Don't be fooled, free banking is a myth – and the banks are making billions from your interest

The high street market is not working because people, despite their dissatisfaction, are more likely to leave their spouses than their banks.

Canary Wharf (Getty)

In economics circles there’s a famous saying that “there’s no such thing as a free lunch”. But according to the UK banking lobby there is such a thing as free banking.

Here’s how they describe it. Think of all those services provided to you by your bank – the debit cards, the credit cards, the cheque book, the printed statements, the always reliable website, the efficient call centres, the branches packed with helpful staff. All of that is provided to you with zero monthly or annual charge. The banks are giving it away. Unlike in many European nations, ordinary banking is “free” in this country.

And this, argues the lobby, is a terrible commercial distortion. It means banks are making a loss on their day-to-day businesses and need to make the money back from other activities. It is why, some members of the lobby suggest, there have to be penal charges on those customers who dip into overdrafts.

Some even suggest free banking is the underlying reason banks have mis-sold so many dodgy products to customers such as Payment Protection Insurance (PPI) over the past fifteen years. “Because banks are not charging, it drives them inexorably into this sort of position” said Sir David Walker, the chair of Barclays, a few years ago.

So the solution, we’re told, is for banks to charge a monthly fee on current accounts. Then all these nasty overdraft charges could melt away. And the banks would probably behave better too.

Does that sound plausible? Don’t be taken in. Free banking, as the Competition and Markets Authority pointed out today in the latest instalment of its investigation of retail lenders, is a myth. To understand why it’s necessary to grasp a couple of very basic points about how a bank works.

Banks borrow money from ordinary depositors like you and me and then lend out the money at a certain interest rate. The difference between the interest rate at which they lend out the money and the interest rate at which they borrow it constitutes their revenue.

Now, how much interest do you receive on the cash that’s in your own bank current account? The chances are that it will be a vanishingly small amount. It may well even be zero. It will most probably be less than the economy wide interest rate for borrowed funds set by the Bank of England which is about 0.5 per cent. Or less than you could earn in a dedicated savings account.

This is the true cost of your bank account: the difference between the economy-wide interest rate and what you receive in interest from the money in your current account. This is known as “foregone interest” and this feeds directly into the top line revenues of your bank.

So how much is this foregone interest worth to the banks? There are no hard figures available. But the Office for Fair Trading estimated that personal current accounts generated just under £9bn in total revenues for the banks in 2011. And 40 per cent, £4bn, of these revenues came from the “spread” between interest charged to borrowers and interest paid out to depositors. Foregone interest is likely to constitute a significant slice of this £4bn. And then there’s the difference between the amount your overdraft actually costs banks and the amount of interest you pay for the borrowing. The OFT estimated this at around £1bn in annual revenues for the banks. Some put the total implicit cost of your “free” current account at £100 year on average.

One almost has to laugh at the chutzpah of the banks when they quietly extract such hidden charges and then moan about having to work for free. But when they proceed to argue they should be allowed to charge us even more on top to dissuade them from ripping us off in other ways it really ceases to be amusing.

The CMA rightly dismisses the “free banking” canard of the banking lobby. But as a response to the dysfunction of high street banking today’s report is a huge let down for customers. The problem with high street banking is well established. Trust in banks is at rock bottom after waves of mis-selling scandals. Customer service is generally awful, with websites breaking down regularly. The sector is highly concentrated, weakening competition pressures. And the market is not working because people, despite their high dissatisfaction levels, are still more likely to leave their spouses than their banks.

The response of the CMA is some light tinkering. The economic textbook response to a chronic lack of competition in a market is for regulators to create more competitors through enforced structural reform. But the CMA has ruled out breaking up the big high street banks such as Lloyds, RBS and Barclays and HSBC, despite their domination of the current account market. The regulator has also ruled out the one policy proposal that might have a chance of energising the market in the absence of structural reform: account number portability.

Switching bank accounts has become a quicker and more efficient process than it used to be. After being disgusted by the levels of customer service offered by various banks, I’ve done it myself three times in the past few years. Setting up a new account is no longer the main problem. Transferring regular outgoing payments such as direct debits is automatic. The problem is letting others know my new account details.

Each time, I’ve had to inform my employer of my new bank account number and sort code and also anyone else who makes regular payments to me. Perhaps some people will think that doesn’t sound so onerous. But imagine a small business with dozens of creditors having to do the same. Having a portable account number and sort code would eradicate all that hassle. Switching banks would then be as simple as moving mobile phone network provider when you’re out of contract. Survey evidence suggests many more people would do it.

Yet the CMA argues that its new plan to require an extended automatic redirection of payments from old accounts will achieve the same boost to switching rates as implementing full account number portability. Precisely why it believes this is a mystery since the regulator offers no evidence in support.

There really is no such thing as a free lunch as far as Britain’s beleaguered current account holders are concerned. But thanks to weak competition authorities, who repeatedly shy away from doing what needs to be done, banks can continue to chow down at the expense of their customers.