June 23, 2009

Free Checking: A Customer Favorite is Re-Examined

By Chris Costanzo, AMERICAN BANKER

Free checking, a darling of retail banking since its introduction 15 years ago, is under pressure.

Resistance among regulators and consumers has intensified against the revenue model that for years has propped up free-checking: The charges levied against the relatively small share of customers who pay for account overdrafts and nonsufficient funds. As scrutiny increases over how free checking works, the business model that underlies what has become an industry standard may have to evolve.

Banks are reluctant to tinker with a product that has attracted waves of depositors over the years. But as forces including legislative action, new products and emerging competition begin to work against the profit model for free checking, a rising number are questioning its future. “In this environment, all bankers have to ask, ‘Where are our sources of revenue?’ ” said Thomas Dyck, the executive vice president of retail deposit products at TD Bank in Cherry Hill, N.J.

Today the biggest source of revenue in the retail deposit business is fees imposed on customers who are careless with their checking accounts. These so-called incident fees now produce 74% of all deposit fees, according to a report released in May by Oliver Wyman, the New York consulting firm. Without those fees, which run $35 to $40 per incident, the industry would not be able to cover the costs of offering no-monthly-fee, low-balance checking accounts to all customers.

The current fee structure is precarious, some say, because of its heavy reliance on a small number of customers. Sixty-eight percent of the fee revenue related to nonsufficient funds comes from 5% of banking customers, according to Oliver Wyman, which examined FDIC data. These customers on average are paying $1,610 a year in nonsufficient-funds-related fees, but 74% of customers pay no such fees.

Banks should not continue to rely on the revenue stream coming from that 5%, said Aaron Fine, a partner in Oliver Wyman’s retail and business banking practice and the author of the report. “The industry has to change pretty dramatically because a substantial amount of the revenue that paid for free checking is likely to go away,” he said. “That business model is not sustainable.”

One reason is that consumers who tolerated high fees now have other options available, such as prepaid debit cards, which replicate many of the functions of a checking account without imposing overdraft uncertainty. Another reason is more aggressive regulatory activity, including a push for improved disclosures on overdraft policies, as well as proposed changes to Regulation E that would let customers limit overdraft costs.

The lengthy recession is another factor threatening free checking’s fee structure, Fine said, because consumers use their debit cards less frequently as they curb spending. Debit cards have historically caused consumers to incur more incident fees by making it easy to deduct money from checking accounts at the same time that checks might be pending.

Despite the dire warnings about free checking’s viability, many banks expect the product to have a long life. “There will always be a role for free banking,” Dyck said. “The question is, under what context?” He predicted that banks might require customers to buy additional products to obtain free checking.

Hugh Gallagher, a senior vice president at SunTrust Banks of Atlanta, was more direct in his optimism. Paraphrasing Mark Twain, he said, “Recent reports on the death of free checking have been greatly exaggerated.” The fact remains — and any consumer research report supports it, he said — that the general public does not like to pay monthly maintenance fees on checking accounts. Banks with the fastest deposit growth over the last four to five years have charged the lowest service fees, and those with the slowest growth have charged the most, Gallagher noted. “Given the importance of deposits, why be in the high-fee, low-growth category?” he asked.

An institution’s strategy — for instance, a focus on high-net-worth customers — may dictate a move away from free checking. But for those institutions focused on the mass market, “I don’t see the elimination of free checking as a viable option,” Gallagher said.

His opinion may be well-founded, especially since some of the regulatory changes that stirred up fear about free checking’s future appear to have less bite in their latest incarnation. The proposed changes would prohibit banks from imposing overdraft fees unless they offer customers the ability to opt out of the service. Originally, the opt-out requirement applied to automated teller machine withdrawals, debit card transactions and checking accounts. But the latest proposal would not require banks to offer an opt-out on checking accounts.

According to “Consumer Compliance Outlook,” a publication of the Federal Reserve System, “Testing revealed that consumers found overdraft fees acceptable in the context of checks.” People figured they would be charged a nonsufficient-funds fee even if they opted out of an overdraft service.

Though the regulatory stance may have eased, new products coming to market will make it increasingly difficult to keep hitting customers with punitive fees. ING Direct, for example, now offers a checking account called Electric Orange that pays interest along with free overdraft protection. Under ING Direct’s model, people pay interest on overdrawn balances but do not incur incident fees. Online-only ING Direct can still earn money on these accounts because it does not have a traditional branch network to support.

The changing competitive landscape is beginning to register with the industry. SunTrust, for example, remains firmly in the free checking camp but has recently made changes in its three core checking account offers that indicate a responsiveness to the growing backlash against punitive fees.

On its basic free checking account, SunTrust now offers a discounted rate on a customer’s first nonsufficient-funds incident. Its mid-range account now waives one nonsufficient-funds item per year, and its premium account waives three such items per year. These changes derived from an effort begun more than a year ago to expand deposits, Gallagher said. “We knew we had to evolve to something that was consumer-friendly, versus a nickel-and-dime approach,” he said.

Many paths are open to banks that want to lessen the importance of incident fees to the bottom line. “We think this is the time for real innovation and product design on the fee side,” said Sherief Meleis, a managing director at Novantas in New York and the head of its retail banking practice.

Meleis expects banks to develop more creative checking and savings account products. Already some “really distinctive” products have been developed, he said, including PNC Financial Services Group Inc.’s Virtual Wallet. Virtual Wallet’s attraction does not revolve around free checking but rather the way the account is structured. In keeping with the way PNC’s research shows young people compartmentalize money in their minds, the account lets them funnel money into label buckets labeled spend, reserve and grow.

In the long term, SunTrust’s Gallagher said, he expects banks will find ways to drive debit card use, since higher debit card activity can significantly boost the profitability of associated checking accounts. “If you can get clients more engaged to do debit and double your profit, you don't need to stick them with a fee.” he said.

Bank of America has been particularly energetic in its efforts to spur debit card activity through product innovation. At the same time B of A is steering clear of overemphasizing the low cost of its checking accounts. The word “free” does not appear as a descriptor on any of the bank’s checking accounts, even for those that do not charge a monthly maintenance fee. Though free checking may be here to stay, banks clearly are exploring other ways to get consumers’ attention. “There are lots of levers to pull,” said Gallagher.

Ms. Costanzo, American Banker’s technology editor from 1998 to 2002, is a freelance writer in Maplewood, N.J.