Free Checking Thrives at Smaller Banks, Durbin Notwithstanding

Free checking may be nearing extinction at large banks as they attempt to recoup lost debit interchange revenue, but at smaller institutions the product is not even an endangered species.

Nearly two thirds of big banks have eliminated free checking since the end of 2009, adding fees or changing the terms of some 4 million consumer deposit accounts, according to the research firm Moebs Services. The cuts were largely in anticipation of the Federal Reserve Board's new restrictions on debit interchange, which will slash the revenues that banks earn every time their customers shop with their debit cards.

Since the regulations were proposed in 2010, bankers and payments industry executives warned loudly and repeatedly that they would no longer be able to afford to offer free checking and debit rewards. Many of the biggest banks, including JPMorgan Chase & Co. and Wells Fargo & Co., now are making good on that threat.

But free checking is still alive and well at most banks and credit unions with less than $50 billion worth of assets. Community bankers say they will continue offering free checking for the foreseeable future, even if they're not entirely happy about it.

Charging for checking accounts is "just not going to be possible for us. … We'd lose the accounts," says James Maloney, Chairman of Mitchell Bank in Milwaukee.

"We're kind of in a holding pattern, and until we know anything more, we're just going to live with it," he says. "It's been a discussion for the last three or four months at the board, and everyone seems to be of the consensus that we shouldn't be the one to start charging."

Like most bankers, Maloney dislikes the Durbin amendment on debit interchange. Under that provision of the Dodd-Frank law, the Fed capped debit interchange fees at about 24 cents for the average transaction, almost half the previous average of 44 cents.

Big banks including JPMorgan Chase & Co. and Bank of America Corp. have since cut rewards programs, discontinued certain types of accounts, or started charging customers for deposit accounts that were once free. Wells Fargo & Co. said this month it would start charging some customers $3 per month to use their debit cards, as part of a test in some states.

But unlike their largest competitors, Mitchell and other community banks have few immediate options for recouping their lost debit interchange revenue. For the smaller banks and credit unions that have long relied on close relationships with their customers and local communities, charging new fees could be tantamount to suicide.

"To tell our customers that we're going to start to charge them when we have the free checking, we think that might be a big problem," says Maloney.

Some community bankers see free checking as their latest opportunity to set themselves apart from the purportedly "Too Big to Fail" banks that have become lightning rods for public criticism since the financial crisis. The ultimate goal, of course, is to poach those big banks' customers.

Noah Wilcox, chief executive officer of Grand Rapids State Bank in Minnesota and director-at-large of the Independent Community Bankers of America, says his company has benefited from the larger banks' struggles.

"We've certainly picked up business. I operate in a market that has multiple systemic institutions operating. … This whole entire crisis really has caused consumers to pay a little closer attention to where they put their money and how that organization behaves," he says.

Marcus Schaefer, CEO of Truliant Federal Credit Union in Winston-Salem, N.C., similarly calls free checking "an opportunity for us to have another way of differentiating ourselves from large financial institutions."

Truliant has no immediate plans to start charging for checking, and Schaefer says the policy would change only as a last resort.

"The worst-case scenario is if we have households that only use our checking, that don't use any other services … If they have an auto loan and a debit card, and that's all they have, we might look at that [charging some customers for checking accounts]. I could envision that happening, but we don't have plans to do that right now."

Moebs Services, which surveyed more than 2,500 banks and credit unions in June 2011, found that only 34.6% of banks with at least $50 billion in assets still offered free checking, down from to 96% at the end of 2009.

But almost 71% of smaller banks still offered free checking accounts at the end of June, according to Moebs, off just slightly from about 78% in 2009.

Customer service is one reason that small banks are maintaining free checking, but another is that they have a counterintuitive cost advantage, according to analyst Mike Moebs.

Big banks actually spend more on average to operate each deposit account than small banks, and they have long relied on overdraft fee income to help subsidize free checking. But a 2009 regulation restricted banks' abilities to charge overdraft fees, which prompted the first wave of cutbacks in free checking.

Conversely, it costs less on average for smaller banks to operate checking accounts and they historically relied less on overdraft fee income, according to Moebs.

"Those that are in this huge bank group, they are truly beyond their economies of scale, and their expenses are usually high in processing areas," he says.

But Louis Hernandez, Jr., whose Open Solutions Inc. sells software to small banks, is more pessimistic about the costs facing small banks in the future - and the ultimate impact of those costs on their pricing for checking accounts.

Complying with the new regulations from Dodd-Frank will ultimately be more costly to small banks, which have fewer resources, he says. Those banks will need to find a way to charge consumers for checking accounts to offset their lost interchange revenue and their increased compliance costs, according to Hernandez, the chairman and CEO of Open Solutions.

"The big banks can already see a strategy that works. The small banks, they can see that they don't have an alternative yet," says Hernandez. "If we keep offering it for free we're going to go out of business."