Overdraft protection is disproportionately used by those who rely on it heavily. According to Consumer Financial Protection Bureau research, less than 20% of account holders incur three or more overdraft fees annually, yet they pay over 90% of the overdraft fees triggered by debit cards, ACH transactions and checks.

The ability to overdraw an account is much like taking out a payday or car title loan, but with the advantage that you don't have to do anything to get the credit. Overdraft is also less likely than a payday or car title loan to morph into a longer-term debt since it is repaid as soon as new funds hit the account. But if you are one of the regular and habitual overdrafters, you can end up in a similar financial situation to a payday borrower because your fees can be ruinously expensive.

It is important to acknowledge that overdraft protection serves a significant need for a segment of the population who are living on the edge due to variable income and expenses. But the banking industry has made the situation worse for this segment of its customer base by prioritizing profit over customer financial health. Many banks engage in practices such as reordering transactions from high-to-low to make overdraft more likely, charging a high fixed fee (typically $35) unrelated to the size of the overdraft and boosting consumer costs by charging the fee each time for multiple overdrafts on the same day.

Apart from concerns raised by the CFPB and other regulators, these practices should stop because they are just bad business — totally at odds with their customers’ interests and financial health.

At a higher level, banks are also taking advantage of the latency in the U.S. consumer payments system. It is a fact that many customer overdrafts are caused by the lack in the U.S. of instant funds availability and the account transparency problems that creates for consumers. When a consumer looks at his or her account balance before taking cash from an ATM or buying something with a debit card, they get a false signal about how much money is in the account.

The balance shown when the transaction occurs is no guarantee that there will be funds in the account that night. Any other transaction — like an old check or an ACH debit — that hits the account that day can change the outcome. This latency problem drives a large percentage of overdrafts — transactions described in the industry as “good when authorized, bad when settled.” It makes low-balance customers play financial roulette when they decide to pay for something with a debit card or take out cash for a meal. It's yet another case of banks not aligning their processes with their customers' interests.

Real-time payments is something that the banking industry has slow-walked for years while others (e.g., Europe) long ago fixed the problem. Why? It’s hard not to believe that the advantages banks get from delayed funds availability — including float and, especially, overdrafts — haven’t influenced the delays. The Federal Reserve is moving way too slowly on this issue.

There are better alternatives to the current overdraft system, in addition to real-time payments adoption, that banks could implement to help their customers. A variety of mobile fintech solutions can help consumers manage their money, bills and payment timing issues. Companies like Varo Money, Digit, DoubleNetPay, Moven, MyFin, Mint, Earnup, Prism and Albert are all doing things to help customers avoid the need for overdrafts in the first place, and banks could partner with these companies to help their customers. Other fintech companies that work with employers to help employees manage income and expense volatility — like Even Responsible Finance, Flexwage, Active Hours and Payactiv — provide better ways to put consumers on the road to improved financial health. And some banks and credit unions are returning to the old system of overdraft lines of credit, where the credit cost is clear, rather than fee-based overdraft protection.

But what can be done right now to fix this situation? First we need to acknowledge that the banks have a real revenue problem which is stopping many of them from doing the right thing on overdraft. The name of that problem is the Durbin amendment.

One of the key reasons that many banks have kept bad overdraft practices, despite public criticism, is that they have been trying to make up for the dramatic loss of revenue caused by the ill-advised provision added to the Dodd-Frank Act, by Sen. Dick Durbin, that caps debit interchange fees.

Banks need fee income to continue to serve low-balance, lower-income customers who don’t buy other services, particularly in a low interest rate environment where the financial value of deposits is low. It’s a sad fact that, without adequate fee income, the banks lose money on most of their mass market and lower-income customers.

The Durbin amendment benefited only retailers’ bottom line, not that of consumers. Durbin gutted banks’ ability to serve mass market and low-income customers who, despite having low deposit balances, were heavy users of debit cards. If you want banking services for mass-market and low-income consumers to be delivered by banks, you can't take away too much fee revenue without replacing it with something, or banks will continue to move away from the mass market to serve only the 1%.

I, for one, think that would be a terrible outcome for all of us.

The banking industry should use the current deregulatory mood to cut a deal with the CFPB, consumer groups and Congress to exchange the repeal of the Durbin amendment for a code of acceptable overdraft practices. A good place to start would be the Pew Charitable Trusts’ proposal on best practices. New overdraft standards could deal with transaction ordering, limit the number of overdraft fees charged per day and a reasonable annual limit on the number of overdrafts on an account.

Trading overdraft practices for Durbin relief would help enable banks to stay on the right side of their customers' financial health.

Todd H. Baker

Todd H. Baker

Todd H. Baker is a senior fellow at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School, and managing principal of Broadmoor Consulting LLC.

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