By Patrick Dickson | 05/19/2022
Topics:BLOG, MARGIN COMPRESSION
For most consumers, an overdraft or NSF fee feels like a penalty, even if the financial institution charging it has funded a transaction beyond the balance in the account. Consumers don’t really see it as a short-term loan, they see it as a bad mistake being made even worse. And for low-income consumers, an NSF event can trigger a cascade of problems.
For community financial institutions, NSF fees represent a significant source of non-interest income (NII). They are an ingrained source of revenue that is not easily replaced. The big question for community banks and credit unions is how they should balance their dependence on NII with the dislike that consumers feel towards NSF fees.
In this article, I’ll unpack this issue and examine strategies that community financial institutions (CFIs) are using in the real world to grow their NII in consumer-friendly ways.
The double threat to NSF income
No CFI relies solely on NSF fees, but any time that net-interest margin compresses, bank and credit union leaders look for ways to use NII to fill the gap... unless you’re Ally Bank, Capital One or a handful of other institutions who have found ways to eliminate NSF income and keep their revenue healthy.
This competitive threat puts CFIs in a difficult spot, especially when you consider the dim view that federal agencies have of overdraft practices.
The regulatory threat is real, but the competitive threat is greater and has an immediate effect on consumer sentiment. Many neobanks and institutions can eliminate NSF fees because their income is highly diversified — the lost income (or in some cases never included NSF in the first place) barely damages their bottom line.
Take Ally for instance:
The return on average assets for Ally after eliminating NSF fees fell by a quarter of 1% — think about that: it still rounds to the same number! If other institutions (banks holding +$1B in assets) were to follow, their ROAA would fall by nearly 4%.
When you’re watching neobanks and megabanks slash their NSF fees to ribbons, remember that they can afford it thanks to diverse income streams. Does this mean that NSF income might disappear for the entire industry? Unlikely. The future of NSF fees isn’t set in stone, but CFIs need to plan ahead and examine alternatives.
What are the viable alternatives to NSF?
One of the most common sources of NII is interchange, or the fee charged to retailers and merchants every time a consumer uses their debit or credit card.
Here’s a typical breakdown of NII and interest expense from a checking account with an average monthly balance of $4k.
You would need to double the monthly debit card transaction volume of that account in order to offset lost NSF fee income.
Consumers might use their debit cards more if you ask them really nicely, but they’re not going to double their point-of-sale purchases overnight. Seems like interchange isn’t a very sustainable option then, right? Not so fast. Let’s look closer.
What NII strategies are community financial institutions using to succeed?
The road to a more diverse income stream isn’t paved with a single solution. It takes a comprehensive strategy with four primary components:
Use consumer segmentation and analytics.
Implement flexible retail products.
Continuously monitor and optimize programs.
Leverage consulting and enterprise tools that drive results.
The trouble that many CFIs find themselves in is caused by looking too narrowly at their account holders and underestimating the potential of products that drive profitable behaviors.
Which brings up the next question you should ask: “Where will next year’s profit come from?”
Analyzing account holder behavior to find opportunity
In this chart you can see data from an actual Kasasa client in 2021. We were looking for “what NEW activity was produced by account holders?”. In other words, who was generating transactional income and opening new consumer (auto, home, personal, etc.) loans? These four account holder segments reveal some remarkable findings. If you compare Group 1 and Group 4 you see a high contrast in nearly every metric. While Group 1 is the oldest and holds the most deposits, they also generate the least annual profit — it’s reasonable to assume they’re financially mature and are winding down their economic activity. Group 4 is clearly far more transactional, has high lending needs, and has the most NSF events (not that we’re aiming for that).
The answer to where next year’s profit will come from is, “Younger, more transactional consumers.”
The future of NII is the future of income in general
I’d like to expand the four-part formula from earlier, that you can use to transform your approach to generating revenue across the board:
1. Use consumer segmentation and predictive analytics.
Broaden your definition of account holder relationships. Understanding consumers and anticipating their needs allows you to deliver a world-class account holder experience. Look at how consumers fit into the entire balance sheet, not just cost of funds or interest income — include non-interest expense, products per relationship, transaction volume, and loan-balance-to-deposit ratios. Recognize that consumers have different product entry points and it’s your job to communicate all the ways you can help them.
2. Implement flexible retail products.
Select products and tools that drive engagement (such as interchange). Products that are tailored to consumers’ needs can give you control over your balance sheet when the economy is in flux. Financial literacy has its place, but it’s far more effective to offer products that lead consumers into beneficial behaviors. The best products deliver a win-win for your institution and the consumer.
3. Continuously monitor and optimize programs.
Engage with new relationships from the start and monitor for the behaviors that you want — you can even incentivize behaviors that fit into your goals. The ability to analyze and respond quickly to shifts in consumer behavior will help you improve profitability and long-term growth.
4. Leverage consulting and enterprise tools that drive results.
Armed with micro and macro perspectives on the industry as a whole, as well as enterprise tools, you can stay ahead of your competition. You can also improve marginal engagement with existing relationships through communication, especially 1:1 tools such as SMS text and customized email campaigns using behavioral triggers.
As you examine your institution’s strategy for generating NII, you should aim to make your account holders feel as empowered as possible. Recall that consumers often feel frustrated and overwhelmed by NSF fees. How can you turn that service into something that feels like a value-add instead of a penalty? What products and services can you offer that help account holders reach their financial goals and feel good about their money?
I can’t answer these questions for you, but if you follow the four-part formula I outlined above, you’ll uncover the answers that fit your account holders and your goals as an institution.