The Clustering of Interest Rates - Literature review Example

Introduction The article written by Ashton & Hudson discusses the interest rate clustering in UK financial sector and provides important insights into the policy making aspects of the interest rate clustering by UK Banks. The basic aim of this paper is to highlight some of the practices of UK financial services firms while charging interest rates with the sole purpose of exploiting the customers’ limited ability to recall information regarding interest rates. This has policy implications because banks are required to base their interest rates on some fundamental elements such as cost of borrowing, overheads etc. however, due to clustering of interest rates, financial institutions tend to get away with this limitation and charge interest rates which may be higher and exploit the customers. The clustering of interest rates takes place in a complex manner and innocent consumers hardly notice the actual intentions behind the mechanics of setting the interest rates. There are many instances where large street banks such as HSBC etc have been found in practices wherein they were involved in clustering of interest rates through their various products such as mortgages, loans, saving accounts etc. it is however, to be noted that this practice is not only common in UK but banks in other countries of the world are also involved in clustering of interest rates in order to earn higher from their customers. This paper will review the article written by Ashton and Hudson and based on the analysis present in the article will discuss the marketing approaches practiced by HSBC with regard to charging interest rates. A review of article This article basically attempts to point out the exploitative practices of UK banks in charging interest rates to their customers. With the help of interest rates clustering and taking benefit of the slow recall ability of their customers, these firms attempt to charge higher interest rates and take benefit from higher charges. This article argues that the interest rate setting by the banks is mostly based on weaknesses shown by their consumers in number processing. By truncating the numbers in their prices and interest rates, banks and financial institutions basically by exploiting the limited cognitive ability of the persons to process numbers charge rates that are complex and hard to understand by the customers. Authors discuss that UK consumers are relatively more innocent when dealing with the banks therefore banks and financial institutions may be engaged in practices which are based on exploiting the limited ability of the customers to properly understand the pricing and may pay higher interest rates on their loan products and lower interest rates on their deposit products. Authors also mentioned some of the factors such as distance between numbers, frequency of numbers as well as the size of the numbers contributing towards limited recall by the customers. This ability of the customers become more complicated when they are faced with the complex nature of the interest rates because to easily interpret the interest rates, not only processing ability is required but also the clear recognition of the prices. This complexity of understanding and interpreting the numbers is further complicated by the marketing techniques used by the firms for advertising their interest rates charged on various products. Many banks and financial institutions provide information about their interest rates in a manner that may be misleading for consumers and may be difficult to interpret. Authors further discusses as to how through rounding off and truncating the numbers, the prices are set for the deposit and mortgage products. Authors also make a distinction between the sophisticated customers and naïve customers and discus the strategies that both of these groups of customers make in order to evaluate the prices on various products. It is also important to note that price setters in banks, with historical review of their customer base, set the prices according to the nature of their customers. If customers are more sophisticated having limited recall and truncating ability may be offered some rates whereas naïve customers, based on their ability to process numbers may be offered different numbers. While concluding the papers, authors assert that price clustering is done with a sole aim of maximizing the returns by exploiting the limited ability of the naïve customers. This naïve attitude of the consumers therefore is exploited by the financial institutions despite the fact that regular inspection is conducted by Regulatory bodies. The authors therefore assert that these practices by the banks shall be under scrutiny from the regulators in order to protect the consumers. Interest rate setting Abstract of one of the studies conducted by Ashton indicates following about the interest rate setting by UK banks: “This study examines the frequency and form of deposit account interest rate change. Specifically the question of whether deposit interest rate change is synchronized with other banks or staggered at periodic intervals is addressed. Overall, evidence consistent with individual banks changing deposit interest rates in a staggered manner is recorded. Further larger banks are seen to change interest rates in a more synchronised manner than smaller banks. Lastly, when banks offer multiple deposit accounts, these products interest rates are generally changed simultaneously by individual banks. These findings extend the current understanding of deposit interest rate change, and indicate that UK deposit interest rate setting is relatively rigid.” (Ashton) The above quote of the study indicate that the changes in the deposit rates by the UK banks is realtively rigid indicating that the banks are too strict in their dealing with depositors while setting the deposit rates. However, the rate setting on loan products is relatively more synchronised as large banks tend to have relatively more manipulate power. The reason this study has been mentioned is due to the fact that this study provides a direct insight into the way interest and deposit rates are fixed. Further, the policy implications for such practices can be more critical for the consumers. HSBC Bank HSBC claim to be world’s local bank and is one of the oldest banking groups in the world. Originally named as Hong Kong Shangai Bank, HSBC is headquartered in London since 1993. It is also the world’s largest banking group but also the 8th largest company in the world having presence in many countries of the world. HSBC was founded in 1865 and converted its name to HSBC Holding Inc during 1990s and is now controlling HSBC bank and other businesses. A closer look at the retail website of the bank will indicate that it is offering different consumer products such as current accounts, saving accounts, financial planning, mortgages, credit cards, insurance as well as the personal loans. Bank does not show any ads on its site however, the whole website may be considered as an advertisement by the bank to present information regarding its products. Within this site, bank has however, tailored different marketing messages and ads which are directed at particular customers. This analysis therefore will be limited to the messages and information present on the site of HSBC. The site can be accessed at http://www.hsbc.co.uk/1/2/. Savings Accounts The marketing tricks or techniques adapted by HSBC while setting the deposit rates paid on saving accounts indicate a very unique approach to marketing the service. Mostly, the bank focuses on the added benefits or additional services which a person will get while availing the savings accounts facility from the bank. As such the marketing techniques used are different for different types of saving accounts offered by the bank however the underlying idea is based on AIDA model of marketing. For example, in case of its Cash e-ISA account, bank is focusing on grabbing the attention of consumers by outlining the need to utilize the income of a person in tax free savings so that they can avoid paying taxes. Bank offers only 1.75% 1AER on this product which is clearly indicating a truncating of the number as consumers may perceive this number differently. Credit Cards Rates offered on credit cards also indicate the relative benefits which a person can get by using the credit card of the bank. For example, in one of the marketing messages displayed on site, 20% is mentioned for 15 months balance transfer facility however there is a fee of 2.6% on the same thus further confusing the customers regarding the actual charges levied on balance transfer facility. A typical APR of 16.9% (variable) is also mentioned thus again showing the tendency to cluster the interest rates by offering the customers a complicated number to make calculations before they actually pay for the services. Mortgages There are four different marketing messages designed for the mortgage customers and each specifically target a certain type of mortgage borrower. For example, a borrower who is willing to remortgage his house is offered with competitive rates however, rates are not clearly mentioned. It may therefore be implied that if a person who is looking for remortgaging his home may be a desperate borrower because of the potential high cost involved in his first mortgage. However, bank does mention the fixed and variable rates offered to persons who are looking for remortgage of their homes. For first time movers, bank has designed its message in manner which can effectively camouflage its interest rates charged on the mortgage. It has been practice in the industry that higher rates are charged to first time borrowers because of their overall risk profile and other factors. Therefore underlying these messages, bank may be attempting to convey a message about the higher interest rates to be charged against the mortgage facility to be offered to first time customer. Bank however, offer mortgage calculators to calculate the rates offered on the mortgages and installments to be paid by the borrower. So the overall marketing approach is to present the information in relatively convoluted manner in order to disguise true interest rates to be charged by the bank. Bank also mentions 11 different fees3 that a customer has to pay and have taken a unique approach to market its mortgage product while at the same time disguising its fees charged on mortgage products. However, bank have not directly mentioned a particular % of fee to be charged to the customers indicating that the overall pricing of the mortgage products may be based upon the risk evaluation of each individual customer. Conclusion Over the marketing approaches adapted by the Bank while mentioning and setting the interest rates are relatively more confusing for the consumers. This is due to the fact that the customers have very limited ability to recall- as per the studies conducted by Ashton- and in presence of this, it becomes easier for financial institutions to charge interest rates which may be relatively higher and does not reflect the actual calculation based upon different structural variables. Bibliography Ashton, John K. "Synchronisation and staggering of interest rate change by UK financial services firms." International Review of Applied Economics 23.1 (2009): 55-99. Read More