Potentially excessive prices and switching costs banking cases

Potentially excessive prices and switching costs: banking cases from Hungary (OTP Bank) ACE 2007 Bruno Jullien

A case in « Hungarian » Short but based on economic reasoning (effect based approach) I will focus on termination fees (on personal loans) and ignore « handling fees » 2

Summary OTP former monopoly facing growing competition The credit market has been growing fast and seems to stabilize OTP personal loans : 40 -60% contracts (30 -40% value) OTP raises termination fees unilaterally in 2005 (personal loans, housing loans) Allowed by regulation, legal requirement fulfilled 3

On Banks are intermediaries that transform deposits into loans Complex activity: mutualization/ risk management / moral hazard / adverse selection Heavy regulation Contractual relationships The rates on one side are related to rates on the other side Deposits and credit rates are jointly determined There are switching costs Financial cost Bundling loans and deposits → transfer costs Relationship banking based on learning and information : raising competition may lead to more relationship banking (flight to captivity). 4

Termination fees Early termination is a disruptive action Profit = flow of interest received on loans - flow of interest paid on deposits Securing regular flows is important If a credit R is repaid, the bank will have to lend R again to secure a new flow r per month → this is costly (direct costs, rate risk due to arbitrage) If there is an unexpected increase in the flow of termination, the cost increases, the bank can then Raise termination fees Raise interest on loans (risk premium) Reduce interest on deposits (saving rates) The bank may rebalance the tariff if the market conditions changes 5

Is an increase in termination fee exploitative ? Trade-off on the credit market between incentives and insurance Termination fees induce consumers to internalize the cost of termination Risk premium allows to share the risk If the risk is aggregate (refinancing rates, TF seem appropriate). The market has a two-sided market characteristic Effect of termination fees / credit rates on the saving rates should be assessed If the retail deposit market is competitive, this is a transfer from borrowers to depositors but there is no global harm to consumers 6

Market assessment An “effect based” approach No real assessment of a “relevant market” Substantial switching costs, high market share for OTP But evidence of competition on the credit market Unilateral changes of contract Lack of information due to inadequate regulation, lack of market transparency, switching costs The text establishes that there is No significant market power on the credit market But “SMP toward their locked-in consumers…. ” No discussion of the saving side But no assessment of the elasticity of termination to the fee 7

Economic theories of abuse with switching cost No excessive price (similar to competitors → alignment) Exclusionary abuse The firm obtains a large market share during the growth stage (low switching cost so moderate competition) Then demand stabilizes, the firm increases switching costs, which prevents others to “poach” Here this has been ruled out because there is little market power, small numbers of contracts But according to the estimate, 33 to 50 % consumers were prevented from terminating compared to benchmark Remark: The TF is waived if refinancing by OTP loan Presented as a sign of exclusion, but could be simply a simplification for the procedure because loans are negotiated on individual basis : the TF is irrelevant for the pair Client-OTP. 8

Economic theories of abuse with switching cost Exploitative abuse The firm obtains a large market share during the growth stage Demand stabilizes → the firm balances captive clients and potential clients, and decides to increase the price Here the TF is just one component in the total price This is the view adopted in the text The increase in price is not an abuse! but the unexpected change in the contract is an abuse under some conditions! lack of adequate information and transparency Is it assumed implicitly that consumers are irrational? 9

The decision is based on finding little effect of TF on the demand for loans measurement problem creates an illusion as the ex-post individual cost is observable but not ex-ante cost Both the benefits of OTP on captive clients and the cost imposed on new clients are proportional to the probability of termination Needs to be quantified ? How was it done ? In the text, the TF is viewed as another price, not as part of a banking contract No discussion of rebalancing of the rates / counterfactuals The main motive for raising TF could be to reduce the amount for termination Pro-competitive effect if termination is not efficient Strong elasticity of termination ? There is a tension between treating the TF as a price and the nature of TF (hence insistence on information) Does the same reasoning applies for other fees → handling fees ? 10

Abuse ? Regulation or anti-trust Here the issue is not the price level but the change in contractual terms The abuse is: not informing consumers and not giving them enough opportunity to react But there is a regulation for information and the firm followed it Different from no regulation when there is a regulator Obligation to act beyond regulation ? There is the common law for contracts 11

Exploitative abuses Regulation or anti-trust Can AA intervene if there is a regulator? Yes for exclusionary practices that cannot be addressed by ex-ante structural remedies But exploitative abuses ? Most economists argue that Exploitative abuses should be the exception Difficulty in defining “normal prices” Effects of prices on entry , Motor of innovation and growth Ex-post monitoring for remedies Remedies should be structural When there is a regulator, “excessive prices” should be left to regulators Little on non-price abuses Little on how to discipline regulators with different agendas 12

Remedies The remedy has two dimensions 1. Correct for the “inadequate” regulation by imposing a structural remedy 2. Compensate the consumers If the facts are established, the structural remedy seems to generate an improvement for the sector, but But the decision creates jurisdiction conflicts Regulator uncertainty / regulatory squeeze It would be preferable to convince the regulator to change the rules There is no fine, but the authority decides on the consumers’ compensation All the decisions are concentrated in the hand of the same entity This has a flavor of ex-post price regulation 13

Conclusion The existence of a market failure is not sufficient to establish an abuse: How to draw the line with effect based approach? Outcome would most likely differ with a relevant market definition and dominance test (compatibility with art. 82? ) Lack of an analysis of financial contracts (including rates, fees, insurance, …), incentives of OTP, business justification (in the handout). Abuse reduced to “lack of information”, no excessive price What to do when the regulator is not doing the job? 14