By Steve Simpson
Checking accounts have traditionally been the bread and butter of banking. Through transaction accounts, banks generate 40 percent to 70 percent of their fee income, and give themselves a base from which to cross-sell other financial services.
Most financial institutions today have an overdraft or courtesy pay program. These programs automate the decision to pay or return a check when there are insufficient funds (NSFs) in an account and pay up presented items to a standard overdraft limit. Further notices and other follow-up activities are executed at standard intervals to get repayment of overdraft funds from overdrawn accounts. This is the typical profile of most overdraft programs today.
There are two scoring factors not commonly used today in overdraft programs that can substantially improve risk management, revenue and optimize public policy. These two factors are deposit regularity and the number of days to clear up overdrafts.
Definition of New Scoring
Risk managers in financial institutions generally look at customers’ payment histories of past obligations as a means of evaluating the risk of collecting funds back from consumers. However, repayment history of NSFs has not been available and, as a result, overdraft programs have relied on other measures such as age of account, average deposit activity or other related factors. Yet we know from experience with direct deposit customers that deposit consistency lowers risk and improves customer retention.
Our research shows there are patterns among accounts that present NSFs. So, it is logical to use a customer’s history in clearing up overdrafts and their history in making deposits to assess the risk or likelihood of an account to overdraw again. At every financial institution we have studied, there is a consistent pattern of NSF activity. As Chart 1 shows, typically about two-thirds of the customers never present NSFs, 24 percent present a handful on an annual basis and about 10 percent of the customers present more than 10 insufficient checks annually. The customers presenting more than 10 annually generate nearly two-thirds of the total volume on NSFs and average 32 NSFs annually.
As shown in Chart 1, typically 70 percent of the revenue and the risk of NSF overdraft activity is related to those customers who average 30 or more NSFs annually – that’s one every 12 days. Knowing a customer’s deposit history and how quickly they clear up NSFs can greatly enhance risk management, fee revenue and the overall customer relationship.
Chart 2 shows a sample account’s activity over 42 days. This customer has historically made a deposit about every seven days. As checks come in, the deposit balance is reduced, and sometimes the customer has a negative balance and overdrafts. In this example, the standard overdraft program identifies the NSF and up to a negative account balance of $300. On day 35, the customer did not make a deposit, as was his usual pattern. And on day 40, this customer presented an NSF that was paid according to the overdraft program. Clearly, the risk of paying an NSF had increased for this customer at day 35 when the pattern of deposit activity had changed. In all prior cases, this customer had a regular deposit pattern and had cleared up overdrafts in just a few days, but this time something changed.
These factors are not used in most overdraft programs because the historical data is not captured and tracked. Through our extensive banking experience and research, Sheshunoff isolated this improvement opportunity and developed Deposit Score, a software program to capture, track and score each account’s information. The management of NSF activity and associated risk can be substantially improved by tracking deposit regularity and changes in number of days overdrawn. And now with Deposit Score, this can be automated and managed easily.
Another interesting fact we have uncovered is that risk can be managed more effectively by improving follow-up activity with the overdrawn customers. About 70 percent of the revenue and risk is coming from customers presenting and repaying 30 or more NSFs annually. We have found contacting the customers quickly and early when changes in deposit patterns occur or when they are overdrawn substantially improves repayment and ultimately creates better customer/bank relations.
For example, Chart 3 shows how our software scores customers differently as repayment or deposit patterns change, but also how it implements immediate and automated follow-up correspondence. If the customer’s deposit pattern changes, they are notified immediately in writing. If an overdraft occurs, the software automatically initiates a letter to collect funds. Clearly, the customer’s risk characteristics have changed and immediate collection activity is required.
Using trends of overdraft repayments and deposit regularity can substantially improve the timing and effectiveness of bank communication with their customers, while reducing a bank’s risk.
A customer’s overdraft limit is really only establishing the depth of the bank’s risk. The real risk in handling NSFs is if deposit or repayment patterns suddenly change. Some customers with consistent deposit patterns have standard or low overdraft limits. However, these customers may actually deserve higher overdraft limits based on their deposit regularity. Banks can further enhance revenue and still conservatively manage risk by using deposit regularity to score customer accounts. Many consumers would prefer to pay an NSF fee to their bank rather than being late on an important payment. Our research shows that financial institutions are only capturing about one-third of all “late fees” in the market (see Chart 4). Finally, public policy can be better served with scoring tools that anticipate and help customers who may be getting into financial trouble because of NSF activity.
Steve Simpson is director of product development at Sheshunoff Management Services (www.smslp.com), a company that assists financial institutions in improving their bottom line and gaining competitive strength. For more information, call (800) 477-1772, ext .695.