To Fee or Not To Fee?

At the beginning of 2000, Stock Yards Bank and Trust in Louisville, Kentucky contemplated free checking. Doing so meant SYB would be the fourth financial institution in its market to introduce free checking and to give a premium gift to its new account customers. What would its chances be of success?

Established in 1904, Stock Yards Bank (SYB), with current assets of $937 million, had a track record of success: It boasted 13 straight years of record earnings, a net income increase of 19% over the previous year, and a rise in diluted earnings per share of more than 20% over the previous year. SYB had just posted a return on average assets of 1.55% and a return on average equity above 20%, the third consecutive year the return had exceeded 20%u00e2u20ac”an accomplishment investors associate with strong, rapidly growing companies. This sustained, record growth had not been achieved through acquisition; rather SYB had grown through deliberate expansion in its market and by offering comprehensive banking services customers want and need.

As a result of competitors offering free checking in its market, SYB had begun to experience account erosion, so following thoughtful deliberation, it launched its own program in July 2001. Though not the first to enter its market with free checking, SYB has now doubled its new account openings to 1,000 new accounts per branch annualized across its 17 branches. Average balances in these new accounts are $950. Today there are seven or eight competitors in its market offering free checking; and while new account openings have slowed slightly, they nevertheless remain at significantly higher levels than before the introduction of the free checking program.

What do Stock Yards Bank, Charter One Bank, Washington Mutual, TCF Financial, Fifth Third, and Commerce Bank have in common? They are all exceptionally high performing banks. They are growing faster than the market in general. They also each offer free checking.

Charter One Bank, a $38 billion institution based in Cleveland, Ohio, with banking centers in Illinois, Massachusetts, Michigan, New York, Ohio, and Vermont, last year had an 18% ROE and 12% earnings growth. It has offered free checking for 13 years. It has a minimum 7% market share in most markets, and in its banking center trade areas it has 20%-25% of the households. “Our growth strategy,” states Mark Grossi, EVP, Retail Banking, “is an aggressive adoption strategy predicated on free checking. We believe you get as many customers as you can, as quickly as you can over time.” Last year Charter One’s organic growth was 17%. Its free checking accounts grew in Ohio by 33% last year where it’s had free checking for 13 years. For the sixth consecutive year it has experienced 20% revenue growth, mostly deposit related. It opens 1,100 checking accounts per banking center annually across its 456 centers. And of its 13%-15% earnings growth target, one-half of its EPS growth will come from deposit related revenues.

What’s so great about free checking?

There are pundits who say banking is a mature industry, that checking, especially, is a mature product. In Leading the Revolution, Gary Hamel states, however: “There are no mature industriesu00e2u20ac”only mature managers who unthinkingly accept someone else’s definition of what’s possible.” Tom Brown, co-founder of the website bankstocks.com, recently stated at the 7th Annual Best Practices in Retail Financial Services Symposium, “I don’t believe for a minute that any part of financial services, whether it be in banking or anything else, is mature. When you look at the numbers of Commerce Bank, of Charter One, of Twin Cities Federal, there’s nothing mature about the way those companies are growing. There has been nothing mature about the way Fifth Third has grownu00e2u20ac”not for the last five years, not the last ten, not the last fifteen, not the last twenty. This is not a mature industry.”

George Schaefer Jr., president and CEO of Fifth Third Bancorp, keynoted a recent Bank Director conference at which he revealed that whenever Fifth Third enters a new market by acquisition or internal expansion, it always leads with its free checking product. Its corporate priorities: maximizing deposit growth (for spread income), fee income (NSFs and such), and loans, in that order of importance.

Commerce Bank, Cherry Hill, New Jersey, markets free checking and last year grew its core deposits 39% in a market that the Wall Street Journal reported as one of the slowest growing in the nation. Branch growth last year hit 26.5%u00e2u20ac”an all-time highu00e2u20ac”and total revenues advanced by 41%. Over the past six years, Commerce’s compound annual asset growth has been 25%, with its rates being less than both national averages and its competitors’ rates. Its branch growth has ranged from 15%-21%. What have each of these successful banks had in common?

It may or not be coincidental, but these winners over the last several years are free checking banks. Three of them are clients of bank consulting firm Haberfeld and Associates in Lincoln, Nebraska. These banks have followed the recipe that Ralph Haberfeld and his firm have established over the last 22 years, assisting more than 250 financial institutions nationwide ranging from $60 million to $24 billion in assets. But how do they make money?

Haberfeld’s high-performance checking account marketing program is predicated on a very simple formula:

total profits = average profits
per household x number of households

Focusing on the primary checking account relationship enables banks to “own the customer” rather than “renting money,” explains Haberfeld. Furthermore, the emphasis is on households rather than accounts. Banking is a fixed-cost business; thus, doubling the number of accounts cuts in half the fixed costs per customer. Total profits are maximized by optimizing average profits per household while maximizing the number of households.

To this macro concept Haberfeld applies two basic economic principles: 1) Economics is the study of scarcity, and price is the vehicle society uses to allocate scarce resources. 2) You maximize profits by marketing until marginal revenue equals marginal cost. That is, avoid niche marketing and love all your customers. Interest expense is the “scarce” resource banks must allocate, which is accomplished by successfully implementing regular service charges and other pricing schemes. The March/April 1999 issue of the New England Economic Review reported that 1) the checking account market is not sensitive to interest rates 2) regular service fees don’t add up to much and 3) NSF fees are the only fees that count. In choosing a checking account, people choose the type of price they like least. Therefore, bankers should isolate each type of price into its own account; that is, have only one charge in each account. Figure 1 demonstrates Haberfeld’s sample array of checking products.

In this model, there is something for everyone. Each account is simple, saleable, and perceived to be fair. With free checking as the driver, the sales process is amenable to a quick drill, whereby the customer service representative with five simple questions can assist the customer to choose the right account, though 50% choose totally free. This approach uses price to allocate the scarce resource of interest expense.

Haberfeld reports that banks using this structure have seen an average of $143 annual noninterest fee income across the seven accounts, with the highest being $207 per year. The obvious profitability drivers are NSF fees and debit card revenue.
Counterintuitively, Haberfeld recommends unbundling debit cards and charging an annual fee of $12. The take rate of those banks that charge an annual fee is approximately 56%, which is the same as the take or usage rate when the card is free. NSF fees, according to Haberfeld, are the “gold mine of checking.” He says banks he has worked with have generated 86% of fee revenue from NSF and related fees. He recommends three fees: 1) returned NSF check fee [$16], 2) honored NSF check fee [$24], and 3) sustained NSF fee [$5 per day beginning 5 business days after the account is overdrawn and the balance not made positive].

Know your customers, and price accordingly

Based on 22 years of experience with hundreds of banks, Haberfeld’s fundamental insight into NSF checks is that most are written by customers who have simply made an honest, albeit careless, mistake. They do not constitute the low balance, unprofitable accounts. Seventy-five percent of customers write no NSF items, 40% of the remaining 25% write only one to three NSF checks. A mere 3.5% of customers write 50% of the NSF items, with an additional 1.8% writing 33%. Thus, slightly more than 5% of customers write nearly 90% of the NSF items. Some people pay hundreds of dollars a year in NSF fees, but they are not undesirables. Rather, they are often successful entrepreneurs and other professionals. These customers view NSF service charges as a convenience, realizing that it costs them less when banks honors the checks than to have them returned to a vendor. In the final analysis, Figure 2 supports the conclusion that free checking can be profitable by examining the economics per account per year.

Successful free checking depends on superior execution. Greg Hoeck, EVP of Stock Yards Bank, identifies five keys to the success of his bank’s program. First, he says, is consistency. SYB mails 100,000 pieces to 15 branches every six weeks. With 15% of customers swapping checking accounts every year, SYB wants to be squarely in front of the 1.25% monthly who are considering a change. The second key is premiums. “Quite frankly, we were very surprised at people’s enthusiasm for the gifts,” says Hoeck. With each mailing, a different gift or premium is offered to anyone opening a new checking account. Hoeck believes that gifts are the tie-breaker for customers considering several free offers. The third consideration is the personal touch. When a customer opens a new account, he or she is given five coupons that entitle the new account holder to another gift when a friend opens a new account. The tellers also present coupons with each transaction. Hoeck states that the monthly goal is for 2% of branch customers to tell a friend about free checking and for the friend to open a new account. Its actual experience has been that slightly more than 1% of customers introduce a friend to free checking. SYB’s cost of acquisition for new accounts since it began free checking has been $51. The national average for banks under Haberfeld’s program is $44.

The fourth key, according to Hoeck, is employee buy-in. Commitment from the top down throughout the bank is crucial. Employees must be trained, must believe in the process, and must execute consistently and unwaveringly, including decorating branches to create a retail atmosphere and issuing coupons. Finally, success depends on taking a disciplined approach that includes repetitive direct mail, carefully monitoring the response rates to those mailings and adjusting premiums, deliverables, and mailing lists as needed. Finally, Hoeck says, success is contingent on examining carefully the NSF fee process to maximize fee income and minimize risk.

Paying for what’s important

An attractive variation on the NSF theme, called Overdraft Privilege, has been implemented in more than 430 banks ($12B and less in assets) in 38 states by Strunk and Associates located in Houston, Texas. Bill Strunk, a banking consultant for nearly 30 years who developed the overdraft program in 1993, is evangelistic in his belief that banks need to change the paradigm of NSF fees from punitive to privilege. Strunk contends that banks are not going to realize an increase in fee income by raising prices; rather, they should provide a service that generates fees. According to Strunk, banks implementing this program have more than doubled their NSF fee income.

Strunk asserts that typically, NSF fees constitute 25%-30% of net fee income, yet banks undermanage the process. Many have attempted to provide the option of overdraft protection tied to a line of credit or to a credit card, but the business of making small, short-term loans has been neither efficient nor profitable. Most NSF items have been handled by bank personnel who tended to pay overdrafts based on the people they knew. From the customer perspective, overdrafts are frustrating, expensive, embarrassing, and inconvenient. The addition of merchant charges and occasional late fees to the normal NSF fees makes overdrafts more expensive and certainly an aggravation.

Since the old model was working neither for the bank nor the customer, Strunk’s philosophy has been to turn a customer penalty into improved service and an administrative chore into an improved line of revenue. Overdraft protection programs are valuable to customers because they provide a discretionary service where the bank will pay overdrafts up to an assigned limit. This service is neither a right of the customer nor an obligation of the bank. It can be withdrawn at any time. The customer pays the bank’s normal fee for each item that would create an overdraft on the account, and a notice is sent each time an overdraft occurs. This discretionary overdraft service requires no action on the customer’s part. They do not have to sign any additional documents, and it costs them nothing until they use the service. For the bank there are no compliance issues or credit decisions, just customer service. Customers are informed that as long as they keep their account in good standingu00e2u20ac”often defined as making regular deposits and bringing their account balance to a positive position every thirty days or lessu00e2u20ac”the bank will extend the overdraft protection as a noncontractual courtesy.

Strunk provides his clients with a marketing and operational package that includes consulting and training. He advocates free checking as a means to drive new account growth, with overdraft protection primarily promoted internally. In addition to marketing materials, Strunk provides a module to manage the program along with collection letters and a repayment plan to assist banks in providing customer service as well as increasing collections.

The Farmers Bank, a $224 million financial institution in Portland, Tennessee, implemented an overdraft protection program in May 2000. Jerry Taylor, president and CEO, tells of a “little old lady” who drove up to the drive-thru window with a letter in hand shortly after the bank implemented the program informing customers of the new service. “I have $70 in my account,” she said, “and my pension check doesn’t arrive until Friday, but I need to write a $200 check. This letter states that if I write it you will pay it. Is that correct?” The teller responded, “Yes, that is correct. We will pay it, but there will be a fee of $18.”

“I don’t care about the fee,” the woman responded, “I think it’s a great service.”

When Strunk first presented the program to the bank, Taylor says his board needed convincing on two points: offering free checking and the need for a full-time person to manage the NSF process. Since Farmers Bank was already generating about $750,000 annually in NSF fees, Taylor and now the board thought they might improve fee income 20%-30% to cover the overhead and make it worth their while. Instead, fees increased 120% to $1.71 million, and the average balance in the free, noninterest accounts is now $1,000. Such an increase more than justified assigning a person to manage the process. Today, Lynn Henson successfully coordinates the notification and collection process. Last year The Farmers Bank wrote off $250,000 but recovered $150,000 through its managed collection process, yielding a net writeoff of only $100,000 on $1.7 million in revenue.

In the end, banks need to look inward at their customers and decide what they value the most. For many boards looking for ways to enhance customer loyalty while at the same time creating a means to boost bottom-line growth, both free checking and overdraft protection have shown proven results.