A study by the University of Arkansas shows that U.S. banks are losing anywhere from $3.8 billion to $5.3 billion in annual revenue due to the Federal Reserve’s 2010 changes to overdraft policy under Regulation E, the Electronic Fund Transfer Act which required banks to request that their customer opt in to overdraft fees.

Low consumer opt-in decreased the number of accounts charging overdraft fees, adversely affecting bank revenues.

Where Did All the Fee Revenues Go?

Until recently, most banks automatically enrolled consumers in an overdraft protection service thatcharged a fee for one-time debit card transactions and automated teller machine withdrawals that exceeded a customer’s account balance. However, effective July 1, 2010, changes to the Electronic Fund Transfer Act required that consumers opt-in to these overdraft services. Accounts created after the mandatory compliance date of July 1, 2010, were immediately subject to the new opt-in procedure.

If an existing account holder did not opt-in to a bank’s overdraft protection service by Aug. 15, 2010, the bank was required to remove the fee-based, overdraft protection service from the consumer’s account.

Although banks tried to advise their customers on the benefits of overdraft, fewer account holders opted for overdraft:

  • A survey of Arkansas banks found that only 31.4% of all account holders opted for overdraft protection on one-time debit transactions and ATM withdrawals.
  • A recent Center for Responsible Lending study showed a similar rate of 33%.

The overall effect of the Federal Reserve’s new policy has limited the banking industry’s ability to generate fees through overdraft protection services. Banks have seen overall revenues from service fees on deposit accounts fall from $39.2 billion in December 2007 to $34.1 billion in December 2011, a decline of 13%.

How Can Banks Respond?

Because the drop in revenue is quite sizeable, banks will likely take steps to reduce overhead expenses or raise fees elsewhere to offset the lower revenue.

However, the debacle of the $5 debit card fee introduction  shows that consumers are very sensitive to additional banking fees for services they feel they should not even have to pay for, a conclusion recently confirmed by MRI’s recent research. Dan Geller of Market Rates Insight took took this into consideration and recently offered this idea in an article to Banking Strategies.

If each of the 175 million U.S. adults with bank accounts pays $5 per month, potential monthly debit card fees could total $875 million. But banks can generate nearly double this just by lowering their deposit rates by as little as 0.01% a month. A decrease of 0.01% in the current national average deposit interest rate reduces interest expense for banks nationally by about $1.5 billion a month, which impacts the bottom line in the same way as earning this amount through fees.

The national average interest rate for deposits was 0.80% at the end of 2010 and 0.74% in June of this year – a decrease of 0.06% in six months or an average decrease of 0.01% per month. Thus, maintaining the “normal” decrease of 0.01% per month reduces interest expense nationally by $1.5 billion per month, which is nearly twice as much as the total potential income from the $5 debit-card fee if every bank account holder had to pay it.

Dan explains that customers are not likely to react to a slight decrease in deposit rates as they did in the debit fee controversy.

Why? The 0.01% monthly change should not adversely impact deposit balances if accompanied by higher levels of pricing precision and analytics to avoid deposit mispricing.

The leading cause of deposit mispricing is the inability to identify various types of CDs (beyond term and tier) when establishing a rate. The APY variance between a regular CD and other CD types, such as the callable CD, can be as much as 39 basis points (bps), so if a rate is set without knowing the type of competing CD, an overpricing of up to 39 bps can occur.

By improving their pricing precision and analytics, banks can maintain a healthy net interest margin and protect their bottom line during the next two to three years until the economy recovers. Better yet, this objective can be achieved with minimal effort and, most importantly, without alienating customers.