Why Bank Overdraft Fees Merit Some Regulation

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The NY Times had an article Wednesday decrying bank overdraft fees. While I believe much recent press coverage of the bank industry has been unjustly impugning legitimate practices, in this case I think the complaints are justified.

The interesting thing to me is that payday lenders are routinely vilified while bankers are often regarded as pillars of the community, despite the fact that standard bank overdraft practices are far less consumer-friendly than payday loans. The debate over payday lending is relevant because bank overdraft charges effectively form the umbrella under which payday lenders can function. Far more than banks care to admit, overdrafts and payday loans are substitute products. In fact, the biggest difference is that payday lenders offer consumers a better deal than banks do.

The typical payday loan costs a fee equal to 15% of the amount borrowed for a two-week loan, which equates to an APR of 391%. Borrowers must actively seek out payday loans, and the terms and conditions are all laid out immediately prior to the transaction. In contrast, the effective APR on a typical overdraft transaction can exceed 1000% (it varies by type of transaction – check/ATM/debit) and disclosure, while excellent at some institutions, is broadly far inferior to that of the payday loan industry.

The pro-overdraft fee argument is not without merit - the fees allow banks to offer free checking services to many customers, and the fees are frequently the product of customers paying insufficient attention to their finances. However, weak disclosure coupled with the common bank practice of batching each day’s debits and paying them in descending order of size does tend to expose economically vulnerable customers to cascades of overdraft fees. The standard bank justification for this practice - that larger payments are more likely to be more important ones - is sometimes true but frequently not, and based on my discussions with bank managements, is much more of a fig leaf for fee-maximization strategies than a genuine reflection of concern for customers’ well-being.

So what to do? I actually think the bill proposed by my Representative, Carolyn Maloney, is quite sound. It doesn’t ban overdraft fees, or even cap the amount, but does require much better disclosure, including disclosure of a fee prior to approving a transaction that would incur one, and the ability to cancel the transaction instead. Critically, this would be required even for debit transactions, which tend to be smaller and thus the most costly to consumers. Her bill would also preclude banks from pursuing fee-maximization strategies, even if a more benign-sounding justification for them can be found.

As a practical matter, this might spur many banks to stop offering “free checking” and move to annual fees or much higher minimum balances, so each customer’s fee load would be more closely tied to his own value as a customer, rather than being subsidized by fees paid a small subset of customers that includes a disproportionate number of low-income and unsophisticated customers.