Will consumers always want free banking?

The High Court has decided consumer contract law can be used to determine whether bank overdraft charges are fair. This ruling will mean banks have to find more subtle ways to profit from their customers, argues Carol Wheatcroft.

Last month's High Court ruling on overdraft charges sparked widespread media speculation about the future of the free banking services that UK customers have enjoyed since the 1980s.

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But these services are unlikely to be under threat. Because of the court case, consumers can expect greater transparency in bank charges, which will further increase competition in an already highly competitive retail banking market.

For once, the main beneficiary will be the consumer, as market developments already under way speed up.

UK banks generally do not directly charge consumers for account management, payments and cash utilisation services.

In other words, for customers who use the bank purely for payment transactions, settle credit card payments in a timely fashion, and do not overdraw their accounts beyond agreed limits, the bank's services - which could include cheque, credit card and debit card facilities - are free of charge.

In addition, most banks even make a small interest payment on current accounts. Banks are able to cover the costs of providing these services from three sources: income from interest rate margins, fees from exception handling and penalty charges.

Banks cannot move away from this free banking model without making a significant impact on their customer base and so remain willing to offer free banking as a loss leader to attract customers.

They expect to make a profit on interest rate margins and cross-selling of other products such as loans and insurance.

However, a lack of transparency about charges has created an increased reliance on revenue from this source, ultimately leading to the court case.

Consumers have little understanding of what represents a fair cost for banking services, and free banking has not led to contented customers.

Although individual customers have probably always been upset by charges imposed by banks, few took action until consumer groups educated them on how to make effective complaints.

The power of such groups has been considerably enhanced by both the internet and the wide reach of media channels that have picked up the issue. The court case merely created the tipping point for a process that demands greater transparency, with the result that banks will be less able to rely on what are seen as penalty charges, as a source of revenue in the future.

This consequence is beneficial for the industry because it will force banks to focus on improving customer service rather than using a lack of transparency to gain additional revenues.

To improve customer service, banks will look for more effective ways to segment their customer bases and develop products that offer customers greater value. In fact, a number of institutions already are working on such processes.

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Customers can expect to see more parameterised and bundled account offerings and to benefit from price optimisation processes. Bundled accounts, for a fee, offer additional benefits or services that customers perceive to have a value in excess of the cost of the fee.

Services currently offered include travel and gadget insurance, roadside assistance and reductions in loan rates. Parameterisation involves assigning values to the various properties of a product, such as features, performance and pricing, so that the underlying product can easily be changed to create new, highly customised products.

Offset mortgages that offer sweep facilities to current and savings accounts linked to mortgage loans are examples of parameterised products. Price optimisation processes use consumers' price sensitivity to retain customers, particularly those who have lending arrangements with the bank.

To deliver these types of products, banks will continue to need integrated delivery channels and core processing systems that are capable of sharing information easily.

Profit-based pricing is a relatively new concept for financial services, and banks can adopt the specialised applications needed either through modification of pricing engines or as a component of a service-oriented architecture approach.

By creating a range of products targeted at the customer base at a highly granular level, banks can move away from a position from which they react to market events, to one from which they drive market developments.

In turn, consumers will perceive that they are receiving better value and be more willing to pay for services. Free banking is here to stay, even though consumers may not always want it.

This article is based on research by the Banking & Payments Practice at TowerGroup, where Carol Wheatcroft works as an analyst.