Large national banks reportedly are losing many customers to smaller community banks and credit unions. This is a general, if delayed, response to public disgust at the actions and privileged treatment of the big banks over the past four years. It also reflects specific anger over increases in fees for household and small-business customers typified by Bank of America’s aborted attempt to impose a $5 monthly fee on debit card users.
But are banks really losing out? Large banks reportedly are happy to see some customers go, especially those with low average balances and many transactions. In reporting on this, the Wall Street Journal this week cited annual costs of administering a checking account of $350 to $450 for large banks but only $175 to $250 for smaller ones.
Banks offer checking accounts as a way of capturing deposits that can then be lent out. But there is no profit in having accounts for which the administrative costs exceed the cost of obtaining the money from other sources, such as the money market. This is an example of what economists call “opportunity cost.”
The Fed’s easy-money policy since 2008 has pushed the opportunity cost of funds from such alternative sources to record lows. That lessens the incentive for banks to offer customers services like checking or credit cards in order to get deposits.
If a bank can get wholesale money for 3 percent, a small depositor who runs an average balance of $500 only saves the bank $15 per year in interest paid. Not even the most efficiently run banks can administer an account for that. And many accounts have average balances even lower. Hence the push to increase income from fees to cover the cost of administering such accounts.
However, bankers who scorn small deposits need to understand the crucial distinction between average and marginal costs. Average costs are total costs, both variable and fixed, divided by the number of units produced.
Fixed costs are those that do not vary with output, in this case the number of customer accounts. Non-economists often refer to this as “overhead.” For banks, a high proportion of costs, including physical facilities, IT departments, ATM networks and so forth, are essentially fixed.
Marginal costs are those that do vary with output. In the old days, this included envelopes, paper and postage for sending statements, time tellers spent helping customers and so forth. But such marginal costs are shrinking as more and more deposits and payments are made electronically. I myself often go months without physically entering our bank and have not been in our credit union for five years.
Another way of putting it is that marginal cost is the amount by which total costs go up with one more customer account, or the amount by which they drop if one customer leaves for a competitor.
The average cost per account for a big bank may be $400, but you can bet that its costs do not drop by that amount with every lost customer because so many of its costs are fixed. Yes, if thousands of customers leave, the bank can lay off a few accountants, a few MIS technicians and perhaps a teller or two. But most fixed costs don’t shrink.
So, when someone switches financial institutions, the crucial managerial question, both for the losing bank and the gaining one, is what will happen to marginal costs. An average cost of $400 or $150 per account is irrelevant if total costs only change by $50 when one customer leaves or one arrives.
If customers leave faster than total costs shrink, the average cost per remaining customer rises. (That is the same phenomenon as the per-unit costs of military aircraft rising as the total number of each model bought shrinks. All of the fixed costs of design and tooling must be absorbed by a smaller number built.)
That leads to a final topic, “economies of scale.” These exist when average costs drop as production rises. This is true over some range of output in many industries from farming, steel or autos to banking.
Thirty years ago, it became apparent that a computer powerful enough to run a community bank with 800 accounts was powerful enough to run one with 8,000. (Or 10 little ones with 800 each.)
This led to a dramatic consolidation of small-town banks as ones that led in adopting information technology bought up others, often those that had been owned by one family for decades. The same was true at a larger scale in urban areas and led to a wave of mergers and buyouts.
But economies of scale are not infinite. At some size, average costs start to rise, even if managing behemoths grows more difficult.
General Motors and the Soviet Kama River truck plant were so large, they destroyed value rather than created it. The same could be said for some of our biggest banks..
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.