Why the Bank of England may have just signed free banking's death warrant

The latest base rate cut may be the excuse some banks need to begin charging for current accounts.
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Could Britain's falling base rate, now at another historic low, spell the end of free banking? In a post-credit crunch world, where banks are being urged to return to their traditional business model, a base rate of 0.5 per cent certainly doesn't leave much room for making a return from paying savers less than you earn from borrowers.

No wonder some analysts have warned that this week's base rate cut might be the final nail in the coffin of fee-free current accounts. So low have interest rates fallen that savers are now withdrawing their money in droves, tough on banks trying to fund mortgage lending now that the wholesale money market is shut. The combination of dwindling margins and a shrinking market is not a recipe for profitabilty.

Such a dilemma could hardly come at a worse time for Britain's current account providers, which also face a serious threat to their profitability from regulatory action.

Their ability to sell very lucrative payment protection insurance alongside loans and mortgages will this year be curtailed by strict new regulations from the Financial Services Authority, which will in effect stop lenders offering the cover at the same time as borrowers arrange their finance.

An even bigger iceberg looming into view is the Office of Fair Trading's investigation into unauthorised borrowing charges. While the OFT's attempts to limit the charges made by current account providers when customers breach borrowing rules have been bogged down in a seemingly interminable series of High Court hearings, the watchdog is winning its cases one by one.

The endgame on unauthorised borrowing charges is for the OFT to apply the same rules to the current account market as it has already enforced with credit cards, where such fees are strictly capped. Overnight, that would deprive banks of a revenue stream thought to be worth up to £4.5bn a year.

Kevin Mountford, the head of current accounts at Moneysupermarket, the personal finance analyst, believes the pressures on the sector's profit margins are now so numerous that some erosion of the free banking principle is inevitable.

"Banks are fairly resourceful and when their margins get squeezed they tend to find ways to mitigate that," Mr Mountford said. "The options for mitigation are getting fewer and fewer, and one of the areas where there is some room for manoeuvre is on current accounts."

In fact, there has already been a concerted effort by the industry to increase the profitability of parts of their current account business. Two years ago, for example, First Direct announced it would begin charging current account customers who did not put minimum sums through their accounts.

More recently, the interest rates paid by banks to customers in credit have, on average, fallen, during a period when average overdraft rates have risen. The customers affected may not have been charged fees for their bank accounts, but they are, nonetheless, now paying more.

Moreover, while any provider that introduced current account charges would face customer opprobrium, there are some signs that banks are prepared to incur such wrath. Take Nationwide Building Society, for instance, which has quietly introduced fees on some overseas debit and credit card usage after years of advertising campaigns predicated on its free international services.

"Free banking as we know it in this country is different to what they have in the rest of the world," Mr Mountford said. "I think we'll begin to see something more akin to business banking, where customers pay for accounts on the basis of usage."

However, James Thorpe, of HSBC, says his bank for one has no intention of abandoning free banking – and he doesn't expect rivals to do so either. "To say free banking is on its way out is not realistic," Mr Thorpe said. "We have seen paid-for banking coming into the sector in recent years, with packaged bank accounts, say, but free accounts are here to stay and I don't see that changing."

Mr Thorpe points out that banking margins have not taken quite the battering one might think given what has happened to base rates over the past six months. The Bank of England's bank rate may now be 0.5 per cent, dramatically down from 5 per cent last summer, but mortgage rates have not come down by anything like that much.

Halifax, the UK's biggest mortgage lender, is a case in point. While the bank has yet to respond to Thursday's reduction, during the five months in which base rates fell from 5 to 1 per cent, its mortgage rate came down from 5 to 4 per cent. That response is broadly typical across the home loan market, while the cost of other types of personal lending – particularly unsecured loans and credit cards – has, if anything, increased in recent months.

Savings rates, by comparison, have been much more likely to reflect base reductions in full. The effect, though it is yet to start showing up in banks' publicly available trading figures, is that profit margins in the sector have widened considerably since last autumn. There may have been an unprecedented fall in the amount of mortgage lending taking place in the UK, but margins on those advances that are being made have not been so wide in living memory.

This is not to say there will be no creepage on free banking. HSBC and most of its rivals now offer different types of account to different customers. Packaged deals, where customers pay a fee for an account with additional services, such as travel insurance, thrown in, are becoming increasingly common. It may also be the case that those customers who channel very little cash through their accounts, or buy nothing else from their bank, find service levels diminishing.

Andrew Hagger, of Moneynet, believes that such is the scale of the threat from the OFT's decision on borrowing charges, many banks have already started changing their products.

"A move away from free banking is coming, no matter what happens to base rates," he says. "We are going to see products being tweaked and tiered so that if you want anything more from a bank account than the absolute basics, you're going to end up paying for it – and the more you want, the more you'll pay."