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      Home » Debit Card, Fee Income, Regulatory, Strategy

      The Evolution in Non-Interest Income

      Submitted by on Friday, November 1, 20132 Comments

      Three seminal but seemingly unrelated events are suggestive of the pressures the financial services industry is likely to face in 2014. These pressures are changing the fundamental business models of financial institutions.

      First is the decision by US District Judge Richard Leon to send back to the Fed for revision its cap on debit card interchange.  As most are probably aware, in 2011 the Fed issued its ruling on debit card interchange rates in response to the Durbin Amendment.  That ruling in essence cut the effective interchange rate in half for the largest banks.  The indication now is that debit card interchange rates will be cut another 50%.  All this was done ostensibly to benefit the consumer.  We have yet to see any hard evidence that the consumer has benefitted from this action.  If fact, it is safe to say that the consumer has been hurt by this action – many of the debit card rewards programs that were so prevalent prior to Durbin have been scaled back or eliminated.

      The second event was the release by the Consumer Financial Protection Bureau (CFPB) of a study on overdrafts.  The study found, surprisingly, that those consumers who had opted for overdraft coverage on their checking account paid more in overdraft fees.  The study also found that while 16% of all accounts had opted in for overdraft protection, those with high levels of overdraft activity, defined as 10 or more overdrafts in the first half of 2010, opted in at a rate of 45%. The CFPB views this as negative – those who have higher levels of overdraft activity are more likely to opt-in to overdraft coverage and thus are paying more in fees.  However, a market perspective would view this positively – consumers who want their items paid and don’t want to be rejected at the point of sale are able to obtain this service.

      The bigger implication of this CFPB study, however, is that when a government agency studies an issue, it often is a pretext for regulating it.  In this case, we should not be surprised if additional regulations / restrictions on overdraft programs emerge.  For example, it is not outside the realm of possibility that the CFPB will undertake a study of the cost to the financial institution of processing an overdraft item, similar to the Fed study on the cost of processing a debit card payment.  Such a study could ultimately result in a cap on the size of fee that could be imposed on overdrafts. Other types of limits could emerge, including a cap on the number of OD items each day that could incur a fee.

      The third event was the recent decision by the Federal Reserve to not alter its bond buying program. This decision shocked many industry observers because some believed that the Fed had been telegraphing an imminent change in its policies.  The implication for financial institutions:  no change in Fed behavior means no significant movement of rates in the short term, and thus no reduction in the margin pressure the industry is experiencing.  However, it’s more likely that margin pressure will persist regardless of the direction or movement of interest rates.  The CFO may say that as interest rates move up, loan and asset yields will improve and they will hold the line on cost of funds, thereby increasing margins.  The reality is that customer demands as well as competitive pressure are likely to force your cost of funds to rise as rapidly as asset yields.

      The bottom line is that earnings generation is likely to be challenging in 2014, especially as loan loss provision expense has generally returned to pre-crisis levels.  Margins are flat, non-interest income is under pressure, expenses continue to climb, and the provision expense cannot be reduced any further.

      The solution for the industry will be to grow its non-interest income, but not in the traditional categories.  Non-interest income will have to be an increasing portion of a financial institution’s bottom line, even as some of the traditional sources of non-interest income (overdraft income, debit card interchange) are under increasing threat.  Greater innovation will be required in this realm, and high performers will be characterized by growing non-interest income from non-traditional sources.

      Given this, we will leave you with four considerations regarding non-interest income:

      1. Don’t build a dependency on income sources that are cyclical in nature.  The entire industry has benefited from the mortgage refi boom, but if achieving your ROA goals was dependent on mortgage refi, you may be in trouble in 2014.
      2. “Fee” is not a dirty word.  Understand that the purpose of fees is in many cases as much about changing behavior as it is generating income.  Prime examples are paper statement fees and debit card or online bill-pay non-use fees.  In imposing these fees your objective generally is to generate as little income as possible; instead you are looking to create a change in behavior among your customers that is even more beneficial to your organization, and ultimately, to your customers.
      3. Products which at one level of service cannot be priced can (and perhaps should) be priced at elevated levels of service.  This is the Amazon model of expedited shipping.  If you want an item sooner, you pay a little more.  The example in this industry is mobile deposit capture.  Given the competitive state of things we may not be able to price for standard funds availability, but could we price for expedited funds availability?  For example, for a fee we might give the customer immediate access to the funds deposited through the mobile device.  We are taking on risk and are being compensated for that risk.  Expedited funds availability in turn may help a customer avoid an overdraft charge, so they may be very willing to pay that fee.
      4. Non-fee sources of non-interest income should represent an increasing share of the total.  What this means is simple – think beyond the balance sheet.  Revenue generated by products and services that are not deposits and loans should be increasingly emphasized. Wealth management, insurance and other similar services should have a higher priority in an organization.

      Point #4 may be the most important of the four items. Within the banking industry, the non-bank subsidiaries have to take on a greater responsibility for the success of the organization.  In the credit union industry it is the CUSOs which need to move to the forefront.  In an upcoming Raddon Report article, we will examine a program created by a bank to drive more non-interest income to the organization through a very innovative wealth management program.

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      2 Comments »

      • Rich Jones said:

        Excellent overview Bill, a little pessimistic, but that seems to be the state of affairs in the banking world today… Thanks.

      • Tony said:

        Excellent article. We are in a post-responsibility era, and the regulations are expanding exponentially. Earning a profit is cause for suspicion by the CFPB.

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