Opinion

Felix Salmon

Overdraft fee datapoints of the day

By Felix Salmon
October 6, 2009

The Center for Responsible Lending has a new report on overdraft fees, which has some startling numbers on the degree to which these things have increased in recent years:

Overdraft fee income for banks and credit unions rose 35 percent between 2006 and 2008, going from $17.5 billion to $23.7 billion. Add in non-sufficient fund fees, and the totals rise to $25.3 billion and $34.3 billion, respectively. (The difference between an overdraft fee and an NSF fee is that an overdraft fee is charged when the payment is made; an NSF fee, or bounced-check fee, is charged when the payment is not made.)

The Center also notes that “as recently as 2004, 80 percent of all institutions denied debit card overdrafts” — it’s astonishing how quickly such charges went from the exception to the rule.

Overdraft fees now dwarf the actual overdrafts themselves:

For 2008, we estimate that checking account holders receive only $21.3 billion in credit for the $23.7 billion they pay in overdraft loan fees. Put another way, consumers were obligated to repay $45 billion for $21.3 billion in extremely short-term credit.

The Center has some good recommendations, including this one:

Require that overdraft fees be reasonable and proportional to the actual cost to the financial institution of covering the overdraft. On average, overdraft fees exceed the amount of credit extended, which is particularly troubling given the short time period until repayment—usually only a few days. Since banks are able to repay themselves out of the accountholder’s next deposit, these loans carry a low default risk relative to their high cost. Overdraft fees should be proportional to the actual cost to the institution of covering the overdraft, taking into account the cost of funds, default risk, and a reasonable profit margin. Indeed, a product designed to be proportional to the cost to the institution of covering the overdraft already exists—an overdraft line of credit at a reasonable interest rate.

In fact, the status quo is even worse than the Center here implies. Yes, it’s true that banks are able to repay themselves out of the accountholder’s next deposit. But they never do.

Where I come from (England), an overdraft is simply a negative balance on your checking account. You pay interest so long as the balance is negative, and if you put in enough money to bring the balance back into the black, you stop paying interest. Not here. In the US, there’s normally no such thing as a negative balance on your checking account: instead, when you go into overdraft, you not only pay the usurious overdraft fees, but you also start running up a debit balance on your overdraft account. If you then deposit money into your checking account, it’s entirely possible (and indeed common) to have a positive balance in your checking account and an overdraft, all at the same time. In order to get rid of the overdraft, you need to actively transfer money from your checking account to pay off your overdraft — which of course you’re never going to do unless and until you find out that you’re overdrawn in the first place. Which might not happen until you get your next month’s bank statement.

If I may, then, I’d like to make one addition to the Center’s recommendations: that all deposits into checking accounts be put first towards any overdraft, and only then towards a new positive balance. But that of course would be consumer-friendly, so it’s probably never going to happen.

Comments
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Felix,I work in management at a small community bank. And in many respects, I agree with you. However, having run small businesses and now working in the banking industry, I would like to hear you respond to the functional role that overdrafting plays in the financial system in America.As a small business, taking checks always represented a risk – will the document cash? And what recourse does a business owner have? At one time, unless the customer was upstanding, the only recourse was to have an arrest warrant issued until the contract was paid. I can imagine that law enforcement is glad to have that “duty” displaced – an externality in economic terms – a cost to society. Further, the business has expenses related to collecting on the bounce, the fee that is assessed by the Fed for returned items – this is passed from the bank to the business that took the check. So now, not only did they not get paid for the transaction, but the bank is also charging them money. In theory, that can be recouped in the $20-30 returned check fee that most businesses charge (and how is that different than an overdraft fee?). Then there is the time the business invests in collecting, aren’t there other activities that would be better to engage? I imagine there are.Then there is the banking end. Transaction banking, largely free, is highly dependent upon mass information processing. Why banks do so much for free is somewhat surprising once on the inside, but that is what customers expect. Now, a returned item, that isn’t paid, turns into an exception item nightmare. Ok, maybe not nightmare, but having to staff individuals to handle returned items, exclusively, does cost money – and as I said, transaction banking is largely free. A returned item, that is paid, you see as just turning into a negative balance on a checking account, however, it does represent a significant risk to financial institutions. There is even less recourse for a bank to recover funds on an overdrawn account than a business has in a transaction. Banks pay close attention to who has jilted them in the past, because there are account loss reserves to minimize.So, it may be that the fee appears usurious, and as I said, in many respects, I agree with you. It hits people the hardest that can afford it the least. I understand that. But we may be better off, systemically, coming up with solutions to the problem that do not displace or shift costs – they need to be minimized. The overdraft fees may represent significant income and profit to a bank, but it is likely that the cost to the system of not paying is more than the overdraft fee itself (and its being paid by the offending party), it is also protecting the bank from increased losses (ie non-recoverable, written-off losses, like a defaulted loan) on overdrawn accounts, and it is reducing borrowing cost for everyone (how many banks would remain profitable without overdraft fees, ceteris paribus?).These are issues, Felix, that I feel you and many other of the blogoshpere that I read on a regular basis, haven’t really dealt with. On the philosophical level, you have my vote. I am on your side, and the consumer’s. Our community bank works hard to hold accounts to the customer’s favor, so your remonstration may not be universally applicable. Further, without addressing the structural and economic causes for the fees, you don’t really gather the credibility to be truly persuasive in the industry. In any case, I do look forward to hearing what you have to say.ThanksKen

Posted by Ken | Report as abusive
 

Not well understood are the tremendous fraud losses that banks take from checking accounts. The costs associated with offering these services is actually quite a bit higher than most people realize. Fraud losses across the US are well into the Billions of dollars each year.Further, on-line and brick-and-mortar Payday lenders would be beneficiaries of further legislation here. Clearly, the unintended consequences of moving consumers more deeply into a completely unregulated market are much greater than allowing banks to earn some profits on checking and debit accounts.Banks must be able to earn their way out of the current crisis. Continuing to starve them of any revenue source will continue to make them wards of the state at all of our expense.

Posted by MarkH | Report as abusive
 

Ken and Mark, you make good points. But as Felix noted, other countries have banking systems that do just fine without charging these fees. So why does a bank in the US have to do this when one in the UK does not?

Posted by Tim | Report as abusive
 

The comments posted so far present the banking perspective without full consideration of how banks have leveraged new technologies to their benefit and the detriment of consumers and small business. In the new world of banking, debits and charges are processed real time while in many (most?) cases, deposits are held for later processing. Let’s consider the system as it now operates.Let’s say that I am a small business owner. I go to my bank in the morning to deposit my receipts from yesterday’s transactions. Because of my relationship with the bank, they accept the checks I give them without placing any holds on them and, as far as I can tell at the moment, my account now has those funds available for future transactions.Later that day, I go on-line and use the bill pay system at another bank to pay my monthly loan payment. I also use on-line systems to process a payment to my credit card and to order a new software package that I have been waiting for. Finally, I use my debit card to put gas in my car on the way home from work and to buy myself some dinner at a fast food restaurant.How does all this play out? In most banks I will likely get charged several overdraft charges as a result of these activities. Here is why – the debits and charges being process both on line and at local retailers are processed real time while the deposit transaction is being held by the bank until sometime later in the banking day. At my bank, the process debits immediately, but deposits are not processed until 3:00 a.m. The result can be hundreds of dollars in overdraft fees in a single day without the consumer or business owner having any warning or recourse. And in this case there is typically NO RISK to the bank. The funds are already on deposit and the technology exists to process those deposits real time just as it doesto process debits real time. But if the banks chose to use this method, they would lose the profits from the fees.So, you will say, put some money on deposit in your “overdraft” account. Great idea, except for two problems. First, most of those accounts offer very low interest rates so that the money on deposit there is doing nothing to grow your wealth. Second, and more important, banks like mine are now implementing policies to charge a fee when funds are swept from the overdraft account into the primar account. In my case every sweep costs me $10.00. Since those sweeps are done in increments of $100.00 and since the typical overdraft amount to be covered is less than 100.00 (at least in my case it is), then the effective cost of money for me on a best case scenario is at least 10% while my best case return on investment is 2%. And oh by the way, the cost to the bank to make this process is virtually nothing since their systems are fully automated and the funds are held internally.In my view the current banking policies are criminal. They are nothing less than stealing from people who do not fully understand the new technologies and who are not able in most cases to speak for themselves on these issues. If ever there was an issue that cries out for action by the government in defense of consumers, this is it. Especially since most of these banks are still benefiting from my tax dollars spent to “bail them out” while they continue to take billions from the pockets of consumers.

Posted by Kevin Kragenbrink | Report as abusive
 

Ken, to carry on the comparison with England, checks are more or less redundant on this side of the Atlantic. People use credit cards, cash and (European style) debit cards for virtually all face-to-face transactions. So bounced checks are not much of a concern for businesses any more. Indeed, there doesn’t seem to be much risk to business at all from this approach. If a customer has an overdraft facility, or is using a credit card, the business gets paid. If the customer doesn’t, or has reached the limit, the payment is rejected.

Posted by Ginger Yellow | Report as abusive
 

“that all deposits into checking accounts be put first towards any overdraft, and only then towards a new positive balance”yes, at least.Commonsense would dictate, and most would assume if they didn’t know otherwise, that this was already the case.

Posted by Dan | Report as abusive
 

Banks have established all sorts of schemes to maximize overdrafts.It’s what you’d expect when you consider that 45% of banks would not be profitable without the fees they collect from overdraft penalties.

 

I agree with Felix that instead of charging consumers more than what the amount a consumer is short, they should charge the consumer an amount in ratio to the amount their account is short. The banks would still make money, and the consumer’s finances would not be slaughtered during a time when they are already obviously hurting. For example, if the consumers account was negative $100 at the end of the day, the bank could charge them 20% interest on that amount, a total of $20. If the $100 consisted of say 5 transactions then, the amount would still be $20 instead of $35 per transactions which some banks would charge today totalling $175, more than the original debt.

Posted by Rachel | Report as abusive
 

I work at Which?, the Consumers’ Association in the UK. Following the conclusion of a high profile court case about bank charges last week, there have been plenty of debates about them this side of the pond. We’ve just done some research which shows that almost half of UK current account holders would prefer not to have an unauthorised overdraft, and instead, would prefer that any payment which carried them into an unauthorised overdraft was blocked. Our view is that we want banks to show they’re willing to respond to what their customers want by only making unauthorised overdrafts available to those who ask for them. We’ll let you know how we get on. But if you want to hear more, then check out our campaign – Britain needs better banks – http://www.bnbb.org.

Posted by Martin Chapman | Report as abusive
 

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