Fees have afforded the banking industry shelter in a difficult interest rate environment. But such “easy money” is actually a threat to banks that have an overreliance on fee income. Two recent Wall Street Journal articles1 touch on the topic, which I’ll explain and expand upon here.
In 2020, banks earned over $31 billion in overdraft fees. While down about 10% from prior years, such fees still represent a big part of banks’ bottom lines. In addition to overdraft fees, banks earn revenue from wire fees, account maintenance fees, etc.
The cost of administering these fees is fairly low so most of the revenue falls to the bottom line. Such fat profits set up a big target for fintech companies. And that’s as it should be. A credit card company might need a wide net interest margin to cover average losses which are higher than other lending products, but at least there’s a relationship to the basic underlying economics.
But another way to view those “easy” profits to a bank is as a win-lose situation with the customer. Such a situation probably won’t (and shouldn’t) last long. The competition will find its way in eventually.
The risk to bank profitability isn’t small. In Bank of America’s Consumer Banking division, for example, service charges amounted to $3.4 billion. Removing these from the equation results in the bank’s efficiency ratio deteriorating from 56.8% to 63.3%2. Banks will either have to live with this new normal (and analysts will revise their expectations accordingly). Or banks will need to become more efficient.
When I’m analyzing a bank I look for those with minimal reliance on non-interest income, especially fee income. There are banks that have figured out how to operate efficiently doing the basic but profitable business of lending to consumers and businesses. These banks keep overhead in check and realize that their primary goal is to make sure they’re 100% on top of the risks they’re taking with shareholders’ capital.
The days of easy money for banks are gone. Investors and managers should recognize that basic reality and act accordingly.
The efficiency ratio is the ratio of non-interest expense divided by the sum of net interest income and non-interest income. It’s an overhead ratio essentially, which means the lower the better.