Concern over overdraft fees has been voiced by regulators for over a decade. The agencies, and in particular the CFPB, have focused more attention on this in the past few years, urging banks to change their practices in regard to such fees or eliminate them altogether. As a longstanding practice for banks, and for many part-and-parcel to their business model with regard to both expenses and risk, this has been a difficult issue with which to contend. We provide a brief summary of what the issues are for regulators as well as the challenges banks face in making changes.
Overdraft vs NSF Fees
First, a distinction should be made between overdrafts and insufficient funds (NSF) fees.
An overdraft is defined as an item presented for payment which exceeds the account balance, but the item is paid and the account incurs a negative balance. In the case of an NSF, the same situation occurs except the item is returned without being paid and the account balance does not change.
Banks have traditionally charged fees for both. In both cases these are typically a per-item charge, and in the case of the overdraft there may be additional charges depending on the length of time the account remains overdrawn.
The Regulators’ Concerns
There has been a good deal of research both academic and otherwise that argue for or against this practice and if it is harmful for consumers or a benefit. The issue for the regulators, however, is generally two-fold.
First, when does a bank allow an overdraft versus an NSF? Most banks do have hard fast rules, and these are often more case-by-case with a good deal of discretion. Usually there is waiving of fees as well, and this again typically is more on a case-by-case basis. This, of course, raises consistency concerns and equitable treatment of customers.
Second, for both overdrafts and NSF’s, a small group of customers pay the vast majority of the fees as vast majority of overdrafts occur by a very small number of customers who have are overdrawn frequently. As in the case with many banks, they offer “free” checking accounts, but still charge for overdrafts and NSF’s. For customers that are never overdrawn the account is truly free, but customers that overdraft, which again tend to be a very small group (1%-5%) but do so frequently, incur substantial fees. Therefore, in effect, this small group of customers funds the cost of the accounts for all customers.
How the Banks See It
Banks, on the other hand, have viewed overdrafts in particular as a service to customers. In addition to covering their expenses and generating fee income, it is also designed to discourage customers from writing bad checks. For most it is not as simple as just eliminating the fees, and there is likely concern about eliminating the incentive to avoid overdrafts and NSF’s. The pressure to eliminate these fees from bank regulators have created a serious dilemma which is much more complicated than it may seem. But the pressure on banks to make changes continues to mount.
As of this writing, most banks, with the exception of larger institutions, still charge fees for both overdrafts and NSF’s. Some institutions have eliminated fees for NSF’s but still charge for overdrafts, although a few of the largest institutions have eliminated both. Some institutions that have eliminated both no longer allow overdrafts but all items with insufficient funds are returned NSF.
Options Available to Banks
The nature of the regulators’ concerns leaves banks with few alternatives.
Although offering overdraft protection is an option, and most banks do, if the frequent-overdraft scenario holds, this creates the same problem, as fees are still incurred when this service is used. This results in a disproportionate number of customers incurring the fees.
On the other hand, eliminating fees altogether requires creating an alternative fee structure to cover costs, possibly sets up a moral hazard by encouraging behavior which is costly for the bank, and potentially attracts a disproportionate share of high-cost, low-profit customers. High-frequency overdraft accounts tend to be low-balance, high-transaction accounts.
One viable mitigator for banks is increasing use of digital payments with less and less reliance on checks. It is possible, therefore, that this issue may take care of itself in the long run. In the short-term however, this will continue to be a challenge with no silver bullet.
Banking institutions should be proactive by evaluating their business models, increasing understanding of their customers and their behavior, and examining alterative fee structures. This will avoid having decisions made for them as regulatory pressures will likely continue.
Additional Information:
