Banks Face a New Regulatory Environment: From Overdrafts to Fair Lending

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Regulatory risk for banks is evolving as they emerge from the darkest days of the pandemic and the economy normalizes.

Banks must stay on top of regulatory updates and potential risks, even as they contend with a challenging operating environment of low loan growth and high liquidity. President Joseph Biden continues to make progress in filling in regulatory and agency heads, and financial regulators have begun unveiling their priorities and thoughts in releases and speeches.

Presenters during the first day of Bank Director’s Audit & Risk Committees Conference, held on Oct. 25 to 27 in Chicago, provided insights on crucial regulatory priorities that bank directors and executives must keep in mind. Below are three of the most pressing and controversial issues they discussed at the event.

IRS Reporting Requirement
While politicos in Washington are watching the negotiations around Biden’s proposed budget, bank trade groups have been sounding the alarm around one way to pay for some of it.

The proposal would require financial institutions to report how much money was deposited and withdrawn from a customer’s bank account over the course of the year to the IRS in order to help the agency identify individuals evading taxes or underreporting their income. Initially, the budget proposal would require reporting on total inflows and outflows greater than $600; in subsequent iterations, it was later pushed to $10,000 and would exclude wage income and payments to federal program beneficiaries. It has the support of the U.S. Department of the Treasury but has yet to make its way into any bills.

Like all aspects of the spending bill, the budget proposal is in flux and up for negotiation, said Charles Yi, a partner at the law firm Arnold & Porter, who spoke via video. Already, trade groups have mounted a defense against the proposal, urging Biden to drop it from considerations. And a critical senator needed for passage of a bill, Sen. Joe Manchin (D-W.V.), came out against the proposal; his lack of support may mean Congressional Democrats would be more apt to drop it.

But if adopted, the informational reporting requirement would impact all banks. Banks would have to report a much greater volume of data and contend with potential data security concerns.

“Essentially, you’re turning on a data feed from your bank to the government for these funds and flows,” said Arnold & Porter Partner Michael Mancusi, who also spoke via video.

Overdrafts Under Pressure
Consumer advocates have long criticized overdraft fees, and regulators have brought enforcement actions against banks connected to the marketing or charging of these fees. Most recently, the Consumer Financial Protection Bureau settled with TD Bank, the domestic unit of Canada-based Toronto-Dominion Bank, for $122 million over illegal overdrafts in 2020. And in May, Bank of America’s bank unit settled a class lawsuit brought by customers that had accused it of charging multiple insufficient fund fees on a single transaction for $75 million.

Pressure to lower or eliminate these fees and other account fees is coming not just from regulators but from big banks, as well as fintech and neobank competitors, said David Konrad, managing director and an equity analyst at the investment bank Keefe, Bruyette & Woods. Banks have rolled out features like early direct deposit that can help consumers avoid overdrafts or have started overdraft-free accounts. These institutions have been able to move away from overdraft fees because of technology investments in the retail channel and mobile apps that give consumers greater control.

But insufficient funds fees may be a significant contributor of noninterest income at community banks without diverse business lines, and they may be reticent to give it up. Those banks may still want to consider ways they can make it easier for consumers to avoid the fee — or choose when to incur it — through modifications of their app.

Fair Lending Scrutiny Continues
Many regulatory priorities reflect the administration in the White House and their agency picks. But Rob Azarow, head of the financial services transactions practice at Arnold & Porter, said that regulators have heightened interest in fair lending laws — and some have committed to using powerful tools to impact banks.

Regulators and government agencies, including the Consumer Financial Protection Bureau and the U.S. Department of Housing and Urban Development, have stated that they will restore disparate impact analysis in their considerations when bringing potential enforcement actions. Disparate impact analysis is a legal approach by which institutions engaged in lending can be held liable for practices that have an adverse impact on members of a particular racial, religious or other statutorily protected class, regardless of intent.

Azarow says this approach to ascertain whether a company’s actions are discriminatory wasn’t established in regulation, but instead crafted and adopted by regulators. The result for banks is “regulation by enforcement action,” he said.

Directors should be responsive to this shift in enforcement and encourage their banks to conduct their own analysis before an examiner does. Azarow recommends directors ask their management teams to analyze their deposit and lending footprints, especially in zip codes where ethnic or racial minorities make up a majority of residents. These questions include:

  • What assessments of our banking activities are we doing?
  • How do we evaluate ourselves?
  • How are we reaching out and serving minority and low-to-moderate income communities?
  • What are our peers doing?
  • What is the impact of our branch strategy on these communities?

Focus On Two Key Areas to Capitalize on Overdrafts

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overdraft-10-16-18.pngBy all accounts, the outlook for overdraft programs is encouraging for community banks.

Increasingly more consumers are choosing to access the service as a short-term funding solution, while regulatory burdens are easing. Banks that manage their customers’ overdrafts with outdated programs—those that do not put their account holders’ best interests at the forefront or utilize outdated technology and procedures—cannot capitalize on this real opportunity to improve service and compliance, as well as fee income.

The Overdraft Landscape
According to Moebs Services Inc., an economic-research firm, overdraft revenue increased 3 percent industry wide from 2016 to 2017, the largest increase since 2009, and is on pace to an all-time high above $37 billion by 2020.

One reason for this increase in overdraft fee income is more consumers are making the decision to access the service when funds fall short. Moebs Services reported there were approximately 1.12 billion overdraft transactions in 2016, up from nearly 1.09 billion in 2015. According to a 2017 Wall Street Journal article, these numbers suggest many consumers consider overdraft a safety net—a convenience—for which they are willing to pay a price. Analysts said in the WSJ article that the increase in overdraft revenue should be expected, since rules and regulations have been in place for some time now.

In addition, the Consumer Financial Protection Bureau withdrew overdraft rulemaking from the agency’s spring rulemaking agenda in May after having been on the agenda for years, signaling that no new overdraft regulations will be forthcoming.

With this landscape set, how should your bank capitalize on it?

A Data-Driven, Automated Solution
The first place to start is to review your current overdraft procedures and software capabilities to ensure you are using a modern, data-driven solution—one that automatically manages risk and strives to meet customer expectations. Although there are several essential components of such a system, two are listed below.

Intelligent Limit-Setting
Updated automated overdraft programs should enable your bank to set individual overdraft limits that align with an account holder’s ability to repay the overdrawn balance. The software analyzes the key risk variables of your accounts, identifies the accounts that have the highest probability of charge off and calculates individual “intelligent” limits. It then reassesses that ability to repay daily.

Providing these dynamic limits helps to serve customers better than employing fixed overdraft limits (where the same overdraft limit is assigned to every customer of a certain account type) by granting higher overdraft limits to those customers whose ability to repay warrants it, while pulling back on those who have more limited repayment capacity.

Just as important, using intelligent limits addresses the Federal Financial Institutions Examination Council (FFIEC) 2005 Joint Guidance on Overdraft Protection Programs, which states, “Institutions also should monitor these accounts on an ongoing basis and be able to identify consumers who may represent an undue credit risk to the institution. Overdraft protection programs should be administered and adjusted, as needed, to ensure that credit risk remains in line with expectations.”

Reg. E Outreach
Eight years have passed since most banks conducted a formal outreach program in response to the 2010 Amendment to Regulation E, or Reg. E, which requires affirmative consent from customers for banks to charge an overdraft fee on ATM and one-time debit card transactions. Does your board know the number of customers who did not provide a decision back in 2010 or at a subsequent account opening?

Without consent, banks do not extend overdraft privilege through these channels, which can result in multiple unexplained debit card declines. Customers may not recall making a Reg. E decision or are unaware it is even an option, which leads to confusion and irritation for the customer.

Data-driven overdraft software allows your bank to identify these denied transactions and sort them by a customer’s Reg. E decision. With this knowledge, you can reach out to those customers who have not provided a decision and explain the reason for the denial, offer overdraft alternatives and obtain a Reg. E preference. Customers appreciate this level of communication, which provides assurance your debit card will consistently help them meet their liquidity needs.

Capturing just a few percentage points more Reg. E opt-ins can result in a tangible increase in both interchange and fee income as well. A qualified third-party overdraft provider will offer employee training, best practices and scripts to ensure your Reg. E outreach program is successful and compliant.

Is your bank positioned to capitalize on the opportunity for better service and income that a well-run overdraft program represents? With the right technology and procedures, you can.

Boosting Income Without Losing Customers

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The Durbin amendment and new overdraft rules significantly cut into fee income, creating more unprofitable accounts. So what should banks and other financial institutions do to generate more fee income? StrategyCorps’ managing partner Mike Branton talks about how financial institutions can increase fee income from these accounts without scaring off profitable customers.

What are banks doing today to get more checking-related fee income?

There are three camps. One camp continues to do nothing. Maybe they think overdrafts are going to make a comeback.

Another camp is doing what we at StrategyCorps call “fee-ectomies”—charging for things banks have been giving away for free or relying on past tactics like balance requirements with penalty fee (maintain a $500 minimum balance or be charged $6). These fee-ectomies are perceived as unfair by customers—paying fees while adding nothing of value. Economists describe this as “an unfair value exchange.”

The third camp recognizes that consumers have been trained to value traditional checking benefits at zero due to free checking; that perceived fairness drives customer reaction to fees; and that you must not make the same checking account changes across the board with no recognition of the individual customer’s existing relationship profitability with the bank. We think the third camp will be the winners financially and with their customers.

What specifically is this third camp of banks doing?

These banks have first found a way to understand which checking customer relationships are profitable and which ones aren’t. Doing this allows for checking account changes to selectively fix the unprofitable ones and protect the profitable ones, rather than a wholesale change that may raise fees on every customer.

Once the banks have this identification and segmentation, the account design changes include adding non-traditional benefits if you are going to add a checking fee. Adding a fee without blending in new benefits results in customers feeling their bank is just greedy by charging for things that have been given away for so long. Think about how you feel about when airlines charge for luggage.

Third, once banks have determined the precise checking account changes to each customer segment, they should communicate these changes clearly and directly to each customer with an “upgrade” message rather than a “we need more fees but aren’t providing you any more value” message. And they train their branch personnel to understand how these changes are truly fair for the customer, so they can deal with inquiries from customers about those changes.

In a nutshell, these three things are what StrategyCorps does for financial institutions.

So I guess you don’t agree with banks or thrifts charging fees for the use of a debit card at $4 or $5 per month?

It’s insane. You’re taking the number one most convenient, most popular way that customers want to pay for something and now you start charging a usage/penalty fee for that card right at the time you need significantly greater transaction volume? This negative reinforcement won’t work and there’s consumer research showing 80 percent to 90 percent of consumers oppose this idea and 20 percent to 30 percent will change banks over it.

With the Durbin amendment (which caps debit fees at 21 cents per transaction for banks above $10 billion in assets), banks have to make it up with volume. So incentivize customers to use it more. We’ve designed our products to do this and are seeing transactions at least double. Charging a fee is going to not only tick off customers but also cause material account attrition that will offset significantly any fee lift.

Aren’t there going to be a lot of customers who say, “I don’t want to pay for a checking account?” Won’t a large number of people call the bank and say, “I don’t want the five dollar account, give me the free one?”

Actually, no. We understand this expectation and concern here by bankers, but we’ve done this account upgrade process hundreds of times. The reality is there is no appreciable negative response and minimal incremental attrition if you incorporate a fair fee-based account.

Doing this will get banks more fee income annually per account—the range is between $60 and $75—from unprofitable accounts, which is usually 40 percent to 50 percent of all checking accounts. Do the quick math; this is a significant number. The financial reward far outweighs the risk of losing accounts that were costing the bank money anyway.

And for the profitable accounts, there are several ways the relationship can be protected with this kind of “fair and upgraded” account strategy that significantly reduces their attrition risk.

What’s Next for Consumer Checking after Durbin?

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checking.jpgThe two major checking-related fee income sources have been the targets of regulation. Durbin will decrease interchange fees by about 45 percent (44 cents per average transaction down to 24 cents). Sure, there’s still uncertainty regarding the exclusion for financial institutions with less than $10 billion in assets, but even the most optimistic banker will concede that interchange fees will not be at levels where they’ve been before. Add to that, the estimated financial impact of FDIC and OCC overdraft guidance – a reduction of an additional 15 percent to 25 percent on top of Reg E’s first year negative impact of about 10 percent to 20 percent. So, checking account products and pricing will have to change to adapt to these new rules.

These changes to replace lost fees won’t be popular, given overall consumer sentiment towards banks these days. This challenge is compounded by the fact that free checking has convinced consumers that traditional checking benefits aren’t worth paying for. In the minds of many consumers, since banks have been able to financially justify not charging for these benefits for the last decade or so, no longer doing so is just another “fee grab” by greedy banks.

This means the easy and convenient changes like starting to charge fees for the same benefits that have been free or instituting certain requirements, like minimum balances to avoid penalty fees, is a risky move. It will anger customers, especially the most profitable ones, and chase many of them away to competitors. Plus, history has proven that these kinds of checking changes will generate only a fraction of the revenue that needs to be replaced.

Banks must make changes to their retail checking accounts to incorporate a fair exchange of value with customers. This means an upgrade in what they get when their bank begins charging fees for services. Sorry to sound like a broken record, but charging fees for benefits that customers haven’t paid for in the last decade or adding requirements to avoid a fee is a tough sell, and just defaulting to this approach will be unproductive at best.

So smart banks see the post-Durbin world of checking as an opportunity to launch innovative checking products-including adding non-traditional checking benefits deemed worthy of a charge, such as local merchant discounts and identity theft protection. And look for pricing strategies that simply and immediately reward customers by reducing checking fees based on desired banking behaviors from customers that don’t revolve around minimum balances. This differently defined “pathway to free” will replace the traditional free checking account, which will be hard to justify in the future from a profitability standpoint.