Shakedown clampdown: Joint regulation of bank interest rates and fees

Darron Thomas, Guest Columnist

On April 19, the Consumer Affairs Commission (CAC), along with the National Consumers' League, released a Draft Code of Conduct - Banking Services, regarding the conduct of banking entities. The code reads: "This draft code is put forward for consideration as a voluntary code of conduct which sets standards of good banking practice and should serve as a guide for banks to follow when dealing with persons who are, or may become, their customers, in order to promote transparency and avoid conflict. The commitments ... shall serve as the minimum standards by which banks may execute their practices, so as to encourage higher standards for the benefit of its customers."

In January, the Fair Trading Commission (FTC) released a study on regulating bank fees. This was yet another contribution to the debate as to whether bank fees should be regulated. This debate has come front and centre since the increase in bank fees supposedly precipitated by the Jamaica Debt Exchange (JDX). It is also clear that the wedge between deposit and lending rates have been a point of contention for at least the entire inaugural decade of the 21st century. In the early to mid-2000s (and currently on an ongoing basis), the Jamaica Manufacturers' Association and the Jamaica Agricultural Society, among others, were consummate advocates for reduced interest rates.

The latest draft code from the CAC comes approximately six months after its October 2010 study, which revealed that banks had increased fees, in some instances, by up to 400 per cent. These fee increases coincided with the interest-rate reductions precipitated by the 2010 Jamaica Debt Exchange (JDX) programme which was part and parcel of the 2010 International Monetary Fund (IMF) Standby Agreement. The CAC's draft code identifies 11 major areas of focus. These are: (i) non-discriminatory access; (ii) service standards; (iii) product information; (iv) terms and conditions and contract format; (v) cooling-off period; (vi) credit information; (vii) variation in fees and charges; (viii) elderly, disabled and pregnant consumers; (ix) dispute resolution; (x) breach of code of conduct; (xi) commitment to three-year review of the draft code. While these are all important in improving consumer welfare and general economic outcomes, there are shortfalls, as will be outlined below.

main source of income

According to a January 23 Gleaner article by Dr Kevin Harriott, competition chief at the FTC, based on analyses of National Commercial Bank Jamaica Ltd and Bank of Nova Scotia Jamaica Ltd regarding profitability with reduced fees, among other expositions, "it is unlikely that lower fees, stimulated by greater competition, would compromise the sustainability of these large banks". The FTC study from which Dr Harriott gathers his information goes on to suggest that the main source of income for the banking sector is interest charges. Income from fees and commissions account for between seven and 20 per cent, while interest charges, according to the study, account for between 60 and 80 per cent of net revenue.

To underscore the increase in fees, Business Observer analysis of the data showed that income from fees (other than from loans) increased from year-earlier levels by $885 million, or 12 per cent, during the first nine months of 2010. On the other hand, net interest income fell by $2.5 billion, or 7.5 per cent, over the comparative periods while pre-tax profit made collectively by the seven commercial banks reviewed, fell to $13.4 billion during the nine months to September 2010 from $15.2 billion a year prior."

Seemingly, fee increases do not cover the full amount of lost revenue from interest-rate reductions, but it should be clear that there was a significant increase in fees at or about the time of the interest-rate reductions. As a matter of fact, according to the above information, fees increased some 4.5 percentage points above the increase in interest rates. Clearly, this keeps the cost of interacting with banks, including borrowing to invest, high and, therefore, at least partially offsets benefits derived from reduced interest rates. As such, fee increases are partially defeating the painful and tough decisions taken in the form of the JDX and other measures to stimulate investment through reduced interest rates on loans.

Against this background, what is really necessary is to regulate the pricing decisions of banks in a manner which treats interest rates and fees as components of a single price charged by banking firms. Of course, the Jamaica Bankers' Association (JBA), through its president, and otherwise, has offered a countervailing view, suggesting that interest rates and fees charged by banks are not too high. Specifically, the JBA has argued that the fee increases are not excessive in light of the interest-rate reductions.

It seems, however, that the debate has not viewed bank interest rates and fees as part of the same whole in making the case for regulation. Hence, there is no discussion of this integrated nature in either the FTC or the CAC studies. In the context of usury laws imposed in some states in the USA to curtail predatory and other unfair lending practices, a maximum amount is usually set for the sum total of rates and fees taken together. This should serve as an example for the Jamaican experience!

Distinct product

While strong cases have been made on either side of the regulation issue, some basic questions of interest and characteristics of banks and bank-type entities have been absent from the debate. The diversity of banking charters and operational policies and procedures allows each bank-type entity, if not individual banks, to be viewed as offering a distinct/differentiated product. For example, commercial banks deemed "too big to fail", with "deep pockets", more branch locations and ATMs across geographical space, and pioneers of new services such as mobile, Internet and telephone banking, are viewed as higher-quality service entities by way of reduced risks to customers and easier access, among other benefits (the FTC study does note this).

Another crucial issue is the 'Scale Characteristics' of the banking firm. As an inherent network-type facility, banks benefit from synergies among members. As the network membership grows, increased benefits and reduced cost accrue per member. This generates increasing returns to scale (IRS) as a feature of banking entities, which is widely posited in the banking literature (for a more elaborate discussion, see 'Implications of Optimal Price Regulation in Sub-Prime Banking Markets' available at: http://ssrn.com/author=1510887).

average-cost pricing

In the presence of differentiated products and IRS, standard economic theory suggests that firms should be regulated in terms of prices. In particular, an average-cost pricing rule should be imposed. Of course, the recommendation in this environment runs counter to the argument front and centre of the Jamaican debate. In the local debate, one of the foremost arguments is that banks exist in a competitive environment and should, therefore, not be regulated. This, notwithstanding several studies which have found that there exist anti-competitive outcomes in the Jamaican banking market (see '... The Case of Banking Sector Competition in Jamaica 1990-2004', available at: http://ssrn.com/author=1510887). The argument here is that given IRS and product differentiation, banks should be regulated, with their fees and interest rates viewed as one price and set according to their average cost.

Clearly, the challenge to this view is the inherent difficulty in measuring a bank's economic cost. This is, of course, one of the debates which have emerged from the FTC's study. The simple idea is that we need to employ state-of-the-art scientific investigative tools to uncover these issues and gain better insight into these matters. Quite frankly, average-cost regulation would force banks to become more efficient, with the outcome being reduced costs. Furthermore, in the context of differentiated product offerings, each entity would then be forced to improve its own quality in order to garner market share and, therefore, boost its profitability.

Darron Thomas is lecturer, School of Business Administration, UTech, Jamaica. Email feedback to columns@gleanerjm.com and darron.thomas@gmail.com.