De-Politicizing the Overdraft Discussion

As financial institutions look to evolve overdraft services, they should look at data to enhance customer service and manage risk.

While there has been an abundance of political statements about excessive overdraft fees in banking, there has been a shortage of rational discussion to “unpack” this service with data regarding cost, value, and risk. Banks have the opportunity to evolve this product in a manner that truly services customer needs and avoids unintended consequences in consumers’ financial lives.

Bottom line: the idealistic view that returning all checks, rejecting all ACH transactions, and declining all point-of-sale transactions for insufficient funds somehow helps the consumer is dead wrong. When consumers are unable to make planned payments, bad things can unfold: they are charged late fees, they have to spend time working with merchants, and their credit scores may be negatively impacted.

While it’s accepted that social and competitive forces are driving banks to make overdraft services more friendly, both policymakers and bankers need to consider the whole picture.

Overdrafts Are Not Just the Domain of Low- and Moderate-Income Consumers

Having done detailed data analytics in the financial services industry for more than 25 years, I have never come across a significant correlation between overdraft activity only falling in a low-to-moderate income segment. In fact, a detailed quantitative analysis of hundreds of financial institutions reveals many important insights:

• There are clear segments of overdraft users. While there is a mass-market segment that incurs one to three overdrafts per year, the vast majority of overdraft activity is centered in a segment of “recurring users.” Less than 10% of checking accounts typically make up more than 85% of an institution’s overdraft activity.
• Some academic articles propose that recurring overdraft users are predominantly lower-income. While this logic seems intuitive, the data indicates otherwise. Quantitative analysis of transactions reveals that as overdraft activity increases, so do deposit transaction amounts. This is because payment activity, including overdrawn payments, indicates true engagement with a financial institution, and therefore the share of the wallet grows.
• We’ve found that a minority of checking accounts bring in the vast majority of total funds deposited into banks, as measured by the number or dollar amount of monthly deposits over 12 months of transaction behavior. Overdraft activity is concentrated in the highest quartile of these accounts — ones that makeup 70% to 80% of all deposit activity.

The Pay Ratio Matters

While banks and policy advocates focus on overdraft features like the per-item charge, the de minimis exception, and daily limits, they fail to elevate a critical feature of the service: the pay ratio. The pay ratio is defined as the ratio of items paid versus returned unpaid when a customer item is presented against an insufficient balance. A good pay ratio is above 70%. Many financial institutions that actively manage their deposit portfolio have pay ratios that top 80%.

When consumer advocates recommend one FI-checking product over another, the pay ratio should be a consideration. Which FI truly “has the customer’s back” in getting payments and purchases made? 

A financial institution with a lower pay ratio causes more unintended consequences for the consumer: late fees, time spent rectifying payment with the merchant, and potential impact on their credit score. Fees charged by the merchant for car payments, rent, or mortgages are typically multiples higher than the typical FI fee, so the consumer would be better off if the FI paid the item. 

A fintech started recently touting “no NSF fees” and even claims to consumers that it “has your back.” Yet, it states in the fine print deposit agreement that it will not pay any ACH or check items and that the consumer violates the account agreement if they overdraw their checking account. Is this truly consumer-friendly? 

Optimization For All Can Be Enabled Through Data

While there have been plenty of opinions and published studies, very few of these publications include any quantitative analysis of account-level data. As financial institutions look to evolve overdraft services, many opportunities exist to leverage data to enhance customer service and manage risk. For instance, data indicates that a simple flat overdraft amount for all customers makes no sense. Based on engagement activity and balances, banks can employ dynamic limits that best fit the preferences of customers while keeping these exposures reasonable for both the consumer and the financial institution. This same data is highly valuable from a risk standpoint, as the analysis indicates that as deposit engagement increases, risk declines and approaches zero for customers highly engaged with the institution. As the average life of a customer account increases, the odds of the account becoming a charge-off become very low.

For bankers, this is a time when product strategy is meeting policy and politics. Like any rational challenge, it’s best to look at the data.