CFO Focus: The State of Overdrafts

Editor’s note: This article is based on Moebs $ervices’ research.

The transition of overdrafts from a float-based, paper check transaction to a plastic card swipe or ACH transaction mirrors the heavy influence of technology on financial culture.

Overdraft revenue hit a zenith of $37.6 billion in the third quarter of 2008. Since the peak, overdrafts dropped to a low of $30.1 billion in the first quarter of 2011. The first quarter of 2017 shows overdraft revenue at $33.6 billion, only 10.6 percent below the all-time high.

The federal government, some states and consumer advocates have attempted to kill overdrafts in the past. But now, with the Financial Choice Act likely to pass Congress, compliance on overdrafts appears headed for less restriction.

The consumer has been hoarding cash in checking accounts since the 2008 Great Recession. With legislative uncertainty, lack of wage growth and total unemployment (U6) still at 8.4 percent, the consumer is not engaging in the market. As a result, overdraft transactions for a single consumer fell from 4.4 a year in 2007 to 3.1 in the past four years.

When a checking account goes negative, depositories have six options for how to respond: 1) overdrafts (often called by credit unions “paid NSFs”), 2) NSF (bounced check or “non-sufficient funds”), 3) stop payment (often used to avoid an overdraft or NSF fee), 4) return of deposit items (RDIs usually hide kiting), 5) transfer from a share account or other deposit account, and 6) transfer from a line of credit, whether that’s a credit card or standalone overdraft line of protection or other line of credit. (A debit card not being approved carries no fee.)

NSFs, RDIs and SPs are penalty items carrying higher risk and subsequently equal or higher cost to the member than an overdraft. For example, a NSF would be the most risky and heavily labor intense since it requires being returned. In contrast, an SP is costly because of paperwork involved with managing the likelihood of fraud. 

In all, an overdraft is less risky and less costly than an NSF, SP or RDI. An OD is more costly than an automated transfer or self-center transfer done by the member/consumer, but can be of equal or less risk than automated transfers.

A little over 87 percent of depositories offer overdraft deposit transfers, while 69.9 percent offer line-of-credit overdraft transfers. Some have no charge if the consumer makes the transfer himself but incorporate a fee if automated. The price differential emphasizes the value of the automated service and risk incurred by the depository.

When the consumer keeps money in checking, it reduces the occurrence of all six types of overdraft transactions. When times are good, the consumer is engaged in the economy and overdraft revenue is higher. When times are difficult, like today, consumers stockpile cash in checking, thus reducing overdraft activity.

When overdraft revenue was at its highest, between 2005 and 2007, consumer checking balances averaged $1,000. Currently, checking balances average over $3,600 and overdraft revenue has fallen. But the marketplace and consumer is poised to re-engage. When this happens, it is projected to drive overdraft revenue to $40 billion, a historic high.

Diluting potential depository overdraft revenue is competition. Payday lenders, who once served less than 10 percent of people making overdrafts, now serve over 50 percent. The reason is price. The median overdraft fee is $30, while the median price for a $100 payday loan is $18. Consumers with financial difficulties have no problem figuring out where to go when an overdraft is imminent.

The overdraft trade is a transaction business and not a multi-service relationship. Many depositories have shunned the transaction business in favor of a relationship strategy—defined as offering free checking as a loss leader to gain accounts per consumer. While some say free checking is linked to overdrafts, Federal Deposit Insurance Corp. and U.S. Census Bureau studies show free checking goes to fully banked households, not the underbanked. The reality is free checking is linked to cross-selling other services, with overdrafts way down on the list.

Many financial service executives believe overdraft price is inelastic and that overdraft users are insensitive to price changes. This is no longer true. The Washington, D.C., core-based statistical area—which includes parts of Virginia, Maryland, Pennsylvania and West Virginia—showed a price reduction of $3 to $0.50 for an overdraft fee earlier this year. This statistically significant change was the first time a market as big as Washington, D.C., lowered the overdraft price.

In 2000, banks charged $20 for an overdraft and credit unions $15. Adjusting these prices for today, using the Minneapolis Federal Reserve Inflation Calculator, the overdraft price for banks is $27.82 and $20.86 for CUs. More than 26 percent of banks price below the inflation-adjusted price, while 7.7 percent of CUs price below. Overdraft value, providing short term unsecured credit, has stayed the same while overdraft price continues to increase.

Why? The consumer wants the price of the overdraft transaction to reflect value. $4.7 billion Police & Fire Federal Credit Union, Philadelphia, recognizes this. The CU charges $19 for a paper check overdraft and $6 for a debit card overdraft. Splitting the price by type of checking and payment channel makes it friendlier and more profitable since value and volume, not price, is emphasized. Other friendly overdraft features include grace period, daily caps and having a “de minimis” balance or transaction. (In an example de minimis scenario, if the account’s negative balance at the end of the day is $10 or less, the transaction or transactions causing this are paid or allowed and there is no fee.)

Overdraft volume is often restricted by low limits averaging $500, the same limit since 1998. Overdraft limits can range from $100 to more than $5,000 to reflect the needs of consumers in today’s marketplace. Limits are a function of risk determined by FICO score and not age, gender, deposits or employment. 

The state of overdrafts is sound. Overdrafts and the process of providing overdrafts have dramatically changed though. Credit unions need to adopt technology and promote value with friendly features driven by volume, not price, weighted by FICO risk scores. If depositories do this, overdraft revenue exceeding $40 billion by 2020 is in sight.

Mike Moebs’ economic research firm, Moebs $ervices, Lake Forest, Ill., has provided data, information and intelligence to government agencies, news outlets and thousands of financial institutions. The former credit union director and bank director holds several patents on risk management for loans and overdrafts.