A New Approach to Covering Overdrafts

The drive to provide innovative products has become an all-out race. To stay ahead of the competition, many bankers have been getting into new product lines on unfamiliar terrain. In this competitive environment, you should know that one of the best income-producing ideas to come along in many years simply builds on a product that is very familiar to all of us: overdraft coverage for retail checking accounts.

What’s the new twist on a product that has been around for decades? Banks that offer the program are modifying their practices to automatically pay good customers’ overdrawn checks up to a predetermined limit while charging their customary NSF fees. When done correctlyu00e2u20ac”that is, with supportive customer communications, sophisticated management and tracking software, and compliance toolsu00e2u20ac”the program is capable of doubling banks’ NSF income while prompting customers to write thank-you letters to their bankers for taking the sting and stigma out of bounced checks.

More than 1,000 banks nationwide have already modified their practices to provide automatic overdraft coverage for checking account customers, and the practice is expected to grow dramatically over the next two to three years.

A conservative approach

Many excellent reasons exist for offering the program, including its ability to significantly increase noninterest income and simultaneously improve customer service. The Office of the Comptroller of the Currency, however, has raised a number of legitimate regulatory concerns about some existing programs that must be taken into consideration.

In conjunction with the development of our custom overdraft service over the past year, our senior staff and two law firms carefully looked at the many issues that attend overdraft procedures and identified a set of principles that should guide any bank that is considering implementation. The focus was on responding to current regulatory concerns and, most important, anticipating future concerns. Our overall conclusion is that communicating with your customers and monitoring and tracking account activity are critical to the success and regulatory compliance of an automatic overdraft program. Sophisticated software tools designed specifically to support these critical relationship management and compliance elements of the program are the essential foundation for improving both noninterest income and customer service. Explore your options, but choose a partner that understands all these issues very well.

An innovative approach

Banks return over 300 million checks per year and, as a courtesy to their best customers, pay countless more overdrafts. Most bankers, however, readily admit that their process for handling NSFs is not always fair, consistent, customer-oriented, or even efficient. Overdraft services extended as a courtesy to customers are an innovative way of handling overdrafts that solves each of these deficiencies.

But don’t confuse overdraft coverage with overdraft protection lines, which are a credit extension and can be an administrative and compliance headache. Instead, you incorporate in your transaction account products a pre-established overdraft thresholdu00e2u20ac”for example, $500 or $750. There is no contract that binds you or your customers, and any overdraft payments are a discretionary courtesy extended to customers and automatically supported by the bank’s procedures. For their part, customers pay the customary NSF fee and are expected to bring their accounts into balance as soon as possible.

To obtain all the benefits, you will need customer relationship management-style software that carefully manages the bank’s relationships with these specific, highly profitable customers. Operational and customer communication efforts are supported by screen-based software that should, among other things, notify customers of the overdraft and fee posting, record phone call information, produce scripts for employee interactions with customers, generate customized letters, support customer rehabilitation, and provide management reporting.

In addition, the software should integrate with your existing core data processing system and also support database capabilities that permit you to assemble a complete history on overdrawn customers for analysis and data mining and to engage in ongoing strategy development.

Three goals

Banks that install high-quality overdraft programs can significantly increase their noninterest incomeu00e2u20ac”typically more than 100% within four to six monthsu00e2u20ac”substantially improve customer service, and stay within regulatory compliance:

1. Increase noninterest incomeu00e2u20ac”It’s not often you have an opportunity to double fee income without raising fees. A courtesy overdraft program can cover check, debit card, ATM, and Internet banking transactions. For each item presented where insufficient funds are available, you pay the item, charge your customary fee, and notify the customer that the service has been provided.

Customers who do not expeditiously deposit funds into their accounts are reminded with a series of communications concerning additional options. Here is where the relationship management software is critical. It should be capable of generating and tracking these customer touchpoints.

It is important to note that any subsequent contacts are very different from ordinary “collections” activity because the overdraft coverage is not a credit, it is a service for which the customer pays a preset fee. Of course, some customers will fail to replenish their accounts. But even in those few cases where this might happen, your credit exposure is limited by the overdraft threshold. If losses from chargeoffs do occur, they are typically only 9% to 12% of incremental revenue, so “credit risk” is very small.

Salary costs are also typically very minimal. Experience indicates that only one full-time equivalent employee is required for every 20,000 accounts.

2. Improve customer serviceu00e2u20ac”You know how it works: A customer bounces a check, the bank imposes a fee and returns the check to the merchant, who imposes a fee and redeposits it to the bank; the check bounces again and goes back to the merchant, who then imposes another fee and makes angry phone calls to the customer, who then has to come pick up the check and pay with cash. The total time, fees, hassles, and embarrassment amount to a lot more than the typical $25 bank NSF fee.

And the ordeal is not over. The customer comes in to ask you why you did not cover his check when you covered someone else’s check that was written for twice the amount. Your branch personnel are faced with an awkward situation, and the customer ends up unhappy. This adversarial situation has played out time and time again over the years in banks all across the country.

The solution is as straightforward as changing your procedures. Besides providing convenience and peace of mind, an automatic overdraft program is fairer and more equitable because you provide the service to approximately 95% of the customers who use overdrafts, either by mistake or as a convenience. No longer are your branch managers put in the difficult position of deciding which checks the bank will pay and which ones will be returned to the merchant. Nor will they have to field complaints from customers who are angry about a check being returned or a fee they did not expect (and did not really think they deserved).

By providing automatic overdraft up to a certain threshold, you immediately change the customer dynamic on overdrafts. Rather than seeing NSF charges as punitive, customers recognize that the bank is providing a valuable service, and they simply pay a fee for the added convenience and peace of mind. The service formalizes customer interactions that, in the past, were handled inconsistentlyu00e2u20ac”and sometimes inequitably.

Customer service is also enhanced by the communications management tools that should be integrated in your program software. If the program is structured with attention to all the details, the customer notice of an overdraft stops being a “penalty” notice and becomes a customer communication tool. Any subsequent communications are additional opportunities to reinforce your customer service commitment.

3. Stay in complianceu00e2u20ac”If you have already looked into automatic overdraft procedures, you may be familiar with Interpretive Letter No. 914, released last September by the Office of the Comptroller of the Currency (OCC). In the letter, the OCC expressed a lack of confidence in a specific overdraft program offered by an unnamed vendor because of various compliance, supervisory, and policy issues that the letter identified.

The interpretive letter is a positive step toward clarifying the relevant regulatory issues. How often do the regulators point out specific concerns before your program is up and running? The interpretive letter gives you a head start, allowing you to structure your program to mitigate potential regulatory problems.

What are the regulators concerned about? Among other things, the OCC wrote that some programs appear to entice customers to overdraw their checking accounts. This is a legitimate concern. The purpose of the program should not be to encourage reckless financial behavior. But in reality, a certain percentage of our customers choose convenience over financial prudence. For these customers, it may be worth it to pay a fee to their bank if it gives them other benefits, such as avoiding higher late fees or other consequences resulting from late payments on their mortgage or credit card accounts. This fee-shifting ability is a benefit for customers who occasionally must juggle their income and obligations.

Consumers who use overdrafts as a financial management tool, however, are in the minority. Fully 70% of checking account customers never overdraw their accounts, and about half of those who bounce checks do so only once or twice a year. For them, automatic coverage provides piece of mind for the occasional lapse or mistake. When your bank covers overdrafts, your customers’ perception is that you took special care of their needs. That’s customer goodwill, and it’s very valuable.

But getting back to the problem of enticement, the OCC noted that banks should refrain from mass marketing overdraft protection. Mass marketing is the wrong approach for this product anyway. Remember, the majority of customers never overdraw their accounts.

Instead of spending precious mass marketing dollars, you need only communicate effectively with your customers in the ordinary course of serving their needs and incorporate overdraft thresholds in your transaction accounts as a procedural feature. Typically, about 95% of your retail checking account customers will be eligible for the service.
As it turns out, improper enticement and the other concerns outlined in the letter can be readily addressedu00e2u20ac”but, remember, they must be addressed. I’ll just briefly mention a few other regulatory issues and a conservative approach recommended by law firms:

  • Whether the NSF fee is a finance charge subject to the disclosure requirements of Truth in Lending and Regulation Zu00e2u20ac”To avoid Reg Z complications, the fee should be imposed for NSF items regardless of whether they are paid or returned, no contractual agreement should exist between the bank and the customer, and no per diem fees should be imposed in addition to the flat initial NSF fee.
  • Whether the program raises equal credit opportunity issues under Regulation Bu00e2u20ac”No potential for disparate treatment of customers exists because branch personnel no longer exercise discretion over items paid or returned.
  • Whether program materials could mislead customers in violation of the unfair and deceptive acts and practices statutesu00e2u20ac”All statements and materials should clearly and completely set forth the program features, including the exact amount of the overdraft coverage and that customers are expected to immediately make a deposit to cover the overdraft.
  • Whether adequate loss recognition and MIS reporting practices are in placeu00e2u20ac”Well-designed software incorporates loss recognition methodologies and customer tracking and reporting for overdraft activity that are more robust than those offered on existing internal systems.
  • Whether the program includes adequate consumer safeguardsu00e2u20ac”The software should monitor customers with unusually high overdraft activity, enabling the bank to work with them to find other ways of solving their financial needs. The software should also provide tools and reports to identify customers who may abuse the program and should limit the overdrafts a person can make to the established threshold.

Courtesy overdraft is a new way of thinking about customer relationship management, dramatically improving fee income, and pleasing your customers. The bottom line is that if you install a well-conceived program that takes all these issues into account, you will start to see the financial results almost immediately. It’s one of the best ideas for improving noninterest income I’ve seen in a long time.

Join OUr Community

Bank Director’s annual Bank Services Membership Program combines Bank Director’s extensive online library of director training materials, conferences, our quarterly publication, and access to FinXTech Connect.

Become a Member

Our commitment to those leaders who believe a strong board makes a strong bank never wavers.