A Matter of Interest

By Lauri Giesen

Proposed legislation may hurt the profitability of small business deposits, forcing institutions to work harder on relationships.

Serving small businesses, always a challenge for banks, is likely to become even more difficult should some pending legislation be approved. The exact timing is uncertain, but the expected eventual repeal of Regulation Q will raise the cost of servicing small business accounts at the very time banks are losing market share to nonbank competitors.

In force since the 1930s, Reg Q has prohibited — some say excused — banks from paying interest on commercial checking accounts. Since larger customers typically have "sweep accounts" in which their daily balances are moved to investment accounts that pay higher interest rates, Reg Q mostly affects companies whose balances are too small to justify such accounts — typically businesses with annual sales of less than $5 million or account balances of less than $5,000. It also affects those community banks that lack the resources to offer sweep accounts.

Legislation introduced in both the House and Senate would permit banks to provide interest on demand deposit accounts beginning after an as-yet-undetermined transition period following the law's enactment. While not yet a done deal, the legislation does enjoy support from business groups and the Bush administration.

Would the loss of Reg Q necessarily be a bad thing for banks? Clearly, the direction of interest rates is a key factor. With rates as low as they are today, customers may not earn enough in interest to justify the higher fees banks will likely impose to administer the interest-bearing accounts. Consultant Charles Wendel estimates the added cost to banks industry-wide to be as high as $5 billion, assuming a high-rate environment, and between $1 billion and $2 billion if rates stay low.

"As rates go up, these accounts could become a much bigger factor," agrees Taylor Vaughan, senior vice president of cash management services for First Tennessee National Corp., Memphis.

Community banks, according to Wendel, may be hit harder than the larger regional institutions because of their greater dependence on "free" deposits. But at the same time, these institutions may improve their ability to compete with larger banks and nonbank financial companies because they can now offer interest-paying accounts.

All banks, however, will see some increase in interest expense. To prepare for that eventuality, institutions will have to develop new product and service mixes that attract and retain the most profitable customers while finding ways to generate additional revenue or lower the cost of serving others.

Regulatory Relief?

The importance of Reg Q to financial institutions that serve small businesses has to do with the vital role that deposits play in the profitability of those relationships. "Eighty percent or more of the profits from small business comes from deposit accounts — either from the ability to profitably reinvest these funds or from fee income," says Wendel, president of New York City-based Financial Institutions Consulting.

Generally speaking, lending per se plays a very small role. Wendel's research, in fact, shows that the profitability of small business relationships tends to match up with larger deposit-to-loan ratios. A recent survey of five banks with two million small business customers by Novantas, a New York-based consulting firm, found that 85% of these institutions' most profitable small business customers had deposits but no loans, 14% had both, and 1% had loans only.

"We constantly see banks continue to focus on the loan side, but they're overlooking the fact that the majority of their small business customer base only has deposits with them," says Jason Hardgrave, a principal with Novantas.

Banks have been forbidden from paying interest on corporate checking accounts since 1933, in part because Congress thought the economy would be better off if companies invested their money in new plants and equipment instead. Modifications in the early '80s allowed companies to make up to six transfers per month between a checking account and special accounts used for bill payment. This facilitated the development of some special large-scale automated bill payment services.

In practice, however, large corporations have found plenty of nonbank alternatives for investing their excess funds, such as bonds and money market accounts. And sweep accounts offered in recent years allow these businesses to make routine transfers of surplus cash from checking accounts into their other interest-bearing accounts. The only businesses still largely affected by Reg Q (besides the banks) are small businesses whose balances aren't large enough to justify seeking out these alternatives.

The repeal legislation, introduced in Congress in April 2002, would permit banks to provide interest on demand deposit accounts. There has been some disagreement among legislators as to how to manage the transition from the current system. Right now, the draft legislation requires a year-long transition period, but some lawmakers are pushing for a longer time frame.

However long the transition, the odds of some version passing are considered good, which leaves bankers groping for a response. "We haven't determined what our strategy would be, although repeal certainly will affect the economics of our small business group," says Elaine McMahon, a senior vice president at Comerica Inc. and manager of its small business group for southeast Michigan. "All we can say now is that we intend to be well-positioned in that environment."

First Tennessee is likewise in a wait-and-see mode. Vaughan says his bank has several products ready should Reg Q be repealed. He declines to be more specific except to say First Tennessee is working to make sure its processing systems can support daily sweeps between checking and standard savings accounts. Part of the decision to offer the new products, he adds, will depend on how the competition behaves and the direction of interest rates.

More Sweeps

But even if banks can start paying interest directly on checking accounts, businesses with larger balances are likely to continue to use sweep accounts, which may pay higher rates.

These accounts, which are legal under Reg Q, allow businesses to routinely move large sums of surplus cash between a checking account and an interest-bearing investment account as needed.

Sweep accounts have been especially attractive to businesses that keep large sums in their accounts to pay big bills that may only hit once or twice a month. Russell Davis, a practice manager with the Washington D.C.-based Business Banking Board, estimates that 62% of the funds kept in small business checking accounts are in excess of the working capital needed, which underscores the usefulness of these accounts.

Nonbank competitors such as Merrill Lynch & Co., in fact, have deployed sweep accounts to wrest small business deposit market share away from banks in recent years. "Banks were slow to respond to competitive changes in the market and Merrill Lynch ate their lunch," Davis says.

While many banks did introduce sweep accounts, others have either been reluctant to offer the product or have restricted it to a small number of important customers because of concerns that the additional interest expense cut too severely into their profitability. "According to our estimates, if you move most of your small businesses from no-interest accounts to sweep accounts, you will see a 19% decline in the profitability of those accounts," Davis says.

Even so, the consequences of not offering the accounts are probably worse. Davis estimates an institution can see a 44% profitability decline in its small business account business by losing customers to the competition.

Comerica, for one, accepts the implications of this logic. "There are so many factors to consider in deciding whether a sweep account is right for a given customer — its liquidity, its transaction patterns — but overall, we find the number of companies that qualify for sweep accounts is growing," McMahon says.

In any event, sweep accounts won't provide the total solution to retaining small business customers in the wake of a possible repeal of Reg Q. Sherief Meleis, a director at Novantas, suggests tiered pricing based on average account balances — the higher the balances, the more interest paid. This would help align the bank's expenses more closely with the customer's profitability.

Segmentation Criteria

Any attempt to institute tiered balances needs to be based on an effective segmentation strategy and some robust scenario planning to model impacts in various interest rate environments. The industry's track record on this, so far, hasn't been very good. "Most banks today are not particularly good at segmentation with regard to their retail customers, let alone segmenting small business customers," Wendel says.

First Tennessee, for example, bases its segmentation on a limited number of criteria — typically sales volume, type of business and profitability to the bank. "We've never gotten very scientific," Vaughan says.

Such arrangements might be passable for now, but they probably will require improvement if there is rate competition for business deposits. "If you try to segment using only one or two criteria, you won't be effective," says consultant Russell Wehrlin, senior vice president of Atlanta-based Speer & Associates. "You might have three companies, all of which have sales of $2 million a year, but it would be wrong to assume their needs are all the same. A retailer with $2 million in sales is going to have different needs than a manufacturer or a law firm with the same sales volume."

Other factors to be considered in developing products for small business segments include the company's position in its life cycle and its cash flow requirements. In looking at life-cycle issues, banks can offer startup companies credit plans that can help them grow, as well as provide cash management services to companies that may be new at handling funds. At the other end of the age spectrum, mature companies may need assistance with trust issues and assistance in passing ownership on to another generation.

Using cash flow as a criterion, businesses can be separated into two categories: those that make large numbers of deposits and withdrawals for relatively small amounts, and those that only post a few deposits and withdrawals a month for large amounts. "Some businesses write a lot of checks, while some write very few but for large amounts. We need to be selective in finding a product fit that works for each company," says Comerica's McMahon.

Comerica has developed a wide range of criteria for segmenting its small business customers. The Detroit-based bank has worked, for example, with a number of small business associations to develop products that serve the needs of association members. "We hold a lot of workshops that help emerging companies manage their businesses," McMahon says. "We also bring in financial experts to talk about handling cash flow, marketing techniques, technology implementation and leadership issues."

Segmenting its customers by demographic groups, Comerica offers packages for businesses run by African Americans, Asian Americans, Arab Americans and Hispanic Americans. It also has products geared for women business owners.

However they accomplish it, banks will need to become more innovative in serving small business customers as Reg Q is put out to pasture. "They can't afford to let small business deposit accounts fall between the cracks," says Speer's Wehrlin.

Ms. Giesen is a freelance writer based in Libertyville, Ill.

Copyright © 2003 by Banking Strategies, published by BAI.

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