The Agenda

On BankSimple, Richard Branson, and the Regulation of Consumer Financial Products

Ever since I first heard about BankSimple, I’ve been avidly following its progress, and I’m hoping to write about it at greater length. For now, I recommend watching the video below, which illustrates its approach in broad outline:

BankSimple Demo from BankSimple on Vimeo.

BankSimple comes to mind because Richard Branson, the entrepreneur behind the various Virgin brands, is launching a new initiative that might in some sense be related:

 

Speaking exclusively to Marketing, Branson said he was confident an entrance by Virgin would ‘shake up’ the sector.

‘The banks nearly destroyed the financial world as we know it and the public is crying out for a really good, honest brand to get into that sector,’ he added.

Branson, who is boosting Virgin’s focus on sustainability projects, is also set to launch a book, ‘Screw Business as Usual’, outlining how businesses should ‘switch from a profit focus to caring for people’.

‘With the Virgin brand, we genuinely try to do what’s right. Any company that does that, hopefully, gets a good, positive brand, and if you’re not trying to do what is right in life, then your brand is damaged. We like to run our company ethically.’

It is fairly clear that the Branson business model will be quite different from that of BankSimple. Branson is bidding on Northern Rock’s local bank branches, for example. And BankSimple is not exactly a bank. Rather, it is a customer-facing service that offers its users a seamless way to save money, write checks, and do most of the other things we’d use a bank to do, yet that relies on partnerships with a few small banks, chosen on the basis of financial soundness and openness to the BankSimple approach, to actually hold deposits and comply with various regulations. The exclusive focus of BankSimple is on offering a really good user experience. 

And BankSimple intends to make its money differently from traditional consumer banks, as the company explains in its FAQ:

 

BankSimple makes money in two ways, interest margin and interchange:

Interest margin is revenue a bank earns from loans, less the interest the bank pays its customers on deposits. For example, if a bank earns 12% interest on its loans and pays 5% interest on its customers’ deposits, the interest margin would be 7%. Our partner banks split this interest margin with us.

Interchange is revenue earned by a card-issuing bank when customers make purchases using that bank’s card. Our bank partners split this interchange revenue with us.

 

Since BankSimple is exclusively online, we don’t have any expensive physical branches to build or maintain. That keeps our costs down and allows our business to be supported by interest margin and interchange alone. We don’t profit from fees because we don’t need them.

This reminded me of the work of Xavier Gabaix and David Laibson on why firms don’t tout generally tout transparent pricing structures that minimize reliance on hidden fees, which Tim Harford summarized back in 2007:

 

Economists Xavier Gabaix and David Laibson recently published an ingenious explanation for why such campaigns are rare. If one bank has tempting interest rates but hidden fees while the rival offers lower rates but no hidden fees, an advertising campaign could easily backfire.

“Our prices include no hidden fees” is a nice enough slogan, but the implicit message to sophisticated customers is, “If you are good at avoiding hidden fees, you might care to bank with our rivals.”

The advertising campaign would drive sophisticated customers toward the exploitative competitor where, being sophisticated, they would not allow themselves to be exploited. Meanwhile, the no-hidden-fees bank would attract naive customers but fail to take advantage of their naiveté. The result would be that the expensive adverts pushed both types of customer to where they would spend less, and both companies would be worse off.

BankSimple believes that it can break this cycle, perhaps due to rising frustration with the dominant providers of consumer financial services. A spirit of openness pervades their literature.

Interestingly, the founders of BankSimple are quite critical of the impact of deregulation on the banking sector. Last year, Shamir Karkal wrote a fascinating post that sheds light on what we might call the BankSimple worldview:

Banking used to be heavily regulated, and the joke was that it was a 3-6-3 business; borrow money at 3%, lend it at 6%, and be at the golf course by 3 pm. Most banks also charged a monthly fee to customers for maintaining a basic account, but most daily transactions were free. But, overall, fees were low, constituting only 30% of total revenues.

 

The wave of de-regulation, beginning in the late 70s, changed this relationship. Main street companies discovered that they could borrow from the bond markets more cheaply than they could from banks, putting the 6 part of the 3-6-3 model under pressure. And lots of new consumer products such as interest bearing checking, credit cards, money market accounts, home equity loans, student loans, etc became available. Banking became a lot more complicated, so bankers couldn’t just head to the golf course at 3 pm; they had to actually work for their money.

Two things ended up happening: banks realized that the bigger they were, the more loans they could make. With deregulation, the big banks grew even bigger by acquiring smaller banks. Banks also realized that the easiest way to make more money was to simply charge consumers more fees. In fact, the best way to make money was to call a product “free” by eliminating any monthly fees, and then charging lots of fees on transactions.

Technological advances and the cost advantage of online-only banking have convinced the BankSimple team that they can offer a high-quality product that doesn’t rely on fees. And despite the findings of Gabaix and Laibson, the founders seem to have concluded that even the most sophisticated consumers find managing their personal finances with the dominant banks so exhausting, and so frightening (i.e., customers are constantly afraid that they’re being gouged, simply by not virtue of being on high alert at all times), that they can attract a large number of customers, particularly tech-savvy Alpha Geeks (at least at first). 

In an interview last winter (still searching for it), Josh Reich described banking in his native Australia, where a more regulated sector meant that people didn’t have such an anxiety-inducing relationship with their banks. Customers weren’t afraid of making some dreadful “mistake.” That kind of advantage-taking wasn’t really possible, so the sector remained fairly staid. Reich is, in essence, trying to recreate that kind of experience. 

What I find interesting is this: if BankSimple is indeed successful, does it imply that we don’t actually need heavy regulation of consumer financial products — because over time we’ve learned that the hidden fee regime is actually really terrible, so we will shift away from it pretty quickly once BankSimple points the way forward? 

One sign that this might be true: if a savvy entrepreneur like, say, Richard Branson tried to mimic aspects of the BankSimple strategy, pouring massive resources into the endeavor and scaling it up quickly. Branson, of course, is launching in the UK, which has a different regulatory climate. But I like the idea that Branson’s effort represents a vote of confidence in the economic potential of more ethical consumer banking. 

Another possibility is that BankSimple will establish itself as a sustainable niche product for people savvy enough to know that they’re not very savvy. Basically, the people who need BankSimple most might never embrace it. 

Speaking of which, Sumit Agarwal, John C. Driscoll, Xavier Gabaix, and David Laibson have a paper on the differences in fee and interest payments across the lifecycle:

We find that middle-aged adults borrow at lower interest rates and pay lower fees in ten financialmarkets. Our analysis suggests that this fact is not explained by age-dependent risk factors. For example,FICO scores and default rates would predict the opposite pattern of age variation.

We believe that our findings are driven by three complementary factors: age-related cognitive effects, selection effects, and cohort effects. We are unable to disentangle the contributions of each of thesefactors. We speculate that, to the extent they are present, cohort and selection effects have larger effectson the reported outcomes for older borrowers, since the natural cohort- and selection-stories for youngerborrowers imply that those groups should on average be paying lower prices (controlling for observable riskcharacteristics).

Might this happen at a societal level as well? After the initial chaos of a less tightly-regulated consumer financial market, might we collectively learn to embrace better financial products? The underlying anxiety, as always, is that some of us will learn and that others will not, and this gap will contribute to inequality.

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.

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