Strategic Review of Retail Banking Business Models (including an "I was wrong!")

It was lost in the media coverage of the FCA’s consultation on overdraft fees, but at the same time the FCA also published a Strategic Review of Retail Banking Business Models. It’s fascinating.

Key messages:

  • “The traditional retail banking model faces challenges” but
  • “Major banks still have competitive advantages over other business models”

In particular:

  • Major banks have a lower cost of funding because they have more ‘on-demand’ deposits – including current account and instant access savings balances - and pay lower rates of interest on them. In a higher interest rate environment, this funding advantage would likely be even greater.
  • PCAs [Personal Current Accounts] and BCAs [Business Current Accounts] bring higher levels of transactional revenues and charges including from interchange, foreign exchange, and packaged account fees and charges. These types of charges come with low marginal costs and little additional capital requirements.
  • Major banks earn high yields on overdrafts associated with their PCA and BCA businesses.
  • These cost and revenue advantages are not outweighed by higher operating costs such as those associated with large branch networks, legacy IT systems, and provision of traditional functions such as cheque and cash handling.

The FCA is considering intervention in three areas: cash savings, overdrafts, and mortgages.

But… “regulatory initiatives and technological developments may cause unprecedented change to business models”

our analysis suggests that in the near term:

  • We are likely to see increased ‘unbundling’ of the PCA as new business models seek to offer services to customers that provide enhanced functionality using customer data and capture profitable revenue streams such as interchange, foreign exchange, and overdrafts.
  • Use of data by firms and consumers will be a key determinant of how retail banking markets will evolve. New entrants are developing digital propositions using data in ways that help consumers, for example to manage their money or to get better deals. This could encourage more consumers to interface directly with a third party in the future, rather than their bank.
  • Switching could increase, if new business models succeed in capturing the customer relationship. Traditional banks could become increasingly distant from their customer base, potentially eroding brand loyalty and encouraging more consumers to look around for better deals. For this to happen, new business models need to engage consumers and make the prospect of switching more appealing than it has been.

Emphasis mine. This ties in neatly with the banking as a service / commoditisation model I’ve posted about before.

Major banks are relatively well positioned to address future competition, subject to reconfiguring legacy IT systems. They are investing in fintech: for example, in developing aggregator apps to allow customers to view data from multiple accounts. Further, rising interest rates may squeeze margins for challengers and make it more difficult to attract new customers, potentially reducing their ability to constrain major banks.

Emphasis mine again. I think this is a huge “subject to”!

Free-if-in-credit banking is unlikely to disappear quickly as a result of our overdraft proposals, but may become less widely available in future because of other factors

FIIC PCAs depend on banks generating funding benefit from balances, as well as earning fees on overdrafts, interchange revenues, and other fees and charges. Our analysis of account-level data shows that the majority of FIIC accounts make a positive contribution to bank profits from a combination of these sources of value. A small subset of consumers – around 10% - are responsible for 60% of the value that banks derive from PCAs. This subset of consumers mostly either hold high balances in their current accounts or are heavy overdraft users.

Emphasis mine again. This links to the mea culpa / I was wrong admission. I’ve always thought that free banking is a bad thing, because the least well off would subsidise the better well off through fees and charges. In the annex to the main report, the FCA is clear that this is not the case:

Around three-fifths of UK consumers held a free-if-in-credit (FIIC) personal current account in 2016. FIIC accounts do not charge regular fees for core transaction services and continue to spark debate about how they are paid for and who is paying. There has been public concern that provision of these accounts is primarily paid for through overdraft charges incurred by vulnerable consumers, covering losses generated by other FIIC users.

These concerns are largely unfounded. Funding benefit, not overdrafts, is the main source of revenues that banks earn on FIIC accounts. Funding benefit makes up almost half of FIIC revenues. It is earned by banks being able to fund their lending through consumers’ deposits, since the interest that banks pay on these deposits is less than what it would have cost them to raise the same funds from the wholesale market. Overdraft charges are significant at around a third of revenues but not the main driver. Overdraft charges are also not specific to FIIC – they are important sources of revenues for packaged bank accounts (PBAs) and reward accounts as well.

Back to the main report, there are some interesting graphs and stats. This one, for example, might helpmexplain the sudden interest in business banking:


(But also some interesting ROI numbers for switching incentives that pay out £100 or more - that’s over 5 years til break even… :thinking:)

This might be relevant to the debate on cheque imaging and paying in cash:


And some general stats on the sector:

The Retail Banking sector performs a vital role in the economy. There are around 73 million current accounts and 4 million business accounts in the UK, and retail deposits – including current accounts, savings accounts and SME accounts – total around £1.5 trillion. Retail lending is a key driver of economic activity; UK households owe around £1.4 trillion in mortgages and £198 billion in consumer credit.

Underlying profits measured on a return on equity basis for major banks’ UK retail banking activities were 28% compared to 6% and 11% for small retail banks and building societies respectively.

There’s also a whole section entitled “Fintech revolution? Or incumbent evolution?” which I didn’t think really told me anything new, but is worth a read.

Finally, here’s a graphic with some interesting stuff (much of which isn’t really spoken about much in the report):


(Oh, and mentions of Monzo: nil).