Fee income, once thought by bankers to be the answer to declining interest margins, has become an increasingly complex management challenge. Bank fees considered inappropriate or excessive contributed to the atmosphere that led to passage of the Dodd-Frank Act and are certain to be addressed in upcoming regulations. But banks have always found fee generation to be challenging.
The core challenge for bankers can be explained in a single phrase: it is difficult to disguise or bury the markup on a dollar. For example, when I buy a suit, I exit the clothing store carrying the suit, perhaps with alterations, on a hanger in a garment bag.
I know from my sales slip what I paid for the suit and perhaps for the alterations, but it is unlikely that I have the information to break down the cost of the hanger and garment bag. But in a well-run store, the cost of each is certainly included in the price.
Contrast that experience with going to an automated teller machine (other than one at my own bank) and withdrawing money. Not only is the fee for withdrawal explicit, but I am allowed to reconsider making it if I am unhappy about the fee. Fees added to most transactions are obvious and provide an opportunity for customer disgruntlement.
To put this in context, consider the remarkable advancement of ATM access. Before ATMs became ubiquitous, it could be quite difficult to convert bank balances to cash — especially while traveling or away from an area with a branch of one's own bank.
But the banking industry spends hundreds of millions of dollars establishing, running and updating ATMs worldwide. Banks overcame both technological and antitrust challenges to integrate multiple systems, allowing customers not only to withdraw cash but conduct a number of banking functions thousands of miles from their bank or branch. Even when out of the country, bank customers can still conduct business at competitive exchange rates.
Three decades ago such services were hard to imagine. Now they are common. But if one listens to bank customer reactions one is more apt to hear complaints about the fee rather than admiration for the ease of today's banking services.
The growing reliance on fee income was a natural industry reaction to declining interest rate margins, a trend that began in the 1980s and has continued steadily. Some of the fees came from the addition of products such as insurance sales. Some banks chose to focus on low-hanging fruit for fee growth, such as overdraft fees or late fees on installment loans or credit cards.
Some of the more risk-prone bankers actually promoted products that were likelier to generate the "gotcha" fees, such as subprime credit cards or minimum balance checking accounts with heavy fees for overdrafts.
As is often the case, the practices of a few banks came to be seen as representative of the entire industry and therefore came to the attention of consumer groups and ultimately Congress.
Banking fees thought to be unfair or disproportionate to underlying costs were a prime area of debate surrounding Dodd-Frank. Some fees were unjustifiably high and made the entire industry vulnerable, but all banks will need to rethink their approach to fee income in light of the new focus.
The highest-profile example of the fee focus is the Durbin amendment, which directed the Federal Reserve to draft regulations that mandated a precise formula for the interchange fees that could be charged to merchants for debit card transactions.
While merchants view the amendment as banks finally getting their due, many banks say that the required formula does not even cover their full cost and that it will reduce the availability of debit cards. In addition, the newly established Consumer Financial Protection Bureau is expected to scrutinize both the types of products offered by banks and their fees. The agency will emphasize fairness and service to consumers.
How should bank management respond to this focus? Our strong recommendation for banks is to rethink product selection, fee generation and compliance integration with a renewed emphasis on customer fairness. Beyond safety and soundness, bankers need to think about services from the consumer perspective. In addition to cost considerations, fees need to be value-based and not simply determined by what the market will bear.
Product selection also will be a key part of the banking industry's commitment to customer fairness. Certain retail financial products — subprime credit cards come to mind — provide limited consumer value but tend to generate maximum up-front fee opportunities for banks and often longer-term credit risk exposures.
Fee generation is an increasingly difficult management issue for bankers, but it will be more manageable for those bankers who give strong consideration to the customer's perspective.
