Last rites for free banking

[Legal Beagles]

A long-awaited test case to establish the legitimacy of bank and building society current account charges kicked off in the High Court yesterday ? the start of a legal wrangle between the Office of Fair Trading and eight of the sector's biggest institutions that is unlikely to reach a conclusion before 2009.

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[Amethyst]

Re: Last rites for free banking

A long-awaited test case to establish the legitimacy of bank and building society current account charges kicked off in the High Court yesterday – the start of a legal wrangle between the Office of Fair Trading and eight of the sector's biggest institutions that is unlikely to reach a conclusion before 2009.

Hanging in the balance is the future of so-called "free banking" – a misnomer that is now commonly used to describe the British retail banking market.

In fact, Britain's banking system, even in its current guise, is far from free. While consumers are not charged for regular current account services – such as cashing cheques and setting up direct debits – banks still make a turn by paying their customers a small rate of interest on their balances, while using their cash to earn much better rates in the overnight money markets. Furthermore, banks are all too aware that a loyal current account base provides a captive audience for cross-selling other, more profitable, financial products.

Nevertheless, there is no doubt that Britain's banks are forced to survive on much leaner margins in their retail businesses than their overseas competitors. According to a report by the financial consultants Oxera, the British pay less in banking fees per head than the citizens of any other country in the world (bar the Dutch) – an average of just ¿18 (£13.67) a year. At the other end of the scale, the Italians pay six and a half times more – an average of ¿119 a year. In fact, only the Finns and Americans pay less than double the UK average.

But while the UK banking system represents comparatively good value for those who keep their accounts in the black, customers who bust their overdraft limits or have a cheque bounced can quickly find themselves on the end of fees running into tens and even hundreds of pounds. Given that the real cost of these incidences to the banks is a fraction of the fees they levy, the OFT believes they are falling foul of the "Unfair Terms in Consumer Contracts" regulations.

The trial, which began yesterday, will aim to determine, firstly, whether these regulations – part of a European Union directive – cover the UK retail banking sector at all. And, if they do, a second trial will then be held to determine whether the charges are indeed unfair.

Although consumer groups are impatient to see an OFT victory, it is far from clear whether a loss for the banks would be the best result for the average UK banking customer. Banks' margins have already been put under significant strain in recent years, with clampdowns on credit card and mortgage exit fees forcing them to begin looking for other ways to recoup lost profits.

Furthermore, the Competition Commission is in the middle of an inquiry that looks likely to curtail banks' profits in one of their most lucrative markets – payment protection insurance – at the same time that bad debts are rising, and pressure from the ongoing credit crunch is continuing to nibble at their margins.

Ultimately, a loss in the courts over the next 18 months may be the final straw, forcing British banks to convert to the more severe pricing structures used in other countries. "The reality is – in all likelihood – that this case will further accelerate the end of free banking as we know it," said Nick Sandall, the partner in charge of retail banking at Deloitte. "In effect, we don't pay anything for having a current account at the moment. If you lived in a foreign country, however, you would."

A loss for the banks may at least serve to eliminate the current perverse situation, whereby the country's poorest citizens subsidise banking for the more wealthy. All too often, those who are being hit with the heaviest charges are those who can least afford it, while the more affluent get a free ride.

If the banks are no longer allowed to keep charging high fees, a likely result will be monthly charges for all current account users, or perhaps additional fees for regular services that we currently take for granted.

"If the banks lose, they'll definitely try to recoup their fees elsewhere – possibly by charging for more individual items within current accounts," David Black, the head of banking at Defaqto, the financial analysts, said. "They could either make the customer pay for certain individual transactions, such as cashing a cheque, or they could start charging flat fees for current accounts."

The banks are certainly reluctant to introduce unpopular new charges. Whoever moves first would inevitably scare off many of their customers, and run the risk that their competitors may not follow suit.

Stephen Green, the chief executive of HSBC, suggested last year that a loss for the banks in the test case would be likely to lead to branch closures and other cost cuts, rather than a change in the fundamental pricing structures.

Nevertheless, HSBC was one of the first to test out an alternative solution – introducing new charges on its First Direct current accounts in 2006, designed to scare off its least affluent (and ultimately, least profitable) customers. The bank now charges current account customers £10 a month if they do not have at least £1,500 paid into their account, ensuring that those on lower incomes – who are both less likely to take up cross-selling offers and more likely to become bad debts – are forced to take their business elsewhere.

The banking sector is unlikely to transform overnight, however. With a verdict for the first test case unlikely to be delivered before Easter, and numerous appeals to follow, it is almost certain the case will not be finished before the end of the year – even if it never gets to a second trial. If it does, it is not inconceivable that it will be 2010 before the case is closed.

In the meantime, consumers can expect to continue to see a gradual creep in the cost of banking, as banks test the water to see what they can get away with. Already, mortgage and credit card fees are on the rise, loan rates are becoming less competitive and overdraft charges are being redesigned, in an attempt to protect revenues, while keeping the regulators happy (or oblivious).

"Free banking" (as it we used to know it) is already dead. Whether the banks win or lose, consumers should expect it to become more expensive in the years ahead.