Many small and midsize banks and credit unions are introducing fee-based overdraft coverage to make up for low interest rates, shrinking loan volume, and reduced interchange fees.
Such services provide legitimate benefits - including covering consumer errors at a time when 87% of account holders neglect to balance their checkbooks. But given the lack of regulatory guidance, financial institutions must police themselves by pricing overdraft services responsibly and establishing ethical guidelines for honoring overdrafts.
Furthermore, there are signs that aggressive manipulation of overdraft services to enhance noninterest income may soon attract scrutiny.
Though consumers embrace overdraft services, many watchdog groups are alarmed by the steady increases in the fees. According to data we collected for the Federal Reserve and Congress, since 2000 the median overdraft fee has grown 25% - significantly more than the inflation rate - to $25 today.
Watchdog groups are equally concerned about a variety of other aggressive practices. For example, some institutions include the overdraft limit in the account balance displayed at ATM machines, thereby misleading account holders and encouraging overdrafts. Some mandate direct deposit tied to free checking with small overdraft limits and high overdraft fees. Others use marketing campaigns that actually encourage account holders to bounce checks.
These practices have led to charges that overdraft services are nothing more than payday loans - without the built-in consumer protections that govern credit transactions.
Institutions face bad publicity, regulatory censoring, and erosion of consumer relationships if their overdraft services fail to balance their own interests with those of the consumer. They should therefore evaluate their current services from the customer perspective.
Program Definition
The first step is to determine whether the current service is a credit or a deposit service. The distinction is clear and simple.
Credit-driven services require an implicit agreement with the consumer. Under these agreements, institutions can charge different fees to cover the insufficient funds or to return the check. Overdraft fees can be higher than the return fees.In addition, a daily interest fee can be charged until the account holder makes a deposit that covers all outstanding checks and returns the checking account to a positive balance. These charges must be disclosed as an annual percentage rate on monthly checking statements - just as they would with any other form of credit.
- Deposit-driven programs require no agreement, because no credit is extended. Institutions simply charge a fixed fee to cover overdrafts within the individual limits established for qualified account holders.
Qualifications
Determining which consumers qualify for overdraft services must involve more than FICO scores from consumer reporting agencies. Banks can protect themselves by going beyond financial history to understand a consumer's ability and inclination to promptly cover bounced checks.Consider the case of a professional mother of two with a healthy income and solid payment history whose contentious divorce proceeding has tarnished her short-term consumer reporting agency information. This account holder would truly benefit from overdraft services and would be willing to pay for the convenience of an occasional bounced check caused by her own mistake.
Institutions that deny overdraft services to such consumers without considering the full array of fraud and econographic data available turn their backs on potential revenues from financially responsible consumers. They may also expose themselves to discrimination lawsuits.
Limits
Financial institutions open the door to complaints when their overdraft limits fail to meet the real-world needs of the consumer.With low overdraft limits, it's not unusual for consumers who miscalculate their balance to bounce several checks at once and then face double fees - charges from merchants on checks and charges from depositories that return the checks.
To provide a truly meaningful benefit, overdraft limits must be high enough to cover important monthly payments such as mortgages, where bounced checks can harm credit ratings and cost homeowners 10% of their monthly payments in delinquency fees. They should also cover multiple low-denomination checks.
Institutions that combine correct qualification criteria with higher overdraft limits actually increase total revenues from overdrafts, hold losses to below 3% of revenues, and maintain positive relationships with consumers.
Terms
When banks and credit unions establish overdraft services, they face a variety of policy questions, such as:
- How to determine the appropriate check limit or account cap.
- How to notify consumers of an overdraft.
- How long account holders have to return their accounts to a positive balance.
Institutions will face scrutiny from consumers and regulators if they establish terms that appear to encourage overdrawn accounts.For example, some institutions fail to establish sufficient dollar limits, often guessing and setting limits at or below $500. In other cases, depositories give consumers 30 days or more to return their accounts to a positive balance - and charge daily interest fees and/or flat overdraft fees.
In assessing terms and limits, financial institutions - and consumers - are better served by strict limits on overdrafts and by financial counseling when consumers habitually overdraw their accounts. Institutions should notify consumers of an overdraft the same day the check is presented and require them to deposit sufficient funds to cover the check within 24 hours. This way, the institution covers the consumer's mistake without triggering numerous regulations that turn overdrafts into payday lending.
Fee Structure
With overdraft fees on the rise in many markets across the country, depository institutions have the opportunity to differentiate themselves by offering lower fees for a service consumers value.Today's automated systems can automate much of the decision-making process, reducing administrative costs and financial risks. Institutions can actually more than double fee income by lowering overdraft fees below the national median ($25 for banks and $20 for credit unions).
Even holding fees steady while local competitors ride the wave can quickly create a competitive advantage that produces significant income from extra volume - with no consumer backlash.
IT Interface
Depositories need to decide how overdraft services are handled: manually or through automated processing systems or third-party software.Financial institutions with less than 10,000 transaction accounts need not fully automate their overdraft protocols; they can save money by processing overdrafts manually.
Core processing systems have advanced significantly in the past three years in the area of overdrafts. Banks should be very cautions when using third party software for notices and collections, because installing this software may void licensing maintenance agreements on the core processing system.
Communications
Consumers respond most favorably to financial services and fees when institutions make them easy to understand and provide clear options. Even though depository overdraft services can be built into the checking account service and require no agreements, banks and credit unions have a responsibility to ensure that consumers fully understand not just the fee structures, but also all terms and limits that apply.
