Coping with the overdraft conundrum
What to do about overdraft (OD) fees, or the loss thereof? For banks with assets over $10 billion, service charge income on deposit accounts, with OD income being the largest component, fell by almost half between 2010 and 2013 and at a rate twice as fast as for smaller competitors.
But it won’t stop here. After the impact we have seen from various regulations or guidances, we are now waiting to hear what the Consumer Financial Protection Bureau (CFPB) will do. The outlook is murky, so let’s be clear: We do not know what future regulations will be, and any impact they might have is an assumption at this point. For community bankers, who traditionally have already seen a decline in fee income per customer, it is critical to plan ahead and develop action plans based on potential scenarios – versus shooting from the hip and making dramatic changes prior to having clarity on the CFPB’s actual actions.
Overdraft as Lending
Let’s review the latest. In the first quarter, the CFPB announced proposed regulations for prepaid cards and payday loans. While both are more peripheral to the banking industry than OD income, they allow some insights into the potential future regulations on overdrafts for checking accounts. Looking at the proposed prepaid card regulations, we can see that the CFPB likes the notion of OD services being treated as a lending activity, and therefore, applying disclosure and other requirements from the credit card section of Reg Z.
Also, including OD fees in any annual percentage rate (APR) calculation would result in the APRs violating most state usury laws. The CFPB seems to like the opt-in requirement that was implemented through Reg E for debit card transactions. And, since no compulsory repayment would be allowed, the consumer would need to have 21 days to repay. This would effectively require a different handling of overdrafts. Finally, there’s continued mention of reasonable and proportional fees and no mention of frequency limitations.
The proposed regulations on payday lending, meanwhile, maintain that determining the ability to repay is critical; reasonable and proportional fees remain an issue; and there’s some limitation on the frequency of short term loans.
So, where does this leave your organization? These potential scenarios should motivate bankers to run a “stress test” on this income stream. Assume future regulations would cost you 25%, 50% or 75% of overdraft income. What does that do to your bottom line? How much income will it cost you and how many customers will become un-bankable? Based on these scenarios and your assumptions on what the industry reactions will be, determine your potential solutions.
Industry disruption could be detrimental to some organizations, but they also present an opportunity for those who plan ahead. Here are four recommendations for such proactive planning:
Grow your core customer base. Community banks have invested a lot in their branch networks, but run these branches, at best, at 30% of capacity. Currently the average fee income per customer is $165, of which 60% is in overdraft revenues. In addition, the average consumer household has $17,000 in deposits and $9,000 in loans. Even without the overdraft income, or with a new fee income stream in a different regulatory environment that would replace a portion of the overdraft income, the average consumer household will generate between $300 and $500 in annual revenues. Considering that your branches have 70% available capacity, marginal cost will be very small and overall profitability will dramatically improve when you are able to grow your core customer base.
To do that successfully, you first must understand that this is more than a marketing initiative. It starts with products, policies, and procedures that have to be conducive to growth. A well-trained staff must drive execution and customer experience, while marketing generates more foot traffic. And when all of this is in place, you must make sure that you measure and reward. Accountability is critical to the sustainability of any strategy.
Don’t increase OD prices. Some industry observers recommend increasing the OD fees per-occurrence. That may be an option if your organization is currently charging a below-average price for ODs. It is not an option if you are already on the higher side. Our data shows that clients with far above-average OD pricing actually collect less income and create higher attrition in this customer segment. There is elasticity to OD pricing and most organizations are likely already too high.
Not changing the OD price does not mean that an evaluation of this revenue stream is not necessary. For most community banks, service charge income on deposit accounts (again overdraft income is a large component of this) represents a third of their entire annual net income. An “annual physical “on this revenue stream seems more than appropriate.
Assess and evaluate the state of your OD services. No matter the actual form of future regulations, they are unlikely to change customer behaviors. If the customer who uses OD services for short-term liquidity needs will not be able to utilize that service any more, they will look for a different solution. Currently ODs represent over $30 billion in banking revenue. Other short-term liquidity solutions, such as payday lending, PayPal Credit and subprime credit cards, account for another $30 billion plus in revenues.
The likely restrictions on overdrafts and the potential new rules in payday lending will lead to new product developments, such as automated underwriting platforms for short term lines. FICO scores as a credit evaluation tool have been around for more than 50 years. Technology and Big Data will likely start replacing or enhancing some current underwriting criteria. Your organization already knows what transaction behaviors and deposit patterns your customers currently have. Utilizing this information to make credit decisions, especially in the short-term, lower dollar credit segments seems to be a very valuable tool.
Regulations will have a dramatic impact on the adoption rates of products like this, but we estimate anywhere between 5% and 20% of customers are interested in new products that provide a short-term liquidity solution outside of the current overdraft solution already. If regulatory changes to payday lending are implemented the way they are proposed by the CFPB, it will be very disruptive to this industry and provide community banks the opportunity to serve and monetize customers that currently avoid the traditional banking channels.
Industry disruption will require us to rethink how we price traditional checking services. The degree of regulatory changes will determine what level of checking product changes may be appropriate. As outlined above, a potential decline in overdraft revenues from future regulations will lead to a change in checking product offerings. After losing 50% of their service charge income on deposits accounts, almost all larger banks abandoned free checking. Implementing service charge-based accounts did not help them recoup the lost fee revenue. However, if the decline of overdraft income is accelerated through future CFPB regulations, large banks will go down the same path again and continue to increase their regular service charges. Community banks will have to find creative solutions for new checking products. They should not just copy the approach their larger competitors took.
No matter what these future solutions are – free checking, behavior-driven offers, interest offers or short-term liquidity offers – don’t forget that your institution will still need a compelling offer to grow its core customer base.
Mr. Griesel is chief operating officer at Lincoln, Neb.-based Haberfeld Associates, a customer acquisition marketing and profitability consulting firm for community based financial institutions. He can be reached at [email protected].