Overdraft is a Poorly Designed Product

Regulators should incentivize banks and fintechs to build something better.

"I warn you, Sir! The discourtesy of this bank is beyond all limits. One word more and I – I withdraw my overdraft!” — Cartoon from Punch Magazine Vol. 152, June 27, 1917

Statistics like this make people mad:

currently 1.5 per cent of customers, overwhelmingly from deprived areas, account for 50 per cent of lenders’ unarranged overdraft income.

So regulators do stuff like this:

The Financial Conduct Authority (FCA) has introduced new regulations that, from April 1, bar banks from charging customers more for unarranged overdrafts than for arranged ones…Ahead of the implementation of the rules, many banks and building societies have announced new overdraft rates, with most choosing to set a rate close to 40 per cent.

Which motivates industry observers write bad takes like this:

To conspiracy theorists it may smack of collusion. Outright collusion is unlikely, though. The rates are whopping, but transparently so. Unsecured consumer credit is a risky business. Banks charge accordingly. Not all customers are equally risky. As the FCA has noted, customers with better credit have other cheaper options — such as credit cards at 0 per cent.

A quick primer.

Overdraft — originally invented by RBS almost 300 years ago — comes in two main flavors:

  1. Arranged overdrafts (or overdraft lines of credit), which are essentially a revolving loan bolted on to a deposit account that consumers apply for and are granted if they’re deemed a good credit risk.

  2. Unarranged overdrafts (or overdraft protection), in which a consumer spends more money than they have in their account and the bank covers the transaction in exchange for fees and/or interest on the overdrawn amount.

It is incredibly profitable for banks; generating approximately £2.4bn a year for UK banks and a staggering $34bn a year for U.S. banks. With, as mentioned above, a disturbingly high percentage of that revenue being generated by a small number of financially-vulnerable customers.

Unfortunately, efforts to protect customers from these excesses often fail:

In 2010, a new Federal Reserve rule prohibited financial institutions from charging customers overdraft fees on ATM or debit transactions, unless the customer opts in to their overdraft protection, which generally allows them to make debit card purchases or ATM withdrawals even if there’s not enough funds in the account. The rule was supposed to, among other things, cut down on the amount of overdraft fees that banks were charging consumers. But what’s concerning is that a 2014 Pew Charitable Trusts survey found that more than half of Americans (52 percent) who overdrafted didn’t recall opting in for overdraft protection.

And:

Nearly 3 in 4 overdrafters do not understand that they have the right to have transactions declined without a fee if their account does not have sufficient funds to cover a debit card purchase.

Which prompts an obvious question — why do we keep trying the same types of incremental regulatory fixes for an antiquated banking product that excels at harming financially-vulnerable consumers?

To answer this question, we first need to ask a different question:

Why do consumers use debit cards?

It’s an important question because, in a world in which credit cards exist, the answer isn’t obvious.

After all, credit cards are, rationally-speaking, superior products in every sense. They offer much richer rewards and they typically come with stronger consumer protections.

So I posed this question to the fintech Twitter universe:

And the responses I got (augmented by some additional research) point to two primary segments of debit-over-credit users:

  1. People who don’t qualify for credit cards. One quarter of U.S. consumers who don’t have a credit card claim that it’s because they don’t qualify for one, according to a survey from CNBC Select. These are consumers with poor, thin, or missing credit files. Recent immigrants. College students no longer receiving credit card offers on campus (which is, on balance, probably still a good thing). And a whole bunch of other underserved consumer segments relying on the liquidity provided by overdraft while struggling to find an effective onramp to the credit system.

  2. People who intentionally avoid credit cards. These consumers may have had a bad experience with revolving credit. They may be adherents of Dave Ramsey’s personal finance philosophy (this segment overlaps heavily with the first one). Or they may have other personal, cultural, or religious aversions to debt. Whatever the reason, these consumers make the conscious choice to use debit cards over credit cards.

“Your margin is my opportunity.”

This famous Bezos quote is something I’d be thinking about, in relation to overdraft, if I was a bank executive.

At a time when every bank LOB is under attack from fintech startups and big technology companies, you have to figure that a product that generates billions of dollars in revenue, actively harms consumers, and is loathed by regulators is (and will continue to be) a target for disruptive innovation.

And figuring that, you’d like to think that such an executive might be looking at alternatives to overdraft that could better serve the needs of these debit-over-credit customer segments:

  1. People who don’t qualify for credit cards.

    The focus here needs to be on products that safely facilitate access to liquidity while providing a mechanism to build good credit habits and a positive credit history (FWIW: it’s bizarre that paying off an overdraft isn’t reported as positive behavior to the credit bureaus).

    For example, in today’s digital-first world, if you were designing a product to cater to consumers’ occasional need for extra liquidity in real time at the point of sale, wouldn’t you design something like point-of-sale lending?

    The point-of-sale loan sector, which includes firms like Affirm, Klarna and Afterpay, has benefited from technology that allows consumers to get quick approvals for the financing of specific purchases that they make on their mobile phones.

    Or maybe, if you’re thinking about how your institution can create the next generation of responsible and profitable credit card customers, you might revisit an old idea — secured credit cards.

    “I know it's no secret secured credit isn't the most profitable place to play, but when you think about the lifetime value of being the first issuer to lend to someone — and then the value of that loyalty over the course of years and years — for us it made a lot of sense," [Justin] Zeidman [head of credit card products at Navy Federal Credit Union] said.

  2. People who intentionally avoid credit cards.

    These consumers don’t need overdraft at all. It shouldn’t even be an option for them to opt in to. For these consumers, the challenge that banks should be tackling is how to build a better, more rewarding deposit product.

    Like one that rewards customers for saving?

    HMBradley will offer customers up to 3% in annual percentage yields on a combined checking and savings account provided they save a set portion of their direct deposits every month…Customers who save more than 20% of their direct deposits each month are eligible for the highest rate.

    Or how about replacing the concept of a transaction-focused deposit product with a service-focused one?

    The successor to the checking account will have: 1) universal payments (B2C, P2P, bill pay) capability; 2) rewards optimization; 3) account-to-account money movement; 4) receipt management; and 5) value-added service provisioning

A new approach is needed.

Overdraft was invented almost 50 years before the start of the Revolutionary War. It was called at the time “one of the most ingenious ideas that has been executed in commerce”.

Today, it is rightly viewed by both British and American regulators as extremely harmful to consumers. A predatory service disguised as a convenience.

However, if regulators want to see more success in their efforts to ameliorate the negative effects of overdraft, they need to start be recognizing it for what it fundamentally is — a poorly designed product.

And the way to eliminate a bad product isn’t just to regulate it; it’s also to incentivize the market to build a better one.

Additional Reading:

  • If you’re wondering how overdraft became such a big problem for consumers (and such a big revenue driver for FIs), one culprit that we need to look more closely at in the U.S. is credit unions. Yes, credit unions:

    The average overdraft fee at a bank is now $30, up 50% from $20 in 2000. Credit unions, typically lauded for their consumer-friendly practices and prices, aren’t far behind. The average overdraft fee at a credit union almost doubled over that period, reaching $29, up from $15 in 2000.

  • In their research into overdraft, the CFPB classified frequent overdrafters (those with more than ten ODs or NSFs in a 12-month period) into six groups. Most of the groups were characterized by lower incomes, lower account balances, lower credit scores, and less access to formal credit such as credit cards. But one of the groups stood out with much higher deposit balances and monthly deposits, yet still displayed a puzzling inability to keep their checking accounts out of the red. A market researcher I spoke to referred to this affluent and absentminded group of consumers as the “sloppy Doctors”.

  • My argument for replacing overdraft with alternatives that drive better financial outcomes boils down to my belief that customers will, over time, migrate to the service providers that they feel they can trust to protect and advance their interests. Jennifer Tescher (@jentescher) articulated this idea with masterful clarity in her article The Power Of Purpose: Fintech’s Role In Stakeholder Capitalism.

    A hallmark of tech startup culture is an incessant focus on the customer experience. But a good experience is different than a good outcome, and a good outcome is what builds trust. Companies should interrogate their products from the vantage of consumer outcomes to ensure that they are effective in improving financial health.

Thanks,

Alex Johnson

(@AlexH_Johnson)

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