Every banker clearly understands how margin compression negatively impacts bank income. Traditionally bankers have lived off the difference between interest paid on funds they borrow (deposits) and the interest earned on the loans they make to businesses, governments and individuals. With interest rates continuing to hover near historic lows, deposits are being paid very little interest, and the outstanding loans are being re-priced to where they, too, are at all-time lows. The result is that the spreads, or margins, have dropped to unprecedented low levels.
How do banks make up the loss of income due to margin compression? For community banks, this issue has been particularly difficult. As banks grow, they are able to provide additional professional services that customers pay for through fees, such as wealth management or trust services, insurance product sales and, for the very large banks, international transactions.
Recently I was interviewed for an article about this phenomenon. The journalist, who I have worked with for many years and always found to be competent, had never comprehended that size matters in banks’ ability to generate fee income. But size does make a difference. In the area of trust services, for instance, many community banks provide estate settlement services, which typically are short-term and involve a standard process. It is not unusual, then, for a smaller bank to have someone on staff who can provide this basic service. However for additional trust services, it is not cost-justifiable for a smaller bank to add a trust officer to staff, if the bank operates in a community with a limited pool of wealthier consumers who may need those services. In other words, there simply is not enough potential fee income to cover the salary and administrative support for an enhanced level of trust service. The situation might change if the the bank grows to serve a larger geographic area, or moves into a more metropolitan area, at which point there comes a time when hiring a trust officer becomes justified.
What can smaller banks do to generate fee income to offset the loss of income due to margin compression? Last week in an American Banker article titled “Small Banks Taking Serious Look at Adding Fees,” it was suggested that small banks need to provide optional services for a fee. Case in point: A basic checking account could continue to be free, but the option to give immediate credit for checks drawn on out-of-town banks would bear a transaction fee. No one has to choose that option, but the customer who relies on immediate credit will gladly pay a reasonable fee for the service. The key is to create options. An article commenter expressed concern that it would be a hard sell to persuade customers to pay fees on transactions that affect only their money. For example moving a customer’s money from his or her savings account to the customer’s checking account, to prevent an overdraft in the checking account, would not likely be a fee opportunity for the bank, because both ends of the transaction involve moving the customer’s own money.
While I wish I had the answers to this daunting dilemma, I do not. Every bank and every community has its own unique set of circumstances that affect when and how fees can be charged. I will admit that the idea of providing options to our customers is appealing. It permits banks to provide a free, “no frills” option, but also allows banks to add fee-based services for those customers who need or want them. The options are based on customer choice … and we Americans always like choices.