When Accounting Policies Determine Who Is Profitable: How the Allocation of Indirect Costs Rations Access to the Banking System

Doug Simons is a former investment banker, having worked in Morgan Stanley's mortgage securitization business and then leading the advisory efforts at Credit Suisse and UBS related to bank capital, asset/liability management and housing finance reform. Most recently, he served as a Senior Markets and Policy Fellow at the CFPB, where he advised Director Chopra and his team on issues related to the banking industry and represented the Bureau on FSOC’s Systemic Risk Committee.

During my time at the CFPB, banks and their trade associations cried bloody murder at the Bureau’s efforts to reduce overdraft fees. They demanded action and Congress obliged, repealing the CFPB’s 2024 overdraft rule. Given the Trump administration’s general distaste for regulation, there will be no new effort to cap fees until the political winds change. We should use the lull productively and scrutinize the arguments banks advanced. When we do, we see they are quite flimsy, leaning on arbitrary assumptions that disadvantage banks’ most vulnerable customers.

The Core Argument

Defenders of overdraft fees emphasize the downside risks of any change for consumers and community banks.  They contend that capping fees would force banks to more frequently deny overdraft coverage, increase minimum balance requirements, and boost monthly service charges. These higher fees would make having a bank account less attractive for lower-income customers and prompt many to withdraw from the banking system. On the other hand, if large banks refrained from raising monthly fees and absorbed the resulting loss in profitability, they argue it would undermine smaller banks’ ability to compete in the consumer deposit business. 

Of course, banks have multiple levers they can pull to boost revenue or reduce expenses. So why do defenders of the current regime insist the likely response to any reduction in overdraft fees will be for banks to impose higher monthly service fees on their small-balance depositors? When challenged, they assert it’s because these customers don’t provide enough other revenue to cover the cost of servicing their accounts. Fees are therefore necessary to make these small-balance accounts profitable, and the imposition of overdraft fees allows banks to avoid the across-the-board increase in minimum balance fees that would otherwise be required. 

On first impression, this sounds reasonable. Banks need to earn a return for their shareholders and regulators expect them to operate in a safe and sound manner, so we shouldn’t expect them to engage in money-losing business, right? Framing the analysis this way presents an unpalatable tradeoff: limiting the harm from excessive overdraft fees means accepting higher fees for everyone else, as well as the resulting loss in access it will cause. However, we should take this no-win framing with a healthy grain of salt. It assumes all relationships must meet some minimum profitability threshold, ignoring that shareholders care mainly about the profitability of the institution as a whole. Moreover, if banks claim they know a customer is unprofitable, logically they must also know how much it costs to service the relationship. In reality, much of a bank’s expense base can’t be traced to specific customers or activities and is instead allocated by management. In other words, it’s not something banks know, but rather something they decide as a matter of policy.

Allocating Indirect Costs

When I was an investment banker, it was considered best practice to measure a bank’s profitability with as much granularity as possible (e.g., at the level of individual business lines, projects, or classes of customers). It is a cliché in management theory that “you can’t manage what you can’t measure” and more detailed calculations allow executives to fine tune their allocation of resources. It’s easy enough to track the revenues and expenses related to specific transactions, as well as the direct personnel costs related to maintaining accounts. However, if the goal is to derive a measure of unit costs that reflects 100% of the bank’s expenses, a methodology is required to allocate indirect expenses not attributable to any specific customer activity.

What are some examples of these costs? In addition to corporate overhead and maintaining the branch network, much of a modern bank’s expense base relates to its technology platforms. Indeed, over the last several decades, variable expenses related to personnel and processing paper transactions have been steadily replaced by the more fixed costs of maintaining computer systems. Perhaps the industry’s embrace of AI will reintroduce greater variability to the cost structure, but when and how this will play out is difficult to predict. In any case, the majority of a bank’s retail deposit expenses are currently indirect. Critically, that means customers who produce otherwise identical revenues can look very different in terms of profitability depending on how these indirect costs are allocated.  

There are several plausible approaches for how to allocate indirect costs. They could be applied uniformly across accounts, irrespective of account size or the nature of the banking relationship. While this has the benefit of simplicity, it implicitly (and implausibly) assumes branches, technology, and other infrastructure are consumed equally by all depositors. Assuming every depositor generates the same level of indirect costs sets a higher minimum revenue threshold for them to be profitable. A second approach would mirror the allocation of measurable direct expenses. This is consistent with the idea that branches and technology platforms ultimately exist to facilitate transactions. It therefore allocates indirect expenses in line with the observable cost of processing transactions (e.g., time spent by employees). Alternatively, if the presumption is that a bank spends money to make money, a third approach would allocate indirect costs pro-rata with revenues (even if those revenues incur little in the way of direct expenses). 

Let’s Do Some Math

There is enough data in the public domain to make reasonable estimates of how these dynamics would play out for consumer checking accounts. For example, we can assume $2.0 trillion in outstanding average balance distributed across 200 million individual checking accounts (Table 1). While this implies a $10,000 average balance, the distribution is heavily skewed, with a median balance of only $3,000. This implies that 90% of outstanding deposits and associated net-interest income comes from the top 50% of accounts by balance. Net-interest income equal to 1.75% of average balances is based on the assumption that deposits generate roughly half of a typical bank’s NIM. Assumed fees are based on press reports and published research from the CFPB, with the biggest assumed difference between balance tiers being that the bottom half of accounts produce $50 more in service charges than those in the top half. Average expenses are assumed to match the approximate $250 per account mentioned in public reports. As a base case, approximately two thirds of operating expenses are assumed to be indirect and allocated at a uniform $160 across all accounts. The remaining direct expenses are assumed to skew slightly toward lower-balance accounts given the cost of processing fees. Based on CFPB data, average credit costs are assumed to equal $6 per account and are skewed toward lower-balance accounts. 

Table 1: Assumed Checking Account P&L Drivers Sorted by Balance ($ per annum unless noted)

Source: Author’s calculations

Using these assumptions, the bottom 50% of checking accounts by balance aren’t profitable. Indeed, without the $50 higher service charges assumed for these accounts, they would be money-losing. However, if indirect costs are instead allocated pro-rata with net-interest and interchange revenues (i.e., at an approximate 3.5:1 ratio), the resulting $65/$235 allocation would shift $85 per account of indirect expenses from smaller to larger accounts. This would allow smaller accounts to be deemed profitable even if service charges were significantly reduced, particularly if charging lower fees led to less direct expense associated with collecting those fees.

In short, banks’ statements about customer profitability are meaningless without understanding how they allocate costs. If lower-balance accounts are burdened with large indirect cost allocations, it is much more difficult (given the modest net-interest revenue they generate) for them to be profitable absent large overdraft fees and other service charges. 

The Uses and Misuses of Customer-Level Profitability 

The idea that assumed cost allocations might steer the products customers are offered and how they are priced raises more basic questions. Should profitability be the sole criterion for whether to maintain a customer relationship? And from a policy perspective, should banks’ philosophical judgments about how they allocate costs be allowed to serve as a basis for rationing households’ access to the banking system? To be clear, the question is not whether banks should be profitable: regulators expect them to earn sufficient returns through economic cycles such that they retain the confidence of investors and their access to the capital markets. However, this does not mean every component business line or customer segment must deliver identical returns. Indeed, banks often choose to run a business at a loss when they feel doing so is strategically important. 

These considerations are vital to keep in mind when evaluating industry claims regarding the likely consequences of further reducing overdraft fees. Do the current fees appear necessary mainly because indirect costs are being allocated uniformly across accounts? If so, they become little more than a “self-licking ice cream cone,” where allocated expenses are used to justify high fees. If affordable pricing for low-balance accounts produces limited revenue but also limited direct costs, it’s punitive to burden these customers with large indirect cost allocations. After all, banks can’t reasonably claim their branch networks and technology platforms were built to extract revenues from their least wealthy, youngest and often most vulnerable customers. At least they shouldn’t claim something so deeply implausible. Allocation methodologies can provide useful signals, but they are too blunt an instrument to excuse management from responsibility for where they choose to  invest resources. 

Even in a scenario where we stipulate that revenues aren’t sufficient to cover direct costs, much less allocations, there are still good reasons to doubt the necessity of imposing large fees on low-balance accounts. The reality is that serving these customers without substantial profits is not a threat to the earnings, stock market valuation, or safety and soundness of the bank as a whole. A required minimum on customer-level profitability embodies a false choice where the returns banks are seeking for the corporation as a whole are arbitrarily assumed to apply to individual customers. This is inconsistent with the obligation banks undertake to serve their local communities as a condition of obtaining their charters. Providing consumers with affordable access to a bank account should be considered a core element of meeting that obligation, one that banks can cross-subsidize as necessary from the rest of their business.

The opinions shared in this article are the author’s own and do not reflect the views of any organization they are affiliated with.

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