How to solve the problem of free banking?

 RBS recently created a storm by announcing that it would be restricting its basic bank account customers to using only its own ATMs. As well as acres of negative media coverage, and questions from the Treasury Select Committee it has also generated an online campaign against the move, complete with a petition (although at the last count this only had eight signatures).

RBS, together with the other high street banks, is stuck in a dilemma of its own making: traditionally banks have given current accounts away for free (including basic bank accounts). And as with most things that are free, customers don’t actually value the service.

But current account banking is an expensive service to deliver – issuing cards, processing transactions, detecting fraud, running ATMs, sending out statements, running branches, call centres and internet banking sites and so on all comes at a cost. And whilst it is easy to be critical of the service banks provide, by and large all those things happen pretty efficiently, mostly without us noticing.

But with bank profitability under pressure most have adopted a twin track approach of trying to cut the cost of providing current accounts and of encouraging more people to pay for a product. It is no surprise that the issue has come to a head with basic bank accounts (which banks aren’t allowed to charge for) as these carry many of the costs of running “normal” current accounts but with far fewer opportunities to generate income.

There are three main sources of revenue on current accounts – cross selling, overdraft charges and cash on float. All of these are likely to be lower on basic bank accounts. Basic bank account customers tend to have less money and are less credit-worthy, so are less “juicy” a target for cross sales especially of investment, savings and credit products.

Secondly, the average balance on basic bank accounts tends to be low so the opportunity to make money from the “cash on float” is lower.

And finally, the opportunity to profit from overdraft charges is reduced. Overdraft charges are a significant source of income for high street banks. 2010 figures from the OFT show that 6.6m people paid more than £100 a year in unauthorised overdraft charges and 1.4m people paid in excess of £500.  Of those that pay charges 57 per cent paid them in the previous year too. Although the banks have been forced, in part by legal action taken by the OFT, to reduce their charges they are still significant. But most basic bank accounts don’t offer overdraft facilities although they still do charge for “bounced” (returned) items.

One way the banks have been boosting revenue from current accounts is by pushing “packaged accounts” that charge a fee but include a bundle of other services (such as breakdown cover or travel insurance). As well as criticism from the media the FSA has warned banks that it isn’t convinced that packaged accounts always offer customers value for money. Even so about half all current account customers are now paying a fee.

Banks have also looked for ways to trim the costs of running accounts but have been thwarted at every turn. For example despite a collapse in the number of cheques written banks lost the battle of public opinion to scrap them. And despite fewer people using branches they face an outcry whenever they try to close one.

So banks are stuck. They’ve trained many of their customers to expect to receive current account banking for free. At the same time the capital and regulatory requirements are increasing, and their ability to charge customers has been restricted by the OFT, the FSA and, to an extent the media.

Wills bank abandon the free banking model? The short answer is no – at least in public. But in reality most have already moved to the point where free banks accounts are a secondary offering behind fee charging packaged ones. Basic bank accounts, which are provided free as a social obligation are the exception. And as the Independent Commission on Banking’s recommendation are implemented, pushing up costs and capital requirements banks will become even less keen to service this market. But with the Government seemingly taking its eye off the financial inclusion ball, perhaps banks will get away with restricting the service they offer these customers.

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