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March 16, 2020
Overdraft: Payment Service or Small-Dollar Credit?
Funding Gaps in Consumer Finances
Figure 1. Annual Interest and Noninterest Income
One of the earliest documented cases of bank overdraft
U.S. Commercial Banks, 1970-2018 ($ mil ions)
dates back to 1728, when a Royal Bank of Scotland
customer requested a cash credit to allow him to withdraw
more money from his account than it held. Three centuries
later, technologies, such as electronic payments (e.g., debit
cards) and automated teller machines (ATMs), changed the
way consumers use funds for retail purchases, transacting
more frequently and in smaller denominations.
Accordingly, today’s financial institutions commonly offer
point-of-sale overdraft services or overdraft protection in
exchange for a flat fee around $35.
Although these fees can be large relative to the transaction,
alternative sources of short-term small-dollar funding, such
as payday loans, deposit advances, and installment loans,
can be costly as well. Congress has taken an interest in the
availability and cost of providing consumers funds to meet
Source: Federal Deposit Insurance Corporation (FDIC).
their budget shortfalls. Legislation introduced in the 116th
Congress (H.R. 1509/S. 656 and H.R. 4254/S. 1595) as well
Banks generate noninterest income in a number of ways.
as the Federal Reserve’s real-time payments initiative could
For example, a significant source of noninterest income
impact consumer use of overdraft programs in various
comes from collecting fees for deposit accounts services,
ways. (See “Policy Tools and Potential Outcomes” below
such as maintaining a checking account, ATM withdrawals,
for more information.) The policy debate around this
or covering an overdraft. Fees from checking accounts have
focuses on the trade-offs between access to funds and their
grown considerably in the past two decades, peaking in the
associated costs. This In Focus examines the evolution of
2007-2009 financial crisis. (See Figure 2.)
bank overdraft programs and potential outcomes associated
with regulating them.
Figure 2. Service Charges on Deposit Accounts
Evolution and Regulation of Overdraft
U.S. Commercial Banks, 1970-2018 ($ mil ions)
Core banking operations are built around two activities:
accepting deposits and making loans. Banks make money
from the interest earned on loans and from fees collected
for providing certain services. In the mid-1980s, revenue
from fees, known as noninterest income, generally began to
grow faster than interest income. (See Figure 1.)
Source: FDIC.
Overdraft Opt-in Rule
Financial regulators began examining overdraft practices
more closely following the financial crisis. In 2009, the
Federal Reserve published a final rule to prohibit financial
institutions from assessing overdraft fees on ATM and one-
time (point-of-sale) debit card transactions without
obtaining consumer consent (opt-in). Service charges on
deposit accounts fell after 2010; however, it is unclear
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Overdraft: Payment Service or Small-Dollar Credit?
whether this was due to the rule or to improved economic
Small-Dollar Credit. Some consumers may use
and consumer financial conditions post crisis. In 2010, P.L.
overdraft as a form of credit. The 2017 Pew survey also
111-203 (Dodd-Frank) created the Consumer Financial
showed that 32% of consumers with an overdraft said
Protection Bureau (CFPB), granting it broad authority for
they viewed the program as a way to borrow funds when
consumer protections across the financial system, including
short on cash. When paired with the previously
the overdraft opt-in rule.
mentioned data correlating frequent overdraft accounts
with lower credit profiles, one could posit that overdraft
Overdraft Reporting
is used as a form of credit in some circumstances.
After Dodd-Frank, the CFPB began examining fees
associated with insufficient funds in bank accounts.
Policy Tools and Potential Outcomes
(Generally, this includes overdraft fees, when the purchase
Consumers have a number of options to cover a gap in their
is covered by the bank, or fees for a bounced check.) In
budget. Overdraft is a product that consumers with a bank
2015, the banking regulators required financial institutions
account typically have access to. In addition, products like
with more than $1 billion in assets to itemize revenues
payday loans and deposit advances have been offered at
earned from deposit accounts, including a separate line item
different times in the past as ways to provide funds to
for overdraft and insufficient funds fees. Roughly 600
consumers outside of the traditional bank loans. Although
banks have met the threshold each year, reporting $11
overdraft can be an expensive way to make small
billion-$12 billion in fees for insufficient funds. This likely
purchases, many of the alternatives also carry relatively
underreports the amount of overdraft revenue in the
high costs. Regulators must balance their mandates for
banking system, because credit unions and smaller
safety and soundness with their interest in maintaining
community banks are not subject to the reporting
consumer protections. Currently, bills with companion
requirement. In 2017, the CFPB estimated that revenue
versions in both the House and Senate (H.R. 1509/S. 656
from overdraft and insufficient funds fees could be closer to
and H.R. 4254/S. 1595) would address the use of overdraft
$17 billion for banks and credit unions.
through different policy tools, including limiting the fees
and frequency of overdraft charges and increasing
Overdraft Policy Debate
disclosure requirements for overdraft programs.
Bank regulators are responsible for ensuring the safety and
Additionally, the Federal Reserve’s FedNow Service
soundness of the banking system. Diversified revenue
initiative aims to reduce the time for consumers to receive
streams from interest and noninterest income support the
funds, potentially impacting overdrafts where expected
profitability of the banking system. In addition, noninterest
income is needed to cover an expense.
income has proved to be a stable source of income during
periods of economic volatility. However, there is evidence
Limiting Overdraft Fees
that some consumers are not aware that they can opt-in to
Some have argued that overdraft fees should be limited to a
overdraft (or not) and that a small number of consumers
price that is reasonable and proportional to the cost of
bear a disproportionately high percentage of total overdraft
providing the overdraft. Others have argued that because
fees. How policymakers approach overdraft may depend on
overdraft acts as a form of credit, its fee structure should
whether they view it as a service or as a form of credit.
fall in line with fee and interest rate provisions in lending
laws such as the Military Lending Act (P.L. 109-364),
Payment Service Versus Small-Dollar Credit
which caps interest and fees at an Annual Percentage Rate
A 2017 Pew Charitable Trusts (Pew) survey suggests that
(APR) of 36%. If overdraft were priced as credit, it would
almost 40 million Americans incurred an overdraft fee in
typically carry an APR of much higher than 36%. Although
the previous 12 months. Most of those consumers
this type of limit would bring overdraft costs down, it could
experience fewer than three overdrafts per year. CFPB data
limit the options available to consumers as well. To the
show a small number of consumers pay the overwhelming
extent banks were not willing to offer overdraft at the new
majority of overdraft fees—roughly 9% of accounts
price point, consumers may look for funding in markets
comprise 79% of overdraft and insufficient funds fees—
where APRs can exceed 36% by wide margins, such as
these consumers overdraft more than 10 times a year.
state-regulated payday loans.
Overdraft frequency is correlated with negative financial
conditions: for instance, those who overdraft more than 10
Limiting Overdraft Frequency
times a year generally have lower incomes, credit scores,
Limiting the number of overdrafts for which an institution
and available credit. However, while there are similarities
can charge a consumer could help the small percentage of
among accounts with more frequent overdrafts, consumers
bank customers who pay the majority of overdraft fees by
use overdraft programs for different purposes:
overdrafting several times a year. However, to the extent
customers still need funds after the limit is reached, they
Payment Service. Industry representatives like the
may consider other products, such as payday loans, outside
American Bankers Association posit that overdraft
the banking system, or they could use installment loans or
programs serve as a payment service for cash-strapped
deposit advances if their bank offers them.
consumers. For instance, a consumer can cover an
unplanned budget gap for a $35 fee, rather than have a
Enhanced Disclosures
payment denied. Banks have also begun offering
Previous regulation sought to improve the disclosures
overdraft transfer services, linking a savings account or
around overdraft to help consumers understand the
credit card for free or a smaller fee.
programs they opted into. Consumer advocates have raised
concerns about whether overdraft programs are sufficiently
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Overdraft: Payment Service or Small-Dollar Credit?
transparent and how financial institution practices influence
could benefit consumers who overdraft due to a timing
the opt-in decision. Current legislative proposals would
issue where an outgoing payment clears before an incoming
build on the existing disclosure framework by requiring
one is received. However, to the extent faster payments
banks to disclose coverage fees and provide notification of
would result in both outflows and inflows clearing in real
an account’s overdraft status. This could help consumers
time, it is unclear what the overall impact would be on
compare rates as they choose a financial institution.
overdraft.
Funds Availability
Andrew P. Scott, Analyst in Financial Economics
The Federal Reserve’s FedNow Service initiative, expected
in 2023 or 2024, is to make payments settle and clear faster
IF11460
so that consumers receive their funds in real time. This
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https://crsreports.congress.gov | IF11460 · VERSION 1 · NEW