Tuesday, January 19, 2010

I realized the other day that the consumer banking system in the US is highly regressive. Regardless of which business line you look at, banks across the globe target richer people. Whether its Ultra High Net Worth Individuals (assets >$30 million) in private banking, affluent customers (income >$100k)in retail banking, or mid-sized enterprises (revenue > $10 million) in small business banking, size really does matter for a bank. But while these customers generate high profits for the bank, the actual profit margin that the bank makes on them is usually much lower.

For example, a low-income customer may have $1,000 in her checking account, on which the bank pays her no interest but makes 3% a year. A richer customer may have $10,000 in his account, but will probably keep much of this in a savings account where he gets paid interest. The banks net interest margin, the difference between interest paid vs. interest earned, may be no more than 1.5% on this savings account. Of course, 1.5% of $10k > 3% of $1k, and that is why the bank prefers the richer customer.

However banks in the US are especially perverse in how they screw over poorer customers. Banks in the US make a large chunk of their revenue from charging overdraft, bounced check, late payment, and a host of other fees that the average consumers know nothing about until they see it on a bank account. Overdraft fees alone have been estimated at $38 billion in 2008. And these fees are especially regressive, since they are paid disproportionally by lower-income customers:
- lower income customers usually have lower balances and more variable incomes, making them more vulnerable to fees
- their knowledge of the banking system is limited, so they just don't understand things like a bank check taking 5 days to clear
- they have a very low success rate in calling a bank and getting their fees and charges reversed

Once you include the fees and charges, the bank may be making an effective profit margin of 5% or even 10% on that customer with a $1,000 balance, vs 1.5%-2% on the $10k customer. And this is before interchange or bill payment revenue (a topic for another day). And lets not even talk about the 40 million+ people who don't even have a bank account and relay on things like loan sharks and payday lenders.

Now this is also true for a lot of other products and services. For example, lower income customers usually end up paying more for the same groceries than a high-income customer. But in exchange for that higher price, they usually get some value in the form of smaller package sizes, distribution via a store close to their home, etc. I haven't heard of any decent-sized bank in the US tailoring a product for lower-income customers (except to try and charge them higher fees), and banks in the US do the best they can to open branches as far away from lower-income customers as they can.

Is any of this going to change anytime soon? Startups like Wonga are chipping away at the payday world, but it really needs somebody like Tesco to go after it. Sadly, all the action seems to be in the UK for now.

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