Overdraft fees not only generate significant noninterest income for banks, they help subsidize other services, such as free checking and online bill payment.

But if the Federal Reserve follows through on proposed amendments to Regulation E, otherwise known as the Electronic Fund Transfer (EFT) Act, that fee income could dry up, leaving many banks with the stark choice of raising fees or eliminating services.

"When the government interferes in the market mechanism, there are unintended consequences," says James Holly, founding president and chief executive of Bank of the Sierra in Porterville, Calif.

The Fed proposed in December changes to Reg E that would provide consumers the choice to either opt in or alternately opt out of their institution's overdraft program for automated teller machine withdrawals and one-time debit card transactions. In addition, it would prohibit an overdraft fee due for a hold placed on the account for a future transaction.

Opting in would mean that the bank would be prohibited from allowing a transaction that would cause an overdraft fee, unless the consumer consented to the service. Opting out would require the financial institution to notify the customer of the program, and give time to accept or deny the service. Those who decline overdraft services run the risk of having checks bounce or being stranded without cash.

The Fed received roughly 4,700 comment letters on its proposal. The majority of consumers said that they were upset with the "outrageously high" fees connected with overdraft and that they wanted the chance to opt in to overdraft services. "This is the only way that I will truly feel protected," was a phrase used in many consumer letters.

Bankers, though, by and large, oppose the idea of consumer consent. "An opt-in requirement would impose additional administrative burdens and high costs to our bank without any offsetting consumer benefit," wrote Doris Lambert, vice president and chief financial officer at Farmers Citizens Bank in Bucyrus, Ohio.

"Requiring our bank to offer and track either opt-in or opt-out notices would only add to our cost of operations and eventually raise fees for all customers, not just those who may (or may not) benefit from this change," wrote Al Vermeer, president and chief operating officer at Peoples Bank in Rock Valley, Iowa, in his comment letter.

Fees, particularly from overdraft, help to pay for services that often are free to customers, such as use of ATMs and call centers, bill payment and mobile banking. Overdraft fees from electronic transactions generate between $7 billion and $10 billion a year for the industry, and if customers choose en masse to opt out of overdraft programs, then banks will likely respond by ceasing to offer free services, says Tony Hayes, partner at international consulting firm Oliver Wyman.

"It would be very hard to maintain the status quo without $7 billion of supporting revenue; so we could see a move away from free checking," Hayes says.

Jennifer Tescher, director of the Center for Financial Services Innovation, a nonprofit affiliate of ShoreBank Corp., says changes in overdraft could have a similar impact on deposit account fees as new credit card regulations-which limit interest-rate hikes, ban double cycle billing, and restrict charging late fees-could have on card fees. The new card rules-issued by the Federal Reserve, the Office of Thrift Supervision and the National Credit Union Administration in December-take effect in July of next year.

With the changes in credit cards, "you hear credit card issuers saying that we'll see the return of the annual fee," Tescher says. "I would say that it's exactly the same situation in retail banking. With the curtailment of overdraft, we'll see the return of the monthly fee on checking accounts."

Hayes says that he expects that the Fed will make a decision on the overdraft proposals by July. If they are approved, he says the rules are also likely to take effect in July 2010.

It's not just the Fed proposing new overdraft rules. Some in Congress say that the Fed's proposed changes do not go far enough to protect consumers and have proposed legislation of their own. Among the provisions is a bill sponsored by Rep. Carolyn Mahoney (D-N.Y.), which would require retrofitting point-of-sale terminals so that they can notify customers when they are about to overdraw their accounts.

Elizabeth Eurgubian, regulatory counsel at the Independent Community Bankers of America, says that banks would likely shoulder the cost of retrofitting the terminals, and, if that's the case, "then you are going to see a lot of community banks in particular consider not even offering overdraft protection because it's too costly. And that affects consumers because it's a good service for consumers."

Consumer groups disagree, and have been pressuring policymakers for years to take action against banks' overdraft programs. But Bank of the Sierra's Holly, whose bank has a non-notice overdraft program, says the onus of accountholder responsibility can't be overlooked.

"If people are not wanting to pay overdraft fees the answer is very simple: They exercise individual responsibility, they balance their account and they monitor either their debit card use or their check writing in a way that they're not overdrawn," he says.

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