One of the best predictors of bank performance is the level of fee income. The more fee income a bank has, the more likely they have above average performance. Fee income creates a more stable and less interest rate sensitive revenue stream. It amazes us how few banks offer a loan sweep (sometimes called an “ALS” or Automated Loan Sweep) where a customer can set their operating account to sweep balances to reduce their borrowings on their line of credit. CenterState Bank offers the product, and this lays out a case of why you may want to consider the product.
The Loan Sweep
Customers can reduce their interest expense by sweeping idle funds above a certain peg balance from their checking account to their line of credit. This helps avoid overdrafts and associated fees while also making it operationally easier to use their line of credit. Most banks charge $250 for each way of sweep (as you can also sweep from your line to your operating account) but we charge $150 for a round trip.
But Why Would I Want to Reduce Deposits AND Give up Interest Income?
Aaah, thank you for falling into our trap as that is the true question of the day, the answer of which is interesting to contemplate as it is one of the lessons we learned that we believe will serve banks well into the future. For starters, if your bank does not offer a loan sweep then it is highly likely that at one time someone in your bank came to the conclusion as stated above and said – no thanks, we would rather have outstanding balances.
To this, we say, that unless those banks have a rare, high balance and high-credit-worthy customer profile, most likely they are being penny wise and pound foolish. Let’s break this down.
The Economics: The first set of analysis to undergo is to see what your average draws are for the month. To the extent your customer base utilizes the sweep in amounts under $40k, then you make more money on fees with a sweep so you can end the analysis now and move on. The answer is clear.
Lifetime Value: However, if your draws are over the breakeven amount, then you need to figure out the value of what a sweep does to lifetime value. Having a loan sweep increases your probability of having the operating account. This is the gold. Not only do you want an operating account, but you want a business’ main operating account. Having a loan sweep largely gets you that at almost four times the probability of not having an active loan sweep.
Deposit Performance: The additional dimension of value is that a loan sweep allows the customer to be on autopilot. It reduces the time they need to take to manage their cash balances, and in the process, it makes them less interest rate sensitive. What you end up with is more usage on both the line and the operating account. In many cases, you might make more interest income as the line is used more often. Alternatively, you might find that your accounts carry higher deposit balances as more cash is consolidated. Additionally, you might find that these cash balances and line amounts go up as rates rise and business increases. This positive convexity is an important driver of value that might not be there if a bank is forced to manually utilize their line of credit and have their operating account at another bank.
Credit Risk: Then there is a question of credit risk. That interest income doesn’t come free. It comes with both maintenance expense and credit risk. Thus, when you calculate your usage breakeven, you are really not concerned with your return from interest, but your risk-adjusted return on your interest. Having a loan sweep ensures that your bank is reducing that credit risk at every turn. This is important because lines of credit have asymmetric risk profiles. Credit risk is not consistent and increases when the lines are used. Not just because of balances outstanding, but a company’s actual probability of default increases at the time of draw above the customer’s average probability of default. This, along with higher than average maintenance cost, are reasons why lines of credit are not profitable a majority of time. Thus, while all banks want interest income, what they want is positive risk-adjusted spread income. Unless it is very well priced, when it comes to lines of credit, banks usually would rather have the borrower pay down their line at every turn.
Putting The Customer First: Of course, the best reason to offer a sweep is that it is the right thing to do for the customer. It is hard to say your bank has a value proposition built around service when you have a simple solution available for the benefit of the customer, and you choose not to utilize it because you want the fee income. You may succeed in the short-run with that line of thinking, but probably not in the long-run.
Putting This Into Action
Consider a loan sweep against a working capital line of credit to generate fee income and manage risk at your next new product committee. Some commercial banks find that it is their number one fee generator and all banks find that it is a fantastic relationship product.
Top performing banks make their money on managing customers not loans. By making it operationally easy for the customer, reducing their overdraft fees and helping customers better leverage their cash balances, what you end up with is happier and more profitable customers. This is in everyone’s best interest.
Submitted by Chris Nichols on March 16, 2017