FCA update on strategic review of retail banking business models

The FCA has published an update on its strategic review of retail banking business models, launched back in April 2017. The update follows the publication of a purpose and scope paper in October 2017 (see our previous blog post The Open Banking / PSD2 ripple effect: FCA clarifies purpose and scope of retail banking business models review). What have been the FCA's findings so far, and what direction can we expect the review to take in the coming months?

Recap on purpose of the review

The review considers the factors that have helped incumbent banks to obtain competitive advantage and high market shares in the personal current account (PCA) market. In particular, the FCA is considering the potential impact of technological change, increased digitalisation and regulatory developments such as Open Banking and PSD2 on retail banking business models and exploring how free-if-in-credit PCAs are paid for, and how return on equity in retail banking can be attributed to different types of consumers or different products. The FCA's update details the progress it has made on analysing these issues, and how it plans to build on this work in the next phase of the review.

The FCA's key findings so far

Major players enjoy several spin-off advantages from larger PCA offerings and branch networks

In the FCA's initial analysis, it has found that major banks generally have lower funding costs than other banks. This is reflective of their extensive PCA and branch networks, the combination of which has resulted in a larger proportion of relatively price-insensitive customers and a significant competitive advantage over other banks, building societies and specialist lenders.

The FCA notes that the PCA offering and branch network of the dominant retail banks have brought with them four main benefits:

Funding cost advantage

The funding costs of major banks with established PCA businesses and extensive branch networks are close to half of that of other banks. This advantage is driven by large numbers of customers holding balances in zero-interest PCAs, and in savings accounts which pay lower interest rates than other providers.  This acts as a barrier to entry and expansion for new and incoming firms, as they must offer PCAs with significantly higher interest rates than incumbent banks in order to attract more price sensitive customers. It is therefore difficult for challenger firms to replicate the funding cost advantages enjoyed by the incumbent banks.

In the next phase of the review, the FCA will consider the costs associated with PCAs and branch networks, in order to obtain a more complete picture of the true funding cost advantages associated with PCAs and branch networks. The FCA also wishes to explore how these cost advantages are used – are they passed on to consumers in the form of cheaper loans, or simply retained by the banks as profit?

Significant additional non-interest income

The FCA notes that in addition to funding benefits from PCAs, significant income also comes from fees and charges on PCAs, particularly overdraft charges, which contribute over 30% of PCA income. The FCA has also found that other fees such as interchange fees, packaged account fees and forex fees are significant when aggregated, contributing close to 30% of PCA income.

In relation to overdrafts, the FCA notes that many banks have changed or are changing their PCA overdraft charges, partly in response to the introduction of the Monthly Maximum Charge (MMC) in August 2017. In the next phase of its review, the FCA will analyse the impact of these changes on banks' overdraft income, looking in particular at whether banks will try to recover the shortfall in revenue from other sources.  The FCA also mentions that its work in this area (as set out in Chapter 4 of the update) helps to provide the broader context for its work on overdrafts as part of its current High-Cost Credit Review (see further below).

Benefits of cross-selling other products to PCA customers

The FCA's analysis indicates that where PCA holders also hold other financial products (such as credit cards, personal loans and mortgages) there is a strong likelihood that these will be held with their PCA provider. This is particularly true of savings accounts and credit cards, with the FCA finding that over 60% of consumers take out a savings product with their PCA provider, and almost 30% take out a credit card.

Benefits of cross-selling business current accounts (BCAs) and associated business savings balances

The FCA points to CMA analysis which indicates that around 50% of start-ups open a BCA with their PCA provider, and that at least 84% stated that branches were either very important or quite important to their decision on who to bank with. SMEs are also highly likely to choose their main BCA provider for related core banking products, (such as business term loans, overdrafts and commercial mortgages), which goes some way to explaining why the major banks account for the majority of the supply of core SME banking products. This is corroborated by a joint CMA/FCA study, which found that 91% of SMEs obtained instant access deposit accounts from their BCA provider only.

In addition, SMEs provide an important source of low-cost funding for retail banks with established branch networks. The FCA's loan to deposit ratio analysis shows that SMEs deposit around four times as much as they borrow, into accounts which bear low interest yields. Major banks also earn significant additional income through BCA fees, as SMEs will usually pay transaction charges and monthly account fees as standard. The FCA estimates that these fees and charges make up around 55% of BCA revenues.

Who pays for PCAs?  Unarranged overdraft charges and the High-Cost Credit Review

The update also covers the initial results of the FCA's distributional analysis on who pays for PCAs. Its findings suggest that banks generate a positive contribution to profits from the majority of PCA customers, and that this contribution does not come from any one specific group of consumers in terms of vulnerability.

However, the FCA is concerned that some potentially vulnerable customers are contributing significantly through unarranged overdraft charges.  It points out that it is considering steps to address this through its High-Cost Credit (HCC) Review.  Its recent HCC Review consultation paper (CP18/13) includes a discussion on potential measures to tackle the identified issues of complex price structures, high level of fees and repeat overdraft use.  In the current update, the FCA acknowledges that any final package of remedies coming out of the HCC work 'may impact the financial contribution of overdrafts to banks’ operating profit'.  It also makes the point that its analysis on distributional issues has been carried out in conjunction with the work on overdrafts conducted as part of the HCC Review.  For more on CP18/13, take a look at our blog post FCA High-Cost Credit Review: consultations on overdrafts and wider HCC work published.

Impact of branch closures

The FCA has considered the role of branches in retail banking. It notes the significant increase in branch closures, driven by changing customer behaviour towards banking through digital channels, and increasing pressure on banks to cut costs. The FCA is considering the impact of these closures on vulnerable customers and SMEs, and on banking firms' business models and cost bases.

Mortgages: why has the number of customer balances on SVRs decreased significantly?

On mortgage products, the FCA is looking in particular at the proportion of customer balances on Standard Variable Rates.  This has almost halved from 35% in 2013 to less than 17% in 2018.  The FCA wants to understand the drivers of this trend.

What's next?

The FCA emphasises that the update is not a final review and that some of its work is on-going. Two significant issues that the FCA will focus on in the next stage are the nature and behaviour of the customer base of different categories of firm and costs of servicing customers in retail banking. It will also look at how technological change and increased digitalisation combined with new initiatives including Open Banking, PSD2, GDPR, the CMA’s PCA remedies and any changes resulting from its HCC Review will impact business models in the future.  Feedback on the update is requested by 7 September 2018. The FCA also looks to engage directly with banks to discuss the points it has raised.

While the FCA does not envisage taking policy action as a direct result of its Strategic Review, it will use its findings to inform its on-going retail banking policy work.  Banks should take particular note of the tie-in with the FCA's on-going High-Cost Credit Review work on overdrafts, as we have outlined above.

For more information on the FCA's Strategic Review, have a look at our previous blog posts 'No breathing space for retail banks: business models go under the FCA microscope' and The Open Banking / PSD2 ripple effect: FCA clarifies purpose and scope of retail banking business models review.

Back to main blog
Loading data