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Profit vs purpose in financial products

In its publication 'Culture and purpose in financial services', ICAEW’s Financial Services Faculty highlights that for some financial products the profits that they present might not fit with their purported purpose. Here the faculty takes a closer look at two examples: free banking and standard variable rates.

Free banking

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We all know nothing is free in this world, but for people who have money in the bank and aren’t overdrawn, most banks offer a free current account option, or multiple options. But why offer free “in credit” banking?

Low cost funding

Customer deposits (the money kept in a current or savings account) are one way of funding lending, alongside borrowing from other banks and central banks among other sources. These deposits are a really cheap source of funding for the bank as they pay a very low rate of interest to customers on credit balances, 0.0% on some current accounts.When they lend money to customers for mortgages at 4%, this then means a 4% margin or profit. If they are had to borrow money from somewhere else they might have to pay 1% so only a 3% profit. The lower funding cost makes up 40% of current accounts profits.

Swaps

While many individuals’ bank balances will peak after pay day and decrease over the course of a month, the collective amount that customers have deposited with the bank remains broadly the same across a month (in part due to customers having different pay days).

For example, a bank may find that they have at least £3bn of current account balances throughout the month. This may go up to £7bn towards the end of the month and as low as £5bn mid-month, but on average, the current account book is always more than £3bn.

This allows them to take out an interest rate swap offering the counterparty the variable rate (the rate they’re paying customers) and receiving a fixed rate (for example 1.5% as a 10-year swap rate). This earns the bank money and allows them to manage some of their interest rate risk.

Some customers win, some customers lose

Where in credit customers have free banking, other customers do not. Customers who are not in credit will pay overdraft fees and charges.

These fees and charges make up 30% of current account profits. It’s not necessarily the case that the charges reflect the cost of providing overdraft services, in fact those paying the fees (generally those who are least able to afford them) subsidise customers who remain in credit. Just 10% of customers pay more than half of all overdraft charges.

Free banking is not a straightforward customer proposition, and while many see the benefits, the way the product is generally structured means those who can least afford to are most likely to lose out.

Standard variable rates and customer loyalty 

Teaser rates

A lot of organisations make money from customer inertia or laziness. Many mortgages offer an attractive teaser rate at the beginning (for example, two-year fixed rate mortgages are available for around 1.5%), but after a period the customer is rolled onto a different, usually much higher, price (usually the standard variable rate which is probably about 3% higher). Energy tariffs often work this way.

Customers are, of course, free to shop around when that teaser rate is near expiry, but many customers do not. Some choose not to, but for many others it is a case of apathy and inaction.

Standard variable rate prisoners

Some customers, however, are not able to benefit from shopping around as they are no longer be as attractive to a bank. For example, a young couple who have started a family will have seen their income and outgoings change materially in an adverse way. These customers can no longer get teaser rate offers and can become so-called, "mortgage prisoners".  Paradoxically they can’t move to a lower/teaser rate that would be more affordable, because they no longer meet the affordability criteria set out by banks and regulators.

Is this fair?

A large part of a bank’s business model is based on inertia – savings customers roll onto a low deposit rate and mortgage customers roll onto a bank’s standard variable rate, which is usually high and gives the bank flexibility to set it within very broad parameters.

Is it fair that banks take advantage of customer inertia and is it fair that the most vulnerable in society may either not be aware they can shop around/re-mortgage (owing to lower financial capability) or be unable to, due to changed circumstances?

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