It is hard to think of many more important subjects in our world than the future of retail banking – that is, if we heroically put Brexit to one side for a day. There are over 72 million personal current accounts in the UK, with retail deposits of over £1.5 trillion, comprising current accounts, savings products and SME banking. Retail lending is a key driver of economic activity. On the latest evidence, UK households owe £1.3 trillion in mortgages and £198 billion in consumer credit. There are over 5.4 million SMEs in the UK. There are over 61 million credit cards in issue in the UK.
It is not surprising that we can produce very large numbers to represent the scale of retail banking in the UK, or in many other countries, as it is an essential service for all of us. More interesting I would say is evidence of the pace and scale of change in the industry. Sixteen brand new banks have been authorised over the last five years, with 38 in the pipeline, which must be a modern record. The rate of increase of use of digital and contactless channels is fast and unlikely to slow. With that goes a sharp increase in the frequency at which customers wish to extract information from their accounts. And, the scale of operational threats from fraud and cyber-attacks has increased.
Financial crisis 2007
Some of these changes are put into sharp perspective when we remember that we are rapidly approaching the tenth anniversary of the outbreak of the financial crisis in 2007. On its own, that is a somewhat sobering thought. But it does provide a perspective on what has changed over that time and what has not. I want to use this speech to describe those challenges that can arise, and their implications for the future of retail banking.
Balance sheet
I will start with balance sheets. One of the biggest changes is that ten years ago the pressure was on raising deposits, on funding what had become a very substantial expansion of balance sheets over the previous five years or so. There was a huge pressure on funding, which inevitably pushed up the cost and thus squeezed margins. Alongside that was the growth in the opacity of asset structures which made it harder to assess the likely future creditworthiness of borrowers and thus the solvency of banks. It was this lack of confidence in future solvency, combined with a critical shortfall of capital levels that was the undoing of many of those that failed.
It is almost ten years since I was first introduced to the balance sheet and business model of Northern Rock – a very fast growing and doomed retail bank. Three things struck me about the business model which goes beyond the usual diagnosis of lack of capital, important though that was. First, Northern Rock had to generate new mortgages at a faster and faster rate in order to feed the demands of its mortgage securitisation master trust, which was nearly half the overall balance sheet. It is hardly surprising that to do this it became over-concentrated at the lower end of the creditworthiness spectrum of mortgages – it couldn’t be fussy about what it took on. Second, by over-concentrating in wholesale and market funding through securitisation, it had a higher cost of funds than many other retail banks with, in particular, current account funding. In order to earn its target returns, it was pushed towards riskier lending. And third, the 50% of the bank that was not in the securitisation master trust was heavily funded by the cash flows of the master trust. But this funding had hard rating triggers, so that if the rating fell too much the funding would have to go elsewhere. It was in that sense a house of cards. And, we know what happened.
One big lesson I draw from this – for all of us, regulators and practitioners alike – is the importance of understanding business models and thus where banks earn their returns and how stable those returns are.
Different challenges
Let’s roll the clock forward ten years to today. The good news is that the system is more stable, but it faces different challenges. One striking change is that whereas a decade ago the challenge was to fund its balance sheets, today the greater challenge is to find lending opportunities that enable sustainable net interest margins to be earned. Although, it is a simplification, assets often appear to be relatively more scarce than funding. The regulators watch carefully for excessive risk taking in lending because the temptation is there. Fortunately, the experience of the crisis has led to a radical overhaul of the regulatory tools to do this – with stress tests and enhanced asset quality assessment; it feels like a very different world.
But the changes of the last decade have led to outcomes which are an important focus for the FCA as conduct regulator. For example, whereas in the crisis and the aftermath there was a marked trend for more banks to enter the current account market, which was perceived to be lower cost funding, today I see some evidence – not I should say in all cases – for it to go the other way, as current accounts are regarded as more expensive in terms of operational costs. This is, of course, consistent with relatively easier funding conditions.
Lending market
If we turn to lending markets, we see another feature which has a considerable impact on the returns from retail banking, namely the spread between the returns from so-called front and back book loans, newer and older loans. It is a pretty long established practice in UK retail banking that the returns from back books exceed those from front books. That makes the relative mix of back and front books one determinant of overall earnings. It also means that one set of consumers pay more than another set. I will come back to this issue for the FCA. By the way, Northern Rock appears to have gone some way towards solving the back and front book issue by churning their mortgage book at much higher speed – the two year fixed rate mortgage was a standard product. But this created a dependence on the earnings from fees which came from the churning.
Whole sale
When we look at the whole issue of retail banking business models, it is hard to escape the issue of free-if-in-credit banking. I have learned from experience that this is a subject which attracts particularly forceful commentary. So, as they say, let me be clear! I do not advocate ending free-if-in-credit banking. Why? Because there is no such thing to start with, so it cannot be abolished as such. Nothing in life is free – sorry to disappoint. Some of you may be saying “what is he on about”? Of course, banking isn’t free. So, free-if-in-credit means that costs are recovered and charges levied on some products and services more than others. And, this means some customers pay more or less than others depending on what mix of products they use.
The classical product that appears to be free is the current account itself. Indeed, there is a theory that the incentive to create what was a higher return product like Payment Protection Insurance was fuelled by the imbalance of returns across products. But current accounts are not free because, for one thing, their cost depends on the interest foregone in the rate paid on them. This is not an easy calculation to make – it has to be benchmarked against a cost of funding – and it is therefore opaque. The point is that retail banking is a product for which the cost can be hard to know with precision.
Next in the list of hard to knows in retail banking is the issue of unauthorised overdrafts. This product – if we can call it that – has attracted considerable attention recently, and for us it falls under the broader heading of high cost credit. It is one of – if not – the most obvious areas where retail banking crosses over into the high cost credit area. I think it poses a challenge, in relation to a couple of issues.
First, the concept of an “unauthorised” product is odd when described as such. It is perhaps better described as the consequence of an account going into debit. In some countries, this is more often than not covered by the account coming with a pre-agreed line of credit. Moreover, clearly some customers go into their overdraft much more frequently than others, and there is a reason for that, a point I will come back to when I consider the broader issues we face. Moreover, as banks tell me often, advances in technology and payment systems mean that it is now much more possible to control account balances nearer to real time, creating the opportunity to limit the advance of overdraft credit. I will come back to this issue.
The second challenge posed by unauthorised overdrafts concerns their cost. It is quite regularly argued that their cost exceeds the price cap that the FCA imposed on payday lending. We are currently reviewing this as part of our overall assessment of high cost credit. For retail banks, it is also an issue because it illustrates well the challenge of how costs and returns are spread across products and thus customers – since, as I mentioned, customers with some characteristics are more likely to use overdrafts than others. And, of course, it underlines that one of the meanings of free-if-in-credit is that the reverse holds. It isn’t free in debit.
Our work
I want to end by briefly describing three pieces of work that we are doing to improve our ability to enable answers to be produced to the issues I have set out. The first piece of work is our strategic review of retail banking business models. This is very much a piece of discovery work to start with, focusing on links between different products and services and their relative profitability. It includes the impact on different groups of customers. It should enable us to assess better the impact of changes – for instance in technology – on retail banking business models. It is very much an empirically driven piece of work which picks up where the Competition and Markets Authority (CMA) left off, but is not a full evaluation of the functioning of competition in retail banking markets. It is broader in scope than the CMA’s work, which focused on personal current accounts and SME banking. We are covering both sides of the balance sheet of banks – deposit taking and lending. We are already in touch with stakeholders on this work. It is, I should say, an ambitious project. My hope is that we can lay out a body of evidence from which conclusions can start to be drawn. But, let me manage expectations! We expect to be working hard for the rest of this year and into the first two quarters of next year to get the evidence laid out.
We are also taking action on the recommendations made to us by the CMA following their investigation into retail banking. We are making good progress on these recommendations which include measures to improve service and to increase customer engagement with their current account. We will bring forward the first set of proposals on service metrics shortly.
The second piece of work is our review of high-cost credit including overdrafts. Last November we issued a Call for Input covering high cost products, overdrafts, the high-cost credit short-term price cap and report and multiple such borrowing. We are looking at all high-cost products to build a full picture of how these are used, whether they cause harm and, if so, to which consumers. We will then be able to decide if we need to intervene further. We are also reviewing the overdraft market in detail following the CMA’s review which identified problems in the market. We are also reviewing the price cap on short-term high cost loans which came in force in January 2015. We intend to publish our findings on this over the summer.
The third piece of work will appear in the near future, and is a thematic review by our supervisors which responds to a recommendation from the Parliamentary Commission on Banking Standards report in 2013 that banks should assess customers understanding of the products and services they deliver.
As you can probably tell, retail banking is a big agenda of work for the FCA. But, as I hope I have described reasonably accurately, the underlying issues are not small ones. And, finally, if you feel disappointed that I have not set out a view on the likely conclusions and responses, I will say very deliberately – let’s get the evidence together to enable a better assessment of these important issues. Thank you.
Source: fragments of the speech by Andrew Bailey, Chief Executive of the FCA, that is delivered at the BBA Retail Banking Conference, Thursday, 29 June 2017
