Memorandum submitted by Shelagh A Heffernan,
Professor of Banking and Finance, City University Business School
This submission is a summary of a report by
Heffernan (1999), which was funded by and prepared for the Cruickshank
Review of British Banking. Some of the findings appear in chapter
4 of the final report by Dan Cruickshank (2000), though the actual
study was not referred to in his report.
It subsequently appeared as a working paper, which can be obtained
from the website: www.staff.city.ac.uk/s.a.heffernan.
A shorter, more technical version of the paper
will shortly appear in the Journal of Banking and Financesee
1. This study used monthly deposit and loan
rates to analyse the competitive behaviour of financial firms
offering five generic retail banking products from 1993-99.
The products tested were:
Savings Accounts: For 90
day deposits, at two representative amounts, "High"
Higher Interest Cheque Accounts:
Again, two representative balances, "High" and "Low"
are used. These accounts offer all the features of a current account,
paying variable interest rates on the deposit.
Unsecured Personal Loans: annual
Mortgages: Financial institutions
quote basic annual percentage rates for new and existing borrowers.
Credit Cards: The study included
institutions offering Visa, Mastercard or both to their clients.
In addition to the annual percentage rate, information on annual
fees levied by the institution was also collected.
2. The financial institutions examined in
the study included 40 banks, 42 building societies, seven building
societies which converted to banks during the period of study,
15 community building societies and 16 other financial institutions.
3. The analysis focuses on the difference
between deposit (and loan) rates and a bench mark for a perfectly
competitive rate, Libor, the London Interbank Offered Rate. Libor
is the rate banks quote each other for overnight deposits and
loans. Libor represents the opportunity cost of all of a bank's
assets; for a bank that aims to maximise expected profit, Libor
is the basis for determining the marginal revenue for all assets,
and the marginal cost of all liabilities. It is an international
rate, to which all financial firms have access, and therefore,
is representative of a competitive rate. Since retail rates are
unlikely to respond to changes in current Libor immediately, the
rate was lagged by one, two and three months. The study used four
different measures to examine the state of competition in retail
banking market over the last decade.
These include spread analysis, looking for evidence of smoothing,
identifying the extent to which deposit and loan rates deviate
from the competitive rate, and ranking financial institutions
according to whether they offer customers a relatively good or
bad bargain. Each is discussed under separate subtitles, below,
followed by a conclusion.
4. The spread on a deposit is the gap between
Libor and the deposit rate. Consumers benefit from lower spreads
because it means they are getting a more competitive rate. The
spread was found to vary with the size and type of deposit; the
smaller the deposit, the greater the spread. Spreads were higher
for chequing accounts than for savings. Over the period 1993-99,
the general trend is a slight fall on most deposit products. However,
this observation does not hold for all products or institutions.
Low level savings accounts are another exception, however, with
spreads rising until 1998, and banks enjoy wider spreads than
building societies. In the case of higher level savings accounts,
building societies converting to bank status display sharply widening
5. For a loan, the spread is the amount
by which the loan interest rate exceeds Libor. This, too, displays
a slightly downward overall trend in the past decade, at least
for personal loans and mortgages.
6. Spreads on mortgages are much lower than
spreads on personal loans,
though the latter narrowed over the period. There is some evidence
of discrimination between new (offered keener rates) and existing
borrowers. The latter are trapped by redemption penalties and
switching costs, and hence charged more.
7. There are differences in the way spreads react
to rising, as opposed to falling, Libor. When Libor falls, financial
institutions cut interest rates quite smartly but take longer
to raise them when Libor is climbing. Again, the reaction to rising
and falling Libor differ by product and institution. For example,
the converted building societies do not pass on the benefit of
a sustained, falling Libor, while the traditional banks do the
opposite. During a period of rising Libor, the converted firms
pass on the effects more than the established banks. For mortgages,
an asset with a long maturity, all firms absorbed most of the
effects of a falling or rising Libor.
8. In the period 1985-89 (see Heffernan,1993),
rising spreads were found on virtually all the products studied.
In the 1990s, they fell, though when broken down by type institution,
All of these findings point to some degree of market imperfection:
in a highly competitive market, firms would be expected to behave
the same way.
9. Smoothing means a less than one for one
response. Some delay may be explained by the presence of "menu
costs", that is, administrative and other costs involved
in changing the rates. Also, some building societies announce
they will not change rates when market rates are falling to "protect
our savers", or to shield mortgagees when rates are rising.
There was strong evidence of significant degrees of smoothing
for all five banking products.
10. Table 1 below summarises the extent
to which deposit/mortgage/loan/and credit card rates deviate from
a benchmark competitive rate, Libor. Column (1) shows that on
the deposit side, the savings accounts are closer to the competitive
rate than the interest cheque accounts.
11. Compared to the 1985-89 study by Heffernan
(1993), column (2) shows the savings accounts and mortgages have
become more competitive; the interest cheque accounts, less. The
deviation for personal loans has hardly changed. There is supporting
evidence of a mark-up added to the existing borrower rate that
is 2.5 times greater than the new borrower rate.
12. Column (3) of table 1 shows how long
it is taking these products to respond to a change in the competitive
rate. Interest cheque accounts, credit cards, and personal loans
all show a slow response of three months; the other products respond
with a lag of one to two months.
PERCENTAGE DEVIATIONS FROM THE COMPETITIVE
|Length of time it takes to respond to a change in the competitive rate
|Interest Cheque Accounts||62-82%
|Mortgage RatesExisting Borrowers
|Unsecured Personal Loans||73%
Na: not possible to report a figure because credit cards
and new borrowers were not part of the 1985-89 study.
13. This test is based on an idea developed by Salop
and Stiglitz (1977). With unequally informed consumers, there
can be two equally profitable prices a firm can charge, a high
one to a few, uninformed customers, or a low one with a higher
volume. Thus, relative bargains and rip-offs co-exist in the same
14. For example, consider the London restaurant market.
There is general agreement this sector is highly competitive,
because there are so many firms. However, if the amount of information
about the quality and price of these establishments varies among
consumers, then it is possible for some restaurants to offer bad
deals to customers and stay in business. The ill-informed diner
who samples London restaurants on an occasional basis might choose
a highly priced, low quality restaurant. He or she will never
return again, but given a sufficient number of ill-informed consumers,
the restaurant will remain a profitable business. Well-informed
diners chose value for money restaurants which, likewise, stay
in business, depending on regular clientele.
15. In the retail banking market, a similar situation
exists. Some consumers are well informed, others are not. The
econometric test for the presence of relatively good and bad buys
is reported in Heffernan (1999, 2002). Table 2 (see end of submission)
shows large differences in the ranges between the relative best
buys and worst buys, depending on the product. The first or "product"
column in table 2 ranks the mortgage, chequing, savings, unsecured
personal loans, and credit card offerings according to the size
of the margin between the relative best bargain and worst rip-off.
For example, consider personal loans. The second column of table
2 shows a difference of 8.7 per cent between the best and worst
16. According to table 2, mortgages have the smallest margins,
not only because of the number of players, but because the size
of a mortgage (the largest investment the majority of individuals
make in a lifetime) and its duration mean most potential customers
will shop around for the best deal. Furthermore, these mortgages
are considered "safe as houses" by banks because of
the tradition for real property market values to rise.
Once locked in however, there appear to be opportunities for firms
to practice price discrimination on existing borrowers.
17. From table 2, there appears to be persistent (but
not large) relative bargains for existing and new mortgages being
offered by Derbyshire, First Direct, Nationwide, and the Yorkshire
18. The margin of less than 1 per cent between the best
and worst low chequing accounts is explained by the very low market
interest rates throughout the period. Since interest rates cannot
fall below zero, banks encounter a floor, with very little room
to offer relatively bad buys, i.e. low deposit rates. In the 1985-89
study, when nominal interest rates were comparatively high, there
was a difference of 3.74 per cent between the best bargain and
19. One possible interpretation of table 2 is the use
of loss leaders by financial firms. One product might be priced
below cost to attract new accounts, with losses defrayed by higher
prices on other products. However, firms typically engage in this
type of behaviour for a short period. The results in table 2 are
from estimating equations over a relatively long period, 1993-99,
indicating the sustained persistence of relative bargain and rip-offs.
20. Firms may also price products below cost or cross-subsidise
to attract customers into a form of relationship banking, expecting
to obtain services at reasonable (if not the most competitive)
prices. This might help to explain the findings in table 2, though
British banks, in general, are not known for this type of banking
in the mass retail market. A more likely explanation is the presence
of switching costs, causing consumer inertia that can be profitably
exploited sometime after the customer has opened an account.
21. Notable also from table 2 is the absence of any consistency
in the position of financial institutions. For example, Northern
Rock, which converted to a bank, offers the best buy for unsecured
personal loans and the interest cheque account for the low amount,
but is the worst deal for mortgages.
22. Apart from the odd exception, the big four clearing
banks usually offer relatively bad bargains. It is the smaller
players that offer the best deals for the interest cheque account
and mortgages: the relative best and worst buy places are occupied
by comparatively small banks or building societies.
23. The results of this study suggest competition has
increased in some retail banking markets in the 1990s, compared
to the later half of the 1980s. The mortgage market, in particular,
seems to have become more competitive.
However, the price comparison did show existing borrower rates
to be less keen than those for new customers.
24. Unlike the mortgage market for new borrowers, there
are indications of substantially less competition for savings
accounts, interest earning cheque accounts, personal loans, and
especially, the credit card market.
25. Imperfect competition continues to prevail in the
retail banking market, but no single "model" describes
the way firms behave in the pricing of their products. However,
for many of the products, the "good buy/bad buy" model
fits well with the results. Some firms remain profitable by offering
relatively bad buys to the poorly informed consumers. An increase
in the number of firms entering the market (because of, say, a
fall in fixed costs) could actually increase the number of relative
rip-off bank products.
26. Cruickshank (2000) argued that additional regulation
in personal banking is unwarranted
because increased entry will increase competition. This conclusion
is correct, but only in the absence of consumer inertia and in
an environment of full or more complete information about the
products on offer.
27. Policy should be aimed at encouraging banks to supply
consumers with comparable information, so it is more difficult
for the relatively bad buys to survive in the market. Also, financial
institutions should be required to make it easy for customers
to change banks. In the meantime, consumers should search out
the best buys on a product by product basis, and then stick with
that firm (or firms), but be on guard for any decline in the competitive
pricing of a product, and/or the introduction of new, close substitutes
by that financial institution.
* - subsidiary of Robert Fleming Bank ** - subsidiary of
National Westminster Bank.
British Bankers' Association (1998,1999), Banking Business:
An Abstract of Banking Statistics, vols 15,16, London: BBA
Cruickshank, D (2000), Competition in UK Banking: A Report
to the Chancellor of the Exchequer, London: HSMO.
Heffernan, S A (1993), "Competition in British Retail
Banking", Journal of Financial Services Research,
Heffernan, S A (1999), "Competition in British Retail
Banking, 1993-1999"Report for the Cruickshank Review
of British Banking, September, 1999. Subsequently appeared as
a working paper, which can be obtained from the following website:
Heffernan, S A (2002), "How do UK Financial Institutions
Really Price their Banking Products?", Journal of Banking
and Finance, October.
Salop, S and J Stiglitz (1977), "Bargains and Ripoffs:
A Model of Monopolistically Competitive Price Dispersion",
Review of Economic Studies, 4,493-510.
Many background papers were not cited by Cruickshank, and it
would be helpful for researchers if a full list of references
could be provided. Back
The author is grateful to MONEYFACTS for supplying the data,
especially the Chairman of the company, Mr. John Woods, and Mr.
Mike High for their generous help. Back
Financial institutions offer a large range of deposit products.
In early tests done for Heffernan (1993), firms demonstrated similar
pricing behaviour across deposit products that required notice
of withdrawal (to avoid interest penalties) and do not have current
account facilities such as a cheque/debit card or a chequebook.
For this reason, the 90 day account was chosen as the representative
deposit product. Back
Data from the Abstract of Banking Statistics (1998,1999)
were used to obtain the representative amounts. See appendix 1
of Heffernan (2000) for an explanation of how these representative
amounts were computed. Back
Community building societies limit their customer base by geographical
residency requirements, and other financial institutions are all
firms that fall outside the other four categories but offer a
limited range of financial products, such as the various mortgage
corporations. Given space constraints, the community building
societies are not discussed in this summary. Back
Where possible, the results are compared to those reported by
Heffernan (1993) for the period 1985-89. Back
The lower mortgage spreads are partly explained by overhead costs
being spread over larger sums, longer time spans, and a lower
risk premium because the property acts as security. Back
No comparison is possible with credit cards because they were
not part of the earlier study. Back
The exception to the historical rule was the negative equity
crisis from 1990-93, and a high repossession rate from 1991 to
1995 that led managers to raise risk premiums. However the action
was temporary, and the episode increasingly forgotten or treated
as a non-recurrent risk by 1997. Back
This observation is subject to the proviso that non-price features,
such as redemption clauses, were not part of the study. Back
Cruickshank (2000) made numerous policy recommendations but only
those directly relevant to this study are discussed. Back