This is a very informative article on free checking profitability from Bob O’Meara, director or research for the Raddon Financial Group.  O’Meara takes a closer look at the impact of NSF fees, debit card interchange fees, and spread income have on free checking profitability.  The recent overdraft opt-in legislation impacting NSF fees is having some impact on free checking profitability.  Fortunately, most opt-in efforts were successful which means the predicted drop-off in NSF income wasn’t as severe as originally predicted.  But now banks and credit unions face new legislation which may lower the amount of debit card interchange fee income which will also have a negative effect on free checking profitability.  O’Meara’s insightful article includes some informative charts including one showing the percentage of free checking accounts which are profitable due to fees, those that are unprofitable, and those profitable due to spread income.  Now that the free checking account has come under fire from the mega-banks which have dropped free checking, pressure is on the smaller banks and credit unions as it relates to free checking profitability.  One major issue not covered in this article is household profitability versus account-level profitability.  And, does it make sense for a bank or credit union to look at free checking as a loss-leader for some percentage of customers?  The profitability of checking accounts – particularly free checking – is a complex issue that goes beyond what is covered in this informative article.

Is it Time to Take a New Look at
Your Checking Strategy?

by Bob O’Meara

The “free checking/NSF fee” business model just got a little hairier. Recent trends in NSF-generating transactions and consumer behavior are twisting the model. If you rely heavily on it for your checking account business, it may be time to rethink your institution’s checking strategy.

The media’s theme du jour is “What are those greedy, 401K-wrecking bankers going to do next to the poor consumer?”  On the June 4, 2009 NBC Today show, personal finance expert Jean Chatzky warned consumers that banks have a list of 250 ways to increase fees on checking accounts. (Can we get a copy of that list?)  She warned consumers to look out for minimum balance fees, teller fees, telephone banking fees, and fees on seniors and children.

While it is never a good idea to have fees just for seniors and children, the fact of the matter is that the free checking model depends on fee income to sustain profitability.  Since the “free checking/NSF fee” model depends upon a small number of customers to generate a large portion of revenue, the model can become risky for institutions if there is a shift in consumer behavior that reduces the frequency of those fee-generating activities.

NSF income has been declining for some time now.  You may not have noticed it if your NSF charge was below $30, you were adding new accounts, or you were implementing new revenue generation tactics.  Some of the NSF decline is a short term by-product of the economy.  Consumers’ checking balances are significantly higher due to a flight to safety and low returns on deposit and investment alternatives.  High volumes of debit card purchases, which tend to increase NSF fee income, have also declined due to the recession.  Some of this lost income may return when the current economic wave passes.

The non-recession related decline in consumer NSF behavior, combined with the courtesy pay program “opt-out” regulations being considered by the Federal Reserve may have a much longer-term impact on NSF income, and overall profitability of checking accounts.

Consider the following questions:

• Has your checking growth stagnated?
• Have you saturated your existing markets?
• Do you rely on a small portion of your branch markets for the majority of your growth?
• Have your branch expansion plans been delayed or canceled due to economic conditions and capital issues?
• Have your checking acquisition costs increased?
• Has your NSF income per account declined?
• Have you exhausted all of the fee enhancement opportunities?
• Do you have a significant number of inactive “secondary” checking accounts?

If you answered yes to some of the above questions, you may want to consider a “tweak” in your checking strategy.  Consider the following profit model for a checking portfolio.

There are three types of accounts in this example:

Fee Profit Segment: These accounts are profitable solely on the basis of their fee income.  These account holders, who have low balances, produce approximately 90 percent of checking fee income.  This group may represent as little as 5 percent of all accounts.  But, as their behavior changes, the NSF income is likely to decline, driving them to migrate to the unprofitable segment.

Unprofitable Segment: Account holders in this group generate few fees, but their balances aren’t high enough to cover their operating costs through spread income.  This segment can make up more than 60 percent of a bank’s checking accounts.  (Note to consumers and financial reporters who may have chanced upon this article – banks and credit unions lose money on about 60 percent of their customers or members.  Would you want to run a business where more than half the people you serve are unprofitable?)

Spread Profit Segment: This group is typically the top 10 percent to 20 percent of checking balance holders.  The top 5 percent usually produces 90 percent of spread income.

Over the past 25 years we have worked with institutions that were implementing free checking and firms that were phasing it out. Getting out of free checking was a far simpler process before NSF income became such a large part of checking portfolio profitability.  Most profit analyses over the years resulted in a combination of minimum balances and monthly fees that would eliminate the most unprofitable accounts and improve the profits from the remaining base.

Today’s pricing challenge is much more complex.  Strategies to improve the profit of the Unprofitable Segment are much more likely to impact the profit from the Fee Profit Segment. Instituting a minimum balance to avoid a monthly fee may cause a serious erosion of the NSF income we have become reliant upon to pay the bills.  Anything we can do to protect Spread Profit Segment is always a good part of a checking strategy.

Using debit cards as a relationship pricing tool may provide one solution.  Debit card activity has been used as a qualifier for free small business checking at Bank of America and Chase in some markets.  The debit card is also a part of the qualifications for a high interest rate offered on Rewards Checking for consumers.  The strategy is to waive the monthly fee for customers who perform a certain number of debit transactions during the month.  This approach can protect a large portion of your NSF income and generate new interchange income from customers who begin using the debit card.  RFG’s analysis of checking transaction activity shows that there is a high correlation between debit card activity and NSF income.  To maximize that debit card activity, consider incentives like checking fee waivers based on direct deposit or monthly debit card activity or both.

Consider the following example of how debit card activity can play a role in a checking pricing strategy.

Let’s assume that an institution was considering a $6 monthly fee for a basic checking account.  How could they implement this without running off a large chunk of their “Fee Profit” customers?  A common strategy is to waive the monthly fee for customers that have direct deposit.  The logic is that accounts with direct deposit are funded more frequently and the account holders are less prone to defecting.  In our previous example the $6 monthly fee can be avoided if customers are using their debit card a few times per month.

The debit card can also be a part of a retention strategy for the Spread Profit Segment.  Some institutions have moved to insulate this segment by offering them one or more NSF fee waivers with their relationship packages.  The logic here is that frequent NSF occurrences are directly correlated to account attrition.  Some firms have begun reducing or waiving NSF fees for low dollar debit transactions to avoid irking their customers with what’s become known as the “$40 hamburger.”  The $40 hamburger refers to an NSF fee that is added on top of a lunch purchase.  Take a look at your revenue stream to see if there is room to protect some of your Spread Profit Segment with a fee reduction or waiver.

Retention incentives and relationship pricing should play a key role in any new checking strategies you develop.  If you need help adjusting your product menu or analyzing your fee revenue streams, contact RFG for an assessment of your current product menu.  Call 800.827.3500 or email.

Reprinted from The Raddon Report