tempted to run up debts that they
cannot manage. Banks or credit companies often arbitrarily raise borrowing limits
without alerting the borrower or doing a credit check.
Two of the statutory responsibilities of the Financial Services Authority (FSA), the
industry's super-watchdog in Britain, are to promote public understanding of the
financial system and to secure appropriate protection for consumers. Being “fair to
the consumer” is a slogan the FSA has championed. But the FSA has little to say
about correcting anti-competitive behaviour by banks. It insists it is “not a competition regulator”: that is the job of the Office of Fair Trading. But the banks
may be unwise to rely on gouging unwitting consumers for some of their future earnings.
Some French banks too have been making large profits in their domestic market,
prompting a study last year by Que Choisir, the French equivalent of Which?, into
French banks' charges for routine services. Que Choisir calculated that French banks
charge a margin of between 35% and 100% above the costs of technical banking
services such as payments by cheque and online, direct debits and other account
services. In most cases the margins have risen dramatically between 1999 and 2004.
On the other hand La Poste, the post office bank, has been running such services
Germany's banks probably wish they had the French banks' problems. The pressure
on margins in Germany is so strong that many banks cannot make a profit from
everyday retail banking. A decade or so ago this was mainly because of competition
from the savings banks, and to some extent the co-operative banks, which together
make up about half the market, and at that time had little interest in making profits.
Savings banks are mostly owned by the local authority and have a political and social
role. Co-operative banks are owned mutually and are run for the benefit of their
members. The private banks tried to compete on the same terms, spreading their
network of branches widely and triggering a price war.
The big German banks have been paring their costs and closing branches, but they
still cannot make retail banking pay properly. One exception is Deutsche Bank, which
has concentrated on the affluent and reported a 22% return on equity in this sector
for 2004. As for the rest, the phasing out of the savings banks' public guarantees
from July this year should widen their margins a little, and Basel 2 may also help.
It was foreign banks, entering the market without preconceptions, which showed
that well-targeted retail banking could be profitable. Back in 1973, Citibank bought a
small bank, Kundenkreditbank, and has turned it into one of the most successful
small banks in Europe, with a return on equity in 2004 of 39%. Dutch-owned ING
DiBa has been drawing customers by offering high rates on internet deposit accounts.
But the environment is getting ever tougher. Postbank, mostly using the branches of
Deutsche Post, its majority owner, claims to have 11m customers and is expanding
its range of products. Banks owned by carmakers are growing rapidly, targeting the
more affluent customers. VW Bank, Audi Bank, DaimlerChrysler Bank and BMW Bank
provide not just car finance, but credit cards and asset management too. “They have
a fantastic branding advantage,” says a retail chief at one of the big banks. “Walking
into the branch of an ordinary bank does not give much pleasure, but someone who
has just bought a new BMW likes the idea of a BMW credit card and a BMW
investment fund.” Does all this competition mean that the German customer is getting the best and
cheapest deal in Europe? Up to a point. But German banks have generally been
competing on price, not service. For example, branches tend to close for two hours
at lunchtime, just when working people want to use them. To be fair to the
management, it is usually the bank workers' representatives who insist on the break.
An alternative society
Many people thought that the internet would come to replace the simpler parts of the
banking system. If you can order goods, bid at auctions and download articles, music
and films, then why not use the internet to bypass banks and send each other
money? It hasn't happened. Nor has the mobile phone replaced the wallet, except for
buying trivia such as screensavers and ringtones.
No non-bank has yet been able to command the trust that a non-trivial financial
transaction requires, so transactions online, by mobile phone or by credit or debit
card still begin at a bank account. Even PayPal, which is used for payments on eBay,
an internet auction site, is only an intermediary between the bank accounts of the
buyer and seller. There are also various internet projects to provide business-to-
business (B2B) payments without bank intermediation, but again the trust is absent.
One experiment with storing savings electronically is e-gold, which allows subscribers
to invest in gold electronically and pay for goods and services on the internet in units
of gold from their virtual account. That is tantamount to creating a new currency. But
the project has not taken off. At the last count the total of the gold “currency” in
circulation was only $28m.
Electronic purses or cards with cash stored on them are beginning to appear.
Octopus cards in Hong Kong and Oyster cards in London are among the loadable
card schemes used on public transport. These cards can also be used to buy goods at
newsstands. But they are no substitute for a current bank account.
Mobile-phone companies have also flirted with using their billing accounts as a way
for subscribers to pay for large items as well as small. Simpay, a project sponsored
by several mobile-phone operators including Vodafone, plans to launch an operation
by mid-year in Spain, followed by Britain and Belgium, but initially only for items
below euro10. New experiments with financial services on the internet keep popping up.
Sparschwein AG is the latest offering from Munich. Sparschwein (German for piggy-
bank) appeals to the Germans' enthusiasm—nurtured in the lean years after the
second world war—for saving pennies and for recycling, but with a difference. It
encourages them to unlock the dead capital they have in their attics and cellars, in
the form of unwanted antiques, exercise bikes, computers, hi-fis and a host of other
things. Sparschwein agents will come round and assess the goods, and if they like
them store them in one of two warehouses in Germany. Then Sparschwein helps the
customer auction the goods on eBay. The proceeds go into the customer's Sparschwein account.
The founders of Sparschwein are interested not only in getting goods to auction, but
also in developing a secondary market for pieces of paper with a residual value, such
as unexpired mobile-phone contracts, life-insurance policies, health-club
memberships and so on. Matthias Kröner, co-founder of Sparschwein, is thinking of
getting into closed-end property funds, some of which might be available at
distressed prices. “We're the classic recyclers of the financial-services sector,” he
But Sparschwein itself is not a bank. The customer accounts are held at Deutsche
Kreditbank, a subsidiary of Bayerische Landesbank. Once again, underneath the icing
of innovation, the trusted third party turns out to be a bank.
In London, Zopa is trying another new idea: cutting out the intermediaries in
borrowing and lending. Zopa stands for “zone of probable agreement”. The company,
again largely internet-based, aims to get potential private lenders and borrowers
together, establishing a rate that both sides are comfortable with (a zone of probable
agreement). Rates for individual borrowers are guided by the borrower's personal
credit rating provided by Equifax, a credit bureau. Cash committed to lending is
spread over a minimum of 50 borrowers, and the exposure per lender is limited to a
maximum of ?200 for each borrower. Zopa makes its money by charging the
borrower an arrangement fee of 1%.
Whether it will take off depends on the number of people self-confident enough to go
outside the usual banking channels. It has already seen interest from societies and
minority groups that would like to lend to people within their own circle. Again, Zopa
does not pretend to be a bank; it is regulated as an introducing broker by the Office
of Fair Trading, and as an introducer of credit insurance by the Financial Services
Authority. The debits and credits are held in a client service account at the Royal
Bank of Scotland. Self-help groups that club together to reduce their borrowing costs are nothing new.
They are one way of getting finance to the poor, an area neglected by the banks in
places such as India. The Indian banking system is heavily controlled by its central
bank, through a network of publicly owned banks, and shows little sign of liberalising,
as the next article will show.
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