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Overdraft Fee Regulation and the End of Free Checking?

posted by Adam Levitin

Ron Lieber has a thoughtful column about the future of free checking.  Consumers have become quite used to free checking over the last 15 years or so.  The impetus for the column is whether the Fed's new overdraft regulations, scheduled to go into effect in July (new accounts) and August (existing) accounts this year will change the financial equation such that free checking is no longer viable.

I'm skeptical.  The potential impact of the Fed's overdraft regulation impact is greatly over-hyped. 

The Fed's overdraft regulation is very weak, especially in comparison to legislation proposed in the Senate and House.  The main piece of the Fed's overdraft regulation is the requirement that consumers opt in to discretionary overdraft protection for point-of-sale (POS) debit and ATM transactions and prohibits discrimination against consumers who do not opt in.  The rule does not affect check and ACH overdraft or NSF fees (there are various reasons for this, including, but not mentioned in the Federal Register notice, that the Fed did not have to coordinate with other bank regulators to regulate debit and ATM). 

Approximately 50% of overdraft fees come from POS/debit and ATM transactions, according to the FDIC. So, at most 50% of overdraft revenue is implicated by the regulation. (Maybe there'd be some spillover effect to check/ACH overdraft revenue, but I don't see that as likely.)

There's also no reason to believe that most consumers would not opt-in to overdraft protection.  I don't know of any good data indicating what opt-in rates are likely to be, but I think they'd probably be high.  Banks will control the solicitation of the opt-in, and will be able to make it look like the smart thing to do.  In fact, banks can make opting in the smart thing to do because they are free to charge whatever type of NSF fees they want for denied transactions.  With high NSF fees, accepting overdraft protection would be opting for the the lesser of two evils. 

Ultimately, it doesn't even matter if most consumers do not opt-in to overdraft protection; most overdraft revenue comes from a small subset of repeat overdrafters.  It is the repeat overdrafters whose opt-in rate will be crucial.  Those who routinely overdraft might be more inclined to opt-in because they have come to rely on the service.  They might not like the fees, but their repeat behavior indicates that they'll tolerate them and perhaps even opt for them rather than have overdrafts denied.  

In short, I just don't see banks losing that much revenue as the result of the overdraft regulations.  There will, of course, be some transaction costs for banks in doing the solicitations, but that shouldn't be a deal-breaker.  The Fed's overdraft regulations stop well short of what is needed to make the overdraft market competitive, which is what is necessary to push down prices; how many consumers are going to move their accounts to another bank when they are confronted with the level of fees their current bank charges?  There's a huge amount of lock-in with bank accounts. 

(To be sure, Lieber cites Bank of America as claiming that it has already lost $160M in overdraft revenue as the result of changes it has made in anticipation of the Fed's rule.  I'm curious what this figure actually represents.  What changes has BoA made to comply with the regulation?  BoA certainly hasn't implemented a full opt-in system yet.   I'm not sure what else they'd really have to do to comply.  And if the Fed rule is costly, why would BoA want to implement it any sooner than necessary?)

Lieber notes three possible bank responses to the impact on their business model:  (1) start charging fees for checking accounts to offset lost overdraft revenue, (2) bundle checking accounts with over services (like impossible to value, and likely worthless, ID theft protection) and charge for it, (3) go with the Ryan Air à la carte model, with free bare-bones checking, but charges for all add-ons.  

Some banks have already started adopting some of the other models without the regulatory impetus.  Why not also bundle in hard-to-value services and charge for it?  

Even so, I don't see banks jumping to these models even if overdraft revenue were to take a sizable hit.  These models have been possibilities for years, but banks still offered free checking even when overdraft revenue was considerably lower.  In 2004, overdraft fees were $10.3 billion total, while for 2009, they're estimated to be as high as $38 billion.  A regulation that at most would push overdraft revenue back 50% to about $19 billion isn't likely to cause banks to adopt business models they rejected when free checking + overdraft brought in $10.3 billion in overdraft fees.

It's also important to mention a fourth possibility that is often forgotten in the regulatory discussion:  regulation makes the marketplace more competitive, so banks just have to live with smaller profit margins.   Thus, in the context of interchange fee regulation, Todd Zywicki has claimed that there is a zero-sum game between consumers and merchants--if merchant fees are reduced, consumer fees will go up and vice-versa.  The possibility that bank, rather than consumer, surplus might be reduced rarely makes its way into the discussion, but it is the result that should attain in a competitive financial services marketplace.

Don't get me wrong.   I think the opt-in requirement is a good one--meaningful assent is an important part of contracts, and the opt-in moves towards having more meaningful assent to the overdraft credit extension from consumers.  To be sure, overdraft fees are already disclosed in some fashion in the account opening disclosures, but that's buried in pages of fine print that nobody reads.  I wonder, though, just how much a one-time opt-in, the setting for which is controlled by the bank, will affect consumer behavior...or bank revenue.


Consumers already have a number of reasons for switching to credit unions. Instituting checking account fees would give them another one. I recently decided to switch to the local credit union and found that they offer much better deals than the big banks, including interest on deposits. I am getting 4% on deposits up to 25K.

If banks have to charge for checking accounts and can't pay enough interest(if any) to keep savings accounts customers happy, let them lose business. If they do, the market is telling us something. Maybe it's telling us that banks are obsolete, since people already have the options of buying debit cards that facilitate direct deposits, credit union memberships, and money market accounts instead of savings accounts(even through paypal). Even loans can sometimes be obtained more easily through websites such a prosper.com, to say nothing of allowing investors to profit on the other side. Why should our economy depend so heavily on savings institutions that borrow short and lend long?

You've completely missed the mark on part of this. You stated that "In fact, banks can make opting in the smart thing to do because they are free to charge whatever type of NSF fees they want for denied transactions."

That's not true. The FED views NSF fees as overdraft fees. The FED says there are overdraft fees that result in the item being paid - commonly known to banks as "courtesy pay" or "overdraft protection" - and there are overdraft fees that result in the item being rejected - commonly know as "NSF". The FED regulation prohibits BOTH of those in the absence of an opt-in. So, banks can NOT just charge whatever NSF they want for POS transactions - in fact, they can't charge anything, without the opt-in. Not only that, some banks have not offered courtesy pay on POS transactions. In that scenario, the consumer would only be opting in for NSF fees (assuming the bank doesn't change course and start allowing courtesy pay on those transactions) - I can't think of any reason for a consumer to do that, other than ignorance. Logically, this will lead to an extremely low opt-in rate - thereby jeopardizing 50% of fee income. Thus, the thought that, since the users of overdrafts would no longer be able to subsidize the free checking of those who don't overdraft, free checking would become a thing of the past.

(I've used the term "bank", as you did, to mean all financial institutions, including credit unions, because the regulation applies to all of them.)


I beg to differ. The language in the Reg E amendments is pretty clear. It defines an overdraft service as "a service under which a financial institution assesses a fee or charge on a consumer’s account held by the institution for paying a transaction (including a check or other item) when the consumer has insufficient or unavailable funds in the account." The regulation covers "overdraft services" which means fees for payment, not fees for non-payment due to insufficient funds.

Regulatory coverage of overdraft, but not NSF fees contrasts with Reg DD's disclosure provisions, 12 CFR 230.11 (or the analogous NCUA regulation at 12 CFR 707.11). Those regulations require disclosure of both "fees or charges imposed on the account for paying checks or other items when there are insufficient or unavailable funds and the account becomes overdrawn" AND "fees or charges imposed on the account for returning items unpaid." The later are not defined as overdraft, however.

Further, the Federal Register discussion about the Reg E amendments shows that the Fed's staff is aware of fees for non-payment, as well as fees for payment. There is no discussion of why only the latter are covered, but I don't think the regulation leave much doubt about its scope. Financial institutions (as Reg E covers CU, as well as banks and thrifts) are free to charge for transactions when there are insufficient funds, just not for advancing the funds without an opt-in (if it is a debit/ATM transaction).

The lack of NSF coverage is hardly the only seeming lacuna in the final regulations; it is not clear, for example, if a resolicitation of opt-ins would be required upon changes in the overdraft program. I would think so, at least for a material change, but what if the solicitations included very broad disclosures or an any time/any reason term change? And would the resolicitation form have to be the same (same disclosures, opt-in or other disclosures, opt-out permitted)?

Ultimately, whatever the details of the regulation's implementation, it is impossible to know the financial impact to banks without knowing the opt-in rate and which subset of customers opt-in. Even with a 50% hit to overdraft fee income, however, the income (industry-wide) would still be more than it was just a few years ago, and that was easily sufficient to support free-checking.

Please let me know, though, if there is a textual basis for your interpretation about NSF fees being overdraft.


Our staff sat in on the FED's Reg E presentation to financial institutions. They made it abundantly clear that they consider courtesy pay and NSF to be overdraft fees as referenced in the new rule. Believe me, we're highly motivated to interpret it the way you have, as were many other attendees. In the Q&A portion of the presentation, there was considerable grumbling, debate, and consternation on this point. The FED said they are working on revising the language to remove any ambiguity.

Regarding your point on NSF income rising industry-wide. We certainly don't see that at our institution. Since the advent of Check 21, our NSF income has dropped significantly. Combine that with the ever-shrinking margin between loan rates and savings rates, the seemingly exponential growth of resources required to comply with regulatory changes, growing delinquency due to economic conditions, shrinking loan demand, and the declining pool of qualified borrowers (look at how the industry-wide drop in credit card limits and the economic downturn have impacted credit scores) and this regulatory change will cause many FIs to scramble to replace the lost revenue. It makes free checking a logical, perhaps inevitable, target.

Can you point me to the Federal Register discussion? We're very interested in being able to apply the new ruling as you've suggested. If the interpretation you've adopted proves correct, then this hubbub is exaggerated.



Sorry, me again.

Above you quote: defines an overdraft service as "a service under which a financial institution assesses a fee or charge on a consumer’s account held by the institution for paying a transaction (including a check or other item) when the consumer has insufficient or unavailable funds in the account."

For a POS transaction that has been pre-authorized, the FI has no option other than to pay the transaction, even if it results in an overdrawn account. Whether we call the fee to do so a courtesy pay or NSF is immaterial according to the FED - it's an overdraft fee.

Maybe that's where everyone's confusion lies.



The Federal Register notice is here: http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20091112a1.pdf

The text of the final regulation begins at page 79. Whatever the Fed staff has said in private discussions (which might pre-date the final regulation), that isn't what the law currently provides. Maybe the Fed will amend it, but to require opt-in for both overdraft and denial fees doesn't make a lot of sense--basically, the bank can't charge the customer either way--so go ahead and write lots of hot checks to your friends and see if they get paid.

Why did Check 21 cut into NSF income? (And are you using this to refer to denial fees or overdraft fees?) Is it speeding up presentment and making funds more likely to be available? I would have thought that it would reduce float and therefore make overdrafts more likely.

The broader point you make, about a perfect storm of business downturn and regulation hitting FIs, certainly does raise the possibility of free checking getting a second look. NIM decline plus defaults alone are a problem. And interchange revenue is also in the cross-hairs. I think it's key, however, to recognize that there are a confluence of factors, and it's not any single factor that's likely to force a change in the business model.

How many POS transactions are pre-authorized? If you're referring to what I think you are, then that's basically gas stations, restaurants, hotels, and car rentals. As I read the Fed's rule, nothing prevents you from paying an overdraft on such a transaction; you just can't charge a fee for it unless the consumer has opted in. That's a lousy situation for a FI, and is something that FIs need to take up with debit card networks in order to find either a technological or a pricing fix (the cost of either will likely be borne by merchants...).

the feeback that you received from the Fed about NSF being a type of overdraft fee appears to be grossly mistaken. For once NSFs only apply to check and ACH transactions (I never saw a debit transaction subsequently returned to the merchant for insufficient funds and then charged an NSF); secondly NSFs might cause the consumer to incur a merchant fee for the returned item (in addition to an NSF assessed by the consumer’s financial institution), in addition to flagging on ChexSystem or equivalent.
Are you sure that the Federal representative was not just talking about the recent Reg DD amendments?

I haven't heard of debit NSF fees, either, but I imagine they are possible and that even if they aren't consumers don't know that, so they could easily be persuaded to sign up for overdraft protection rather than have to pay a fee AND have their transaction denied.

There are 2 types of transactions with debit cards, those that require a PIN, and those that don't.

For PIN-based transactions (ATM or "debit" at the merchant):
The transaction is either authorized or rejected by the FI. No fees involved regardless (at least at Texas Trust CU).

For non-PIN transactions ("credit" at the merchant): The vast majority of these transactions are sent to the FI for pre-authorization. The FI either gives a pre-authorization or rejects it. If rejected, the transaction is declined and no fee results (at Texas Trust). If the FI gives a pre-authorization, then they MUST accept the actual transaction when it comes in. This can happen in a matter of minutes or days.

To allow for that, the FI normally puts a hold on the account for the amount of the pre-authorization. The FI sets the hold for a certain amount of time. Texas Trust sets a 3-day hold, unless the merchant code indicates that the transaction is for travel (gasoline, car rental, hotel), in which case we expire the hold in 1 minute. When the actual transaction comes in, we post it. If the date and merchant match the pre-authorization hold and if the amount is within a certain tolerance (we use 20%) of the pre-authorization amount, then the hold is "matched" and expires immediately.

This is where things can go wrong. If the transaction doesn't come in before the hold expires, other transactions (checks, ACH, debit/ATM) can take place first, reducing the available funds below the pre-authorized amount. When the transaction actually comes in, the FI is obligated to post it. This results in an overdraft fee.

And this is the fee that the Fed is telling us is no longer allowed without an opt-in. You can call it whatever you want - NSF, overdraft, courtesy pay (although this isn't truly a courtesy pay).

Another issue could be a transaction not matching the pre-authorization amount - perhaps the consumer decided to pay a 25% tip. In this case, the debit transaction would post, but the hold would still be in effect. This could result in other transactions being rejected or incurring a fee (and if it's a pre-authorized debit transaction, then the Fed would call that an overdraft fee and not allow it).

I'm certain that the presenters were discussing Reg E. The presentation did concern both Reg DD and Reg E. The Reg DD portion took up about 10% of the meeting and resulted in almost no discussion. The rest was focused on Reg E, which resulted in a ton of discussion, much of it around this very topic. The presenters were an Attorney and the Managing Counsel for the Federal Reserve Board's Division of Consumer and Community Affairs.

In the document you cited above, the section called "17(b)(5) Exceptions to the fee prohibition" starting on the bottom of page 50 and running to the middle of page 53 definitely states that there is no exception to the prohibition on fees in the circumstances I described in my last post. Such exception was proposed, but the FED Board didn't adopt it, basically telling FIs to work with merchants and card networks to eliminate the delays in getting pre-authorized transactions processed. It's not fair, as the FI has nothing to do with the delay, but that's the rule.
This brings me back to my original point - FIs ARE facing a major reduction in fee income that may very well lead to the demise of free checking. In fact, the FED speculated on that very outcome in the document you cited, pages 25-26.
I appreciate the thorough discussion of the topic and wish you were right.


That's right--there's no exception for debit holds. As far as I know, debit holds come up only certain types of transactions: gas stations, restaurants, hotels, and car rentals. That's a lot of debit transactions, however. So what are the solutions from a CU's perspective?

(1) work with MC/Visa to change the technology on holds so that exposure is limited (this probably means shifting from signature to PIN) or to get higher interchange on transactions involving holds (sucks for merchants and consumers, though).

(2) shift to PIN debit issuance (but interchange revenue might be lower, and PIN isn't an option for all transactions)

(3) charge consumers a debit hold transaction fee (regardless of overdraft) that will be reimbursed if certain circumstances (not precisely matching overdrafting) are met (e.g., the hold results in no more than an average daily overdraft of $X over 3 days, and the average daily balance during the last month has otherwise been positive or has been at least $X).

I hate suggesting transactional end-runs around regulation (especially for free!), but until regulators realize how easy it is to circumvent their regulations, they won't craft effective regulation.

Thanks for the input. We're having another discussion on Reg E changes this week, so your points provide food for thought.
Regarding the debit holds - these come up on all sorts of transactions. You're right that they come from gasoline (where the merchant only pre-authorizes $1) and other travel items. But we put holds on all pre-authorizations. The problems arise when the actual transaction takes longer to get to us than the hold was set for (3 days in our case) or when the pre-authorization amount isn't within 20% of the actual transaction. This happens much more often than you'd think - mainly at restaurants. The restaurant runs a pre-auth for the bill amount, then the customer tips more than 20%.
I suppose we could set the hold for a longer period of time - not sure what we're allowed to do and doubt it would sit well with our members. And we could up the matching criteria to, say, 40% - but that's going to cause other problems, like improperly matching transactions.
We could ban tipping, but that's not fair to servers, who are underpaid as it is.
I'll let you know what we decide to do.

"There's also no reason to believe that most consumers would not opt-in to overdraft protection. "

In credit cards, historic opt-in rates for programs such as this hover below 2%. If the program was opt-out then you would have a case. However,this is considered a negative outcome for the consumer and the consumer much take action in order for the fee to be assessed. I would speculate as 20 bps opt-in response rate. The law will not allow you to discriminate (opt-in or you get a fee) and the marketing surrounding this would be tightly scrutinized by regulators and legal departments meaning you will not get any bump there. For all intensive purposes these fees will disappear completely much like the OCL fee is disappearing in credit cards.


Is there publicly available data on opt-in rates for credit card overlimit? That would likely be of very recent vintage (not required until the CARD Act). The disappearance of OL fees in cards is definitely a sign that issuers don't think they can get sufficient opt-ins, but I wonder if debit overdraft is a perfect match with credit or if there are different factors at play.


Unfortunately there is no publicly available data surrounding OCL opt-ins and I can only speak from experience in dealing with similar programs and even positive opt-in programs (2x points but you have to call or go online, special offers, etc.) Given the extremely low opt-in rates in general and negative programs in particular the decision was an easy one to eliminate OCL fees altogether as the rate of opt-in versus the investment in infrastructure and cardholder communication necessary to solicit and collect fees was just too one-sided.

Debit and ATM overdraft (ACH different story) in my mind is a perfect match to credit OCL. The only difference in mine and the cardholder's mind is subbing one piece of plastic for another. When it comes to payment methods if you are turned down on your debit, you will be just as likely to pull out a credit card and pay then and there and avoid the overdraft fee. This is the same behavior that people exhibit when they use their credit card why would it be any different for debit?

te first thing we need is a publicly available data surrounding OCL opt-ins, i avoid using my credit card and just use my debit card all the time

To tjfxh:

One thing Credit Unions do not do is PAY TAXES. One more way you can short the system for personal gain.

You can get high yield checking all over the place from taxpaying banks. See checkingfinder.com

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