Could negative interest rates trigger the end of free banking?

Posted March 9, 2021
by Alberto Prandini

The Bank of England (BoE) has told banks to take the necessary steps to  prepare their systems for negative rates to be imposed from August 2021. Although the BoE  stated this should not be taken as the Monetary Policy Committee’s policy (which in subsequent speeches appeared divided on the issue), commentators pointed out that it is a sign that the Bank is seriously considering the move, as a means to fuel lending and bolster a UK economy hit hard by the global pandemic.

Interest rates have been held at 0.1 per cent since March 2020 - the lowest levels on record - to limit what the BoE called ‘the downside risks to the economic outlook from Covid’. The possibility of a further reduction could have major implications. It would be the first time in UK history that interest rates were negative, creating uncertainty for banks which will ripple through the industry and filter down to consumers in coming months.  

The implications for retail banks’ IT systems is a considerable one. These systems were not designed to cope with negative rates. Products like tracker mortgages were most likely conceived under the assumption of always-positive interest rates. Big questions remain about whether the banks’ IT systems will need to be re-configured to ensure they can cope with the change - the experience with the Y2K “millenium bug” scare is an encouraging precedent that banks can rise up to the challenge. 

However, the ripple effect of negative interest rates on retail banks’ products will be much wider.  Perhaps somewhat counter-intuitively, negative rates will affect existing products that bear no interest, such as free-if-in-credit personal current accounts (FIIC PCAs). Can the banks continue to offer these in a negative interest environment?(1) 

To understand why this might be, one has to look at the economics. Analysis by the Financial Conduct Authority (FCA) in 2018 found that the revenues from FIIC PCAs can be split into three categories. Since this analysis, these sources of revenue have come under increasing attack from regulatory developments, as summarised in the table below.

(*) Source: FCA, Annex 2, Figure 1

UK banks have long been searching for new ways to make FIIC PCAs sustainable and negative rates by the BoE would add even more urgency to this plight, reducing the last remaining source of revenues unaffected by stringent regulatory constraints. 

The market however seems stuck in an unwanted equilibrium where no bank dares be the “first mover”, so could negative rates mark the end of FIIC banking? Probably not in the short term, given how ingrained this model is for British consumers. 

But negative rates may be the final nail in an already creaking coffin, and accelerate banks’ move away from FIIC banking. We explore here a few possible sources of revenue, from the most direct and transparent to the least visible, and their likely impact on competition and consumers. 

Charging negative interest rates to retail consumers remains extremely unlikely (except possibly for the wealthiest consumers): while many FIIC customers have for years been blissfully unaware of the extent of foregone interest on their balances, a direct explicit hit may well induce even the notoriously disengaged PCA customers to switch banks. 

Charging “subscription fees” on PCAs is another, more explicit route available - HSBC has recently signalled that it may make such a move. Once a “first mover” takes the hit, other large banks that have so far reluctantly stuck with FIIC, may soon follow (the first mover’s plan may indeed anticipate such a swift reaction), potentially unlocking new competitive dynamics. Interestingly, this model appeals also to challenger banks, who see an opportunity to differentiate their offering: Monzo reports that its Monzo Plus and Premium accounts (£5p.m. and £15p.m. respectively, at the time of writing) have attracted more than 100,000 subscribers. Again, consumers used to nominally “free” accounts may resist such a visible move. This may explain why these self-branded “premium” PCAs often come bundled with additional perks and services (from cashback to travel insurance to access to airport lounges) of more or less questionable value for money

We would expect the FCA and the CMA to remain vigilant but broadly welcome such explicit price signals on a core dimension of PCA offering to all consumers. They would want to see whether any such competition benefits all consumers, or whether the market may ‘separate’ into two segments: the first where a subset of banks focuses on premium PCAs to cater for the the most affluent consumers with high spend and high balances, and the second where another subset of banks offers FIIC PCAs to low spend and low balance consumers. Regulatory and political pressure may pile up, if such separation means relatively weak competitive pressures across and within these segments.

We can then expect some banks to try to charge fees for PCAs more discreetly and gradually, as they experiment with the level and trigger of fees that are acceptable to consumers. They may be raising the cost for particular services within the account (e.g. card replacements) or introduce monthly caps on the allowance of ‘free’ transactions. The majority of consumers fail to anticipate using these services or breaching those limits when choosing a PCA product, allowing these cost increases to go undetected or be more accepted (until they hit consumers, ex post!). However, this channel may not be sufficient on its own to keep FIIC PCAs viable, and raising too much revenue from a minority of customers in distressed situations (lost cards) or those making mistakes (exceeding allowances) may attract regulatory attention, as unarranged overdraft fees did in the past. 

Finally, since FIIC PCAs are used as a gateway to cross-sell other banking services (loans, insurance, wealth management), increasing the costs charged on follow-on services could arguably be another way to increase the cost of FIIC PCAs. Tweaking rates to stealthily widen the interest margin may well be the path of least resistance for many banks, but may not necessarily bring about the best outcomes for consumers. Regulators are surely hopeful that the expansion of Open Banking to other products under the FCA’s Open Finance initiative could erode the ability of incumbent PCA providers to go down this route.  

There is hence a realistic prospect that FIIC PCAs will decline, if not yet disappear. Even if they were to, should they be missed? 

FIIC PCAs have been the Marmite of personal retail banking - you either love them or hate them. Just like Marmite, they have proved incredibly resilient over time: reluctantly offered by established retail banks and popular with British consumers - they still are the prevalent source of PCA revenues for UK retail banks (Around 48% in 2018, according to the FCA). For their parts, regulators have long expressed concerns about the competitive and distributional implications of this business model, culminating in the CMA’s Market Investigation into Retail Banking (2016) and the FCA’s Strategic Review of Retail Banking Business Models (2018).

Whatever side of the Marmite debate one falls into, a prolonged bout of negative rates may well be the development that will ‘unstuck’ the PCA market out of the current FIIC equilibrium. Should FIIC decline, the competitive dynamics that would unravel present strategic challenges and opportunities for banks and consumers alike. No-one should miss it.  


(1) For the avoidance of doubt, this post does not refer to  free “basic accounts” that the nine largest providers have a legal requirement to offer - for a total of around 7.2 million accounts in June 2020 according to HM Treasury data