Dumping exit fees

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News today that the big four banks are set to dump exit fees to ward off government intervention on other fronts. Should we be suspicious of this? Absolutely. Let’s face it, the broader issues with the major banks have to do with their ‘free guarantee’ from the public and what this should mean in terms of broader obligations in return (e.g., information exchange, risk requirements, etc that Stephen King outlined).

But let’s quickly think about the whole exit fee issue. The idea is that when you are a consumer and want to switch banks for your mortgage you may be forced to pay your current bank a fee. That makes it more costly to switch. But that is only half of the story. If the bank you want to switch to as a fee for entry (e.g., loan application or other fees) then, even if they have a lower interest rate, you might be deterred from switching. Of course, it is up to the new bank whether they charge you such fees but it remains a choice. In reality, your total switching cost will be the sum of exit and entry fees.

The issue is whether eliminating exit fees will lead to a reduction in these total fees. One thing keeping entry fees lower is precisely that banks are capturing a consumer who will find it hard to leave (allowing them and all banks to relax pressure to compete on interest rates). Remove the exit fees and you might get lower interest rates but it could also be that banks find it more worthwhile to charge higher entry fees. If that is the case, things may improve but not necessarily by much. Playing games with price structure is no substitute for improving market structure.

11 Responses to "Dumping exit fees"
  1. “In reality, your total switching cost will be the sum of exit and entry fees.”
    In theory both components of switching cost should have equal weight in affecting consumer behaviour. However, behaviourally entry and exit costs are not equivalent. When you get a mortgage you don’t think about the prospect of switching later so you ignore the exit fee as its something you will never pay (if you are myopic you don’t even realize that exit fees exist). Therefore exit fees do not hurt banks in attracting new costumers. Entry fees on the other hand are more salient and affect consumers in choosing a certain bank. Hence, it is unlikely that banks would substitute exit fees with entry fees. Actually, I would have no problem if banks were allowed to charge a high entry fee but no other fees. The competition would be tougher on entry fees than it is now on non-salient, obfuscated fees.

  2. Kenan’s dead right.  If an obscure fee is replaced by a salient one that is unequivocally a good thing for customers. In real life information asymmetries are far more pervasive and important than naive market economists think.

    There was a good paper a few years ago about why US risk-adjusted credit card interest rates are so high, despite being an intensely competitive industry.  Turns out it is simply because most punters grossly underestimate their chances of ever paying those rates – they believe they’re going to pay the balance off monthly – and so don’t care what they are.

    The point is in the face of systematic information asymmetries and persistent cognitive biases, competition is not sufficent for efficiency – you may sometimes have to regulate even a competitive industry (eg food safety laws). 

    The banks are right that four major and countless minor banks or near-banks are more than enough to provide real competition.  The problem is that in practice consumer information costs constrain the competition to only certain areas.

  3. The furore over mortgage rates and exit fees mainly stems the fact that Australian banks have complete discretion over modifications to the variable rate.

    I believe that in most countries, variable rates are set as an amount relative to the central bank (XX% over the reserve rate).  The banks obviously do gain some flexibility in being able to set the rates arbitrarily, but they also attract terrible PR.
    A better approach for the government might be to encourage the banks to offer a variable, but non-discretionary loan rate.  This also allows the banks to say “don’t blame us, blame the RBA!”

  4. BruceT,
    I agree.  I can’t imagine that any term business loans would allow the lender to raise interest rates unilaterally.  Why should it be the case for household loans?  Does anybody know of any “tracker” mortgages offered in Australia?  What are the structural or institutional reasons why these mortgages are not generally offered?
     

  5. Begs the question of why don’t more Australian mortgagee-holders sign-up for fixed-term, fixed-rate mortgages and generate some competition for the banks to retain clients.

  6. Well fixed rate mortgages mean that you are betting against the banks, whose estimate of future movements is likely to be a little better than yours.  You replace one risk – that rates will go up – with another – that inflation and rates will both go down but you are stuck paying higher rates for decades.  Heaven help you if we ever have a deflationary episode.

    Tracker mortgages seem a much better arrangement, as others have said.  This might be a great time for some bank to offer them, while the issue of margins is before the public.

  7. @DD,

    Your point is true to a degree, but nothing is risk-free EXCEPT for the irony the banks take on almost zero risk with variable rate mortgages and they have a captive client for 20-30 years. How does that not have a serious downside for the mortgagee in particular and competition in general?

    Australia (and the UK) is a notable exception in that mortgagees in other nations often take loans in 3 – 5 year rolling, fixed-rate loans. We deregulated interest rate settings over two decades ago yet mortagees’ behaviour continues with taking out long-term (and growing), variable rate loans. A matter of context…

  8. You can attempt to hedge your risk by fixing a proportion of your mortgage and leaving a portion variable.  Unfortunately no bank seems to offer the ability to have more than one fixed split of the loan at a time, so you’re still exposed to a risk at the point where your fixed term expires and reverts to variable.

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