The Problem of Free Checking

TL;DR

Persuading customers they should pay for the financial services they are used to receiving for free may be the key to changing financial services for the better.

Why is greed accepted in financial services?

In the US alone, bank fees like overdraft charges and ATM fees cost consumers over $42 billion a year.

And that’s just legal overcharging. Banks around the world illegally overcharge consumers all the time. Wells Fargo in the US scammed customers for years resulting in billions of dollars in penalties. Australia’s biggest banks have levied fees on dead customers. UK financial institutions add a “loyalty penalty” of 4 billion pounds ($4.4 billion) a year, according to the Competition and Markets Authority. Denmark’s biggest bank overcharged Danes for years.

Often these misdeeds are explained away as the result of a “culture of greed” in banking. 11 years after the Global Financial Crisis, it sometimes seems most bankers still operate by Gordon Gekko’s famous mantra: “Greed is good”. 

The unspoken assumptions in this explanation are that the financial system - and those who work in it - are either inherently motivated by greed or that the financial system (and its incentives) are set up to reward bad actors.

But what if greed in banking wasn’t caused by banks? What if the wrongdoings of finance were actually caused by “free” financial services? If the cause of overcharging in banking wasn’t the nature of bankers or the corporate culture that nurtured them, it could have implications for how we set about fixing the financial system. 

To understand this, we need to backtrack a little. 

Medici’s original checking account

It’s 1397 in Florence, Italy and Giovanni di Bicci de Medici has laid the foundation for the modern banking system. For our purposes, his most important legacy is that he helped create a system that gave rise to the world’s most common financial product, the checking account.

Medici didn’t invent banking - financial products were used throughout history. For example, the Knights Templar were “the Western Union of the Crusades”, creating letters of credit that helped pilgrims travel for months without carrying huge sums of cash. Merchants in Tang dynasty China had a system of "feiquan" - or flying money - which let merchants deposit profits in one place and reclaim cash somewhere else.

Medici’s innovation was combining elements of products already in use. It was a tweak borne out of a desire to avoid eternal damnation - a pretty big motivator in 14th century Italy.

Medici started as a type of a tax collector. He collected tithe money from Catholics - donations to the Church in Rome by those wanting to guarantee passage to heaven - and helped these funds flow to the Pope. But, despite handling huge sums of money, Medici couldn’t profit because usury - making loans for profit - was still considered a mortal sin by the 14th century Catholic Church. 

He found a way around this by creating products that let him hold funds and make money from foreign exchange trade and arbitrage. To hold the funds he used letters of credit - which had already existed for centuries - and accounts, which allowed him to hold deposits like a bank.

In finding a creative way to avoid eternal damnation, Medici started a political dynasty, funded the Vatican’s shadow state, and put Florence at the centre of the Renaissance. 

If you ask people today what a bank does, Medici’s innovation of holding deposits would still be the most common answer. It is a core function of a bank. It’s called different things in different places, but the function is equivalent. Let’s stick with “checking account” for this post.

The checking account is used by about 70% of adults worldwide and is a key determinant to financial inclusion. But it might also be the cause of the inadequacies and excesses of the global financial system. Not because it’s a bad product - but because of a small marketing agency in Nebraska.

The origins of “free checking”

The origins are a bit murky but by some accounts “free checking” was created in the 1980s by a direct mail company) in Lincoln, Nebraska. Direct mail is a euphemism for junk mail.

The company created packages that combined “free” checking accounts with gifts. The agency sold these packages to small community banks across the midwestern US, who used them to gain new customers and acquire deposits.

The results were promising and soon more community banks were offering “free checking”. But it wasn’t until the 1990s that America’s largest banks started offering “free checking” on a national scale.

Up until then, most checking accounts had a small monthly fee attached to them. Sometimes this was waived if you kept a certain balance, but for the most part customers were paying for a product.

This idea from Nebraska sparked a change in how financial products were marketed. Financial marketing used to be a staid world of advertising comparison rates and percentage points. But over a decade in America it turned into a labyrinth of loyalty bonuses, frequent flyer points, “no-fee” products, and long disclaimers read quickly at the end of advertisements. 

A new era of consumer finance had started and a whole generation grew up with “free checking”.

Over the four decades since its invention, the free checking account has become ubiquitous. Today, a few banks are starting to eliminate it, but 75% of US consumers still have a “free” checking account.

The notion of free financial products is so common that, today, one of the most accepted things in retail banking is that certain services are free; especially things that most banks don’t charge for - like domestic transfers and checking accounts.

No such thing as a free lunch

Think about your checking account. It’s a useful product. Your employer can deposit your salary there, you can make payments with a debit card, withdraw cash at an ATM, and so on.

While you may think many of these things are free, there are of course costs to operating an account. Funds need to be stored somewhere. Your debit card has operational costs. ATM machines are big pieces of hardware that need to be manufactured and maintained. There are tellers in the branch and developers coding for your bank’s app and website.

But customers don’t see these costs. When was the last time you got a price list when you went to a bank (or used your bank’s app)? Almost never - unless you’re making a large, infrequent product purchase like a mortgage.

That’s because these costs are covered by consumers paying hidden fees elsewhere.

While consumers are used to “free checking”, the Consumer Financial Protection Bureau found  Americans still pay $15 billion in fees like monthly service charges. That’s because most “free” accounts have a long list of fees and banks make money on your “free checking” in other ways.

The most common is cross-selling of other products where banks leverage the transaction data that a checking account provides to sell you products like a mortgage, credit card, or another financial product. 

Another common revenue-generator is hidden or excess charges for things you may or may not use - like ATMs, checks (if you live in the US), card replacement, overdraft, or international money transfers. For example, so-called “overdraft protection” costs Americans around $14 billion a year, according to the Center for Responsible Lending.

Some of you may think that getting a “free” checking account for having a credit card or mortgage with the same bank is a fair trade. If so, your bank probably hates you.

A bank’s least profitable customers are happy to get a ‘free’ checking account in exchange for having a credit card or mortgage. Mostly because they rarely - if ever - use their overdraft, they pay off their credit card in full (or almost) every month, and have probably never missed a mortgage payment. To financially stable and savvy consumers, the status quo of free products looks ok because it works to their advantage. Their bank hates them because these stable customers rarely pay excess fees or unexpected overdraft charges.

A bank’s most profitable customers have the inverse qualities. They often pay overdraft fees, may have credit card debt that keeps racking up interest, and perhaps another product or two. 

This system disadvantages worse off customers while creating a healthy revenue stream for banks.

The cross-subsidisation of bank customers also means that consumers are not used to understanding what they pay for. The existing costs of financial services are not transparent and are usually recovered in a hidden charge or fee. The system allows bad actors within the financial system to exploit this information asymmetry.

Whether or not most people understand this system of pricing (or even care), the fine print matters here. The people who need free products the most pay the most for them. We all like genuinely free services, but we are paying for our “free” checking account one way or another.

If it’s bad, why don’t people care?

But why don’t customers care? Are customers greedy or are we just used to thinking we’re getting a good deal? Free banking, free email or data storage, free news (when there is no paywall) - we now get lots of stuff for free that people paid for at some point. 

Consumers have become so used to “free checking” that we’ve missed the small print. And turns out, in this case, it’s pretty important. 

The status quo of “free checking” means that the charges for each customer are out of proportion to the costs that customer creates for the bank. This inherent tension encourages or necessitates that the bank cross-subsidise products and customers. Banks don’t have any incentive to lower prices on other products or become more competitive because these margins are what make up for the free products, which form a huge part of a bank’s cost base. Even if a bank wanted to, they can’t or won’t put themselves at a competitive disadvantage when consumers expect “free”.

And so we’ve ended up where we are today. We are a long way from community banks in the MidWest offering free checking accounts. The seemingly innocent launch of “free” financial services has mutated and facilitated a lack of understanding amongst consumers on how financial services are priced and paid for. In turn, this has generated a complete lack of transparency from banks in the true price of financial products.

This lack of transparency applies to lots of areas - international money transfer, domestic banking, financial advice - and it has fuelled alternatives as people seek to understand what they’re really buying and how much they’re really paying.

What’s the alternative?

It’s clear that free products in banking levy hidden costs on customers and prevent banks from becoming more competitive (as the system almost necessitates non-transparent pricing). If costs are hidden, there is no incentive to make related charges reasonable in the eyes of the consumer.

Is there a better way? At Wise, we’re trying what we think is a better way. So far, it’s working.

We don’t cross-subsidise amongst our customers. You pay for what you get and you get charged a small margin for transactions that we reinvest into growing our business. 

What does this mean in practice? It means it costs a few pence to pay-out from your Wise account when everywhere else domestic transfers are “free”. We know that in reality domestic transfers have operational costs and our business faces these. So we tell customers and charge them the cost (plus a small margin).

There’s quite a few other examples of this across our business. Pricing our products this way is a pretty radical departure from the status quo that I described above.

It is that small margin (multiplied by over 8 million customers) that covers our operational costs and pays my salary (and the salary of my fellow 2200+ employees).

But Wise doesn’t even offer a traditional checking account, so why are we doing this? After all, people are used to products being priced this way and changing behaviour is really hard (especially when people don’t even realise what’s going on). 

Mission-driven pricing

The reason we’re trying to rewrite the way financial services have been priced for decades comes down to our mission. Our mission is to create a way to move money internationally that is instant, convenient, transparent, and (eventually) free.

This relates to our pricing in two ways.

First, we believe that our method of pricing will help remove hidden fees from financial services and make consumers better off. This will help deliver transparency in the sector.

Second, if we eventually want to make our service free, we have to know how much each customer costs us (and charge them in a correlated manner). This is the only way to understand our cost base enough to push discrete costs downward, while increasing volume. To remove fees from the system, we have to isolate them and find new, innovative ways to systematically remove them.

We think our pricing method is fair and works best for customers, but the issue is bigger than Wise and our customers. 

Companies like Wise have an important role to play in correcting imbalances like this. We have shown that it’s possible to be profitable and price transparently so that customers can understand what they’re paying for. 

In a world where financial transparency exists, you pay for the services you use and banks are no longer incentivized to create complex pricing structures that rip you off. You may lose your credit card points but the financial system will be less prone to misconduct. History and consumers will prove whether this fully corrects for greed in financial services.

The problem of free checking might seem like a small thing, but when you add up a million of these small things, you end up with a financial system that works to create profits for bankers - not to help families buy homes or entrepreneurs expand their business. In other words, something that is fundamentally broken.