De-Politicizing the Overdraft Discussion

There has been an abundance of interest in excessive bank overdraft fees, but a shortage of rational discussion to unpack and analyze this service with data regarding cost, value and risk.

Banks have an opportunity to change this product in a manner that truly services customer needs and avoids unintended consequences in consumers’ financial lives. 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 misguided and shortsighted. When consumers are unable to make planned payments, it can kick off a chain reaction of adverse outcomes. So while social and competitive forces are driving banks to make overdraft services more customer friendly, it’s important that policymakers and bankers consider the whole picture.

Overdraft Insights
In my 25-plus years of detailed data analytics for the financial services industry, I have never encountered a significant correlation of overdraft activity occurring only in the low-to-moderate customer income segment. In fact, detailed quantitative analysis of hundreds of financial institutions reveals many insights:

• There are clear segments of overdraft users. While there is a mass-market segment that incurs one to three overdrafts a year, the vast majority of overdraft activity comes from recurring users. In fact, fewer 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 share of 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 make up 70% to 80% of all deposit activity.

The Ignored Pay Ratio
While banks and policy advocates focus on overdraft features like the per-item charge, an exception for de minimis transactions 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 bank’s checking product over another, they should consider pay ratios. Which institution 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 impacts to their credit score. Late fees charged by the merchant for car payments, rent or mortgages are typically multiples higher than the typical bank overdraft fee – so a consumer would be better off if the bank paid the item and charged the consumer the fee, rather than the merchant.

A fintech started recently touting “no insufficient fund 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 Through Data
While there have been plenty of opinions and published studies, few include any quantitative analysis of account-level data. As financial institutions look to change their overdraft services and approaches, there are many opportunities for them to leverage data to enhance customer service and manage risk.

For instance, data indicates that a simple flat overdraft amount for all customers makes little 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 data is highly valuable from a risk standpoint; our analysis indicates that as deposit engagement increases, risk declines and approaches zero for customers highly engaged with the institution. As the deposit engagement of a customer account increases, the odds that the account turns into a charge-off become very low.

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