Is Free Banking Doomed?

First Direct is to introduce monthly charges for some current-account customers. We explain the impact on its customers and the rest of us.

Only yesterday, in Your Credit Cards Need £1 Billion, I warned that credit-card issuers are looking for ways to make more money from the UK's 32 million credit card holders. Today, current accounts are under the cosh, as telephone and internet bank First Direct announces that it is to introduce monthly fees from 1 February 2007 for some of its current-account customers.

First Direct current-account customers who don't pay in £1,500 a month into their accounts, or fail to maintain an average balance of at least £1,500, will be charged a monthly fee of £10. However, they can avoid this charge if they have another financial product with First Direct, such as a credit card, personal loan or savings account.

First Direct has 1.3 million current-account customers, but reckons that these new charges will only apply to 15% of its accounts, or around 195,000 customers. Nevertheless, if all of these customers were charged £10 every month, First Direct would pocket an extra £23.4 million a year. On the surface, this sounds like a nice little earner, but there's no doubt that this move will create a customer exodus. Despite its reputation for outstanding customer service, few First Direct customers will want to pay £120 a year for what is, in effect, a no-frills current account.

First Direct claims that it has taken this step in order to encourage its customers to make First Direct their sole or primary bank. What's more, it wants to kill off its unprofitable accounts, including 40,000 dormant accounts (those which haven't been used for three months or more), plus another 250,000 First Direct accounts which see fewer than ten transactions a month.

Then again, the Office of Fair Trading (OFT) is reviewing the excessive charges levied by banks on customers who go overdrawn without prior permission. As it's highly likely that the OFT will order banks to reduce these fines, my guess is that First Direct has taken this step as a defensive tactic to protect its profits.

An after-tax income of £1,500 a month equates to a pre-tax salary of roughly £25,000 a year, but only around three in ten adults have an annual income at or above this level. Hence, First Direct is clearly focusing its sights on the relatively affluent 30% who are more likely to buy its other financial products. So, it's free banking for the well-off, but monthly fees for low- to middle-income earners!

Note that British banks make hefty profits from paying very low rates on interest on credit balances, typically 0.1% a year before tax. However, they lend this money at rates exceeding 5% a year, which is a tidy profit margin. Hence, it may seem odd that free banking is under threat these days, especially given the ever-increasing use of automated payments, online banking and overseas call centres, all of which have helped to cut costs.

Nevertheless, free in-credit banking is uncommon outside of the UK. Indeed, in most Westernised countries, current-account banking usually comes with flat or transaction-based fees. Alas, if free banking is indeed on the way out, then we could see the launch of a whole new range of current accounts targeted at different customer bases. This will make an already complicated market even more baffling for consumers!

I've been a First Direct customer for around fifteen years and, as it happens, I'm about to switch to an account which pays a credit interest rate of more than 5% a year before tax, compared to First Direct's 2%. Even so, this news would force me to jump ship, because, as a freelance writer, my income is highly irregular, so I can't deposit the required £1,500 a month. On the other hand, simply opening a First Direct savings account with, say, £1 might neatly sidestep this problem!

Finally, although First Direct is a relatively small bank, it is owned by global giant HSBC, which may be using First Direct to test the water before extending monthly fees to its millions of customers. However, there's no doubt in my mind that other banks will jump on this particular bandwagon, as they seek ever-more creative ways to maintain and grow their record profits. So, watch this space for more bad news!

More: Use the Fool to switch to a better current account, credit card, personal loan and savings account!