“Money [Overdrafts!] never sleeps, pal.”
Wall Street (1987) – Gordon Gekko, the epitome of 80’s greedy bankers.
The FCA determined that banks in the UK were making nearly £2.5bn a year from overdrafts and concluded that the myriad of charges were far too complex and approximately 26 million customers in the UK were suffering. It asked the banks to make changes. I’m sure that it did not ask the banks to levy 40% interest rates but in the past couple of weeks, the FCA has asked the banks to explain their actions.
Banks have drawn much criticism since the Financial Crisis and it was hoped that we had entered a new era of more responsible banking with increased competition in the shape of challengers and open banking. Sure, the banks will be less involved in supremely esoteric financial engineering in 2020 and even the mighty Goldman Sachs is pursuing more vanilla lines of business, with ‘Marcus’ deposits, and have recently expressed an interest in SME lending. So why the big overdraft rates?
“Greed, for lack of a better word is, good…” – For many, this will simply be viewed as greed and exploitation. Others will make the case that there is a science behind why rates like these are justified. What’s going on and how do we (or can we) explain?
Before anyone embarks on bashing the bankers, reminiscent of 2008, lets first look at what drives ‘pricing’ in banks. More specifically, what drives the pricing of overdrafts which is linked to the risks the bank faces.
How do you price these risks? [And I would welcome comment from practitioners who may be able to enlighten us further]
Two principal risks exist: (1) credit risk is the risk of the bank not being able to recover any credit it extends (either on an arranged or unauthorised basis) and (2) liquidity risk, which is the impact such drawings could have on the ability of the bank to fund itself efficiently (not knowing when funds will be withdrawn for example is a key treasury risk) i.e. what level of ‘float’ should it maintain.
“Lunch is for wimps.” – There is certainly no such thing as a free lunch in banking, with the accepted wisdom that credit risk increases (and therefore the price) as the borrowers’ ability to repay decreases. There is also a clear difference between arranged and unauthorised credit where the bank will/will not have had an opportunity to assess and agree a facility, resulting in a penalty being applied to unauthorised lines of credit. (Its interesting to note that the FCA has pushed for no difference between such facilities.)
Liquidity risk is the risk of the bank potentially not having enough money during the day (actually over many periods or ‘tenors’) to honour its customers’ requests to withdraw funds. Again, if there is a facility in place, the bank has some knowledge that the customer may be calling on their agreement. If unauthorised, then the bank can claim it has no prior knowledge and therefore face greater risk. If the bank has no available funds to meet the unexpected withdrawal, it will have to borrow funds in the overnight market at short notice, which are not the cheapest funds to secure.
How do these two risks add up to rates of 40%? Whilst overnight short notice borrowing can be expensive for banks, it’s not likely to translate to double digits. So, credit risk then? Possibly. Here we enter the world of credit scoring, where banks rank you and I in terms of our ability to repay a loan. What rate is the right rate? We can easily find credit cards for those with poor credit scores, with rates of 30+%. They operate in a similar way to overdrafts but the average rate for credit cards is around the 20%. However, with overdrafts and current accounts, the bank is always able to refuse to honour any payment and will block any it isn’t happy with, to limit their own risk. I admit, I’m torn between the need to apply financial prudence as a bank in order to ‘discourage’ poor borrowing behaviour and the fact that banks have continued to make significant profits out of such activity. It’s a little like the speed camera at the bottom of a steep hill or around a blind corner, not really a preventative measure.
We have assurances from the regulator that the most vulnerable should not face any increase in total costs of these facilities and the simpler ‘rate’ is showing the true price that banks are charging. This may be true and hopefully the clearer expression of cost will help to drive better behaviour.
Almost a third of the UK use arranged overdraft facilities and about a quarter exploit unauthorised facilities, so the issue is not a marginal one.
The regulator (and the greater social conscience) were keen to apply common sense approaches to the practices of payday lenders and I would hope that we can achieve the same with our banks. There is something that doesn’t feel right when the vulnerable and those least able to afford high interest rates, are the ones who suffer them. Perhaps financial education can play a role? Perhaps being more socially open about short term money concerns could help identify more options for those who would benefit.
What about the new challengers, perhaps they are different? Well it would seem their rates are similar, ranging from 15% to 40%, depending upon your credit score. Indeed some challengers set out their business case for the bank based upon driving revenue from overdrafts. It’s becoming clear why we now see so many credit scoring services being advertised. However, surely the motive for improving your own credit score should not be to make your overdraft cheaper? Everyone needs a plan, a strategy, help(?), to prevent continually dipping into the red every month. Rather like so called ‘soft drugs’, overdrafts for the vulnerable may well have been a pathway to payday lenders.
“A fool and his money are lucky enough to get together in the first place.” Whether we accept the rates the banks charge or not, Gekko has a point. If we start out with a foundation where we are better informed, better equipped and more aware of the options before parting with our ‘hard earned’, then just perhaps we can begin to make better choices than those offered by overdrafts.