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In all corners of the financial system the established order, where well known institutions play their traditional roles in a time honoured fashion, is being questioned. This reflects the conjunction of different but inter-related factors.

The first of these is the unravelling of inherently unstable cross-subsidies between customers, products, and distribution channels. The second is the the prosecution of new business models. The third is the impact of pervasive regulation.

Their interplay will result in fundamental changes to the financial system. These will not necessarily be welcomed by either customers or regulators.

There are two parts to this question of whether cross-subsidies represent a growing problem. The first relates to the increasing incidence of cross-subsidies and the second the difficulties associated with them.

There is no doubt that cross-subsidies are becoming more prevalent. In international retail banking, for example, both the mortgage and credit card markets show evidence of a situation where those shopping around get a much better deal than those ‘characterised by inertia’.  

Mortgages used to be for buying homes. But in many markets remortgaging to fund consumption outweighs lending for home purchase. Customers are wooed by a growing range of lenders offering a spread of products at tempting rates.

There are two assumptions at work: first that customers will be attracted by a marginally profitable, or even loss-leading, proposition; second, that future profitability will come from customers accepting higher interest rates and from the cross-selling of complementary products and services. However, there is little evidence of customer loyalty if and when interest rates are increased. 

Customers normally change providers in search of the best offers.  Increasingly influential mortgage intermediaries like customer churn and sell their preferred complementary products and services rather than those of the lender. This means lenders choose to renew introductory offers at the end of their term to keep customers. Those who shop around, benefit.

The same occurs in the credit card industry, where customers move their business from one player to another. They benefit at the expense of those that do not adopt this approach, compounding the traditional cross-subsidy from ‘revolvers’ to those paying their credit card bill in full in order to avoid interest charges.

Cross-subsidies are not restricted, however, to international retail banking.  In insurance there are issues in life and pensions and also in the property and casualty business. In life and pensions, where products are sold through intermediaries benefiting from large front-loaded commissions, the product manufacturer can only break even with customer relationships lasting in excess of perhaps eight years.  

But many customers lapse beforehand.  With property and casualty the perennial difficulty of accurately pricing for risk is compounded by the impossibility of amortising rapidly increasing marketing costs across short-lived customer relationships. The cross-subsidy phenomenon is also evident in the exchange environment. Exchanges are doing well financially with burgeoning volume less than offset by keener pricing. Some investment banks are disgruntled, however, feeling they are facilitating supra-normal profits or are bearing a disproportionate share of infrastructure costs.  
But do cross-subsidies necessarily cause problems?  We believe the answer is unequivocally yes.

The problems take a variety of guises:

Inequitable treatment of customers – a moral problem

Unanticipated temporary imbalance where the cost of loss-making relationships outweighs the subsidies actually achieved – a P&L and ultimately a balance sheet problem

Permanent imbalance where traditional players suffer from adverse selection and are saddled with loss-making relationships whilst profit drivers take flight to differently configured or positioned rivals – a systemic problem.

There are obviously links between these different types of problems. A regulator safeguarding the interests of customers will root out the first type. But in ensuring their fair treatment and the unwinding of cross-subsidies, this same regulator will certainly provoke the second problem and possibly the third.  

The regulatory environment shapes markets and we sense that it is a powerful catalyst, speeding the evolution of markets and precipitating a shake-out in terms of both business models and market participants.

There is already ample evidence of regulatory intervention, both in the form of veiled threats or explicit policy, to lessen cross-subsidisation. In the UK mortgage market, for example, the Miles Report commissioned by the Treasury drew attention to the fact that many customers would be better served by long-term fixed rates rather than short-term variable rate products with wider spreads and an unpredictable future cost.  There has since been a growth in both the availability and popularity of fixed rate products but not a decrease in churn rates.

Lenders thus find it harder to augment modest margins enjoyed by customers on introductory rates to match the healthier margins enjoyed from those customers reverting to the standard variable products.  But the pressure for change is ratcheting up. The Office of Fair Trading inquiry into payment protection Insurance will lessen the profits that can be derived from these products to subsidise attractive headline mortgage rates. The forthcoming introduction of home information packs will similarly reduce the scope to secure profit from, for example, valuation fees.  As a result regulatory pressure coupled with other government policies will precipitate a balance sheet problem which may be more significant than a temporary imbalance.  

The further type of problem – that of systemic risk – may be about to emerge.  UK mortgage lenders have become heavily reliant on self-interested intermediaries who are capturing a significant share of the mortgage profit pool. But ambitious direct players such as ING could be set to grow rapidly at their expense.

Regulatory impacts are not restricted to the mortgage market.  Some of the fees and charges that have offset credit card company introductory offers have come under scrutiny and, as a result, have been reduced.  In addition, both Callum McCarthy, Chairman of the Financial Services Authority (FSA), and Clive Briault, FSA retail markets managing director, have invited the industry to explore alternatives to the current unaffordable intermediation model.  The FSA, however, has "not so far concluded commission is bad or should be banned". The discussion paper envisaged in the middle of next year may, however, be more prescriptive if the industry fails to tackle effectively the problem of the magnitude and phasing of commission payments.

Mounting pressures for structural change

We have developed the following simple framework to explore, in financial markets, both the pressures for change and the possible outcomes.

While the situation will differ depending on the geography and market area selected, some necessarily simplistic generalisations will explain the framework. In view of increasing cross-subsidisation we believe we are witnessing calm before the storm. The market system is inherently unstable because, for example, the more profitable borrowers could be wooed by new or differently configured cherry-picking rivals.  

But with like-minded, similarly configured competitors faced with a common problem of cross-subsidisation nothing can happen until someone breaks ranks or there is another catalyst such as new regulation. So the existence of inherent instability is necessary but not sufficient for a change in market structure.  It is the form of external shocks that will precipitate change. And that could be ordered, leading to an influx of new market leaders, or uncontrolled, causing mayhem.
It seems unlikely there will be a reconfiguration of dominant players without external catalysts. 

Rather, like-minded and similarly configured rivals tend to reach an accommodation – no-one rocks the boat. But they labour under an illusion of security.   

Customers are faced with an increasing range of attractive options and it would be dangerous to ignore this. But complacency is common.  Many conflate the notion of customer inertia with that of customer loyalty. Others subscribe to the status quo happy in the knowledge that successful innovation is rare. Those resting on their laurels will be unpleasantly surprised because there will be pervasive shocks to the market system and, once change is underway, the pace will be unforgiving.

One only needs to reflect on how the entry of Direct Line precipitated permanent change in the UK motor insurance market.

In an increasingly international marketplace, those moving into contiguous markets are an important catalyst. By definition those intent on increasing geographic reach will tend to have been successful in their home market. They will have a proven business model and the prejudices that go with this. 

But those exploring new opportunities will also tend to be cautious.  

But it is perhaps regulatory change that is the most important and unpredictable catalyst.  The form and scope of regulation differs between markets. Few would argue for a free for all.  But many, such as the FSA, would argue for principles-based regulations rather than rules-based approaches.
Similarly, some regulators regard omnipresent regulation as necessary while others believe in regulation only when there is evidence of market failure. There are those who see regulation as a device for protecting poorly-informed customers from self-serving institutions. Others see not only a need to protect customers but also to engineer a stable financial market infrastructure.  We are in an environment characterised by both more regulation and more regulatory ambiguity.  

It will take a considerable time to reduce ambiguity, as regulators vie with one another to establish transnational ascendancy and then try to identify and agree upon co-operation protocols. Meanwhile there will be plenty of scope for both confusion and regulatory arbitrage. The result - rather than being either a changing of the guard or a reconfiguration of dominant players - could simply be mayhem.
Richard McManus and Christian Nelissen are part of PA Consulting's Financial Services Practice and members of the PA management group.  They are working with clients in Europe and south-east Asia to pinpoint how the regulatory environment is changing.
 
By Richard McManus and Christian Nelissen
Financial World,  December 2006