The financial industry’s relationship with overdraft/NSF/courtesy-pay (OD) revenue is a weird one. The regulatory environment has had substantial influence over institutions’ willingness to offer – and how they offer – OD services. As I work with clients on this source of non-interest income, I have seen a preponderance of institutions either being very aggressive with the revenue stream or very averse to or embarrassed by it. There are few institutions between those poles. It feels as though the industry believes using this source of revenue is binary: You either go all in, or you minimize it. There are so many dimensions to consider here that I thought it might be worth a blog post – and not just one, but two blog posts. This one will address the argument for OD programs to provide a backdrop for the elements listed in the next post. That one outlays an aggressive program for readers to use as a menu to ask themselves: Could we do that? Does that fit our culture?

When checks were the primary way to access a checking account, no one really thought much about OD programs as a revenue driver. With the advent of debit cards, transactions rose substantially, allowing the OD channel to become a noticeable source of revenue. Around 2005, regulators had a general mindset of “do what you want; just disclose everything and don’t be deceitful about it.” After the ’08 financial crisis, Reg E got tougher with opt-in requirements. The feds started getting nosier in the 2010s, expecting financial institutions to at least monitor what is going on and provide cheaper alternatives to simple OD fees. In the last couple of years, we came close to seeing the feds ban OD programs. Some states have almost banned them by heavily restricting them with limits on the number of charges or the amount a financial institution can charge. It’s easy to look at this history of oversight and conclude OD programs are simply evil. Many CEOs seem to feel that way, and yet many are more open to OD programs but are hesitant to use them strategically.

I would like to make the moral argument for having a robust, enthusiastic approach to OD programs. Now, the reader should realize I am not endorsing the practice; I am just saying OD programs are moral, notwithstanding various state and federal regulations. In the history of moral evaluations, one method of judging a thing is to compare it to the next best alternative. Obviously, it would be better if consumers had lines of credit or other loans or could generally live within their means. However, consumers who use OD programs more heavily are generally believed to be doing so either because of the inability to do something else or because of apathy.

There are many consumers who intentionally over-draft strategically. If you want a fun experiment, do the following: Find the consumers at your institution that bounce 100 or more items a year. Then, call one of them. Ask them why there are so many items over-drafted. I predict their answer will be something akin to this:

“I know I bounce a lot of items. Yeah, I pay you $10,000 a year in OD fees. However, I am running three trucks in my landscaping business. I don’t have time to keep my books up to date. Yeah, I could hire a bookkeeper, but that would cost me $30,000 a year. I figure I am saving $20,000 a year, not spending $10,000.”

That consumer is intentionally bouncing a lot, and they have a rational reason for doing so. It’s true that a line of credit and monitoring of accounts would be cheaper, but the business owner chooses not to do that. Should we regulate a small business out of that behavior just because it makes us feel better?

One misconception about OD programs is that they disproportionately prey on the poor. Actually, they “prey” on the young. Most people who habitually over-draft stop bouncing checks roughly in their 40s, regardless of income. It is true that lower-income people do bounce more than higher-income people, but the real shared variance has to do with age.

Figure 1: Activity by Age and Income

The percentage of consumers having at least one overdraft and their average number of overdraft items in the most recent two years

^{Source: Raddon Research Insights}

Figure 1 shows overdraft activity by Raddon consumer segment. More than 60% of members of the Credit Driven, Middle Market and Fee Driven segments have had overdrafts within the last two years, with an average of 2.6, 2.8 and 2.2 items, respectively. Compare their activity to the Upscale, Middle-Income Depositor and Low-Income Depositor groups, less than 34% of whom have had overdrafts, with average item counts of 1.5, 0.8 and 1.2, respectively.

Figure 1 does not address credit quality. There are consumers who have poor or no credit and need to keep the lights on every month. Yes, these consumers could become “more responsible” and live on a tighter budget. But what is the next best alternative for such consumers – and one they are more likely to do? Payday lending. That is truly expensive. The advertised APR for most of these lenders is 430%. Wow. These lenders often charge $15 per hundred dollars borrowed and expect that the borrower will pay back the loan in two weeks. So, if a consumer needs $700 to cover a car payment and the electric bill for a given month, they could go to a payday lender and pay $105 with a requirement to pay it back in two weeks. A bank or credit union with a moderately liberal OD program could let consumers access money they don’t have at a cost of around $30 in OD fees. Plus, many community institutions will not charge off such a customer until around 30 days – or even 45 or 60 days. That makes the APR on the overdraft approximately 52%, 35% and 26%, respectively. That’s still a high APR, but it’s so much better than payday borrowing. It also comes with the convenience of being attached to a checking account and a debit card.

Here’s another homework assignment: Pull a list of your consumers who have at least one overdraft in the last year. Roughly 10% of those will be consumers who reach their overdraft limits in one transaction. Those are your strategic over-drafters. They have done the math and figured out that over-drafting is a cheaper way to cover the gaps in their cash flow without going to a payday lender. Yes, it is expensive, but worth it in their eyes to keep the lights on, rent paid or car paid, or even to cover the bar tab.

The argument for why OD programs are immoral or unwise is already widely promoted by others, including regulators. I don’t need to make it here. Besides, the argument can basically be summarized as “it’s expensive.”

The next blog post on this topic will present possibilities to consider for developing a middle ground that allows consumers access to quick cash flow. You, the reader, can determine how quick that access should be and what revenue level is appropriate to provide a middle ground for an OD program.