Bank overdraft fees have become a familiar term for anyone who has ever bounced a check. When an accountholder lacks sufficient funds to cover a check or a debit card purchase, the bank imposes an overdraft fee. Not all banks levy these charges, but those that do typically impose a fee ranging from $30 to $35 per transaction. In aggregate, these fees amounted to approximately $12 billion in 2019.
Last year, certain members of Congress introduced two bills, aimed at simplifying banks’ overdraft regulations and restricting the amount they can charge for overdrafts. The underlying objective of these bills is to safeguard consumers from exploitative charges and promote financial inclusion among low-income individuals. Such inclusion could help them save money on fees for services like check-cashing, pre-paid debit cards, and other services offered free of charge to account holders.
Unexpected consequences
Might the laudable aims of these bills have unintended consequences? This is the question posed by recent research from the Tuck School of Business.
Drawing on data from account holders at banks across the United States and an examination of overdraft protection laws at both state and federal levels, the authors analyze whether there exists a trade-off between consumer protection and financial inclusion objectives.
“We wanted to find out if overdraft price restrictions make banks less willing to provide bank accounts to low-income households, as economic models might suggest,” the researchers explain.
Changes in the law
The scholars capitalize on a legislative amendment implemented in the early 2000s. Prior to this, certain states imposed constraints on overdraft charges, which local and national banks adhered to.
However, the Office of the Comptroller of the Currency (OCC), the federal regulator, issued a directive asserting that federal law takes precedence over state regulations on this matter and that it prohibits price constraints on banking services. Consequently, national banks could now impose overdraft fees beyond state limits, while state banks still had to abide by the state laws curbing overdraft charges.
“By looking at these time periods before and after the preemption, we’re able to trace out what state and national banks did,” they explain. “And in those states with restrictions we’re able to see whether low-income households were more or less able to maintain a bank account after the law changed. Our prediction was that when banks are able to charge more for overdrafts, they’re also more willing to serve low-income households.”
Greater incentives
As anticipated, the researchers’ forecast materialized. Following the OCC’s decision to lift restrictions on overdraft fees, financial inclusion experienced an upsurge. National banks, in contrast to state banks, augmented their fees by 10%, extended their overdraft credit by 16%, and boosted their deposit supply by a quarter through a 25% reduction in minimum balance prerequisites.
“High minimum balance requirements rank first among reasons unbanked households are without an account, so this result is notable,” they explain.
What’s more, the fraction of returned checks, wherein overdraft credit is refused, fell by 15% in the impacted states. This indicates that accountholders displayed a greater willingness to enroll and bear the costs of overdraft protection. Finally, and perhaps most crucially, the proportion of low-income households possessing checking accounts grew by 10% subsequent to preemption.
Opponents of overdraft fees argue that by weakening consumer safeguards, the government permits banks to fleece individuals and prey on low-income households who unknowingly subscribe to bank accounts with exorbitant costs. However, the study indicates that the situation is not as straightforward as it may seem. The authors not only observe a surge in new accounts following preemption but also note that these accounts persisted for at least two years.
“This shows a revealed preference for low-income people to have an account and continue to use it, and to assess the costs and benefits of overdraft fees for themselves,” they conclude.
