The Long Goodbye – Regulators and Competitors are Forcing Banks to Abandon Overdraft Fees

Few banking practices have created as much consumer ire and regulatory attention as overdraft fees. Created in the 1990s as a convenience for customers and a new source of revenue for banks, overdraft fees have become a lightning rod for regulatory scrutiny and a competitive disadvantage for banks competing for new retail customers.??Changes in overdraft fee practices will reduce bank revenue and change the way banks manage their retail payment products.

Two factors sent bank overdraft fee revenues soaring in the early 2000s.??The explosion in the popularity and use of debit cards greatly increased the number of transactions on most retail checking accounts.??And banks realized that by managing the order in which items were paid, most notably by paying larger items first even if they were presented later in the banking day, they could further increase revenue. Both these trends prompted legal responses in 2010.

Consumer complaints about overdraft fees on debit card transactions, especially small ones, made the “$40 cup of coffee” famous. In response, the Federal Reserve amended Regulation E (promulgated under the Electronic Funds Transfer Act) to prohibit banks from paying debit items that resulted in an overdraft fee unless the customer had expressly consented to that practice.??

Banks had long been defending claims challenging the reordering of items “high to low” by citing Section 4-303 of the Uniform Commercial Code (UCC), which allowed banks to pay checks “in any order.”??But in 2010, Judge William Alsup of the federal district court in San Francisco issued a scathing opinion in the?Gutierrez?litigation against Wells Fargo and enjoined the bank from continuing the practice.??The court found, based on a series of internal emails and memos, that the bank had intentionally reordered items to increase overdraft revenue, and either failed to inform the customer of the practice or actively misled them about its effect.??The court found that the bank’s actions amounted to bad faith, thus forfeiting its protection under the UCC, and violated California’s Unfair Trade Practices statute.

Although the central holding of?Gutierrez?– that high to low posting itself was illegal – was ultimately overturned by the Ninth Circuit Court of Appeals, the searing language of the opinion motivated many other banks to settle similar class actions, at a cost of hundreds of millions of dollars.??Many banks adopted so-called “real time” posting of items and paid them in the order in which they were received.

But these changes did not stop the drumbeat of regulatory and consumer criticism of overdraft fees.??Class action lawyers filed more cases based on inadequate disclosure of the mechanics of overdraft fees to customers.??This led to challenges to virtually every bank practice related to overdraft fees, including so called “overdraft protection” programs, the practice of charging multiple overdraft fees in a single day, and charging multiple fees when the same item is presented multiple times. Banks continued to settle cases on these and other theories for millions of dollars.

Regulatory scrutiny of overdraft fees also increased, especially after creation of the Consumer Financial Protection Bureau (CFPB) by the Dodd-Frank statute.??The agency issued multiple statements critical of overdraft fee practices, many of which echoed longstanding criticisms by consumer advocates — that the fees affected low-income households disproportionately and amounted to a line of credit that charged an extortionate interest rate. The agency also brought a number of high-profile enforcement actions against banks relating to their overdraft practices and obtained significant settlements.??In one memorable 2018 settlement, TCF Bank agreed to pay $25 million in customer restitution and a $5 million civil penalty related to its overdraft practices.??The bank’s CEO had allegedly purchased a speedboat that he named “Overdraft.”

Despite all of this expense and unwanted attention, banks were reluctant to abandon their overdraft fee practices for a simple reason – they were extremely profitable.??The CFPB reported that bank overdraft fees totaled $12 billion in 2019, which amounted to two-thirds of all fee revenue reported by banks.??Smaller banks had become particularly dependent on overdraft fee revenue.??A 2021 Brookings Institute study identified six smaller banks whose overdraft fee revenue was greater than half of their net income (Three of these banks had overdraft fee revenue that?exceeded their net income). Even larger banks, while able to rely on more diversified revenue streams, still collected billions in fees.

By 2021, however, alternatives to traditional retail checking accounts were emerging. The proliferation of fintech firms and payment applications suddenly allowed consumers to use their mobile phones to receive funds from others and make payments without a bank account, charging either much lower fees or none at all. Seeing an opportunity to seize a competitive advantage, Ally Bank announced in 2021 that it would stop charging all overdraft fees.??Many other banks either followed suit or significantly changed their practices.??Besides reducing the amount of the fee (in Bank of America’s case, from $35 to $10), banks began to provide grace periods to allow customers to cover negative balances, to waive fees on small negative balances, and to limit the number of fees charged in a single day. Other banks no longer pay items if the account lacks sufficient funds. The CFPB reported that by August 2022, 13 of the 20 largest banks had stoped charging overdraft fees, and 4 more were scheduled to do so by the end of 2022.

As a result of these changes, bank overdraft revenue has started to decrease.??The CFPB estimates total overdraft revenue dropped to $7.7 billion in 2022, including a 48% decrease in the 4th?quarter from the prior year. Regulators have continued to scrutinize overdraft fee practices.??In the last several months, the CFPB, OCC and FDIC have all issued new regulatory guidance on overdraft fee practices.??The most recent controversy concerns a practice known as “authorize positive, settle negative.”??Because of the lag between authorization of a debit card transaction and its payment by the card-issuing bank, intervening transactions can result in the customer being charged an overdraft fee for a transaction that was approved at the point of sale. New class actions have been filed challenging this practice.

Despite these trends, many banks will find it difficult to completely eliminate overdraft fees in the short term because the revenue hit is too large.??PNC Bank disclosed that when it instituted new procedures designed to reduce overdraft fees, it expected fee revenues to decrease by $150 million, a significant amount even for a large bank.??Smaller banks with less diversified sources of revenue who are more dependent on overdraft fees will probably try to maintain them for as long as possible.??Regulators - who must balance concerns about a bank’s profitability with the impact of its practices on customers – will be mindful of the impact of reductions in fee revenue on the profitability of the bank.

The controversy over overdraft fees reflects changes in the nature and use of retail checking accounts in the US banking system.??Financially distressed customers – who pay the vast majority of fees – have few other options for short term credit.??Tech-savvy customers find checking accounts less and less appealing.??Faced with these challenges, banks will be forced to offer more consumer-friendly alternatives to traditional overdraft fees and seek replacements for this once-dependable revenue source.

The CFPB’s most recent study of trends in overdraft fee revenue is available at?https://www.consumerfinance.gov/data-research/research-reports/data-spotlight-overdraft-nsf-revenue-in-q4-2022-down-nearly-50-versus-pre-pandemic-levels/full-report/

The OCC’s and FDIC’s most recent overdraft guidance are available at?https://occ.gov/news-issuances/bulletins/2023/bulletin-2023-12.html?and?https://www.fdic.gov/news/financial-institution-letters/2023/fil23019.html

My podcast,?“Risk Management for Financial Institutions - How Banks Stay Safe and Sound,” is?available at?https://youtu.be/2kNWCLQp678.

Fred Egler is an independent consultant who is advises on operational risk issues at financial institutions, including banking, securities and insurance.??He can be reached at?[email protected].