The Future of Retail Banking in the UK
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Speech by Dr. Thomas F. Huertas, Director Wholesale Firms Division
The Institute of Economic Affairs’ 10th Anniversary Conference
6 June 2007
From the perspective of the regulator, the future of retail banking in the UK should have three characteristics. First, it should be fair to consumers. Second, it should not be unfair to shareholders, in the sense that capital requirements should be adequate, not excessive, and they should be risk based. Third, retail banking in the UK should be open to entry from all qualified parties, regardless of nationality.
The Future of Regulatory Banking - A Regulatory Perspective
Assuring consumer protection is one of the statutory objectives of the FSA, and this is embodied in Principle 6 for authorised firms, "A firm must pay due regard to the interests of its customers and treat them fairly," as well as in the FSA's strategic objective to help retail consumers obtain a fair deal.
Under our Treating Customers Fairly initiative we have sought to illustrate this principle in more detail. Briefly put, we have stated that firms should put treating customers fairly at the heart of what they do, that they should bear in mind the requirement to treat customers fairly at every stage of the product life cycle, from the conception of the product design, distribution, marketing, advice and, when dealing with the customer post sale, service, including the handling of complaints, if any.
I am gratified to say that there is real evidence that banks are taking these obligations seriously. At the vast majority of banks dealing with retail customers in the UK, senior management has accepted the principle that treating customers fairly must be an integral part of the way the firm does business, and many of these banks are taking steps to embed the principle of treating customers fairly into the way that they do business.
"Not before time," say many critics, who allege numerous instances of misselling and unfair treatment. Banks dealing with retail customers in the UK will need to find a way to close these previous chapters as well as turn the page to a new one, in which they do in fact treat customers fairly. In some cases, such as pensions misselling and mortgage exit administration fees, a way has been found to close the past. In others no resolution has as yet been found.
In our view, Treating Customers Fairly should result in six outcomes for consumers:
- Consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture. It is the responsibility of senior management to ensure that fair treatment runs throughout the business. Notwithstanding senior management support for TCF, in many cases the follow-through is weak, and systems and controls are deficient. Senior management must satisfy themselves that their aspirations with regard to fairness run throughout the bank.
- Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly. A clear case where this did not happen is the marketing of Payment Protection Insurance to groups that would never have been able to claim on the insurance.
- Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale. Banks should provide clear and understandable information to their customers to enable the customer to make an informed decision. Although we are conscious of the fact that some sectors of the UK population are not financially capable, we are also aware that most households do have a basic understanding of their own financial affairs and can be expected to understand information that is presented to them clearly and succinctly.
- Where consumers receive advice, the advice is suitable and takes account of their circumstances.
- Consumers are provided with products that perform as firms have led them to expect, and the associated service is both of an acceptable standard and as they have been led to expect. Financial products carry risk, and they can have good financial outcomes or bad financial outcomes. Fairly sold products that produce bad financial outcomes for consumers are part and parcel of and efficient market for retail financial services, not a cause for regulatory intervention. Unfair treatment of consumers is. The key is that customers know what they are getting and are being given realistic expectations
That, I might add, holds true for deposits, as well as investment products. The FSCS fully protects the first £2,000 of a consumer's deposit at a bank, but only 90% of the next £33,000 in deposits. Even for deposits, there is a risk that the bank will fail, and there is a risk that depositors with funds in excess of £2,000 will lose money. What we require is that banks explain the degree of deposit protection that customers have. - Consumers should not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint.
We think that the obligation to treat customers fairly extends across all products that the bank sells, including deposits. Technically, the FSA has "switched off" Principle 6 ("Treating Customers Fairly") with respect to deposits, except for a review of the way that banks handle complaints. Deposits are covered under the Banking Code, and banks' adherence to the Code is monitored by the Banking Code Standards Board. The Banking Code is now under review, and the Reviewer has recommended that the new Banking Code contain an overarching fairness provision, similar to Principle 6, "a firm must pay due regard to the interests of its customers and treat them fairly".
We strongly believe that the revised Code should in fact contain such an overarching fairness provision. With such a provision, we believe that a revised Code could be an excellent way for the banking industry to move with us toward more principles-based regulation, particularly with appropriate enforcement by the Banking Code Standards Board.
So much for fairness to customers. What about fairness to shareholders? That is not per se a regulatory objective. What we seek is to assure that banks are soundly managed and well capitalised, so as to limit the risk that the bank will fail and consequently harm consumers and/or disrupt financial stability. In line with the principles of good regulation, our attempts to assure capital adequacy should be proportionate and risk-based – in other words a regime that is not unfair to shareholders.
At a general level, the regime appears to be just that – profits at UK banks have increased dramatically, and the rate of return on equity substantially exceeds the cost of capital. UK banking has been a high growth, high return business and leading UK banks show some of the highest market capitalisations in the EU and, in some cases, the world.
Of course, not all of this increase in shareholder value stems from UK banks' retail activities in the UK. But retail banking in the UK has certainly been an important part of the story. Over the past twenty years the proportion of UK households with a bank account has risen dramatically (today 94% of the adult population has a bank account, up from 60% in 1980). The number of services that a bank sells to a typical customer has also risen dramatically – today a bank typically cross-sells the current account customer a variety of other services, including credit cards, mortgages, personal loans, life and/or general insurance and investment products such as unit trusts. In the marketing jargon, the consumer "wallet" for financial services has grown fatter in line with the tremendous growth in personal income and house prices, and more and more of this fatter wallet has become available for banks to access.
And, over time, technology has enabled banks to conduct their retail business more efficiently. Advances in communications and information technology have driven down the cost of processing and made it feasible to perform this processing remotely from the bank's branches. The advent of cash machines, internet- and phone-banking have driven down the cost per transaction. So did the consolidation of banking enterprises via merger. Together, the expansion in revenues and the reduction in unit cost have led to dramatic growth in profits from UK retail banking.
Is the growth in retail banking tapering off?
The question is whether this growth can continue, or whether UK retail banking is now facing the top of what has been an extended S-curve, especially if banks were no longer able to impose high charges on credit cards, mortgages, and/or unauthorised overdrafts, or no longer free to sell payment protection insurance quite as aggressively? Last year's results at the major UK banks certainly suggest a slowdown in profits from retail banking in the UK. Some suggest that this slowdown is cyclical – a product of increased impairment charges, which in turn have resulted from the adverse impact of recent interest rate increases on disposable personal income and on the buy-to-let market.
Others assert that the slowdown may be the sign of saturation in the UK retail banking market and/or the sign that cost-cutting is reaching its natural limits. The cost income ratio in some of the retail banks is now less than 40% -- can it really go much lower? The Competition Commission has ruled out cost-cutting via in-market mergers or acquisitions among the major banks. Now that banks have centralised and automated processing, introduced internet banking and adopted outsourcing, what new tricks can the banks pull out of the hat? Even if they can, will these new tricks push down the cost-income ratio at the same rapid rate?
When firms face a maturing market, the traditional strategic response is some combination of greater cost efficiency, geographic expansion, product diversification, greater capital efficiency and finer market segmentation. Certainly retail banks headquartered in the UK are responding in this fashion. They have significantly increased their investments in foreign markets, and two of the major UK banks are contesting with each other for a possible further foreign acquisition. Banks have stepped up their activity in the underwriting and distribution of insurance as well as in asset management. And, banks are looking to improve their capital efficiency, by securitising assets and raising capital in innovative ways.
The challenge for the banks and for their regulators is to assure that banks remain soundly managed and well capitalised. The shift to new markets and to new products brings new management challenges. So does the shift from an "originate and hold" model of banking to an "underwrite and distribute" model. Although the obligors on mortgages, credit cards and revolving loans may ultimately be consumers, the credit risks in a securitised environment are essentially transformed into market risks – risks that investor demand for new issues will dry up, risks that interest rates will change, risks that credit spreads may widen, and risks that wholesale funding may disappear. Are banks managing these risks well, and do they have enough capital in place to sustain their solvency and liquidity, even in stressed economic conditions?
That is essentially the question that we are asking as we review the models that banks are proposing to us in the context of the Capital Requirements Directive. We have no objection to allowing banks to reduce their capital and to increase their capital efficiency, if they truly have enough capital to see them through what could be some tough times ahead. Before giving the go-ahead to a bank's model, the bank needs to convince us that it is actually using the model to run its business and that the model is a reasonably good predictor of default, exposure at default and loss given default. We have not approved models that were built solely for the purpose of the regulatory review, and we have not approved models that somehow came up with the result that defaults might occur, but that the loss given default would always be zero. We have, however, approved a number of models and are on course to approve a significant number of others as banks meet the use test and refine their procedures. And, we accept that these models could in fact result in a reduction of capital.
We also accept that finer market segmentation can be an effective strategy for banks. Indeed, banks have found innovative ways of serving an ever broader proportion of the population, and this has contributed to profits. From a public policy standpoint, this activity has improved financial inclusion, but it has also heightened concerns about treating customers fairly. Cross-selling is a perfectly acceptable strategy; misselling payment protection insurance is not. Mortgage lenders should be able to price loans in line with the risk of the loan, but lenders also need to assure themselves that they are lending responsibly, that the loan is affordable for the borrower, especially in an environment where the originator of the loan may simply pocket the origination fee and sell the credit on to a third-party investor.
An open issue is how consumers can obtain advice about financial products in a cost effective manner. Commission-based distribution arrangements tend to lead to conflicts of interest and may result in misselling. Fully personalised fee-based advice tends to be efficient for both the provider and the consumer only if the consumer has accumulated a significant level of personal wealth over and above his own home and needs or wants that level of advice. This has tended to leave consumers without such means without an impartial source of advice – from a public policy point of view exactly the segment of the population that could most benefit from impartial advice.
How do we solve this conundrum? We are genuinely interested in working with banks to find a way to do so. We recognise that, to work, any solution would have to take into account the effect that price caps have on the economics of the products that can be sold, that any advice given must be provided in a manner that provides genuine assistance to the consumer whilst being affordable for the banks and providing a basis for demonstrating that the banks did in fact treat customers fairly. Finally, to work, such a solution would have to provide financial institutions who implemented the solution with some comfort that they would not be the victim of retrospection or second-guessed by a future regulatory regime, i.e. the possibility of someone in the future concluding that a product that lost money must have been mis-sold in the first place.
Again, we are back to fairness. In our view, banks should be able to conduct a retail banking business in the UK that is both fair to consumers and fair to shareholders, and we provide a regulatory regime that demands the first and facilitates the second.
We also have an open door to any bank that wishes to come to the UK to provide retail banking services to the UK population, provided that the bank meets our threshold conditions. These are, briefly put, that the owners and managers of the bank be 'fit and proper', that the bank be soundly managed and have adequate financial resources. Some applicants do not meet those tests, and we have no hesitation in excluding anyone who fails, and we will go out of our way to exclude anyone who is not 'fit and proper'. But we put out the welcome mat for anyone who can meet these tests, and we believe that the UK market is stronger for the hundreds of foreign banks who have established themselves in the UK, and that UK consumers are better served by being able to choose between UK headquartered banks and banks headquartered elsewhere.