New regulations and the potential of additional, legislated restrictions on overdrafts have many saying that the era of free checking has come to an end. After all, overdraft fee income is the only reason these accounts are profitable, right? Wrong.
The profitability of free checking has never depended upon overdraft income.
In the early 1980s, for example, when interest rates were at all-time highs, overdraft income was negligible. Today, we see interest rates at all-time lows and overdraft income has become enormous. Free checking operated profitably at all points during this period. What changed was the large banks’ linkage of free checking and overdraft fees in the last four or five years.
Historically, free checking began with community banks and thrifts (often clients of Haberfeld Associates). Within the last ten years many large institutions began offering the product (rather grudgingly) to stem the tide of defecting customers and because they saw a revenue opportunity with overdraft fees. During this time, consultants began to encourage institutions large and small to offer “free checking with overdraft privilege.” Meanwhile, the use of debit cards exploded, creating a perfect storm of sorts because these cards tend to cause customers (unknowingly) to exceed their account limits. That’s why you read about people getting hit with $35 overdraft charges on $5 lattes.
In the wake of new Federal Reserve restrictions on overdraft charges, many in the industry are predicting that free checking is dead because many financial institutions use overdraft and nonsufficient funds (NSF) fees to subsidize their free checking products. While that may be true for large banks, free checking is likely to remain very much alive at community banks.
Voice of the Customer
The reason is that bank customers today have come to expect free checking and don’t believe they should have to pay the bank to house their money. Customers have also consistently expressed their dislike for regular service charges and minimum balance restrictions. Do they like interest? Of course! However, most customers don’t like the hoops they have to jump through to get it. What they do like is the simplicity and fairness of free checking. New regulations will not change customer preferences.
Can banks make money with free checking when overdraft income is reduced – even dramatically? They can – or at least community banks can. That’s because of the differing cost structures of the two categories of banks.
Large banks open four or five times as many accounts and possess three or four times as many customers as community banks per branch. Because their branches are much closer to capacity, they may decide that they can afford to lose some customers and the incremental costs that go along with those customers if they have to take a 15% to 25% haircut on overdraft fee income.
After all, the biggest advantage large banks offer to their customers is the convenience of large branch and ATM networks. This, as opposed to product, is their competitive advantage; as long as they retain that advantage, they should be able to retain many of their customers by jettisoning free checking.
Community banks, on the other hand, offer customers much less convenience and their branches possess lots of capacity to add new customers with almost no additional cost. The branch system, after all, is a bank’s single largest expense. Once this investment has been made, it is necessary to staff it appropriately. Even the bare minimum staffing still leaves a lot of unused capacity for the typical community bank.
Most community banks operate with around 1,000 checking accounts per branch, according to our data, with capacity to double that without adding any staff or facility upgrades. Each additional customer, meanwhile, only adds between $10 and $15 in expense per year – mostly the costs to render statements. It is a rare customer that does not provide enough revenue to cover those small costs.
So you can see it’s in the best interests of community banks to gather every additional customer they can and free checking is a way for them to attract those customers. Now, consider the benefits the typical free checking customer provides the bank:
- Average account balances of $1,100 that earn no interest;
- At the household level, more than four total products and services and over $7,000 in total deposit balances, 74% of these being low-cost, core deposits;
- Average overdraft income (whatever that may end up to be) and above average interchange – so there will still be respectable fee income per account.
What’s not to like about that? The checking account is the hub relationship for customers (see chart, “The Hub of the Relationship”) and free checking provides that hub. Once you have that, you get first-right-of-refusal on the rest of that customer’s banking needs. While single-service checking customers do exist, in aggregate the free checking group buys many other profitable products and services from the bank (see chart, “Free Checking: Not a Single-Service Product”).
Free checking is a win-win proposition for community banks, even with the new rules on overdraft. Customers love it and it is quite profitable on its own.
As the big banks begin to pull back from free checking, we expect that the product will attain new life as a competitive differentiator for community banks once again. As a result, community banks with a robust marketing plan will enjoy an influx of new customers they have not experienced in several years.
Rudyard Kipling once said, “If you can keep your head when all about you are losing theirs and blaming it on you … yours is the earth and everything that’s in it . . .” As community bankers, we have the rare opportunity to show we’re not being panicked by the overdraft controversy. In fact, we can view it as an opportunity to gain market share.
No matter what happens with regulation or legislation, if you have lots of customers, you have lots of options. Make sure your bank’s options include free checking.
Mr. Friesen is president and CEO of Lincoln, Neb.-based Haberfeld Associates, a consulting and marketing firm. He can be reached at alan@haberfeld.com.