Profitability Under Pressure

By Somesh Khanna, David Schoeman and Jack Stephenson

Arresting the decline in checking account profitability requires a multi-faceted response from banks — and the sooner, the better.

Consumer checking has long been the anchor of profitability for retail banks, with the average demand deposit account contributing from $80 to $120 of profit annually for many institutions. No wonder banks have strived in recent years to boost retail checking accounts, including offering a plethora of "free checking" accounts and embarking on ambitious branch redesign/expansion programs.

Over the next five years, though, the outlook for this core product is not encouraging. Customers are shifting funds to lower-margin products, such as money market accounts and short-term certificates of deposits, squeezing overall deposit income. Account-servicing costs are also rising despite an increase in low-cost channels. And the gradual shift from checks to electronic forms of payment creates uncertainty over revenue streams and puts paper-based revenues at risk.

In the short term, a rise in interest rates — potentially the next step following a prolonged period of rate lowering by the Federal Reserve — could offset these trends. Additionally, banks may recoup some lost profits through the sale of other products, such as investments and savings accounts.

In the long run, however, there is little doubt that the economics of checking accounts are under siege, potentially reducing the profitability of the average account by as much as 20% to 30% at some institutions. To avoid this grim scenario, top managers need to begin planning their responses now.

One tempting response is to slash costs by taking actions such as closing branches and consolidating operations centers. Another is to raise fees. But these short-term approaches could leave full-service banks vulnerable to community banks and focused nonbanks that compete on price and service.

A better approach is to design a multifaceted program that incorporates three fundamental themes: customer segmentation; behavioral incentives; and a comprehensive review of operations spending.

Specifically, banks need to craft their strategies for products, marketing and sales around discrete customer segments. The rationale is to link product pricing and features to the underlying economic drivers for each of these segments. More creative product bundling and tiered offers can help this effort.

Realigning customer incentives means encouraging the most profitable behaviors, such as patronizing electronic delivery channels and products such as debit cards, while discouraging unprofitable behaviors, such as frequent trips to the branch for routine transactions. Rather than taking a predominantly punitive approach, which has misfired at some institutions, the emphasis should be on rewards, such as prepaid phone cards and frequent flyer miles.

Finally, strategists need to assess whether their spending on payments processing, customer servicing and other operations is aligned with projected transaction volumes. This requires a bank-wide review of operational spending, with two aims: reducing costs and developing a comprehensive, multi-year plan to deal with the migration from paper to electronic transactions. Thus equipped, executives can make better-informed investment decisions and rationalize their deposit-taking infrastructure as check volumes decline.

Balances Under Attack

Demand deposits are critical to banks from several perspectives. In addition to serving as a major profit source, DDAs form the hub for customer transactions, offering a host of relationship-building and cross-selling opportunities. Processing retail checks also provides substantial fee and interest income for a bank's wholesale cash management business.

Unfortunately for banks, DDA balances are under attack. Consider that from 1995 to 2001, total bank deposits held by U.S. consumers grew by 4% per year. However, because Americans continued their two decade-long trend of shifting assets toward higher-yielding, lower-margin investment and deposit products, consumer checking balances during this period declined by 7% percent a year, according to the Federal Deposit Insurance Corp.

To be sure, this trend appeared to reverse more recently when consumer nervousness about the economy and the stock market caused a "flight to safety," providing banks with a substantial lift in checking and non-checking balances. Many bankers view this windfall as an anomaly, however, and anticipate that balance erosion will resume once the economy rebounds.

Of deeper concern, especially to the big full-service banks, are the aggressive sales and marketing campaigns by a variety of new local and national competitors. Brokerages, asset management firms and banks serving the affluent are all targeting the coveted high-balance customers. Their offers include high-yielding money market accounts with unrestricted check-writing and automated teller machine privileges, linked investment accounts with sweep capabilities, and checking and savings accounts paying high interest rates. Among the nonbanks, for example, both Merrill Lynch & Co. and Charles Schwab & Co. are aggressively courting high-balance customers with their own federally insured accounts.

Losing these affluent customers has a disproportionate effect on bank profits. While such customers may comprise only about 15% of an institution's accounts, they have historically contributed as much as 60% of retail DDA profits.

Also on the attack are focused commercial banks that are trying to grow deposit share rapidly by targeting mass-market consumers. These institutions are heavily promoting free checking products with either zero or minimal balance requirements to customers with low balances (less than $1,500). They are able to make money on this once-unprofitable segment by imposing hefty fees for overdrawing. Customers rarely consider these fees when opening an account, and the low-balance segment has a much higher frequency of non-sufficient funds incidents than others.

Community banks and thrifts make up a third major attacker group, touting their personalized customer service and management teams that are active participants in local community life. While these banks possess a much simpler product set than their big full-service competitors, they can offer significantly more competitive rates, thanks to their leaner cost structures. Recently these banks have been very successful in growing share in many local markets.

One likely result of all this competition is that deposit balances will be spread across more institutions, lowering the average account size, especially within the high-balance segment. The overall net interest margin is also likely to decline as banks resort to price competition.

Another major threat to DDA income is posed by account servicing costs, which are rising faster than revenue. With the advent of ATMs, call centers and the Internet, customers now have more ways to interact with their bank. Each new channel has generated dramatic increases in transaction volume without a compensating reduction in old infrastructure.

Thus, despite the success of some banks in reducing per-transaction costs by moving servicing interactions from branches to lower-cost channels, our analysis suggests that total account servicing costs will rise 5% to 8% over the next three to five years. This is occurring because total transaction volume — driven by a proliferation of customer transactions, transaction types and associated infrastructure — has increased by 25% over the past five years.

Electronic Migration

The shift from paper to electronic transactions constitutes the third big threat to DDA profitability. Customers are making fundamental changes in their payment behavior — writing fewer checks and making greater use of debit card transactions, electronic bill payments and pre-authorized debits. Volumes in some item-processing shops are falling by 3% a year. At the same time, cash management businesses are seeing some erosion in their paper-based services to retail merchants, including lockbox, cash letter and other deposit categories.

Thanks to rising transaction fees paid by retail merchants, debit revenues from the average checking account could grow by as much as $10 to $15 over the next five years. However, there is considerable uncertainty with regard to future debit fee levels, primarily because of the ongoing legal battle between card-issuing banks and retailers over how much retailers should be assessed for the two different types of debit transactions. Depending on the outcome of this litigation, a typical bank's fees per checking account could vary by $12 a year, plus or minus.

The direction of processing costs is also a question. While electronic transactions could lower costs over time, processing costs will likely rise in the near term. Unit costs could rise quickly if banks fail to shrink their back-office operations and remove fixed costs in line with the anticipated declines in check volume. At the same time, debit card and automated clearinghouse operations will need to be upgraded to accommodate likely volume spikes, along with new product features such as debit card rewards programs and ACH information reformatting — the latter being required for check "truncation," or electronification, by retailers and billers.

Meanwhile, a number of paper-based revenue sources will likely decline. On the retail side, for example, there will be fewer checkbooks and per-item charges, and reduced float. On the wholesale side, there will be falling retail lockbox revenues, disbursements and merchant check-handling fees.

A more reliable source of revenue in the future will probably be "non-shopped," or non-marketed, fees. These are charges consumers rarely consider when opening an account. They include NSF penalties and fees for obtaining help from a person on the phone rather than an automated call center. NSF income is expected to continue to climb as checking balances fall and the number of electronic transactions rises because customers will have more ways to overdraw ever-smaller accounts.

Some banks will continue to raise non-shopped fees, but they should do so with care. This income, and even entire customer relationships, may be at risk if customers begin to resist the fees significantly.

U-Shaped Curve

All these trends have fundamentally altered the profit curve associated with checking accounts. Five years ago, checking profits were tied tightly to customer account balance levels — the higher the balance, the more profitable the customer. Increasingly, banks see a U-shaped profit curve emerging, with low- and high-balance customers holding up the two sides. That's because profits from low-balance customers have risen, thanks to increasing fee income, while profits from medium-balance customers — and, to a lesser extent, high-balance customers — have been hurt by declining interest income.

The net impact on DDA profitability will vary greatly by institution, which means no single strategy will suffice in overcoming these challenges. There are, however, three major themes that should be considered by all institutions in formulating an effective response: customer segmentation, behavioral incentives and a comprehensive review of operations spending.

Tailoring product pricing and features to better match the economic drivers of each customer segment is important because marketing the wrong product to a given customer can substantially reduce profitability.

On a tactical level, there are many ways to accomplish this product tailoring. Banks could, for example, step up efforts to capture a greater share of the total liquidity and investment balances of high-balance customers, who are typically more affluent and profitable. They could offer free financial planning services to identify customers' needs, and then follow up with targeted products. These might include account packages that explicitly link deposit, credit and investment products. Institutions could automatically enroll high-balance customers into all three products, and offer aggressive incentives encouraging them to activate all the accounts.

To ensure the sustained profitability of each product, marketers might consider a tiered-offer structure. For instance, they could limit the "sweep" feature that transfers balances from brokerage accounts into interest-bearing accounts only to those customers who maintain certain minimum account balances. To back up these new products, banks should also invest in sales tools, incentives and training materials that are designed specifically to build penetration of the affluent segment.

Product bundling can be effective for medium-balance customers too, but not without sufficient levels of balance consolidation, and the activation and use of each product in the bundle. To that end, banks should develop bundled accounts that are targeted to the needs and desires of this group.

For instance, customers who activate a savings account and a credit card linked to their checking account, maintain specified average balances and use the linked products regularly could receive a prepaid telephone card, or some other reward. Additionally, banks could offer customers with multiple active products immediate access to their un-cleared funds, up to their credit card limits, with overdrafts earmarked to the credit card lines.

Low-balance customers require a different approach. A number of banks are profitably serving them now with a combination of free checking and high fees for non-sufficient funds. This product should be launched with advertisements that emphasize its "no frills" positioning. In addition, banks could cross-sell simple credit products such as credit cards and unsecured loans.

Carrot and Stick

An important component of any DDA strategy is creating incentives that, while remaining true to the priority of fulfilling needs, encourage customer behaviors that benefit the institution while limiting those that drain profitability. Online bill pay, for example, is considered a desirable activity because while it may not be profitable to the institution on a stand-alone basis, it does bond customers more closely to the bank. It makes sense, then, to provide incentives such as a "while-you-wait" account setup to any customer who brings monthly bills into a branch.

Customers can be offered a similar "carrot" to use integrated voice response automated call systems for basic servicing functions such as balance inquiries, transaction details, and questions about ATM locations. One simple tactic is to offer those using IVR an entry into a monthly sweepstakes. If a "stick" is also needed, institutions can impose fees on customers who phone a call center more than, say, three times a month.

To encourage customers to use signature-based debit cards for as many transactions as possible — and avoid PIN debit — banks can award prepaid phone minutes or frequent flier miles to those who sign for purchases. Banks should also arm employees with sales training techniques, scripts and role-plays to encourage signature-based debit use and to handle customer objections.

Improved training, in fact, should be a component of marketing efforts across all customer segments. In a general sense, this training should reward sales staff for promoting account activation and retention and higher balances. Employees can also be trained to drive customers into specific products.

Meanwhile, in anticipation of the expected shift from paper-based to electronic transactions, institutions should undertake a comprehensive, bank-wide review of payments processing, customer servicing and other operations.

This review should give institutions new baseline transaction projections and a variety of different market scenarios. In turn, institutions should develop a multi-year paper-to-electronic migration plan that covers all operating units, including technology. This migration plan will allow a bank to "right size" its infrastructure to accommodate projected transaction volumes, based on a detailed understanding of fixed and variable cost drivers for each operating unit. The plan should identify functions that can be outsourced, and determine whether the bank can better utilize shared industry-processing utilities such as check clearinghouses.

As a second part of the operations review, banks should assess ways to reduce their overall cost structure using alternative techniques that go beyond the traditional budgeting process. For instance, a number of banks have garnered cost reductions of up to 30% by using offshore vendors to handle select functions such as the call center, account reconciliation and data entry. For functions that remain in-house, banks should consider leveraging process-improvement techniques from the manufacturing sector such as "lean manufacturing," which takes a fresh look at how key processes are performed and focuses on finding and eliminating sources of waste within those processes.

Some combination of these various measures should help banks arrest the decline in their consumer deposit profitability and position them to capture emerging pockets of opportunity.

Mr. Khanna is an associate principal, Mr. Schoeman a principal and Mr. Stephenson a director with McKinsey & Co. in New York.

Copyright © 2003 by Banking Strategies, published by BAI.

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