Stop the Bleeding | By Dan Roderick
The viability of free checking has been a topic of conversation across the industry for many years. Unfortunately for most community banks, little has been done to effect significant change regarding what has become an outdated strategy for quite some time.
Free checking has traditionally been subsidized in large part by overdraft fees, as well as debit card interchange revenue. But overdraft revenue and debit card interchange has dropped dramatically due to regulatory and legislative changes since 2010. Worse yet, the historic decline in interest rates since late 2008 has severely reduced the value of deposits – a problem that has been compounded by lower loan demand.
The chart below shows this impact on fee income over the past six years. Since 2007, deposit fee income across the community banking industry (excluding banks larger than $25 billion in assets and specialty banks) as a percentage of average assets has declined from 0.34 percent to 0.26 percent last year – a 24 percent reduction! To put this fall off in terms of dollars, community bank fees on deposit accounts have dropped by more than $1.5 billion over this period.
When we look at the impact the decline in fee income has on demand deposit account (DDA) profitability – coupled with the impact caused by low interest rates and rising costs – the picture gets even worse.
Since the early 1990s, when “free checking” was first introduced, there has been a radical transformation in the retail banking business. Twenty years ago, banks weren’t providing costly services like online banking, automated bill pay or mobile banking. While these technologies have provided improved service and convenience to consumers, they have also added substantial cost for bank DDA products. Most institutions today do not charge consumers for any of these add-on solutions, so the cost base for a DDA product has gone up with no corresponding increase in fee income. Rising costs and declining interest rates have had a catastrophic effect on DDA profitability at the average community bank.
In the table below, we see that in the early 1990s, free checking was a pretty good idea. It allowed financial institutions to acquire customers that might one day become more profitable – and still earn a small profit in the meantime – with the typical DDA earning just over $12 per year, pre-tax.
However, by the early 2000s, free checking was beginning to look like a questionable proposition, with the typical DDA losing almost $50 per year due primarily to declining interest rates (funds value) and rising operating expense. Rolling forward to today, free checking has become a truly terrible idea – the typical DDA is now losing almost $200 per year! In addition to historically low interest rates and higher expense, reduced fee income is now taking a toll. What was once marginally profitable or a manageable loss leader is now a serious drain on bank profitability.
A loss of $200 per typical DDA account sounds ominous enough, but what implication does that loss have on the profitability distribution of our customer base? It plays a major role in concentrating profitability for community banks to the top 5 percent to 10 percent of the client base. As shown in the table below, the typical community bank generates 100 percent of the “strategic value” of its customer base via the top 7 percent of the client base – Tier 1. The second customer tier represents 19 percent of the customer base and produces 25 percent of strategic value. Unfortunately, things head downhill from there. The middle tier consists of 25 percent of customers but only drives 10 percent of value, and the bottom two tiers – almost 50 percent of customers – produce negative strategic value! (The strategic value of an account is calculated by multiplying the balance by the projected long term spread on the balance net of projected losses, adding actual fees and subtracting estimated variable costs. Relationship strategic value is the sum of the strategic value of the accounts that are part of that relationship.)
So now what? The solution to this problem is fairly simple, but proper execution of that solution is critical to its success. As an industry, we can no longer afford to give away our outstanding services for nothing. It costs the typical community bank just over $320 per year in operating expense to support the average consumer DDA account. For the vast majority of customers, that relatively expensive service is given away for nothing! At best, there are nominal requirements in place, such as a requirement to have direct deposit or a maintaining a minimum balance, but these measures don’t come close to providing the necessary revenue to offset cost.
Significant, ongoing fees must be generated from the vast majority of DDA customers. At the same time, most community banks will feel the need to maintain some type of free checking account. Free checking has a valid part to play in supporting the financial institution’s mission in its community; however, free checking should be reserved for a relatively small part of a community bank’s audience, such as students or active military.
Unfortunately, as an industry, we’ve spent the last 20 years convincing consumers that free checking is a birth right, that no one should pay a fee for their DDA relationship. To execute this solution effectively, a simple customer segmentation strategy will need to be implemented, and a package of services created that drives balance consolidation, increases fees and creates value for each segment.
The optimal way to drive strategic value within the deposit base is to increase balances. Unfortunately, for the vast majority of customers, this simply won’t be possible. Optimistically, increased deposit balances may generate a profitable relationship with 20 percent of the customer base. The remaining 80 percent will need a fee strategy – because increased fees will be the only avenue to achieve profitability with these customers. To avoid a complete elimination of free checking, there may be a free e-checking product as a fallback for clients who want only very basic banking services and are not willing to pay a fee. The resulting product structure would look something like:
Premier checking – relationship-based account with meaningful relationship recognition features and no monthly fee.
Value checking – fee-based product enhanced with features from which most everyone can benefit.
E-checking – limited service/functionality, no fee, targeted to a small segment of customers.
The trick here is to provide enhancements to the value checking product that are in high demand – and that consumers are willing to pay for. These enhancements must be low cost to the bank, but high value to the consumer.
The days of free checking have passed. The industry is facing increasing regulatory pressure that is both increasing the cost base and decreasing sources of fee income. The interest rate environment and low to modest loan demand has squeezed margins. Increasing capital requirements will create additional pressure. The time has come to diversify sources of fee income – and the large, and largely unprofitable – DDA base is a great place to start that diversification.
Dan Roderick is CEO of Strunk LLC, an information technology consulting firm.