Overdraft Isn’t Over

By Christopher Leonard, CEO, Velocity Solutions

Overdraft is definitely in the news. Pundits prognosticate on how overdraft is going away, and create the impression that all consumers detest overdraft and want the service to end.

I have a unique perspective on this issue, having worked with hundreds of financial institutions on responsible consumer liquidity solutions for tens of millions of Americans.

While changes may occur, I’m here to say that overdraft is not over. Here’s why.

Value of Overdraft Services

First, let’s start with the value proposition. Critics make it sound like only a dunce would use overdraft, so why do people keep using it?

Financial institutions provide billions of dollars in liquidity through overdraft. When a consumer needs to buy something and there isn’t enough money, institutions are there to try to cover the purchase.

And despite the headlines, the typical transaction isn’t a $35 fee for a very small purchase. Curinos research found “the average size of purchases that trigger overdraft fees has nearly quadrupled from $50 to almost $200.”

A Morning Consult study found that about half of Americans think overdraft fees are fair. And the Curinos research shows that “two-thirds of consumers indicate that, while overdraft can be expensive, they don’t want to see reductions in their access to the service.”

Covering transactions for consumers also means that our community bank and credit union clients provide liquidity that flows to mom-and-pop businesses in small-town America, communities many megabanks have abandoned.

The American Bankers Association commissioned a research paper analyzing data from banks which use “dynamic” overdraft systems, meaning systems that set individual overdraft limits based on ability to repay. (In full disclosure, our firm provides software that does this.) Some of the report’s key findings were:

  1. Overdraft users realize an economic benefit of over seven to one, providing annual stimulus to the economy of $65.6 billion.
  2. Consumers lose $443 in purchasing power for each returned check or ACH transaction.
  3. Characterization of the heaviest overdraft users as lower-income is inconsistent with the data.
    1. Lower-income households (<$24,000 annual deposits) averaged 10 items paid into overdraft annually vs. 18 items for consumers in the highest income stratum (>$60,000 annual deposits).
    2. The percentage of overdrafts attributable to lower-income accounts is only 21.5%, well less than the 41.3% of lower-income accounts in the bank.
    3. Lower-income customers receive more fee waivers and refunds than higher-income customers and paid lower effective average overdraft charges.

Miniscule Complaints

Overdraft is valued by consumers and rarely results in complaints. Even in 2020 with an economic crisis raging, less than 0.15% of complaints to the Consumer Financial Protection Bureau were related to overdraft.

The CFPB tells consumers on its website that “complaints play a role in everything we do, helping us to identify problems and prioritize our work.” If that’s true, then there are much more pressing matters for the CFPB’s attention.

Proposed Laws Limit Consumer Choice

While we applaud legislation protecting consumers, bills proposed in Congress many times now will not achieve their stated goal of providing consumer choice.

Those bills effectively would end overdraft for any one-time debit card transaction. But because of federal regulations, consumers already must opt in to overdraft coverage for those transactions before institutions may charge an overdraft fee on them.

Consumers who opt in, by making this choice, have expressed their desire for having their transactions covered and are willing to pay the associated fees, and consumers are free to change this decision at any time.

Reduction in Liquidity

If overdraft fees are eliminated or substantially reduced, then institutions simply will not allow consumers to overdraw their accounts or will curtail the coverage amount.

This is not only based on a profit motive in collecting fees. From a risk perspective, it creates safety and soundness issues for banks to take the risk of paying items into overdraft when they receive no compensation for that risk. Therefore, they no longer will float to consumers a substantial liquidity source for which they’re not compensated.

So where do these consumers go for liquidity? Both storefront and online payday lenders continue to proliferate across America, with rates that can be outrageous. Surely pushing consumers out of the regulated banking system for their liquidity needs can’t be what policymakers want to accomplish.

Reducing Financial Inclusion

Most low-income consumers are able to get free or low-cost checking accounts because other people’s overdraft fees subsidize the cost of those accounts. (In responsible programs, as the ABA study found, most of these fees are paid by higher-income consumers.)

If overdraft fees are substantially reduced, we may see banks charging $20 or more per month just to have a checking account, which would drive many low-income consumers out of the banking system.

A recently-published study from the Federal Reserve Bank of New York finds that overdraft “price ceilings caus[e] the rationing of both overdraft and banking services.” It goes on to state:

Regarding public policy, our results highlight a trade-off that has not received due attention in the policy debate: consumer protection via overdraft restrictions comes at the cost of reducing banking services for low-income households. …

We find that fee caps limit fees as intended, but also constrain the supply of overdraft credit and reduce financial inclusion among lower income households.

The Path Forward

The most important change that needs to happen is addressing why overdraft is often the only real option for small-dollar liquidity at banks and credit unions. All five primary federal regulators have encouraged institutions to offer small-dollar short-term loans, but few do.

If a bank would give a consumer $500 in overdraft coverage, why not make that amount available instead in a convenient, digital, fully-amortizing loan repayable over a three-month period?

These small loans are the best answer to questions being asked today about overdraft. Championing consumer choice, whether that’s overdraft or small loans, should continue to be at the core of this policy debate.