Opportunity costs in banking

This week, the UK’s Independent Commission on Banking published its interim report on recommended reforms to the banking system in the wake of various problems highlighted by the recent financial crisis.

Much of the focus has been on structural reforms – for example, should the retail arms of banks be separated from investment banking arms? All this has been much speculated on and discussed. The report also looks at competition in the sector – and here, hidden in paragraph 5.18 is an interesting embryo of an idea:

“…improving transparency is vital to increase customers’ willingness and ability to switch to a better deal. In particular, although interest foregone on positive account balances is one of the key sources of customer cost (especially when interest rates are higher than in the current environment), this element of cost is not visible to the customer.”

At the best of times, consumers tend not be very good at factoring in the opportunity costs of not switching. So an initiative to make the potential gains of switching clearer to consumers seems like a good step. But it is unlikely to be enough to simply present consumers with side-by-side interest rate comparisons. Of course, this makes it easier to see which bank account gives you the better deal, but it’s probably not enough to really get consumers thinking about what the benefits of switching – in money terms – really are.

This is illustrated very well by a study, “Opportunity cost neglect”, by Shane Frederick, Nathan Novemsky, Jing Wang, Ravi Dhar and Stephen Nowlis. They looked at people’s choices of whether or not to make certain purchases. In some cases, it was a buy/don’t buy decision. In others, they had a choice of what to buy – an expensive top of the range iPod, or a lower spec, but cheaper one.

They found that the way the choice was presented was very important. People tend not to take into account what they could do with the money saved from picking the cheaper option or not buying at all – unless the fact that there is an opportunity cost is made explicit. For example, presenting the “don’t buy” option as “keep $x for other purchases” pushed people towards deciding not to buy.

So, the message is: the more explicit you can make the potential gain  from switching accounts, the better.

I suggest something like: “Did you know that switching to this account could earn you £x to spend on clothes instead of using your credit card.”

The article on “Opportunity cost neglect” is here: http://www-personal.umich.edu/~prestos/Consumption/pdfs/Fredericketal_Dhar2009.pdf

You can read the interim banking report here: http://bankingcommission.independent.gov.uk/bankingcommission/

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