Unintended Consequences: The FAIR Overdraft Coverage Act
“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.”
–French economist Frédéric Bastiat
I was in Ireland a few years ago and in between pubs kept running across statues of Father Mathew, a.k.a. The Temperance Priest. In the mid-nineteenth century, Father Mathew began an abstinence movement in Ireland in which individuals would take a pledge of sobriety (judging by what I observed each night in Dublin, the movement apparently didn’t have much staying power). An unintended consequence of the crusade was an increase in the consumption of ether by clever Irishmen who surmised they would still be honoring their pledge if they consumed ether rather than alcohol. Hunter S. Thompson would be better able to explain the subtle nuances between the two, but if Fear and Loathing in Las Vegas is any indication, I take it that ether is rather dangerous.
While it is tempting to accuse the Senate Banking Committee of ether consumption, for their drafting of the succinctly titled Fairness and Accountability in Receiving Overdraft Coverage Act, the correlation I’m making is simply that it is not uncommon to have negative unintended consequences that go along with well-intentioned actions. The law of unintended consequences can be found working its magic in countless examples of government legislation and regulation. This is why it is critical that the potential adverse effects be illuminated now, rather than after the fact. Now is the time to be talking to your Congressional representatives, to educate them on the true impact that the FAIR Overdraft Coverage Act will have on the average consumer. A full summary of the bill can be found here, below are some of the key highlights:
- Customers would need to opt-in to overdraft coverage if it applies to debit card and ATM transactions.
- Monthly limit of one overdraft coverage fee can be charged, with an annual limit of six.
- The overdraft coverage fee charged must be proportional to the institution’s cost of processing the overdraft.
- Priority posting – transactions must be posted in such a way that the consumer will not incur extra fees.
- NSF Fees (presumably for customers not enrolled in overdraft protection) would not be allowed to be charged for debit card and ATM transactions.
On the surface, these may sound like great consumer benefits, but this is reminiscent of an old Saturday Night Live commercial parody for the fictitious itchy scalp medication Trilocaine, in which the possible side effects include “an instantaneous and horrifying sleep-paralysis containing a bleak vision of mortality” for 90 percent of users. To take a cue from SNL and the FDA, perhaps the bill should be required to come with a list of all possible side effects, which would include:
More consumers will experience merchant returned check fees. By requiring consumers to opt-in to overdraft services on debit card and ATM transactions, the expected outcome is that fewer consumers will enroll in general overdraft services due to typical human behavior. While this may achieve the goal of protecting a small percentage of consumers from getting hit with multiple overdraft coverage fees on debit card and ATM transactions, it will also decrease the number of consumers who truly benefit from overdraft protection services. The vast majority of consumers fall into the incidental NSF category, meaning they rarely conduct a transaction which would result in an overdraft coverage fee. RFG has measured the actual activity on several million checking accounts, and find that 81 percent of households have between zero and three NSFs in a given year. The majority of consumers are simply not at risk of racking up hundreds of dollars of NSF fees in a given day. For the occasional NSF that these consumers do incur, the courtesy pay program is a valuable service. While there is admittedly less value to the consumer when linked to a debit card transaction, overdraft protection is extremely beneficial in a check-writing scenario. The alternative is the bank not honoring the check and returning it to the merchant. The merchant will then typically charge the consumer an additional fee on top of the financial institution’s NSF charge. In cases like this, the cost to the consumer is double what it would have been had they been enrolled in a courtesy program, not to mention the inconvenience and embarrassment the consumer may experience by having the returned check posted on the wall of the local grocery store.
The government has the opportunity to drive pricing decisions. The government is suddenly an expert in cost accounting? It seems as if they have quickly taken a liking to the idea of dictating how banks should be run, from executive pay decisions to now pricing. The provision that the amount of the fee needs to be proportional to the cost of processing the transaction is one that is ripe for abuse, by both the regulators and financial institutions. This ambiguous wording opens the doors for the government to not only dictate pricing but also in how a company examines its costs internally. I can only imagine the types of things that will be attempted to be rolled into the “cost of processing” an overdraft.
Free checking will disappear. For consumers, the most crippling side effect of the proposed legislation is that widespread free checking could become a thing of the past. Whether or not consumers like it, the average checking account costs an institution $200 a year to maintain. The expense load is even higher on accounts with a large number of transactions and overdrafts. More than 60 percent of all free checking accounts are typically unprofitable for an institution. As the chart below illustrates, the product is currently subsidized by the extreme ends – either high-balance accounts that generate significant interest spread; or accounts that generate significant fee income. Take away or reduce the fee income contribution, and the business model simply doesn’t work and institutions can no longer afford to offer a free checking product to all customers.
The monthly and annual limit on overdraft coverage fees will have a substantial impact on the income generated from the fee profit segment. This provision has the potential to greatly reduce the non-interest income generated from overdrafts, and wipe out a significant portion of the revenue that the free checking model depends on. The FDIC conducted a study in 2006 and found that 84 percent of NSF fees come from the nine percent of accounts that incur more than nine NSFs in a year. RFG has found similar results when analyzing the checking activity for individual institutions. It should be pointed out that this limit appears to only apply to overdraft coverage fees, and presumably not on the standard NSF fee that a customer not enrolled in overdraft protection might still incur. If fewer consumers are enrolled in overdraft protection as expected due to the opt-in requirement of the bill, the legislation is competing against itself in terms of the expected consumer benefit. This assumes that the standard NSF fee is not capped, other than the restriction on not allowing NSF fees on debit card and ATM transactions.
It should also be noted that if the bill passes, the Federal Reserve may interpret this differently when left to make the actual regulation amendments to the Truth in Lending Act, based on the spirit of the bill. (It happened recently, where legislation intended for credit cards was initially extended to all open-end lending: http://theraddonreport.com/?p=1749.)
Customers that incur large numbers of NSFs will be pushed towards less attractive check-cashing alternatives. It also remains to be seen how the regulators might interpret what happens after the monthly or annual limit is reached. The bill states that after the consumer has reached the monthly or annual limit, the “…institution retains the discretion to pay (without assessing an overdraft coverage fee) or reject overdrafts incurred by the consumer beyond…” the limit. If the institution chooses to reject them, would the institution be allowed to terminate the overdraft protection coverage for the individual and assess a standard NSF? If so, is this providing the intended consumer benefit? If not, what recourse does the institution have for customers who continue with an unlimited number of non-penalized returned checks? The only option would presumably be to close the account completely, in which case the customer could be forced to utilize services outside of the regulated banking system. According to the FDIC study, the five percent of accounts that incur more than twenty NSFs in a given year have an average of 59.6 NSFs each year. These are not consumers getting trapped by gotcha fees, or simply not understanding the policy or fees that are in place. It happens five times a month to these individuals, and yet it is not enough to convince them to change their behavior. It’s just like the old Chinese proverb, “Fool me once, shame on you; fool me twice fifty-nine times, shame on me.” These consumers will clearly continue to draw on their accounts when there are not sufficient funds to cover the transaction, and the financial institution needs an opportunity to protect their losses. If they are unable to do so by assessing fees, they cannot afford to continue offering the checking service to that individual. The end result is that the consumers the legislation is meant to protect will be forced out of the system and into the costly world of check-cashing services.
Low-income households are more likely to incur monthly checking fees. The bottom line is that the expense of a checking account has to be offset by revenue in some form or another. The most likely scenario is that monthly fees will become much more prevalent on checking accounts. We are already seeing this same type of shift on some credit cards, with the return of annual fees in response to the recent credit card legislation. The 75 percent of households that do not incur any NSF or overdraft fee charges each year could now be faced with a minimum balance requirement and/or a monthly checking fee. In that respect, if the monthly checking fee is substantial, a far greater number of consumers would be hurt by this legislation than helped by it. In effect, the bill will have the unintended consequence of spreading out the costs to all consumers, and forcing the 80 percent of consumers who regularly track their checking balances to pay for the mistakes of the 20 percent who do not. The-low income households that the legislation is hoping to protect will be the ones impacted the most by monthly fees, as they will be less likely to have the household balance levels or direct deposit needed to qualify for fee waivers or other checking products. Our latest national research shows that 59 percent of all households indicate that their household’s primary checking account falls below $500 during the course of a given month. If a minimum balance requirement is put in place, some consumers will be able to shift other deposit dollars to their checking accounts to avoid the monthly maintenance fee (although our research also indicates that consumers are already keeping more money in their checking accounts than they have in the past). But of those that have less than $8,000 in total deposit dollars, 47 percent have less than $500. In other words, a significant number of low-income households will not have the funds available to meet the minimum deposit requirement, and will incur the monthly maintenance fee.
The purpose of the legislation is to protect consumers, which is certainly a worthy goal, and one that the industry should stand behind. But if the government is truly interested in protecting consumers, they need to evaluate the full impact that the proposed regulations will have, including the always present unintended consequences. In the end, the negative side effects of this bill have a high probability of trumping the intended consumer protection benefits.
The good news is that I don’t believe we would see an increase in ether consumption as a result of this legislation, although I suppose that may be debatable as well.| Comments (RSS) |