Robert C. Giltner
Robert C. Giltner Apr 9, 2013

A Tiered Approach to Overdraft Fees

In 2012, our research shows bank overdraft (OD) revenues down about 20% from their 2008 levels, although they still constitute well over half of the industry’s total checking account revenues. Is it time to rethink this source of income entirely, given the hostile regulatory environment, consumer reaction and competitive response?

Our experience indicates that financial institutions (FIs) will be better off by swearing off traditional monolithic overdraft fees – and even return check charges – for good, despite the pressure this may appear to place on banking’s already broken consumer checking business model. Instead, FIs in today’s environment should segment their key revenue source, nonsufficient funds (NSF) and overdraft fees, rather than continue the model of simply offering a single service, at a single price and delivered in only one way.

This means offering account types with no overdraft or return check fees ever along with tiered NSF/OD fees according to the number presented over a 12-month period. Under such a scenario, customers with accounts featuring OD services who make just a few mistakes in exceeding their account limits would reduce their cost significantly with a new, lower-tier NSF fee. Those who rack up many OD items year-after-year with the ability to cover the fees should pay a higher per-item tier price. This salutary approach, in place at some banks and credit unions since 2008, has received no negative regulatory or legal reaction according to our database review of relevant regulatory findings and case law.

Just as important, such a segmentation strategy will demonstrate to banks that they can grow NSF/OD revenue. Banks’ revenues are down not simply because of regulatory pressure, but also because alternative providers such as PayPayl’s BillFloat, biller late fees and a growing group of small dollar loan providers are simply beating them in serving diverse customer needs more effectively. It’s well past time for banks to consider the OD/NSF fee situation more flexibly and creatively.

Segmenting OD Customers

The key to understanding the industry’s largest revenue source is defining the three distinct customer segments that exist in relation to OD services. The first consists of customers who want to avoid any surprise NSF/OD fees and have items returned rather than paid so they do not overspend. For these customers, a mistake and a few overdrafts or NSF items can constitute a catastrophic and unrecoverable event for their budget. These customers are switching to prepaid cards like the Walmart/American Express Bluebird account and other options to avoid OD fees.

This segment represents about 20% of the customers at the average financial institution, according to our research, and currently FIs offer no checking service to meet their needs, which is deserving of regulatory comment. How on earth has it come about that an overdraft fee for such customers can average $30 per item, and reach $40 at some FIs, for a small mistake that is easily possible in today’s transaction system?

To answer that question we need to understand another group of customers who present NSF items. This segment represents only 7% of all FI customers but pays 80% of all OD fees. These customers know they present NSF items, do little to avoid it and plan to go on presenting NSFs. They are undeserving of regulatory sympathy or protection, like Eliza Doolittle’s father in My Fair Lady, they “like being undeserving and plan to go on being undeserving.” They average 30 overdraft items a year. They define “service” as having all items paid into overdraft and are not surprised when they get hit with a fee of $30 per-item or more. They see overdrafts as an expensive way to live conveniently, if not prudently, and they can afford such a lifestyle.

Analysis of this segment at the typical FI shows that while they may pay $900 a year in overdraft fees, these fees are a very small percentage of their total deposits. Their average account balance may not be large, but the velocity of deposits and payments moving through their accounts is high. They have the lowest charge-off level of any customer group. Like consumers who enjoy a bottle of wine with dinner often costing $30 to $60 per bottle, which is four times the cost at a discount liquor store, these overdraft customers choose to pay for a lifestyle. When bankers implore them to get a loan to avoid such fees, these consumers respond with the same incredulous stare as would a wine drinker if you proposed that they forego the wine at dinner and buy a low-cost bottle on the way home. Such a question for these consumers completely misses the point; because they are not sensitive to the per-item price, the price per-NSF/OD item has continued to go up without a negative effect on FI revenues. Bankers understand this customer segment well, but lawmakers and regulators do not.

Lastly, there’s a third segment of consumers with one to five overdrafts a year. These customers have simply made an inadvertent mistake and want items paid to avoid further embarrassment. Our research shows that this constitutes about 25% of FI customers, but only a very small amount of total NSF/OD revenues for an institution. For these customers, the $30 fee for a small mistake is outrageous and out of context, which has led to stories about the $35 cup of coffee and brought upon banks the wrath of lawmakers. Bankers do not understand this segment very well and have not designed their overdraft services for them.

What’s the remedy? Specifically, you should develop an account to serve the first segment, which wants to avoid OD fees. This would be a return-all account for a monthly fee with no overdraft or return check charges ever. The second and third segments, meanwhile, can be better served with tiered overdraft fees that slash drastically the per-item prices for those customers with one to five NSF/OD items while paying items whenever possible. No one in segment two or three will switch to the account designed for segment one because they want items paid, not returned. At the same time, per-item fees and OD limits should be raised for the segment of customers presenting many items and with the resources to support their lifestyle.

While FIs have blamed regulation and lamented their loss of revenue in the wake of the crackdown on overdraft fees, competitors like PayPal’s BillFloat, started in 2010, have lured 700,000 users to its overdraft alternative. The burgeoning list of other competitive alternatives too long to list here includes FlexWage and Float Money. If retail bankers seek to segment their customers’ needs according to their key revenue source, overdraft fees, they will find it leads to both revived revenue and advantageous public policy.

Mr. Giltner is CEO of Simpsonville, Ky.-based R.C. Giltner Services, Inc. He can be reached at bgiltner@rcgiltner.com.

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