Bankruptcy

Overdraft Fee Regulation and the End of Free Checking?

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.

Full post as published by Credit Slips on January 25, 2010 (boomark / email).