Is greed good May 19th 2005 From The Economist print edition

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Is greed good May 19th 2005 From The Economist print edition

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 businessthe 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

    below cost.

    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.

    Germanic gloom

    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' enthusiasmnurtured in the lean years after the

    second world warfor 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.

    Copyright ? 2005 The Economist Newspaper and The Economist Group. All rights reserved.

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