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      Home » Checking, Compliance, Fee Income, Regulatory

      Unintended Consequences: The FAIR Overdraft Coverage Act

      Submitted by on Thursday, October 29, 200919 Comments
      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.NSF

      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:

      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.  

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      • Jennifer Oliver said:

        Thank you for bringing so much research to the argument. The basic nature of a punitive fee is “opt in” isn’t it? There is always the choice of modifying behavior and therefore not paying a fee. If this source goes away and free checking is gone, so does the choice to manage an account and not pay extra service fees. Liken it to risk based lending. And, just try to revoke the OD priviledge to those who use it most…they will call you asking for it back immediately. What happened to the consumers choice?

      • Paul Christensen said:

        Pretty good commentary. Hopefully, Senator Dodd will be hearing some of these arguments and have second-thoughts.

        I’ve been curious about the lack of input from the retailer side of the equation or, maybe, I am just not seeing it. It would seem to me like the retailers would be alarmed by this potential legislation for two big reasons: (1) The volume of checks returned to them would have a huge jump; and, (2) A large decrease in POS sales that used to be accepted but will be declined if the legislation goes forward. Like financial institutions, retailers are struggling with this economy and a significant decline in retail sales would not exactly help the economy, either. Or, maybe the retailers are just too focused on getting their reductions to the interchange fees pushed through…

      • Wayne Mansur said:

        Excellent article. Letters to congress should focus on the negative impact to the LOW INCOME people. The low income who are not NSF/ODP abusers will be punished with the requirement to pay a %15 to $20 montlhy service fee on their checking even though they never NSF/ODP. Further, the low income will NOT elect to use NSF/ODP because it will not be available on checking accounts that charge a monthly fee. The unintended consequence is they will no longer be protected by ODP, but instead will be punished by NSF and merchant return fees…twice as expensive as ODP. Finally, when they do need to overdraft, it will no longer be available to them because they will not qualify for ODP in the checking account offerings that will be available in the new regulatory world.

        Your article is spot on….The real solution is to EDUCATE the consumer to the hazards of alcohol and ODP.

        p.s. By the way, if Congress passes this legislation, I suspect the next legislation will be to permit one (1) per month and six (6) per year times to go gambling…afterall, what wholesome good comes from gambling…or drinking…It is how people chose to live their lives.

      • Real Banker said:

        Well written … Most of the consumer protection laws being bantered about in Washington will likley increase costs for those who are on the lower end of the economic spectrum, as well as make banking products and services less available to the same group. Not a good outcome … ether consumption might be advisable.

      • Richard said:

        This seems very chicken-little, with such hyperbolic statements as “I can only imagine the types of things that will be attempted …”

        Surprisingly, it categorizes government and regulators as being subject to the law of unintended consequences without acknowledging that all of humankind experiences it. Did Lehman Brothers recognize the unintended consequence of kiting suspect credit instruments as collateral(bankruptcy)? (A list of Wall Street and the banks’ financial unintended consequences expands exponentially from here – but the point is that every human enterprise is subject to change – some intended, some not.) Parenthetically, when talking with derision about government, its employees are a good part of your (and credit unions’) client base (yes, I resemble that remark – because I *AM* from the government and I *AM* here to help).

        The “government” is not being consumer friendly – it is representing its constituents who are also consumers (weakly and without enogh resolve, but that’s another day). If the financial industry had better represented consumers (basically a conflict of interest except in the true community-based credit union) the pedulum would not be hesitantly edging toward moving back.

        There should be no fear of NSF abusers being pushed to “less attractive” check cashing. Whose credit are they using?

        All-in-all, this has been a somewhat alarmist article. In case it was missed in all the ether fumes, the sky already fell. Digging out of the rubble and staying upright is going to require behavior change. It may not be popular among fans of unbridled capitalism, but to those who lost small to medium bucks, many their life’s savings, while acquiring a massive government debt to save the moneyed class from destruction, it’s not terribly impressive that the sky might fall again on the blue tarp (post-hurricane roofing). Be glad financial institutions neither got all the government citizens paid for, nor the Draconian regulations that are still warranted.

      • Terence Roche said:


        Very astute observations, especially the one that there will likely be more monthly account fees to replace OD protection fees.

        Regarding the unintended consequence that merchant returned check fees will increase because checks will be returned, this can likely be avoided. The financial institution can leave OD protection in place for checks but allow the customer/member to opt out (or require opt in) for debit. Virtually all core systems can handle this option.

        Terence Roche

      • Mary Jo Garofalo said:

        This is an excellent article. This is just another case of the government making decisions on something they don’t understand.

      • Jerry said:

        I agree with your analysis, however I believe you may have missed a very significant possible result. When the overdraft and subsequent returns become a large time consuming task Credit Unions and Banks will most likely begin closing (force closing) those accounts that have the most significant drain on profits via substantially larger processing time and cost.
        Like most institutions we do credit checks and other research on consumer behavior prior to opening checking accounts. After an account is “force closed” the consumer will find it increasingly difficult to obtain another account at another financial institution. This could very well lead to an other non-regulated industry which (like payday lending and check cashing establishments) is significantly more detrimental to there financial well being.
        Unfortunately this again sounds like a re-election idea rather than a consumer protection idea.

      • Johnny said:

        Hmm this whole article is analogous to healthcare reform. Gov’t stay away!

      • buddy aucoin said:

        brings to mind…”I’m from the government and I’m here to help you.”
        Enjoyed the article.

      • Bob O'Meara said:

        Nice job Marcus,

        We just finished a round of workshops with financial institutions across the country and everyone in attendance is thinking about this issue. There is a lot of concern about vastly reduce NSF and debit interchange fees.

        At the end of the day, if fee income from NSF and Debit interchange are substantially reduced, firms are going to need to reasses their retail strategy as a whole, not just free checking.

        Everyone has been fishing with “wide nets” with free checking for the past several years. Some firms may decide that the mass market has become less attractive and they could narrow their focus with more exclusionary pricing on checking.

        As a part of this strategic reassessment, firms are going to really have a handle on their variable cost structure to understand when and if they begin saving “real” operating cost dollars by serving a lot fewer checking customers. Part of those cost savings are employee costs and those discussions can be difficult for management teams.

      • Terry Crews said:

        Nice article but you mention nothing about alternative funding arrangements for overdrafted accounts like a personal line of credit, home equity line of credit or even an automatic deposit from some other deposit instrument to cover the deficiency. All of these are sensible alternatives that can be implemented at a much lower cost and thus fee than $29+ when an account overdrafts by a few dollars or cents. And for the habitual overdrafter, they can still do it, the bank can still earn fee income and the risk is effectively the same as the “automatic/courtesy overdraft” system.

        Face it, if banks had not gotten greedy with(and addicted to)these fees and had not kept ticking up the overdraft fee (and kept it reasonable, around $15 per incident), this would be much less of a consumer issue.

      • Ron Sulpizi said:

        All this will do is continue to absolve consumers from taking any responsibility whatsoever for reconciling their account.

      • Ben said:

        Terry Crews ~ Your argument does not help low income / low credit individuals who cannot qualify for a LOC or HELOC.

        Marcus ~ Great article. Perhaps in a few years we can elect some politicians who will bring some stability to our economy. Until then all this government-driven uncertainty and change is going to continue to leave our economy to be rebuilt on an unstable and unpredictable foundation.

      • Mobile banking | The Raddon Report said:

        [...] speculative basis, should the unintended consequences of overdraft regulation be fully realized — as recently examined in this space by my colleague Marcus Rothaar — this mobile-distinct “checking” functionality may conveniently and readily fulfill the [...]

      • To Opt In, Or Not To Opt In — That Is the Question! | The Raddon Report said:

        [...] Unintended Consequences: The FAIR Overdraft Coverage Act AKPC_IDS += "2414,"; [...]

      • 2009 Year in Review | The Raddon Report said:

        [...] and institutions can no longer afford to offer a free checking product to all customers.” (“Unintended Consequences: The FAIR Overdraft Coverage Act,” October 2009) While the growing sentiment of customer dissatisfaction with the banking [...]

      • Andrew said:

        According to my bank, the overdraft protection does not apply to checks anyway.

      • brent said:

        Wow, your arguments are very weak and almost sound like you are in some way affiliated with the banks. You speak about people who write checks are better off with the “convenient” NSF overdraft service, but who still writes checks anyways? The banks have literally been screwing over lower income families and individuals such as college students for years on theses “fees”, and yes, that may be why they were so inclined to offer “free” checking but if it is just bait and switch to charge people OUTRAGES fees for overdrawing their accounts, then reform is in order as is. I’m glad for consumer protection legislation that gives us the CHOICE to be overdrawn outrages amounts by banks for simple errors. The sad thing is that I guarantee there will still be people dumb enough to get duped into accepting.

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