A Cure That Doesn’t Kill: A Case for Allowing the Fed to Make the Overdraft System Healthier Before Congress Risks Dangerous...

It is probably dangerous to mix metaphors in today’s political environment.

Health care is at the center of the national debate. So is the future of the nation’s financial sector.

Just as in health care Congress must find the right prescription that strengthens the health of our nation’s uninsured without costing so much as to damage the long term viability of their coverage, so must Congress prescribe solutions to issues in the financial services sector that treats the disease but doesn’t kill the patient in doing so.

The overdraft issue, which has received a lot of publicity in recent months about some abuse in the program and is now facing possible congressional intervention to eliminate that abuse, is a good case in point.

Financial institutions earned, according to a study conducted by the Center for Responsible Lending, in excess of $23.7 billion last year from overdraft fees.

The assumption by many is that, if financial institutions are making this much fee income from any one product, there must be something nefarious about that product. Media reports label these programs as nothing short of scandalous. Critics contend that someone is certainly being taken advantage of if that much income is being earned from something like overdraft fees. How could that possibly happen without manipulation and greed-based abuse?

There they go again, the consumer advocates cry. The financial institutions are ripping off the consumer, who can do nothing about it.

Regardless that paying this fee is totally controllable by the consumer who can avoid the fees by simply not overdrawing his account, the critics contend an aggressive cure is needed and soon.

And, without a doubt, it must be acknowledged that there is indeed some abuse in how certain financial institutions manage their overdraft programs that should be reined in. Abusive programs that are not fully disclosed to the consumer are indefensible, should be addressed vigorously, and could be cured with a specific symptom injection to curtail that abuse.

But it is not necessary to come up with an invasive cure that assumes all aspects of every overdraft program are abusive by nature.

In fact, the approach of “let’s cure it, even if the cure could leave both the patient and the practitioner less healthy than before the cure was prescribed” is really not good practice.

Nor is it good public policy.

Although we have come to the point of believing there is no longer any middle ground in the political arena that isn’t so mushy that we must move to one extreme or the other to find something solid to base policy decisions upon, there is actually an effective and reasonable way to make overdraft protection programs responsible for both consumers and financial institutions.

But the answer isn’t another law. Believe it or not, the regulators have found the cure – and it doesn’t kill the patient.

The cure will not be without pain, however, and there may even be some screaming when the treatment is administered; however, there is a way to implement overdraft programs correctly that strikes a balance between consumer protection, personal responsibility and institutional risk management.

The Federal Reserve adopted very far reaching overdraft protection rules in November 2009. Financial institutions will not like them because they are quite cumbersome, laden with regulatory burden, and initially very costly. Consumer advocates will not like them because they don’t completely destroy overdraft programs and eliminate overdraft fees in their entirety.

However, if they were truthful in the quiet of their own offices, both the financial institutions and consumer advocates would have to admit that the Fed has enacted the most comprehensive approach to dealing with this issue ever to come through the financial services industry regulatory process.

The Fed’s approach is strongly pro-consumer. It makes the right of an account holder’s fully disclosed “opt in” to the program the centerpiece of financial institutions’ ability to assess overdraft fees on debit card and ATM transactions. Yet the Fed has left overdraft fees on checks in place; the consumer has the right to “opt out” but is not required to “opt in.

In effect, the Fed has rightly left the success of overdraft programs up to the consumer to decide if he sees value in electing to participate in the program and to the financial institution to construct a program that can be sold to the consumer as having sufficient value for him to choose to participate in.

Although it is seldom popular to speak up for the regulator, the Fed got it right and their solution is not dilatory. It is scheduled to be implemented, not five years from now, but in the summer of 2010. That is a quick implementation date, but it demonstrates how seriously they have taken this issue and their desire to bring the debate over these programs to an acceptable conclusion.

Of course, as is the case so often in Washington, that does not appear to be the end of the issue.

Shortly before or after the upcoming Christmas recess, Congress will take over this issue. Both houses of Congress are scheduled for committee markup of HR 3904 and S 1799 – the most recent in a long line of overdraft protection bills designed to protect the consumer from the abusive practice of charging a fee to front him the money to cover his irresponsibility. This legislation has received a lot of positive press coverage for its sponsors in recent months and serves to change the way consumers and financial institutions handle checking accounts more dramatically than any legislation since Check 21.

Both bills would be described by their proponents as “pro-consumer” legislation as they would sharply curtail and virtually eliminate the ability of financial institutions, particularly banks and credit unions, from charging overdraft fees when a checking account owner writes a bad check, makes a debit purchase for more than he has in his account, or withdraws from an ATM an amount in excess of his balance.

The primary provisions of HR 3904 introduced by Rep. Carolyn Maloney (D-NY) and S 1799 introduced by Sen. Christopher Dodd (D-CT), both identical companion bills, have exactly the same provisions which are as follows:

• Require financial institutions to get a customer’s consent before enrolling him or her in an overdraft program for ATM and debit transactions.
• Limit the number of overdrafts a financial institution can charge to one per month and a total of six per year.
• Require that fees be proportional to the actual cost of processing the overdraft.
• Require customers to be notified by e-mail, text, or traditional mail any time they overdraft their checking account.
• Require that customers be warned in advance of a potential overdraw of their checking account by ATM or debit and given the opportunity to cancel the transaction.

Seems reasonable, doesn’t it? After all, as was indicated earlier, some consumers have been taken advantage of by institutions that manipulated their processing systems to maximize profits without telling the consumers how these programs work.

And some consumers have been charged $35 for a $5 cup of Starbucks because they didn’t know that their debit card was under an overdraft program when they spent money they didn’t have in the account.

Don’t we need legislation to correct these abuses?

Actually, the answer is no. Neither bill is needed now. In fact, after the Fed’s action, either bill would be unnecessary overkill.

A regulatory solution is almost always preferable to a legislative solution.

As a contrast to the proposed legislation, let’s look at the Fed’s regulation and how it addresses the issue without overloading the statute books with requirements that are best put into regulation where they can be adjusted as the marketplace and technology evolves.

According to the Fed in their release announcing the new rule, their regulation is intended to provide account holders with the right to limit the costs of overdraft services by providing consumers a choice regarding whether they want their institution to pay overdrafts for ATM and one-time debit card transactions.

Consumers will be provided a clear disclosure of the fees and terms associated with the institution’s overdraft service and given the following rights before overdraft fees can be charged on ATM and one-time debit card transactions:

• Opt-In. The final rule requires consumers to opt in, or affirmatively consent, to the institution’s overdraft service for ATM and one-time debit card transactions before overdraft fees may be assessed on the account.
• The rule also provides consumers an ongoing right to revoke consent.
• Consumers Covered. The opt-in right applies to all consumers, including existing account holders.
• Conditioning the Opt-In. The final rule prohibits financial institutions from tying the payment of overdrafts for checks and other transactions to the consumer opting into the overdraft service for ATM and one-time debit card transactions.
• Same Account Terms, Conditions, and Features. The final rule requires institutions to provide consumers who do not opt in with the same account terms, conditions, and features, including price, as provided to consumers who do opt in.
• Mandatory Compliance Date. The mandatory compliance date is July 1, 2010 for all new accounts and August 15, 2010 for all existing accounts.

This regulation, while it will be costly for financial institutions, is much preferable to HR 3904 and S 1799. Overdraft programs will be tighter in their application and more transparent for the consumer, but they will survive. Under HR 3904 and S 1799 it is quite likely that overdraft programs would be eliminated as too costly and too risk prone for many, if not most, financial institutions to continue.

The result of HR 3904 and S 1799 would be fewer checking accounts being offered to persons of modest means and more fees for everyone who has a checking account. Those checking account holders who do not cause overdrafts will have to pay additional fees to cover for those who would be able to overdraft under the proposed legislation without fear of being assessed a fee more than once per month and six times annually.

Financial institutions would return to the dark days of assessing NSF fees, returning more unpaid items to the merchants, increased collection costs, and more write-offs on checking account negative balances. Consumers would return to facing late fees, merchant fees, and possible prosecution under local and state bad check laws.

We must remember that, while there is no doubt that a growing number of consumers are utilizing these programs and paying what we might consider quite costly fees for doing so, these programs are not all negative from a consumer perspective. And, while there is no doubt that financial institutions are generating a significant amount of income from the consumer usage of overdraft protection programs, that fact within itself does not mean that the programs themselves are evil.

“Opt in” can work if it’s done right. But monthly limits on the number of overdraft fees that can be assessed rewards irresponsibility. The Fed’s rule captures that distinction.

Disclosure and transparency are crucial. But disclosing APRs is virtually impossible on set fees that are assessed against transactions where each amount is different and therefore each APR would be different. The legislation is totally unworkable with this requirement, but the Fed’s rule allows solid disclosure, an “opt in” option, and personal financial decision making to drive the issue.

A little personal history and perspective on this issue.

I had the privilege of serving as a member of the National Credit Union Administration Board from 1997 to 2004 and as the NCUA Chairman from 2001-2004. I was originally appointed by President Clinton and elevated to the agency chairmanship by President Bush. I saw the approach of two separate administrations from two different political parties when it comes to regulation and consumer protection.

Prior to that appointment, I was President and CEO of the Gulfport VA Federal Credit Union, a relatively small $32 million credit union with approximately 12,000 members in Gulfport, Mississippi. During my years as a credit union CEO, I certainly saw both regulation and consumer protection issues first hand and in the trenches. Since leaving NCUA, I have formed a consultancy that works with credit unions and other financial service entities in their strategic initiatives, again coming into contact with regulation and unintended consequences on a daily basis.

I guess you could say that, from my experience, I have had the opportunity to view the overdraft protection issue, as Judy Collins famously sang in the 1960s, from “both sides now.” I think it is important that both sides be heard on this issue as there are points where both sides have some merit to their cases. A fair look at this issue can result in better disclosed and more equitable overdraft protection programs that disadvantage neither consumers nor financial institutions. That would be a good public policy outcome.

During my years in credit union management in the early 1990s, there was no overdraft protection program offering. If a member wrote a bad check, we charged an NSF fee and returned the item. Due to concern about being discriminatory about which ones we honored and which ones we didn’t, we seldom honored the item in any instance. Our hope was that the NSF fee would have a deterrent effect on the member writing bad checks and, if abuse continued that caused significant loss to the credit union, we often referred the matter to local prosecutors to initiate criminal proceedings.

Needless to say, the members, who like all consumers were opposed to any user fee imposed upon them, did not like this fee assessment process at all. They not only faced our NSF fee, but they were often charged an additional returned check fee by the merchant to whom they wrote the item. Often they also faced late charges if the returned item was for their rent or insurance. I even dealt with some irate members who said we cost them their insurance renewal or their apartment lease because we wouldn’t honor a check on Friday when they had a payroll ready to post to their account at our credit union on Tuesday.

In most instances, those members were rightfully upset. NSF fees can be very punitive and, frankly, ours did very little to deter the need some members felt to write a check for rent, groceries, or insurance when the payment was due – even when they knew a deposit to cover the check was still a few days away. They hoped that either we would later waive the NSF fee for them or that they would be able to cover it from their next deposit, but their situation in life left them few options but to use the NSF process to help them try to manage their cash flow. These folks were not slugs or deadbeats. They were good, hard working members of our credit union who on occasion simply ran out of money before they ran out of month.

Unfortunately, until the past ten years and the advent of overdraft protection programs, these folks were more likely to end up with a felony conviction on their record than our credit union was to end up with a collected negative balance. The conviction on their record might keep them from getting a job, but it would not very often help us collect our balance due.

It was to assist these members that the overdraft protection programs were originally developed. Rather than being charged an NSF fee, the member would be charged an identical fee (it is important to recognize that, if structured properly, an overdraft fee is not an additional fee above and beyond what would otherwise be the NSF fee) to honor the overdrawn item up to a specific fully disclosed limit and that the item must be settled within 45 days or it would be written off and formal collection efforts begun.

Consumers saw value in these programs because they were able to realize the additional cost savings associated with avoiding merchant fees, late charges, and cancellations of service. In addition, these programs (for the same amount of fee they were otherwise being charged when their financial institution bounced their check and assessed an NSF fee) prevented the embarrassment and potential legal liability of writing a check that was returned for insufficient funds. A well-structured overdraft protection program could also enable them to maintain their relationship with a traditional financial institution and not be forced to go outside of the financial mainstream for their short term cash flow needs.

As consumers began to utilize these programs, financial institutions began to find themselves with considerable earnings from these programs. These earnings, at least in the overwhelming majority of credit union cases with which I am familiar, did not come from manipulation of the programs to maximize earnings or failure to disclose the terms of the programs so that consumers did not know what they were doing. The earnings came because the consumer recognized a benefit, or a value, from the program and used it when needed.

The consumer challenge has admittedly been to increase monitoring of checking account balances with the growth in debit transactions. It is the debit and ATM transaction that the Fed’s rule seeks to address, not the writer of checks who in most cases would prefer to avoid the merchant fees, late charges, embarrassment, and potential prosecution if his financial institution bounces a check on Friday when he has money coming into the account on Tuesday.

There is some value provided by these programs in the eyes of the consumer or they would not be using them so extensively.

Think about this conundrum: If the critics are correct that consumers do not see any value in these programs and feel ripped off by them, why are financial institutions making such a significant amount of fee income each year from a user-based program? If they feel ripped off, why not stop writing overdrafts or using the debit card when the account is empty?

It is important to note that overdrafting a checking account, whether it be by check or debit transaction, is a personally controllable action. Consumers can always choose to write the check later, make the debit purchase at another time, or withdraw from the ATM after their next payroll posts. The fact that financial institutions have increased earnings from these programs should not automatically be viewed as suspect, but rather should be seen as evidence that the consumer sees some value in overdraft programs and is comfortable utilizing them when needed.

The real issue is not the value of these programs to either consumers or financial institutions. The real concern is abuse.

Overdraft programs can be done right and should be done right. When that happens, consumers and financial institutions alike benefit.

The Fed’s rule will provide the necessary balance to this issue. Congress could tip that balance with overreaching legislation. Hopefully, this will not happen.

Because of the considerable cost and effort involved, most of the Fed’s recommendations will not be embraced by financial institutions. However, responsible financial institutions desiring to handle their overdraft programs in a manner that is viable for both their institution and their account holders should not oppose the recommendations. In fact, I would say that many financial institutions will be able to come into compliance with the new regulations regarding “opt in” fairly quickly.

If financial institutions cannot demonstrate the value in these programs to their account holders by securing their “opt in,” they would deserve to lose much of the revenue they presently gain from overdraft programs.

With a well structured overdraft program in place and fully explained in plain English, the overwhelming majority of consumers will likely opt in – even on debit and ATM transactions.

In fact, Bank of America and Chase have already implemented several significant changes in how they operate their overdraft programs in anticipation of some regulatory or statutory action. There are a number of credit unions that I work with that have reworked their overdraft programs to make them even more member friendly than they already were, including establishing an “opt in” regime.

Several third party providers who work with financial institutions to assist them in managing overdraft programs have established recommendations over the past year that anticipated some significant changes in the regulations, and perhaps even the statutes, governing these programs. A well-known expert and one of the earliest developers of automated overdraft privilege programs, Houston-based Strunk and Associates, has been working for months developing and implementing products to be ahead of the curve as they anticipated some form of “opt in” requirements. Clearly, there are ways to do overdraft programs right.

In addition to the automated overdraft privilege providers, I would expect that the Fed’s new rule will find core processors, direct mailing companies, phone center agencies, and other vendors willing to leap into the breach to help financial institutions have the products necessary to secure the “opt in” from those who want the service.

So, partners to help financial institutions in complying with the Fed’s new rules are indeed available. Compliance will require significant budgetary adjustments, but it can be achieved. The smart financial institutions will become more consumer-oriented and will become well versed in demonstrating the value of these programs to their account holders. Their success in making these programs viable financially will largely depend on their ability to show value, and their account holders will have more consumer-friendly alternatives available to them after this rule becomes effective.

Financial institutions will have to do overdraft programs right or run the risk of losing them.

Because some institutions might not choose to follow these best practices does not, in my view, make a case to over-regulate those who do with punitive or burdensome legislation that will go well beyond the Fed’s far reaching rule.

What would be impacted by legislation that effectively removed virtually all overdraft income from financial institutions?

Fewer loans when the economy needs more credit, not less. Higher interest rates on loans. More fees on all checking accounts. Shorter hours at the branch. Less interest on a CD. A reduction in new branches. This is just a sampling of the consumer costs and service casualties that could come from financial institutions losing access to this user-based fee program.

Losing access to fee income from the users of services will either have an adverse impact on the financial position of institutions or it will force them to recoup the losses in some other way. This issue does indeed have potential safety, soundness, and service ramifications that could be costly to financial institutions.

There is institutional risk involved in honoring overdrafts. Most financial institutions reserve up to 10% of their negative balances as potential losses. It is only responsible that the decision makers in Washington allow those financial institutions to cover that risk or the result will be to avoid the risk of extending checking accounts to many persons who will then find themselves in the ranks of the underserved in financial services.

There is also a moral hazard in removing a deterrent from the system and real consumer harm in returning that deterrent to the days of NSF fees, returned items, and bad check prosecution.

If there is no deterrent in the system, bad check writing will grow and debit transactions exceeding the account balance will multiply. A half century of NSF fees, often increasing in amount, proved that the number of overdrafts would not be lowered simply by charging fees. Overdraft programs, with the proper disclosures and a financial education commitment on the part of those offering them, can provide greater consumer value and improve the likelihood of someone getting out of their cycle than would doubling their costs with merchant fees and late charges from NSF check returns or making the consumer put his groceries on an overloaded credit card instead of his debit card for fear that it may be rejected because his payroll doesn’t clear until tomorrow afternoon.

To limit the number of overdrafts that a financial institution can charge to one monthly or a maximum of six per year as this legislation proposes would be a moral hazard equivalent of someone being only subject to one parking ticket per month. What would then be in place to prevent an individual from parking by the fire hydrant each of the other days each month if he has already received his one citation for the month? Property could be in considerable danger if a deterrent is not in place. Others should not have to pay for an individual’s irresponsibility.

The same concept applies in the case of overdraft programs.

My background as a federal regulator on the Federal Financial Institutions Examination Council (FFIEC) for four years from 2001 to 2004 leads me to believe that the regulatory agencies are best positioned to police this arena and to eliminate abuse of overdraft programs. In fact, the five FFIEC agencies (Federal Reserve, FDIC, OCC, OTS, and NCUA) have all issued both enhanced guidance and expanded regulation of overdraft protection programs since 2005. The Fed’s final rule of overdrafts issued in November 2009 is only the latest in a series of regulatory actions designed to ensure that overdraft programs are consumer-centric but still available in the marketplace.

These regulations have only begun to be examined for compliance in the past year. Some are only now becoming effective. The new Fed rules become effective in July and August 2010. It would seem to make sense to allow the regulatory process, which is considerably more flexible in adapting to the changes in account structure and technology that will certainly drive this issue in the years to come, to bring about a reasonable and equitable oversight of these programs before imposing statutory mandates that at best will be inflexible and at worst could strangle these programs for the millions of Americans who use them and do not abuse them.

Although my regulatory experience gives me significant pause about the potential impact on the long term safety and soundness of some institutions that could come from effectively eliminating this source of earnings, my primary reason for supporting these types of programs is the benefit to the consumer of getting his check or debit honored (up to clearly defined and disclosed limits) for the same fee that would otherwise be imposed upon him as an NSF fee. In my view, the additional merchant fees and late charges that a consumer will face if items that were previously honored are now bounced could conceivably bring a backlash against any legislation or regulation that makes these programs too costly to offer.

Solid regulatory scrutiny and enforcement action can protect these valuable programs for both consumers and financial institutions. Abuse can be ferreted out and best practices put in place.