Is a Battle Brewing Over Bank Overdraft Fees?

credit card swiperSince February of this year, the Consumer Financial Protection Bureau (CFPB) has been investigating the procedures used by banks when charging overdraft fees on checking accounts. They have also welcomed comments from consumers, particularly those who have a story to tell about excessive charges for overdraft protection.

At the end of April, the CFPB announced they were extending the public comment period to give even more people a chance to weigh in.

They are investigating the overdraft procedures of nine U.S. banks, including some of the largest: Bank of America, JPMorgan Chase and Co., and Wells Fargo. The CFPB said it will decide by the end of 2012 if another round of regulations is needed (in addition to those created by the Federal Reserve in 2010).

But why all the hoopla over this subject lately? Shouldn’t the banks be allowed to charge a fee for an added service like overdraft protection? Or have their penalty-imposing techniques gone too far? Those are the questions at hand.

What is a Bank Overdraft Fee?

An overdraft fee is the money a bank charges for overdraft protection. When a consumer spends more money from his or her checking account than is actually available, he or she has overdrawn the account. The bank can cover this by advancing funds to cover the debit, up to a certain limit. When this happens, the purchase or transaction will still go through — partly with the bank’s money.

There are four types of transactions where this may occur:

  1. Writing a check
  2. Making an ATM withdrawal from a checking account
  3. Making a purchase with a debit card
  4. Automatic bill payments (auto pay) for such things as gym memberships and utilities

Any of these transactions could trigger an overdraft scenario, if the amount spent exceeded the balance of the checking account.

Banks typically charge a fee for overdraft protection. The fees can sometimes be larger than the purchase itself. You’ve probably heard the story of the $2 cup of coffee that ended up costing $37, due to a $35 overdraft fee. At the time this story was published, the average fee for a checking account overdraft was around $30, according to the Federal Reserve.

These fees are typically imposed on each individual occurrence of an overdraft. So it’s possible to rack up a handful of them in a single day, if you use your debit card a lot. Later, we will talk about how your bank might use this against you.

Capitalism or Criminality?

So what’s wrong with this scenario? Why should we be surprised when a bank does everything in its power to maximize revenues. Isn’t that what banks do?

According to Richard Cordray, Director of the Consumer Financial Protection Bureau, there are similarities between overdraft fees and the notorious payday loans that prey on cash-strapped consumers. The crux of the CFPB argument was laid out in statements made by Cordray in February 2012: “We are concerned that overdraft practices employed by some banks unnecessarily increase consumer costs by making it difficult to anticipate and avoid fees.”

Now we are getting to the heart of the issue. Are the banks being sneaky in the way they impose overdraft fees? Are they willfully attempting to fly below the radar, as it were, to charge several fees when one would suffice? This is chiefly what the CFPB is investigating. It’s also why they have opened the floor to public comment on this issue. How to participate: Visit www.consumerfinance.gov if you would like to share your own story.

Different Rules for Debit Cards vs. Checks

A couple of years ago, the Federal Reserve enacted a rule that prevents overdraft fees on certain types of transactions unless the customer “opts in” to the bank’s overdraft protection program. In other words, the customer must knowingly and explicitly choose this service.

Prior to that regulation, banks could automatically enroll their customers when they opened a checking account. Many consumers didn’t even know they had overdraft protection until the resulting fees started to pile up. The new rules created in 2010 prohibit automatic enrollment. But they only apply to transactions with debit and ATM cards.

The rules implemented in 2010 do not apply to transactions where the customer writes a check, or to recurring debits such as an auto-pay for a gym membership. Your bank can still enroll you into its overdraft protection program (and charge the resulting fees) for those types of transactions. They do not need your consent when it comes to checks and automatic bill payments.

A $31 Billion Revenue Model

So how much is at stake here? What do the banks stand to lose if the federal government reels in their overdraft fees, or the techniques used to impose those fees? According to Moebs Services, a research firm within the financial sector, U.S. banks pulled in $31.6 billion dollars worth of overdraft fees in 2011 alone. So you can expect them to have their lobbyists on point during this debate.

There’s another reason the banks will fiercely oppose any curtailment of their overdraft fees. They have fewer ways to squeeze their customers today, when compared to a few years ago. This is a direct result of the Credit Card Act of 2010, and other forms of legislation. That law took away some of their favorite tricks for making money, such as retroactive interest-rate hikes on existing balances. It’s no surprise they are looking for ways to fill those gaps.

Biggest First: How the Banks Maximize Overdraft Revenue

Many banks process daily transactions in a way that maximizes their revenue from overdraft fees. Instead of processing the transactions chronologically, they purposefully process the largest debits first. This can result in a larger number of overdraft fees, because it will deplete the customer’s account more quickly. Consider the two scenarios below:

Scenario ‘A’ – Biggest Payments First

A consumer uses his debit card several times in a single day, mostly for small purchases. He uses the card to get gas on the way to work, to buy lunch, to grab a cup of coffee, and to pick up some groceries on the way home. Four transactions in all. The next day, his bank also receives a funding request from a check he wrote in the amount of $400. The customer doesn’t realize he only has $399 left in his account.

The bank “batches” all of these transactions and begins deducting them from the customer’s checking account. They start with the largest item, which is the $400 check. This wipes out the customer’s checking account balance entirely. Next, they process those four smaller charges resulting from debit card use — the cup of coffee, the gas station stop, etc. Each of these transactions will overdraw the account, so each will result in a separate overdraft fee. If the bank charges the average of $30 per overdraft, it adds up to $120 in charges (4 x 30).

Scenario ‘B’ – Chronological Processing w/ Biggest Payment Last

In this scenario, the bank batches the same types of debits. There’s a check for $400, along with four smaller debit-card purchases. But this time, the bank simply processes the transactions in the order they occurred. The smaller transactions are processed first, and there are sufficient funds in the account to cover them. Lastly, they process the check. By this time, the customer only has $342 left in the account — not enough to cover the check. Again, we have an overdraft scenario. But this time around, there is only one transaction that overdraws the account. So the customer is only charged a single overdraft fee of $30.

The same transactions were processed in these two scenarios. They deducted the same amount from the customer’s checking account. But the order in which they were processed made all the difference. When a bank chooses to process the biggest payments first (as many of them do), it can result in a higher number of overdraft fees. It’s a situation where the bank modifies its internal procedures in order to impose the most fees. Now you can see why overdraft fees are a $36 billion “industry.”

The core question remains: Is it capitalism or thievery? It’s a gray area, to be sure. On one hand, the “biggest first” technique helps to ensure the most important payments are covered first, like a mortgage payment. On the other hand, it clearly increases the number of overdraft fees that may occur in a certain processing period. And that’s not the only problem with the biggest-first strategy. According to Mr. Cordray:

“Because of transaction ordering, along with the vagaries of funds availability and the settlement of various types of debits, consumers may not know when they have reached the limit of their available funds. Therefore, it is easy for them to overdraw their accounts inadvertently.”

This is one of four key areas the CFPB is investigating. They also want to know if bank overdraft policies are disclosed in a clear manner that any layperson could understand. Additionally, they are looking into misleading marketing techniques, and the effect all of this has on low-income and/or younger borrowers. Certainly, these things deserve a closer look.

The ‘Penalty Box’ is a Sensible Idea

The CFPB has created the prototype of a so-called penalty fee box. They are seeking input from consumers and banks alike on the adoption of this box. As seen in the image below, the box would appear in a prominent location on the customer’s monthly bank statement (when applicable). It would draw attention to any overdraft fees that occurred during the latest billing cycle.

penalty fee box
Penalty fee box proposed by CFPB. Click to enlarge the image.

At the bottom of the customer’s statement, there would be a follow-up to the penalty box. Here, the customer would learn how to avoid these types of fees in the future. This includes linking the checking account to a savings account, to cover any overdraft situations. The customer would also be reminded that they can opt out of overdraft protection for ATM and debit card transactions.

Overdraft fee explanation
Part 2 of the penalty fee box. Click to enlarge the image.

Again, this is just a prototype of the penalty fee box proposed by the CFPB. If and when the proposal becomes a requirement, it may look different from the images shown above. But it’s certainly a step in the right direction.

In my mind, every consumer who opens a checking account should understand the three items shown in the second image. Whether or not they choose to read the information is up to them. At the very least, it should be put in front of them in plain English. It should be written to inform, not to obfuscate.