The overdraft revolution — begun by fintechs offering no-fee banking accounts — is now in full swing as one big bank after another eliminates or sharply cuts fees for overdrafts and NSFs. The trend is putting huge pressure on regional banks and community financial institutions.
How will they respond when their customers ask, “Why are you still charging me $35 for an overdraft when the big banks now don’t?”
The implications of this situation cut two ways: 1. slashing a major source of noninterest income, and 2. raising technology costs due to the necessary system changes. In addition, there are credit risks to consider.
The megabanks have huge tech budgets to get the job done in-house, developing overdraft solutions that are embedded in their existing core transaction systems.
As one banker from a regional financial institution told The Financial Brand, it’s not nearly as simple for smaller banks and credit unions. In fact, his institution is looking for technology solutions to automate existing overdraft systems and offer overdraft fee rebates to customers (once they’ve brought their account back into balance).
Christopher Leonard, CEO of overdraft and compliance management company Velocity Solutions, says that overdraft arrangements shouldn’t be jettisoned altogether — many consumers actually like having the option.
“We believe that the current overdraft environment sets up a new competitive landscape where community financial institutions can win against large banks by offering real liquidity to consumers based on ability to repay, whether that’s through overdraft or through small-dollar short-term lending,” Leonard states in an interview.
Fiserv’s Jeff Burton describes the overdraft situation as “getting a facelift.” Burton, who is VP of Product Management for Deposit Liquidity Solutions, says “It’s hard to imagine financial institutions will eliminate paying items into overdraft completely.” He maintains that analyzing and determining repayment risk is the best alternative. “Ignoring this risk by offering either fixed limits or not addressing the limit strategy currently deployed would be a potentially costly mistake.”
Leonard agrees, stating “If you’re thinking about reducing what you charge for overdraft, it becomes more important than ever to pay attention to charge-off risk to better preserve the net income from the program.”
Key Problems With Overhauling Overdraft Plans
Burton says banks and credit unions approaching Fiserv about the overdraft situation have two common issues: “finding alternate sources of revenue when looking at reducing or eliminating overdraft fees and managing the investment in technology that is required to make changes to their overdraft programs or to offer alternative liquidity services.”
The way overdrafts work in banking has come a long way over the years. “In the early 2000s, overdraft was kind of the Wild West of revenue for banks and credit unions,” observes Velocity’s EVP of Sales Steve Swanston.
Over time, overdrafts became more regulated under the Dodd Frank Act and Reg E.
One of the challenges regarding the whole issue is there is a misunderstanding of the difference between a non-sufficient fund (NSF) fees and overdraft fees. It even exists within the industry and certainly does among most consumers. As the Velocity experts explain it, while a customer is charged an NSF fee when a bank declines to pay a transaction due to insufficient funds in the customer’s account, an overdraft fee signals the bank paid the transaction despite the overdrawn amount.
“It’s really the NSF fee that has been hit [by most of the recent changes], even though to the naked eye, NSF and overdrafts are considered the same thing,” Swanston says. Regardless, that shouldn’t be the sole focus of banks and credit unions. “Customers still willingly use overdraft service, and there is an optimal point where the value of the service matches up with what the consumer perceives to be the fee they’re willing to pay.”
Boiled down, it’s about separating the fees from the functionality of overdraft, Leonard says.
“People can debate the fees, but few would seriously debate the benefit of the functionality of providing liquidity to consumers. If financial institutions don’t provide this service, then where will people go? Payday lenders? Pawn shops? Those don’t sound like good alternatives to the regulated banking system.”
As Leonard points out, overdraft systems at their core are very basic, given that most banks and credit unions set a maximum threshold for all their customers at which the institution will pay overdrawn items. Typically, banks and credit unions set their overdraft limit at $500, regardless of the customer.
It’s a simple concept — maybe too simple. “Nowhere else in the institution does a bank or credit union give every consumer the same amount of liquidity,” Leonard says.
Break Out of the Habit:
Instead of giving all customers the same threshold, use personalized data to break out how much of an overdraft an individual can repay.
The issue, too, lies in the fact that banks and credit unions aren’t using technology to automate these systems and calculate an individual’s ability to repay overdrafts.
“If you wanted a car loan with a $500 monthly payment, no bank would give that to you if you had $400 per month in deposits,” Leonard explains. “But they’ll give you a $500 overdraft limit just for opening an account without considering your ability to repay that amount.”
How Small Banks Can Respond to Overdrafts
Smaller banks and credit unions may look to the megabanks — such as PNC with its ‘Low Cash’ program, Citibank and Capital One — for solutions. However, the technology these larger banks invest in is difficult for regional banks and credit unions to justify.
Leonard encourages banks and credit unions to find the weak points of these programs instead of imitating them.
“I had a bank executive whose institution competed in Capital One’s market area ask me, ‘How do I respond to a customer who wants to know why we’re still charging an overdraft fee when Capital One is not?'” Leonard suggested that the banker tell customers to call Capital One and ask how much they will cover if an account gets overdrawn.
The banker could then say: “They probably won’t even tell you, and if they do, it’s likely to be an extremely small number. Our community bank will cover hundreds of dollars of items, maybe more, and we’ll clearly tell you how much we will cover for you this month based on the activity in your account.”
Free Isn’t Always Better:
It’s not all about getting rid of fees. Instead, banks and credit unions can explain why the fee is in place and why their policy may be better for the customer.
To assuage other concerns people may have, and create overdraft systems that will work for both financial institution and customer, Leonard advises building an overdraft system with these capabilities in mind:
- Access to a reporting tool that can tell institutions what’s going on in their overdraft programs (including who their heavy users are).
- Data analysis, including peer comparisons on key metrics.
- Communication tools to be able to reach out to account holders (especially heavy users) and log contacts with them.
- The ability to integrate with a small-dollar lending platform.
What Overdraft Solutions Are Available?
At the end of the day, it will always be easier for the largest banks to ditch fees, because they can regenerate profits elsewhere, Leonard says. For some, that will mean upping the ante for waiving a monthly account fee. “For example, instead of requiring a $500 average balance to have the fee waived, maybe that gets raised to $2,500.”
A study from the Federal Reserve backs this up. It found when banks cut out their fees or cap them, they “reduce overdraft coverage and deposit supply, causing more returned checks and a decline in account ownership among low-income households.”
Leonard says that many people would rather have overdraft protections in place, even if it requires a fee.
“For those consumers, we should be more focused now on technology that can automatically taper overdraft fees when consumers are not able to afford them based on their income,” he says, adding that underwriting a customer’s ability to repay overdrafts is crucial.
Therefore, the solution may not lie in cutting out overdrafts altogether as much as finding the right software that can be built into a bank’s existing tech stack. Velocity offers this approach.
Others, like Fiserv’s SmarterPay program, are designed to sit outside of a bank or credit union’s existing banking software. The program examines millions of individual transactions from the core system to determine consumers’ capacity to repay and the risk, Burton says.
“Financial institutions need to consider what other offerings they can provide to promote both proactive and reactive client solutions to liquidity,” Burton says. “Being short on funds is not anyone’s goal. However, if the accountholder feels they have options, and the financial institution can be proactive in solving the customer’s needs, everyone benefits.”