Is your bank’s overdraft strategy letting you down?

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For most consumers, being hit with an overdraft or insufficient funds (NSF) fee feels like a penalty, even if the bank that charged it funded a transaction beyond the account balance.

Consumers don’t really see NSF charges as the price of a short-term loan; they see them as a fine that makes a bad mistake worse. And for low-income consumers, an NSF event can trigger a cascade of issues.

For community banks, NSF fees represent an important source of non-interest income (NII). They are an ingrained source of income that is not easily replaced. The big question is how they should balance their reliance on royalty revenue against consumer annoyance with NSF royalties.

In this article, I’ll unpack this problem and look at real-world strategies community financial institutions are using to grow their NII in a user-friendly way.

The Double Threat to NSF Revenue

No bank relies on NSF fees alone, but every time the net interest margin squeezes, bank executives look for ways to use NII to fill the gap…unless you’re Ally Bank , Capital One or a handful of other major financial institutions that have found ways to eliminate NSF income and maintain healthy incomes.

This competitive imbalance places community banks in a difficult position, especially given the low opinion 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 so diversified – the loss of income barely hurts their bottom line. In some cases, they never had NSF income in the first place.

Take Ally for example:

*Only banks with over $1 billion in assets are required to report overdraft fees

Ally’s return on average assets after eliminating the NSF charge fell by a quarter of 1% – think about it: it still rounds up to the same number! If other institutions (banks holding more than a billion dollars in assets) were to follow, their ROAA would fall by almost 4%.

As you watch neobanks and megabanks cut their NSF fees to ribbons, remember that they can afford it through various revenue streams. Does this mean NSF revenue could disappear for the entire industry? Unlikely. The future of NSF fees is not set in stone, but community banks need to plan ahead and consider alternatives.

An eye on the future:

Don’t assume that overdraft fees should be eliminated entirely, but start looking for substitutes to foster profitable behaviors.

What are the viable alternatives?

One of the most common sources of NII is interchange, or the fees charged to retailers and merchants each time a consumer uses their debit or credit card.

Here is a typical breakdown of the NII and interest charges of a checking account with an average monthly balance of $4,000.

You would need to double the monthly debit card transaction volume of this account in order to make up for lost revenue from NSF charges.

Consumers may use their debit card more if you ask them nicely, but they won’t double their point-of-sale purchases overnight. Sounds like swapping isn’t a very sustainable option, is it? Not so fast. Let’s take a closer look.

What NII strategies do community banks use to succeed?

The road to a more diverse income stream is not paved with a one-size-fits-all solution. It takes a comprehensive strategy with four main components:

  1. Use consumer segmentation and analytics.
  2. Implement flexible retail products.
  3. Continuously monitor and optimize programs.
  4. Leverage consulting and business tools that drive results.

The problem many banks find themselves in is that they look too closely at their account holders and underestimate the potential of products that drive profitable behavior.

Which brings us to the next question you should ask yourself: “Where next year’s profit comes from?”

Analyze account holder behavior to find an opportunity

In the table below you can see data from a real Kasasa customer in 2021. We were looking for “ New the activity was generated by the account holders? In other words, who was generating transactional revenue and opening new consumer loans (auto, home, personal, etc.)? These four account holder segments reveal remarkable results. If you compare group 1 and group 4, you see high contrast in almost all measurements. While Group 1 is the oldest and holds the most deposits, it also generates the least annual profits – it is reasonable to assume that it is financially mature and is winding down its economic activity. Group 4 is clearly much more transactional, has high loan needs, and has the most NSF events (not that we’re aiming for that).

*New loans opened after the launch of our products

The answer to the question of where next year’s profits will come from is “younger, more transactional consumers.”

The future of NII is the future of income in general

The previously mentioned four-part formula can be used to transform your revenue generation approach at all levels:

1. Use consumer segmentation and predictive analytics
Broaden your definition of relationships with account holders. Understanding consumers and anticipating their needs enables you to deliver a world-class account holder experience. Look at how consumers fit into the overall balance sheet, not just cost of funds or interest income – include non-interest expenses, revenue by relationship, transaction volume and loan balance ratios -deposit. Recognize that consumers have different entry points for products 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 swapping). Products tailored to consumer needs can help you control your balance sheet when the economy is changing. Financial literacy has its place, but it’s much more effective to offer products that encourage consumers to adopt beneficial behaviors. The best products offer a win-win solution for your bank and the consumer.

3. Continuously monitor and optimize programs
Engage in new relationships early on and monitor the behaviors you want — you can even prompt behaviors that align with your goals. The ability to analyze and react quickly to changes in consumer behavior will help you improve profitability and long-term growth.

4. Leverage consulting and business tools that drive results
Armed with micro and macro insights into 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 personalized email campaigns using behavioral triggers.

When considering your institution’s strategy for generating NIIs, you should aim to make your account holders feel as empowered as possible. Remember that consumers often feel frustrated and overwhelmed by NSF charges. How can you turn this service into something that feels like added value rather than a penalty? What products and services can you offer to help account holders achieve their financial goals and feel good about their money?

While I can’t answer these questions for you, if you follow the four-part formula outlined above, you’ll discover answers that align with your account owners and your goals as an institution.

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