The Rise And Fall Of The Beloved Overdraft
Be prepared to OD on OD – no harm intended 🙂
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This fintersection is a sub-fintersection within financial services, if you may say so. We’re tackling one of the controversial and exploitative aspects of financial services—the overdraft fees. We’ll be analyzing how various FinTech undercurrents overlap and eat into the money-making pie of financial institutions that is overdraft fees.
Be prepared to OD on OD – no harm intended 🙂
Overdraft fees are among one of the most controversial bank fees and have faced major criticism from the public and regulators alike in recent years. This practice, in which a bank covers for its client’s payments even in case of insufficient funds by charging an overdraft fee, was introduced by The Royal Bank of Scotland almost 300 years ago in 1728. A customer of the bank requested a cash credit to allow him to withdraw more money from the account than the balance it held. Three centuries later – the practice has not only survived but has also thrived to become a key revenue stream for banks.
During these three centuries, banking has evolved in many ways where customers fund and transact with their bank accounts through various mechanisms – such as ATMs, debit cards, mobile wallets, cashless payments, and so much more – which allows them to transact more frequently and in micro-denominations. Overdraft fees, having adapted through the means of hidden fees and fancy terms and conditions clauses, have largely escaped the regulatory radar and customer awareness to have a long and lavish life.
In the last few years, a few banks have initiated the option to reduce this fee under the overdraft protection program, where additional money to cover a transaction is transferred from another linked account. However, increasing public pressure and disruption from emerging FinTech business models have forced traditional banks to rethink their overdraft policies. Let's take a look at some of the key events that influenced this longtime mainstay of banks to quickly fall into disfavor… and one that hopefully disappears.
From Convenience to Connivance
Overdraft, a service that allows consumers to make transactions in excess of their available account balances, started out as a convenience that banks offered to customers. Customers, who inadvertently landed up in situations of account balance shortfall, were allowed to make transactions while the bank charged a fee for the convenience offered to them.
From these humble beginnings, it has grown into a monster that punishes the lowest end of society by cornering them into debt traps. Overdrafts are a silent but dangerous aspect of personal finance. Ironically, the customer segment that bears the maximum brunt of overdraft fees is the one who can least afford them. From being a convenience offered as a value-add to customers, overdraft has spiraled into becoming a key revenue source for banks which most often comes at the expense of customer well-being.
In 2017, the CFPB estimated the revenue from overdraft and insufficient funds fees to be closer to $17 billion for banks and credit unions. In 2019, another CFPB research found the overdraft and non-sufficient funds (NSF) fees generated $15.47 billion in revenue for the US banks; where three banks – JPMorgan Chase, Wells Fargo, and Bank of America – accounted for 44% of that revenue. Overdraft fees ended up costing consumers $12.4 billion in 2020; and subsequently, as per S&P Global Market Intelligence data, the US banks raked in $6.13 billion in overdraft revenue in the first nine months of 2021. While the downward trend is apparent in the overdraft fees collected by the US banks, the way it has sustained through all these years is quite remarkable.
Enter FinTechs: Awesome Alternatives To Overdraft
FinTechs in the US have taken aim to dismantle overdrafts in many different ways. While neobanks like Chime and Dave have brought subscription plans to allow customers to overdraw their account up to $100 on their debit cards without incurring a fee, earned wage access players have intermediated the employer-employee relationship to bring flexibility in the payroll process where employees can access their earned wages on demand.
Cash advance players such as Brigit and Floatme have launched unique decoupled and preemptive credit offerings by gaining insights on customers’ financial and lifestyle behavior via connecting with open banking data aggregators. Brigit, a cash advance player, underwrites customers using their cash flow history and proactively predicts if and when they're going to run out of money. If necessary, Brigit automatically transfers up to $250 into a user’s account before an overdraw charge hits, thereby saving them from incurring overdraft fees. Brigit also extends emergency loans upon request that can be delivered in under 90 seconds.
Bill negotiation startups such as Trubill and Billshark negotiate with service providers on customers’ behalf to help them save money on everyday bills and allow them to avoid hefty overdraft fees. Budgeting and money management apps such as Digit and Mint have armed customers with the knowledge and insights on their financial behavior and have helped customers improve their money management skills to avoid overdraft scenarios. Buy now pay later (BNPL) – another Fintech segment though witnessing its own identity crisis and regulatory scrutiny – has also allowed customers to make essential and discretionary purchases without overdrawing their accounts.
First Movers: Banks Begin To Soften Overdraft Impact
One of the earliest attempts to disrupt the existing overdraft structure came from Lloyds Bank in 2017 when the UK-based banking giant announced its plans to completely scrap overdraft fees for customers of Lloyds Banking Group, which includes the Halifax and Bank of Scotland. Across the pond, another banking giant in the US, Wells Fargo launched a one-of-its-kind ‘Overdraft Rewind’ program, under which the bank stopped charging overdraft or insufficient funds fees as long as the direct deposit received the morning after a customer's account is overdrawn covers the charge. Along with this, the bank also announced that it will no longer charge overdraft fees for any transactions that are $5 and under.
Regulatory Hammer: Policymakers’ Nudges Along The Way
However, the revenue generated by the banks as a result of their overdraft charges still were significant enough to avoid the scrutinous eyes of the financial watchdogs across the globe. In the US, the Consumer Financial Protection Bureau unveiled the ‘Know Before You Owe’ overdraft disclosure prototypes – designed to improve the form that banks and credit unions provide to consumers weighing overdraft coverage – in a bid to make overdraft coverage easier to understand and evaluate. Brazil's central bank placed a cap on interest rates for overdraft credit, prohibiting local banks from charging monthly interest rates of over 8%.
In the UK, the Financial Conduct Authority (FCA) stepped things up a notch when it declared that Britain’s banks and building societies will have to charge the same amount for all overdrafts from April 2020. In response to this ruling, most of the high street banks introduced a near-identical overdraft rate of 40%. While Nationwide hiked overdraft rates for its FlexAccount customers from 18.9% to 39.9%, HSBC and Lloyds set a single annual overdraft rate of 39.9% for its UK customers. Although Santander announced the removal of unarranged charges, it introduced a single interest rate of 39.9% for arranged overdraft borrowing. This similar pricing by the British banks irked the FCA to a great extent and it demanded that the financial institutions provide evidence of how they concluded their pricing decisions. Nationwide learned their lesson the hard way, when the Competition and Markets Authority (CMA) ordered them to refund £6M to customers – following a breach of Part 6 of the CMA’s Retail Banking Market Investigation Order 2017, which ensures customers with personal current accounts receive a text alert before banks charge them for unarranged overdrafts.
The Pandemic Push: Overdraft’s Tipping Point
The pandemic outbreak witnessed a major shift in the stance of financial institutions on overdraft fees. Following a request by the US regulators to waive overdraft fees, FinTechs Ally Bank and NorthOne paved the way for a major reform by eliminating all kinds of overdraft fees for their current and future customers. In the UK, Barclays became the first major bank to scrap overdraft charges for customers during the coronavirus outbreak, as the bank announced its decision to waive interest charges on arranged overdrafts until the end of April 2020. Lloyds Bank also joined this noble initiative by offering customers a £300 fee-free overdraft for three months starting from 6th April. A similar measure was undertaken by HSBC UK, when they introduced a temporary £300 interest-free buffer on overdrafts for customers with bank accounts and advance accounts for a period of three months in addition to their support package. Towards the end of 2021, Santander Bank launched the ‘Santander Safety Net’ program that raised the no-fee overdraft threshold to $100, eliminated the overdraft protection transfer fee, as well as reduced the daily overdraft fee by half.
2021: Beginning Of The End Of Overdraft
The year 2021 proved to be a pivotal one for the US banks as their exploitative overdraft practices came under intense scrutiny from lawmakers and regulators alike. In a bid to mount pressure on the banks, US Rep Carolyn Maloney reintroduced the Overdraft Protection Act, aimed at restricting the number of times banks can collect the fees and ensuring that the charges are reasonable. Towards the end of 2021, research by the Consumer Financial Protection Bureau revealed that banks made approximately $15.47B from overdraft and non-sufficient fees in 2019; with JPMorgan Chase, Wells Fargo, and Bank of America accumulating about 44% of the total amount. This heavy-handed approach by the US watchdogs saw a number of proactive measures initiated by the banks, with CapitalOne completely eliminating all overdraft fees and non-sufficient fund fees for its consumer banking customers.
2022: Overdraft’s End Is Nigh
In December 2021, JPMorgan announced its plans to give customers a full day to restore overdrawn balances and to allow them to tap funds from direct deposits of paychecks two days early from 2022.
Bank of America followed suit, and reduced its overdraft fee from $35 to $10; even eliminating the $12 transfer fee from linked accounts to an overdrawn account. Wells Fargo was hot on the heels when it provided its own array of offerings – including earlier access to direct deposits, a 24-hour grace period before incurring any overdraft fees, and the elimination of transfer fees for customers enrolled in Overdraft Protection. The biggest disruption to the long-standing overdraft practice came in Feb 2022, when Citigroup Inc. became the first major US bank to fully eliminate overdraft fees along with returned-item and overdraft-protection charges.
Game Over For Overdraft?
We definitely think so.
With FinTechs across sectors challenging the traditional business models of making money at the expense of customers’ well-being, awareness and understanding amongst the masses around hidden fees and unfair pricing policies of banking products has increased as of late. These FinTechs have grown to become massive multi-billion-dollar behemoths, and some of them are now publicly listed institutions. This has significantly improved the trust and brand recognition among customers for the new players. Incumbent banks can no longer ignore the real threat of losing massive chunks of their retail customer base to these challenger FinTechs if they don’t get their house in order, and that too, do it really fast.
Regulatory steps and competition have also forced financial institutions to rethink their overdraft policy. The restructuring of this traditional system provides banks with an opportunity to offer better products and services to create stronger and more supportive relationships with their customers and—in the process—create a fairer banking system for all.
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