The Banking Game: Literature Review Part Three and Conclusion by Doreen Soutar
The Banking Game: Analysis of the extinction of the bank as trusted institution and NONIIs as an indicator of non-reciprocal strategies by Doreen Soutar. This is the third part of her literature review and conclusion to her investigation…
Retail Banking: a Co-Operative Model
The savings and loans banking division operates in a social environment which is built on repeated encounters, engendering the growth of mutual trust and cooperation (Motashemi & Mui, 2003). Here, customers are given to believe that the bank is essentially working for the augmented good of the group, where community wellbeing is the main focus rather than the wealth of the bank, as is implied in the statement by the CEO in Barclays’ annual statement (Diamond, 2010). This is not restricted to the equality of reciprocity of a single lender and the bank, but also applies to altruism “fed forward” in an emergent, and customers benefit at different times in differing amounts.
Retail Banking Reputation and the Evolution of Trust
Indeed, the Governor of the Bank of England described the basic function of the retail division of a bank is to be trustworthy with their customers’ money, and handle everyday transactions reliably (King 2010). They also provide sources of capital investment in the form of loans both to individual customers and to businesses. Retail banks make profits by providing loans at a higher rate of interest than they offer for savings interest (e.g. Boot, 1999). They can assume that at any given time, customers will not all wish to take their money out simultaneously, so they are able to utilise these funds to make loans elsewhere (Casu et al 2006).
Of course, there are limits to how much of their customers’ funds they can give out in loans, and current debate in bank regulation surrounds the ‘multiplier’: the ratio of funds to loan, or liquid assets to total liabilities (ibid.). The multiplier ensures that the banks have enough liquid assets to meet customer demand for cash, and one of the issues for future bank regulation has been a potential increase in the amount of liquid assets a bank has to retain. This, in turn, limits the amount of assets the bank can use as funding for loans (ibid.).
These limitations, prompted by an infiltration of competitive initiatives from the trading division, lured banks into creating new business strategies which they can use for leverage. There are two broad ways they can achieve this: they can look for alternative charges and products which they can levy from their already alienated customers to retain their shareholders, or they can restructure their business model to produce smaller, but more reliable, income sources to retain their stakeholders, but risk alienating their shareholders (Casu et al, 2006, Johnson, 2003).
In evolutionary terms, rather than adapt to their environment, the retail banks have chosen to import a strategy which puts them in competition with their customers. Such a maladaptive strategy has resulted in the destruction of customer trust (Kennedy, 2010). However, there is evidence to suggest that there are ways in which the bank could mutate to the demands of a retail environmental complex.
Bank Size and Customer Relationships
The internal structure of a bank has been shown to affect the way the bank relates to the customer, and this can have a substantial influence on the bank’s potential return on investment (Kim 2007). Whilst the UK has a few very large banks which have almost entirely replaced small independent banks on the High Street, the USA banking system has several small banks. This divergence of strategies allows comparisons to be made between types of bank and how this can influence performance and customer relationships (ibid.).
Within the US, Akhigbe & McNulty (2005) suggested that small banks can increase their profit efficiency by having more personal contact with their customers. In a similar study in 2006, Chukwuogor-Ndu and Wetmore noted that between 2000 and 2002, small banks charged lower non-interest fees (NONII) as a percentage of average assets than larger banks, had a higher rate of return (ROI) on their loan investments, and tended to take less risks than larger banks (Akhigbe & McNulty, 2005). The reason suggested for these results is in the way banks assess the credit-worthiness of their loan applicants (Berger 2002).
In small banks, the lender tends to be part of the community, and has some social awareness of the lender’s general attitude to finances, and tends to rely on more informal methods of assessment, whereas larger banks tend to rely on homogenous rating systems (ibid.). This finding supports the theoretical notion of game theory discussed earlier (Nowak & Sigmund, 2000). Of course, large banks can employ considerable economies of scale in utilising large databases of credit information, and therefore can out-compete smaller banks in times of recession on the basis of more competitive headline interest rates to customers.
However, small banks tend to be able to run with a much smaller loan loss reserve provision, which means that more of their liquid assets can be utilised (Kim 2007). Of course, in times of recession, small banks are vulnerable to competition, and the introduction of high technological banking strategies such as ATMs and online banking can reduce their customer base (Barrutia, 2002), particularly in rural areas.
The above research tends to suggest that the overall banking health of a community may rest in limiting the size of banks (Berger & Humphrey, 1991 in Akhigbe & McNulty). This would reduce the barriers to entry into retail banking services and may reduce the perceived distance between customer and institution, reduce the relative volatility of the British banking system (Hogarth et al 1998), minimise default rates and re-engage customer loyalty (Kennedy 2010) by being seen to invest in the community. However, the Western banks have taken a more marketing-oriented approach to re-engaging with their customers: they engage in manipulative advertising.
Fitness Indicators and Honest Advertisements
Darwin published a second book on evolutionary theory, The Descent of Man in 1871. In this book, he sought to explain some of the theories and anomalies present in the Origin of Species. Foundational to Descent was a model which explained the reasons for evolutionary reproductive decision-making: why mates chose each other. Some of the details of these reasons remain live debates, including the evolution of some human traits known as fitness indicators. Some evolutionary theorist postulate that apparently useless parts of physiology, such as brightly coloured feathers on birds, exist to advertise just how healthy the individual is (Gould & Lewontin, 1979, Zahavi & Zahavi, 1997).
Financial statements have a similar affect on shareholders. Rather than having shareholders defect, some banks have resorted to continuing to present an impression of cooperation to their customers, whilst simultaneously continuing in competitive practices with their customers. In both marketing and evolutionary theory, this is known as dishonest advertising (Zahavi & Zahavi, 1997). One of the exemplars of dishonest advertising within the banking system in the last few years has been the way the banks find of extracting additional fees from their customers which are not interest-related.
The Cost of Customer Cooperation
Large UK banks tend to sell more non-loan products than some other European banks (Hogarth et al 1998). Indeed, very recent High Court rulings against the banks have shown that the UK banks have substantially over-sold products such as loan protection insurance (FT 2011). German banks, for example, tend to be more specialised in their areas of operation than UK banks (Hogarth et al 1998). It may be notable for future banking regulation within the British system (King, 2009), this means that German banks are not so badly affected by inter-divisional crises (Hogarth et al 1998) of large multi-faceted British banks. In effect, German banks are more highly adapted to their local environments.
As British banks have grown in size and power, they have severed the link with their customers which would allow them to maximise their earnings from NIIs (Kim 2007). The preferred strategy of the UK banks has been to increase their profits from loans in other ways. Of course, the margin between the borrowing rate the bank is charged from the central bank and the interest rate it charges customers on their loans has broadened in the last two years, meaning that the UK banks are continuing to profit from NIIs (FT 2009). However, in addition to this, one-off fees (NONIIs) on loans to customers such as mortgage arrangement fees (FT 2008) also appear to have risen (ibid.).
However, the extent to which NONIIs have risen within the last five years is not easy to establish. According to a Syscap survey in the Financial Times (2009), 90% of business owners believe that loan arrangement fees have risen to an excessive level. Intriguingly, although the Bank of England collects detailed information on the lending decisions of banks, these NONIIs are not part of the information-collecting process (ibid.). This means that currently, information on the arrangement fees for loans to SMEs and individuals is not available for scrutiny (ibid.).
UK have effectively distanced themselves from their customers, not only physically through digital banking, but by withdrawing from the traditional reciprocally altruistic relationship with their customers. They have achieved this by adopting a unilaterally competitive strategy in a largely cooperative environment. In so doing they have lost a valuable source of information on profit maximisation on their rate of return from loans.
Although there is political pressure on banks to realign themselves with their environment, such as separating the trading and retail divisions, the banks appear to have sought to maximise profits from their customers in less overt ways, such as inflated arrangement fees on loans. This strategy is not reflected in their retail division marketing, where the focus is directed towards a mutually altruistic stance.
Theoretical models suggest that although the bank’s strategy of extracting increasing fees from their customers will reap benefits in the short term, this type of strategy will result in customer defection in the long term.
However, the existence of an increase in non-interest-bearing fees has not attracted statistical analysis by banking regulatory bodies, and therefore the allegations of profiteering by the banks remain unsubstantiated. The purpose of the current study is to discover the level of interest-bearing-fees as a proportion of the loan principle, and whether these fees comprise an increasingly large part of the banks profit.