The Ends of the Month: The Convenience of Blaming The Other Guy
By Corey Stone, Entrepreneur in Residence, CFSI
My last post described the surprising cost — and inexplicability — of chronic overdrafting in the lives of households who struggle at the ends of the month. The small amounts and short periods of borrowing that overdrafts constituted led me to wonder why these consumers weren’t better able to avoid them..
I thought I might have an opportunity to explore this question when I joined the start-up team at the CFPB. There, we were building an interdisciplinary team of economists, behavioral scientists, and industry veterans dedicated to rigorous data collection and analysis as part of a commitment to evidence-based policymaking. I led the office responsible for intelligence gathering and market analysis related to many of the financial products we regulated, including the various sources of “liquidity credit” used by struggling households in a pinch — installment lending, payday lending, and deposit accounts (including overdrafts).
As part of our market monitoring responsibilities, my colleagues and I participated in frequent visits to the agency from industry leaders and their trade associations. Periodically,we met with members of one of the state associations of community bankers on a “fly-in” to visit their members of Congress and to meet the new agency. Routinely, these visitors voiced concern that the CFPB would impose further regulations on overdraft fees, which were an important source of revenue for many of them.
With mandated disclosures in place, the bankers argued, customers understood how overdrafts worked and used them because of the benefits they provided: overdrafts made it possible for customers to make a payment when they were short on cash, avoiding late fees or a utility service shut-offs — penalties that could be much more costly than an overdraft. Opting-in to overdraft on a debit card could enable a customer to pay for an emergency car repair, or obtain a medical prescription when bank balances were short. Overdrafting, the bankers also pointed out, beat having a check or electronic bill payment returned, for which the customer would also be charged a similar fee. And, some bankers asserted, overdrafting was also better than the less savory alternative of borrowing from allegedly more predatory non-bank lenders.
At other times we met with the payday lenders. In light of the Bureau’s mandate to examine their businesses and potentially write rules that could severely constrain them, these visitors were eager to explain the important benefits of the short term credit they provided. Their loans’ purported benefits were similar to the ones bankers attributed to overdraft: avoided late fees or utility shut-offs, evictions prevented, emergency expenses taken care of. Further, payday lenders asserted, many customers came to them in order to avoid having to pay overdraft fees. A typical two week loan for $300 and costing $45 could prevent multiple overdrafts (at $35 each). Moreover, the lenders pointed out, the terms and costs of each loan were disclosed (under the Truth in Lending Act, from which overdrafts were exempted) and initiated by the consumer (in contrast to overdrafts, which could result from a miscalculation or inattention). If anything was in need of more government intervention, the lenders argued, it was overdraft.
These conversations replayed many times over. Implicit in the strong convictions and two-way finger-pointing was an assumption that overdrafts and payday loans mostly substituted for each other. This seemed reasonable: Each were sources of small dollar credit and each claimed similar benefits from their products’ use. But we wondered if there was more going on.
Could using payday loans, taken out initially to avoid overdrafts, also lead to some overdraft or NSF fees? Consumer advocates had argued this was what happened — indirectly when the consumer repaid the loans in full on the next payday, leaving the borrower short on cash (again), or directly when the lender submitted (or resubmitted) the post-dated checks borrowers usually left as collateral. Similarly, was it the sting of the most recent overdraft, as much as the knowledge overdrafts had been avoided, that led borrowers to take out new payday loans? Could overdrafting and payday borrowing actually compound each other, leading to greater use of both products (and greater expense to the consumers who struggled at the ends of the month)?
We got a chance to explore these questions in a natural experiment. In late 2013, the OCC and the FDIC had issued guidance that caused several large banks to discontinue their “deposit advance” programs the following Spring. Deposit advances were essentially payday loans that a customer could initiate online through their bank. Borrowed funds were added to the customer’s checking account instantly at the time of the advance, then repaid to the bank out of the next deposit. Notably, the banks had pitched deposit advances as a way to avoid overdrafts.
We asked the banks to compile some key behavioral statistics before and after the discontinuation. What we found suggested that overdrafts and payday-like loans were hardly pure substitutes.
- During the period when they had access to the product, deposit advance users overdrew their accounts 14 times per year, on average — far more than non-users. Moreover, heavy users overdrafted the most, and light users overdrafted the least. The findings indicated that even with deposit advances available as an overdraft avoidance tool, advance users remained at considerable risk of overdrafting.
- The banks also measured overdrafting among the same customer groups after access to deposit advances had been terminated. If advances and overdrafts were principally substitutes, we would see big increases in former users’ overdrafts. And since the typical deposit advance involved about twice the average amount of credit as the typical overdraft, we would have expected overdrafting by the former deposit advance users to increase dramatically. But only a slight uptick occurred during the first two months following DAPs’ discontinuation (possibly explained by seasonal differences in overdraft rates or by borrowers having to repay their DAPS without the ability to reborrow during the next pay period). Thereafter, the advance users’ overdraft rates declined to slightly below previous levels.
- The banks also tracked DAP users’ transactions with known online payday lenders before and following the discontinuation of deposit advances. They found no evidence of any increase in non-bank borrowing that would have accounted for lack of increase in overdrafts.
These simple findings (found in Chapter 2 of this report) suggested that there may have been as much complementarity as substitution going on between overdrafting and the short term credit the DAP programs made available. But they also deepened the mystery: What was it about overdrafting that made it so hard to avoid even when there were cheaper sources of short term credit available?
In my next post I’ll share results from another research project that might begin to answer that question.
Visit www.cfsinnovation.org to learn more about the author and CFSI.