The Ends of the Month: The Elephant in the Room

By Corey Stone, Entrepreneur in Residence, CFSI

My last post described the experience of serving cash-strapped consumers who needed to pay their bills at the last minute. Our business gave them a “faster payment” channel (before that term came to refer to next generation ACH). And we charged a small premium ($1 in person, $3 — $5 by phone or online) for consumers who needed to avoid much higher late fees or costly shut-offs of their utilities. But sometimes they paid before their paychecks had hit their accounts, resulting in bigger fees to their banks for overdrafts or having their checks returned.

We were proud that American Payment Systems became the biggest in-person payment provider, eclipsing even Western Union and Moneygram in our category. But it was only after our $40 million company was purchased by a much larger payment processor that I began to learn how much bigger the market for “just-in-time credit” was compared to the market for just-in-time payments.

Our new parent had another subsidiary whose primary service enabled banks to post larger payments ahead of smaller ones in their end-of-day processing. In an era before the Fed made opting-out of debit card overdraft a default, high-to-low posting increased the probability a customer would incur more than one overdraft fee on a day when debits exceeded available balances. The incremental overdraft fees generated by the service were worth half a billion dollars annually to its largest client alone. A few years later, when I was at the CFPB, and thanks to federal regulators’ decision to require banks to break out overdraft and returned-check fees (NSF) on annual call reports, we were able to size our industry’s revenue from overdraft and NSF fees at $15 billion in 2015. When it comes to “small dollar credit,” overdraft is the elephant in the room.

Let’s put that number into perspective. $15 billion was nearly twice what the entire payday lending industry earned in interest and fees in 2015. It also approached the $18.4 billion earned by the entire US banking system on merchant interchange from all debit card and general-use prepaid cards in that year. And it was considerably greater than what banks earned on all other deposit account fees combined. The average debit card interchange fee paid by merchants on the national payment networks has been around 25 cents since 2011. The fee paid by consumers who overdraft or have a check returned is about $35 per transaction — more than a 100-fold difference.

Just a few consumers are responsible for the vast majority of overdrafts and NSFs. At the CFPB, using 2012 transaction-level data from the largest banks, we tried to understand who was overdrafting. We found that about two thirds of consumer checking accounts had no overdrafts during the year. At the other end of the spectrum we found that the 9 percent of checking accounts with more than 10 overdrafts and/or NSFs during the year paid more than three quarters of all the penalty fees. The 5 percent of accounts with more than 20 such transactions accounted for more than half of them. For many of them, overdrafting was a monthly occurrence.

What distinguished the frequent overdrafters from the occasional- and non-overdrafters? Not surprisingly they had somewhat lower incomes, as suggested by their average monthly deposits. But their average daily account balances over the course of the month were much lower: money was going out as fast as it was going in and few funds, if any, were left over at the end of each pay period. Frequent overdrafters looked like many of our former customers at American Payment Systems.

Tellingly, the frequent overdrafters’ median credit scores were down in the 500s (as opposed to the mid-700s among non-overdrafters). Many of them had credit cards, but most of these were maxed out, so they had little if any available credit for emergencies. Their credit scores further suggested many were delinquent or in default on one or more of their obligations.

Other things my CFPB colleagues had learned about overdrafts made our findings about frequent overdrafters all the more striking. The amount of shortfall that most overdrafts represent — $42 on the median check overdraft and $15 on the median debit card overdraft — are small, both in absolute terms and relative to the amounts they paid in fees. Similarly, the median length of a “negative episode” (i.e. how long one or more overdrafts take an account negative) is just three days. And the median term of the “negative episodes” caused by one or more overdrafts was just three days.

These small amounts meant that the majority of frequent overdrafters paid more in fees over the course of a year than they ever used in overdraft “credit” (i.e., how much they took their accounts negative) at any given point in time. They also meant that many overdrafters’ fees could have been avoided with small modifications in the amounts or timing of their spending over the course of a pay period or month and with just a little more savings to provide a safety margin. If relatively small changes could save these consumers a good deal of money and put them on a better financial footing, why isn’t this happening?

The inexplicability of overdrafting — of why a small group of people seems willing to pay so much for transactions that could be easily avoided — has been the subject of policy debates within our industry for some time. The questions revolve around how much of overdrafting behavior is intentional versus accidental, the extent to which consumers understand how overdraft works, what it means to be opted-in or -out of debit card overdraft, and whether they know what their opt-in status is. The question also gets at “alternative” and — at least at first blush — less expensive forms of small dollar credit, such as deposit advances and payday loans, and whether or not these benefit overdrafters by serving as substitutes.

These are questions worth asking to better understand and empathize with those who struggle at the ends of the month. Answering them may also help explain how banks and credit unions have become so reliant on overdraft revenue — and what innovations are beginning to put this revenue at risk. My next two posts will take pokes at a couple of them.

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1. After adjusting for the large number of non-overdrafting accounts that were inactive and had no regular income.

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