FCA Strategic Review of Retail Banking Business Models Progress report
Early analysis by the FCA of its ongoing competition review of the retail banking sector may reveal some nuances in its recent consultations on overdrafts and high cost credit. The FCA's latest indication is that a key component of competitive advantage in retail banking to date has been the combination of personal current accounts (PCAs) and large branch networks, which bring:
- Funding cost advantages: around 40% of PCA income is earned from PCAs paying no interest, and savings account with lower rates than other providers
- Additional income: from overdraft charges (contributing around 30% of PCA income) from interchange, packaged account and FX fees (also around 30% of PCA income); and additionally from cross-selling to PCA customers: debt, business current account (BCAs) and business savings accounts
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Although reserving its position on potential policy work on other aspects of the retail banking market, the FCA does not currently envisage policy action resulting directly from its review. The FCA will instead feed its findings into:
- Overdrafts interventions: as part the High-Cost Credit Review (HCCR); a subsequent HCCR publication will draw on the Retail Banking Business Model review to provide a "broader perspective"
- Potential mortgage remedies: coming from the Mortgage Market Study to facilitate mortgage comparisons and switching
- Improving competition in cash savings markets: coming from its work on longstanding customers
Funding cost advantages
The FCA found that funding from retail sources comprised 87% of total funding for banks in 2016. Major banks with a large PCA customer base and branch network have retail funding costs on average around half of those of other banks. Smaller providers attract more "rate chasers" than larger providers. Major banks also use SME deposit balances to finance other business lines, despite a low loan-to-deposit (LDR) ratio for SMEs, which is lower still for the smallest SMEs.
Next, the FCA plans to explore the costs associated with PCAs, BCAs and branch networks to provide a more detailed analysis of the net costs of this funding. It is also exploring reasons for the lower LDRs for SME compared to personal banking, and the profitability of SME lending. Improved understanding of competitive advantages and disadvantages of alternative business models will help the FCA evaluate the scope for changes to different categories.
Overdrafts were found to produce higher margins (28%) than for credit cards (8%) or unsecured personal loans (5%). For three major banks, overdraft fee income represents between 20-50% of total income from overdrafts. The FCA's data is from 2016, so does not capture the effects of the Maximum Monthly Charge introduced in August 2017.
Back on 31 May 2018 the FCA published its consultation paper CP 18/13, "High Cost Credit Review – Overdrafts". The remedies set out were far reaching and have potential to fundamentally change the overdraft market.
The Strategic Review progress report notes that the package of measures that the FCA is modelling includes:
- A single interest rate for arranged overdrafts on each individual account. This could vary for different account types, or even different customers holding the same account, but could not have different tiers within a single account.
- Pricing alignment for arranged and unarranged overdrafts. Unarranged overdrafts are also to be priced using a single interest rate, no higher than a fixed percentage uplift of the interest rate for arranged overdrafts. The FCA will carry out further work to determine what this uplift should be, or whether unarranged should be no more expensive than arranged.
Next, as part of the Retail Banking Business Model review, the FCA is quantifying costs relating to overdrafts. It will also compare risk-adjusted income with regulatory capital costs for overdrafts, credit cards and unsecured personal loans.
Who pays for FIIC PCAs?
There are well-publicised concerns at the FCA that unarranged overdraft (UOD) charges are disproportionately incurred by vulnerable customers. UOD charges are paid by less than 20% of customers, and most UOD charges by a small subset of those.
But free-if-in-credit (FIIC) banking may be a misnomer after all. The review data suggest that banks receive more funding benefit from less vulnerable customers with larger balances. Around 10% of customers generate between a third and a half of PCA income. Overdraft charges account for around 45% of those customers. While funding benefits account for around 40% of the contribution from this group – from those less potentially vulnerable, older and with larger credit balances. These consumers generate a higher contribution per person than consumers who mainly incur overdraft charges.
Next, the FCA will refine its analysis of the effects of FIIC, including by:
- Analysing different types of PCAs such as basic bank accounts, reward accounts and packaged bank accounts
- Incorporating further marginal costs including from risk-weighted assets
- Looking at combinations of consumer attributes, and alternative proxies for vulnerability.
While digital channels have increased in importance, there may be a limit to branch closures: the branch network is critical in attracting and retaining personal and SME customers; and banks are focusing customer retention strategies on branches for key customer groups.
Next, the FCA is considering two questions:
- Are vulnerable customers disproportionately impacted by recent closures of branch banks?
- Is there a core number of branches that firms need to compete nationally?
Most mortgages are sold on short term "introductory" rates, typically fixed before reverting to a Standard Variable Rate (SVR) or a base rate tracker. Many customers do not switch their mortgage immediately on expiry of the introductory rate, and pay a higher reversion rate for at least some time.
Around 800,000 customers could benefit from switching from reversion rates, and another 30,000 could benefit but are unable to switch, according to the FCA. Customers on SVRs make up 14% of average mortgage balances at the six largest lenders, but contribute 30% of mortgage net interest income. Conversely, customers on legacy reversion rates (tracking base rate by no more than 2%) make up 29% of balances, but contribute only 19% of income.
The interim report on the Mortgage Market Study proposed potential remedies, including: enhanced information to compare mortgages; tools for calculating mortgage costs; easier switching, especially for older mortgages, possibly via a voluntary industry agreement; and regulatory reporting on internal product switches and performance data on mortgage books sold to unregulated entities.
The focus of the Strategic Review is on the business model: how much are firms reliant on these customers for profitability? Next, the FCA wants to understand:
- The extent to which firms' business models rely on reversion rate payments
- The impact of fees, impairments and other costs
Four future scenarios for retail banking business models are depicted, varying in the rate of take-up for technological change, and the rate of customer switching from branches to digital channels:
- Gradual evolution: planned branches closures continue in favour of digital channels, with incumbent banks retaining competitive advantage
- Banks as utility: high take-up of new digital services disrupts bank relationships with customers; incumbent banks focus on product manufacturing and infrastructure; deposit and lending balances remain with large banks
- Waterbed: take-up of new technology is limited to more engaged customers; incumbent banks introduce new charges to recover lost revenues
- Big switch: customers switch to alternative providers; incumbent banks lose their cost and scale advantages
The FCA notes that it is not predicting any one of these scenarios, but is interested to understand the implications of each scenario: the effect on business models, and the potential benefits and harms for consumers. Submissions in response to the progress report are requested by 7 September 2018.
FCA overhauls overdrafts - overview, AG FS Update, June 2018
Summary of the proposals from the FCA in its high cost credit review, AG FS Update, June 2018
FCA Mortgage Market Study interim report, AG FS Update, May 2018
FCA Strategic Review of Retail Banking Business Models, Progress report, 27 June 2018
FCA Consultation Paper on Overdrafts, CP18/13, 31 May 2018
FCA Consultation Paper on High Cost Credit, CP18/12, 31 May 2018