Small Banks Developing Ways to Compete Against Payday Lenders

More community banks are preparing to fight payday lenders and technology upstarts for a bigger share of short-term, small-dollar loans.

For smaller institutions such One PacificCoast Bank in Oakland, Calif., and National Bank & Trust of Sycamore in Illinois, the battle isn't about booking loans. Rather, the goal is to win back fee income that community banks have ceded to others in recent years.

During the fourth quarter, service charges at banks with less than $20 billion in assets fell 3% from a year earlier, to $1.96 billion, according to the Federal Deposit Insurance Corp.

Payday lending is a factor, says Brad Brown, senior vice president of retail banking at National Bank & Trust. He found out how pervasive payday loans were among his customers after the $592 million-asset bank bought a software program to assess its overdraft fees.

"There were so many [automated] debits coming through for payments on payday loans," Brown says. "I wasn't aware of the volume of our clients using" payday lenders.

National Bank is looking into offering individual clients credit lines for up to $1,000. It is also planning a tiered overdraft system, where only a small number of customers pay higher fees.

Tiered overdraft could add $80,000 to $120,000 in annual revenue at National Bank, Brown says. "We think it will be a way to compete with payday lenders, largely for people who want to avoid overdrafts," he says.

First Financial Service (FFKY) in Elizabethtown, Ky., also charges a variable overdraft fee, based on how often a customer bounces a check. The system offered a way to enter the short-term liquidity market, because many of First Financial's clients were already using overdrafts, says Greg Schreacke, the $1 billion-asset company's president. "They just assume we cover their checks, so they don't have to worry about it," he says.

One PacificCoast also has an alternative to paycheck advances. The $282 million-asset bank offers a service to employers that lets workers take out small-dollar loans. Executives at the bank could not be reached for comment.

Payday lenders, for their part, wonder why it took community banks so long to realize the need to go on the offensive.

"The traditional banking market hasn't worked for the middle class, but there's an absolute need" for these products, says Amy Cantu, a spokeswoman for the Community Financial Services Association of America, the trade association for payday lenders.

There are potential pitfalls for banks that raise their overdraft fees. Consumers have filed lawsuits against scores of banks over the issue. The Office of the Comptroller of the Currency hit Woodforest National Bank in The Woodlands, Texas, with a $33 million penalty in 2010 for unfair and deceptive practices in the $3.7 billion-asset bank's overdraft program.

Legislative concerns also exist. Earlier this month, House Democrats introduced the Overdraft Protection Act, which would codify a 2010 Federal Reserve Board rule requiring consumers to "opt in" for overdraft protection. It would also cap the number of fees banks can charge an individual for overdrafts and prohibit ordering debit charges from "high to low," among other things.

Still, small banks are ignoring demand for short-term liquidity services at their own risk, says Robert Giltner, a consultant at Velocity Solutions who advises banks on retail products. Bigger banks like Fifth Third (FITB) and Regions Financial (RF), along with credit unions and other nonbanks, are developing small-dollar loan products, he says.

Overdraft fees are also on an upswing. After hitting an 11-year low in early 2012, overdraft volume rose sharply in the final nine months of the year, according to a study by Moebs Services. If the trend continues, overdraft fee income could eventually reach new highs, the study said.

"So many community banks are defensive about their overdraft fees, but overdrafts are a service and people ought to be able to do what they want," Giltner says. "We're losing the battle against other companies that are servicing customers better than we are."

Technology-oriented firms also want a bigger piece of the action. BillFloat, which raised $21 million in venture capital in January, already offers an online short-term loan product.

BillFloat will soon launch a product to partner with small banks to offer loans, says Ryan Gilbert, the San Francisco company's chief executive. "Banks are in an extremely powerful spot in terms of the data they have on" customers, he says. "We can use that data to make better decisions on approving loans."