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Will easier switching change the banking industry?

Posted on: Friday 13th of September 2013

From Monday 16 September UK banks will offer their customers a guaranteed ability to switch current accounts in a simple, reliable, hassle free way.  The product of two years’ work by the payment industry’s regulator the Payments Council, there are high hopes the new switching guarantee will force banks to be more competitive and improve their customer service.

This comment from Metro Bank chief executive Craig Donaldson is typical. “At the moment far too many consumers put up with poor service from their bank simply because they believe switching to be too complicated,” he says. “Increased competition forces banks to work harder to innovate, differentiate themselves and keep their customers happy,”

Perverse incentives

The problem the Payments Council is trying to address is deep seated. For decades, the ways banks have levied charges and fees have often angered customers, undermining trust and brand reputations. A typical example is this  recent BBC report of a man who had a £45 penalty charge for going overdrawn by £2.

There are two important things going on here. First, the customer’s anger and the bad publicity it generated. Second, the economic incentives shaping banks’ policies and behaviours. If a bank levies this sort of fee twice a year that’s a total charge of £90. If this bank has 3 million customers, that means its charges earn it £270 million (£90 times 3 million) a year. That’s a quarter of a billion pounds : a significant sum of money that, in the scheme of things, is  relatively easy to make.

The BBC also reports that under the same bank’s terms and conditions, an unauthorised overdraft of £100 lasting 28 days would cost the customer £200: an interest rate of 819,000%. Again, if you multiply these charges out against a customer base of millions, the net income is large.

There’s a dilemma here. A bank focused on customer service would have alerted Mike in advance, so that he could avoid the charge. That would be good for the brand’s reputation. But the long-term, diffuse reputational incentive would have clashed with immediate financial incentives. Providing that sort of alert service costs money, whereas sitting back and waiting for Mike to go overdrawn is an easy way to make £45. Why choose a cost when you can have revenue instead?

The argument behind the Payment Council’s current account switching initiative is that banks’ are suffering the consequences of perverse incentives. Because customer inertia predominates with few customers bothering to change banks even when they feel they are incurring unfair charges or fees, it’s tempting for banks to take advantage of this inertia. It’s easier for banks to make money out of poor service than it is to make money out of good service.

The Payment Council’s initiative is designed to change these incentives. Now, outraged Mike from the BBC story will find it much easier to switch to a bank offering lower overdraft fees. So, if Santander (the particular bank in this story) levies too high a charge, the risks of it losing Mike to competitor are much higher. Competition between banks kicks in, leading to better levels of service all round.

Theory and practice

That’s the theory anyway. We doubt it will work out quite like that. Why?

First, current accounts are a low interest utility that people prefer not to have to think about. This means that even when people get really cross, many end up not bothering to switch: even though switching is easier now, it’s still a hassle. Most regulatory theories about the competition benefits of switching are based on the assumption that we are all ‘rational economic men’ who always do the perfectly rational thing. But rational economic man is a grand fiction. He (and she) doesn’t exist. We are human, and humans don’t always behave ‘rationally’.

Second, easier switching can easily replace one perverse incentive by another. Right now, for example many banks offering incentives such as ‘£125 cash!’ to encourage people to switch. That’s great. But this isn’t competition around quality of service. It’s competition around the size of the switching bait. And that money has to be recouped. How? By higher fees and charges, of course.

This is not to say the Payments Council initiative is mistaken. Absolutely not. It’s an important step in the right direction. But it doesn’t complete the journey.

Reinventing banking

Our research into customer loyalty in the banking industry shows another set of competitive dynamics are beginning to change the banking industry. They revolve around data and the use of data. Banks are beginning to realise the next generation of banking services won’t be based on a series of separate, narrow financial products like ‘current account’ or ‘credit card’. They will focus on information services – such as money management services that use data to help people understand and change their spending patterns better, manage money flows better (such as the timing of payments) and use payment information better.I

Initiatives like the Payment Council’s Switch Guarantee alter the balance of incentives a little (by making it easier for customers to ‘punish’ poor service by switching to a competitor). But that’s not enough. Increased competition is a stick. But where’s the carrot?  Banks need a truly positive reason to invest in better service.

That’s where new information services come in. From the customer’s point of view, well designed data-driven money management services that really help me save time, money and hassle may actually be worth switching for. At the same time, these services can generate all sorts of spin-off revenues for the bank, as the customer’s focus shifts to ‘how to use my money better’. For banks, these new types services can act as a driver of both customer retention and customer acquisition, a new source of revenue. And, crucially, they align economic incentives to brand/reputational incentives. They help build trust rather than undermine it.

In this way, information services for customers can transform banks’ incentives. The banking industry’s evolution in this direction is only just beginning. But it is under way. And it’s unstoppable.