Overdraft Fee Income: What Your Bank Is Missing

Unless you are the very rare circumstance, your overdraft fee income could be significantly improved. Why? Because, as an industry we have taken our eye off the overdraft fee income ball. The hyper-focus of regulators on overdraft fees created compliance concern, rule changes and class action litigation caused fee income to drop, and some banks even reduced their overdraft fee. As a result, fee income began to drop dramatically year-over-year, and we just accepted that as a reality we could do nothing about. That’s no longer the case! In fact, overdraft fee income across the industry has actually been increasing slightly over the past year. Is yours? Plus, the regulatory concern has softened significantly.

What did this trend cause us to do? We stopped thinking about how we could increase our OD fee income. We stopped managing our overdraft program as a line of business! I see it every day with prospects and clients. Penetration rates are far below where they should be. Reg E opt-in rates are extremely low. Management oversight is not focused on the processes to ensure these things don’t happen. If I asked you to tell me right now, what your current penetration rate is or your opt in rate – would you know? You should. Strunk provides all the tools you need – but someone must monitor the metrics so you can take action if necessary. And the ‘taking action’ part is not a process that can be ‘automated’.

Penetration and opt-in are the key indicators underlying the health of your overdraft program. When you think about it, no one can cause consumers to just decide to overdraw their checking account more often. The best we can do is communicate the fact that the program is available and let them know what their limit is, so if they have a need, they will use it. But creating a dramatic shift in consumer behavior, well, that’s the fool’s errand.  However, what you can do is make sure virtually all of your accounts are IN the overdraft program. And you can put initiatives in place to improve Reg E opt in. These things increase the number of consumers who can potentially produce an overdraft fee, and they increase the transaction activity that can produce an overdraft fee. That’s how you move the needle on fee income.

Another issue that plagues overdraft program performance is an irrational focus on charge-offs. This might sound almost sacrilegious, but if you are focusing on charge-offs you are watching the wrong line item on the P&L!  It’s natural for us to think about minimizing losses because we think about losses in the context of our lending business. However, unlike any other line of business we manage, the metrics of an overdraft program do not behave in the same way as the metrics of a loan portfolio. In the case of a loan portfolio, generally speaking, if you manage to find ways to reduce delinquency and loan losses within your existing portfolio that just reduces expense and improves profitability. It does not have an impact on the interest income produced by those existing loans. But, in the case of an overdraft program the behavior is dramatically different. Actions that may reduce charge-offs – taking certain consumers out of the program based on some subjective criteria or reducing certain consumers limits – don’t just reduce perceived risk and potentially reduce losses, they reduce the revenue of the program as well. In fact, far more than they will reduce losses!

Typically, our average program experiences losses equal to 5% of fee income. As shown on the pro forma below, if the program generates around $2.5M per year in fee income the annual charge-offs would typically be about $125K. Operating expenses and funding cost (cost of funds to fund the average overdraft outstanding) are very low. So, the bottom line for the program is still significant – over $2.1M. If you were to compare this with the profitability of any other line of business you manage – well…there is no comparison. To compare fairly you need to common size the relative profitability. We have done that using ROE – or return on capital – as the common-size measure. The typical commercial or consumer loan portfolio might generate an ROE of 18% – and extraordinary performance would be in the 20-25% range. The ROE on the typical overdraft program is about 100 times that! Even if charge-offs were double our 5% guideline, the bottom line would still be almost 100 times the ROE of a loan portfolio. The reality is that it would be impossible to end up with a charge-off result high enough to make the program not look extremely profitable – and more profitable than any other line of business you have. When you think about it, why else would regulators target this business like they have for the last decade and a half?

That’s what I mean when I say managing the charge-off line on the P&L is the wrong line to be worrying about. What we want to do to maximize profitability is make sure we have the highest possible percentage of consumers with a limit, try to get as many of those opted in for Reg E, and make sure everyone has a reasonable limit and knows exactly what that limit is so they use it. That’s been the formula that has made the Strunk program work for over 30 years. When we start trying to over complicate the process – decide that certain individuals shouldn’t be in the program because we believe they may be higher risk than others or decide to give certain individuals lower limits than others – we upset the apple cart. We take too many people out of the program or reduce the limits on too many accounts and reduce fee income more than we reduce losses – possibly far more.  Remember, only 8% of accounts produce almost 80% of overdraft fees. What happens if you take too many of those account holders out of the program or reduce their limits? There’s no way reduced charge-offs could come close to make up the difference!

Strunk has implemented and assisted with the management of more overdraft programs than any other firm in the industry. Let us help you maximize the performance of yours! For more information, please contact us at info@strunkaccess.com, visit https://strunkaccess.com/bank-and-credit-union-overdraft-privilege-software/ or call 800-728-3116.