The Evolution of Overdraft – It’s not the Wild West Anymore!
In the early 2000’s, as overdraft processing was evolving from a back-office burden into a full-blown business line and revenue stream, it seemed that everywhere you turned there were vendors flocking to offer the best way to run a program.
These early programs were built on one thing and one thing only…revenue. Institutions were realizing 300%, 500% and even up to a 1,000% increase in their annual overdraft revenue!
The New Solutions Were Touted as a “Win/Win/Win.” And the Winners Were:
- The Financial Institution
The institution won by maximizing a revenue stream that was previously viewed as overhead burden. The formula was simple: the more the program was advertised, the more overdraft volume they realized.
- The Consumer
Presumably, the account holders won, because they now had access to short-term liquidity that was previously unavailable to them.
- Overdraft Vendors
The overdraft providers certainly won by cleverly marketing the program on a contingency/success fee basis and collecting a percentage of the newfound revenue.
The Early Overdraft Programs
These early programs were simplistic in nature. The basic strategy was to offer a flat or tiered overdraft limit and provide it to as many account holders as possible. There was no data analysis or technology that could provide a reasonable limit based on a consumer’s ability to repay. Rather, limits were set across the board based on product type, such as free-checking or free-checking plus direct deposit, and then these simple limits were marketed and advertised to the consumer regardless of their financial health.
But the Winners Were Starting to Lose
As these programs continued to grow, it was apparent that some of the Win/Win/Win started to fade. Institutions realized that by providing and marketing generic limits, their pre-charge off collection efforts were growing as fast as their revenues, sometimes requiring entire departments to work on the collection effort before a consumer was ultimately charged off. Institutions also realized that the newfound revenue was, at best, artificial. Once the overdraft marketing stopped, the revenue dramatically fell, so the sustainability of revenue became dependent on the institution continually reminding/notifying the consumer of their limit, spending tens or hundreds of thousands annually to do so. The revenue share vendors, eager to continue their overdraft paydays, cleverly reclassified overdraft marketing as “Disclosure,” after the 2005 Joint Guidance on Overdraft Protection Programs was released, encouraging financial institutions to keep that overdraft volume coming.
Marketing, or disclosure, of overdraft programs also evoked another challenge: When you inform the same person repeatedly that they have the same “fixed” overdraft limit is it still a discretionary program?
Account holders were also negatively impacted. Because the constantly disclosed limits never considered the individual’s ability to repay, many consumers quickly found themselves in financial holes from which they couldn’t recover.
For instance, two individuals with the same product type would have been given the same $500 overdraft limit, even if:
- Consumer 1 was a tenured professional who deposited $8,000/month
- Consumer 2 was an entry-level worker who deposited $1,500/month
These individuals have radically different abilities to consume, and hence, to repay. Ultimately, those that were given more than they could repay found themselves charged off and potentially out of the banking system.
The vendors, on the other hand, were committed to maintaining that win for themselves, by sharing in a percentage of the increased revenue. They worked hard to ensure that the institutions continued to keep the volume coming in, even to the detriment of the consumer and the institution itself. It brings to mind the adage, “Just because you can, doesn’t mean you should”.
A New Way to Manage Overdraft: as a Line of Business
Meanwhile, the top institutions in the county were not participating in this hammer and nail approach to overdraft. They realized that while overdraft certainly generated a revenue stream, it was a business line that needed to be managed with the proper data, technology and risk management. They built their own true discretionary programs based primarily on the consumer’s ability to repay. There was no longer a commitment to a specific fixed limit, and they didn’t aggressively market overdraft or disclose it as a form of short term liquidity.
Why would the largest institutions in the country invest to build the technology, put in the extra time and effort to manage their programs, vs. adopting the simplistic approach that already existed? The simple answer seems to be “because they could.” After realizing that a true overdraft program generated sustainable revenue, decreased charge offs and provided better service to their account holders, they also determined that they should.
Fortunately, as we fast forward 17 or 18 years, the technology that was once only available to the mega- institutions is now readily available to deploy in community and regional institutions of all sizes.
This technology provides a deliverable that is not built on the back of the consumer but rather for the consumer, considering risk and compliance, providing a superior service level to the consumer, and generating fee income organically rather than artificially. These programs are built to preserve the longevity of the account, and based on consumers’ true “ability to repay,” rather than obtaining short-term gains that will ultimately get charged off later.
As we continue into 2018, think about how you are managing your overdraft program, and how you would like to service your account holders. Always remember that today’s consumers have evolved and continue to evolve—and the value of that long-term relationship to your institution is exponentially more valuable than generating just one more overdraft fee.