Banks are not popular these days. Mike Konczal, a fellow with the Roosevelt Institute, wrote What are you worth to your bank? in The Washington Post a few weeks ago. He estimated that a bank makes about $500 a year off an average retail customer. That story also made its way to NPR’s Planet Money blog.
I have a good explanation for that and it’s not because banks are cheating customers.
Before we continue, let’s take a look at how Konczal got the $500 a year number. He first gave this formula:
Value = Fees + 2.5% * (savings + checking) + 1.7% * (debit card transactions)
He then gave an example of a hypothetical family who makes $60,000 a year, holds $10,500 in checking and savings accounts with the bank, charges $1,155 a month on debit card, and avoids all bank fees.
$0 + 2.5% * $10,500 + 1.7% * $1,155 * 12 = $498.12
After arriving at the roughly $500/year number, Konczal asked rhetorically “do you get that much quality from your bank?”
My answer is, yes, you do. Let me explain why the bank should make that $500.
For the sake of this exercise I will accept that both the formula and the hypothetical are completely accurate and representative.
It’s not a secret that one can make purchases on a credit card, pay the bill in full, and earn rewards from the purchases. The standard cash rebate rate is 1%; better cards pay more than that. This family must know about it and they still choose to use their debit card. I can think of several good reasons:
(1) They carry a balance on their credit cards. Forgoing the reward is better than paying interest.
(2) They like to keep track of their spending. Debit card purchases generate a record trail; cash spending is hard to account for. The fees the bank charges the retailers cover the bookkeeping service and the elimination of cash handling cost for the retailers – counting, shrinkage, armored truck, etc.
(3) They don’t want to be enticed into overspending. With their debit card, they only spend the money they have in their account. Using a debit card helps them spend less and save more.
In each case letting the bank earn the fee from debit card transactions must be totally worth it to this family; otherwise they wouldn’t use their debit card because they can easily get $140 a year from using a credit card and paying the bill in full every month.
We now turn our attention to the money in their checking and savings accounts.
It’s true the bank loans their money out to other customers at a higher rate. However, the bank earns the higher rate by taking credit risks and locking up liquidity.
By now we know that not all customers pay back their loans. So many banks failed because of customer defaults. Risky money earns a higher rate than safe money.
Those loans – car loans, home equity loans, small business loans, and so on — also have longer terms than checking and savings accounts. Long term money earns a higher rate than short-term money. Our family understands that for sure.
If this family becomes angry about the bank earning a higher rate on their money, they can bypass the bank and do the same thing the bank does: taking risks and locking up liquidity. 10-year Treasury is paying close to 4% now. Making a safe, long-term loan to the US government will deny the 2.5% the bank earns from the family. If the family wants to take risks, there are all sorts of bonds and bond mutual funds. They can also send their money to P2P lending sites and play banker. I don’t recommend it but I have those referral links too.
Given ample opportunities to earn the extra 2.5% by taking risks and/or locking up their money for longer term, this family still chooses to keep their money in their checking and savings accounts. They rationally pass those opportunities to their bank. Good for them.
So, what’s the fuss about the bank making $500 a year off this family? The bank makes $500 a year so our family can avoid risk, maintain liquidity, avoid paying interest, have records of their expenses, and keep their spending within budget. That’s why.
[I don’t work for a bank. Hat tip to Austin for sending me the story.]
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Wai Yip Tung says
I clicked the link to the original story.It did not explicitly says debit card transaction. In the formula it says credit card transaction. In the text it says credit card or a debit card expense. I think credit card use is more likely for an average family.
Very good analysis nevertheless. I think the original post is too provocative. This is a more levelheaded article that helps people understand how a bank really makes money (by creating value).
Harry Sit says
The NPR Planet Money blog changed the formula to debit card transactions because it makes more sense that way. If we are talking about credit card transactions, that 1.7% ought to be 0.7% after the standard 1% cash rebate.
dale says
Good article. As a former banker I find the analysis most interesting. As a bank customer, I don’t mind the bank making a profit from our relationship. On the contrary, I expect them to make a profit. I’m more interested in convenience and service. I’m a low maintenance customer, doing the bulk of my transactions on line or at an ATM, but when I need to speak to someone, or have an issue with an account, I want it handled quickly and efficiently.
What perturbs me about banking is the “hidden” fees, and the way they clear checks so that they can charge you more overdraft fees if you happen to make a mistake. I suppose it’s still “caveat emptor” in the financial services business, regardless of all of the so-called “Consumer Protection Acts”.