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Free Checking Profitability and the Role of Fee Income
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.
| Segment | Objective | Debit Card Role in Checking Strategy |
| 1) Fee Profit | Retain Fees | Waive Monthly Fee for Debit Users |
| 2) Unprofitable | Improve Profit | Charge Monthly Checking Fees for Non-debit Card Users |
| 3) Spread Profit | Retain Relationship | Reduce NSF Fees for Low Dollar Debit Transactions |
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
Some Truths About Free Checking
Attention financial writers – many of the articles over the past year about the pending death of free checking are based on erroneous information.
One of our goals with this site dedicated to the free checking account is to provide the truth about free checking. As a financial writer we trust you’ll visit this site when writing any articles about free checking or when free checking is mentioned. Should you have an inquiry that cannot be answered by one of the many articles on this site, please contact us immediately and we’ll provide the information to the extent possible.
As for information we’ve encountered in recent free checking articles, here are some examples of information that is wrong or misleading:
- The free checking account is on its way out, it’s dead.
- The free checking account was created or started by a major bank in Minnesota.
- The free checking account is unprofitable.
- The mega-banks have been offering free checking for years.
- Free checking was started by the big banks.
- Free checking attracts only the lower income consumer who keeps a low balance.
- Banks can’t survive if they continue offering free checking.
- Banks have to drop free checking because of loss of overdraft fee income, a reduction in debit card interchange fees, and predicted high compliance costs as a result of the Dodd-Frank legislation.
None of the information above is even remotely correct and should not be used when writing articles and blogs about the free checking account.
Free Checking is Alive and Well
About the only banks dropping free checking are the four mega-banks – Wells Fargo, Bank of America, Chase, and Citibank. Unfortunately, because of their combined market share and nationwide coverage, their actions dominate the media. Occasionally, another smaller bank will follow along because of the lemming instinct – if the big banks are dropping free checking, it must be the right course of action.
What isn’t being reported in the media are the thousands of smaller community banks and credit unions still offering free checking. Most of institutions have no plans to drop free checking – especially now. They now have a stronger competitive advantage over the mega-banks operating in their market areas.
The Free Checking movement was launched in 1982 in Lincoln, Nebraska
Free checking as we know it today started in Lincoln, Nebraska in 1982, with the launch of the Totally Free Checking and Free Gift marketing program. It was not a bank or credit union that created this unique account or marketing program – it was a direct mail vendor that specialized in marketing campaigns for small banks. So, in effect, free checking had its origins at hundreds of small, community banks across America.
It wasn’t until the late 1990s that the four mega-banks and other large banks began offering free checking. And they did so strictly as a competitive or defensive move. They were among the last banks to offer free checking and first banks to drop it.
The Free Checking Account is Profitable
Free checking is profitable for the thousands of community banks and credit unions that continue offering it. There are two primary reasons for this:
- They don’t have the prohibitively expensive branch networks like the mega-banks with their thousands of branches spread across America. The reason free checking isn’t profitable for the big banks is that they allocate these massive branch costs to their checking accounts using the overhead allocation model. In reality, these mega-banks shouldn’t be allocating much, if any, branch costs to their checking accounts. Why? Since the first ATM was deployed in 1969 at Chemical Bank, the big banks have been employing a combination of new technology and punitive pricing (charging customers to use the branch to make a deposit) to keep checking customers out of the branches. The Internet has made visiting the branch obsolete for most checking customers. So, if checking customers are no longer using branches, why should their accounts absorb the overhead costs for them? These fixed costs should be allocated only to the accounts still requiring branches – like CD’s, safe deposit boxes, loans, and investment services.
- By using a different cost allocation model, smaller community banks and credit unions look at adding new checking accounts from a marginal cost perspective – not the “all in cost” perspective of the big banks. Since almost all community banks and credit unions have unused branch capacity and small branch networks, their fixed costs are basically static. So, the revenue from a new free checking account needs only be sufficient to cover variable costs. Any excess revenue can then be applied to the fixed cost base – thereby driving down the fixed cost of all accounts. On the other hand, like the mega-banks, these smaller banks and credit unions shouldn’t be allocating costs to checking accounts when so few checking customers use branches to transact business.
Free checking accounts have been profitable for the community banks and credit unions since they began offering this account in the early 1980s – long before today’s high overdraft fees and lucrative debit card interchange fees. So, it’s disingenuous for today’s mega-banks to claim that recent government meddling in the pricing of overdrafts and interchange fee amounts has made free checking all of a sudden unprofitable.
Remember, the mega-banks didn’t begin offering free checking until they realized the account was wildly popular – even among the wealthy – and wasn’t going away. But, with the recent federal legislation, these big banks saw an opportunity to launch a campaign about free checking profitability in the hopes of forcing the smaller banks to drop this competitive account.
“Free checking is unprofitable and will soon be dead,” is the perfect media story to achieve the mega-banks’ ultimate goal of killing the free checking account. If they can’t have it – they don’t want their competitors having it either. And the mass media had bought into this “big lie” hook, line, and sinker.
The Mega-Banks were the Last to Offer Free Checking
As stated above, the community banks across America were the first banks targeted for the Free Checking and Free Gift program introduced in Lincoln, Nebraska, in 1982. Free checking got a major boost by Washington Mutual (WaMu) when it began its massive expansion program in the Pacific Northwest during the 1990s and into the new century – ultimately expanding to other states around the country. WaMu’s primary marketing focus was on its free checking account. It basically owned the free checking market in the communities it served.
It wasn’t until the late 1990s that the mega-banks reluctantly added free checking to their checking product line. And then, they did very little marketing of the account. Perhaps the most aggressive free checking marketer was Bank of America with its online banner ads. Adding free checking was primarily a defensive move to protect themselves from the aggressive free checking marketing conducted by the community banks and credit unions in all markets where the mega-banks had branches.
We saw how quickly senior management at Chase Bank dropped WaMu’s free checking account shortly after acquiring the bank as a result of the near collapse of our economy. This was done after first promising these customers that Chase would retain free checking.
Blaming this move on recent government legislation is simply a classic example of employing a red herring.
The Truth About Free Checking Can Be Found Here
In the future, should you be writing a blog or media story about free checking, you should consider interviewing senior management and marketing people working for one of the many community banks and credit unions offering the free checking account. They can tell you the true story about free checking and why it is so important for their success.
In addition, you should definitely contact one or both of the financial services vendors specializing in free checking marketing programs. Both are headquartered in Lincoln, Nebraska. One is ACTON Marketing and the other is Haberfeld Associates. Both have been in the free checking business since the early 1980s. They are the true experts when it comes to free checking profitability.