Overdraft protection has ulterior motives

Published 9:00 pm Saturday, June 19, 2004

Quite a few years ago, a popular magazine published a cartoon on what was then a hot topic. The drawing showed two guys in a prison cell, each sitting on the edge of his bunk. One is saying to the other, “It all began with a letter from my bank saying that I could write checks for more money than I had in my account.”

Banks are once again sending out letters like that, and consumer advocates are worried about them. In the letters, and in other marketing media, banks are offering “overdraft protection” – a deal in which they cover your checks so that they don’t actually bounce. The next time you try to pay your telephone bill with a hot check, the phone company will never know. The bank makes good on the check, and it is simply a “what happens in the bank stays in the bank” event.

The overwhelming majority of people think of their bad checks account as an expensive embarrassment. Banks, however, now view overdrawn accounts as a source of revenue and profit. Both groups are right.

Banks have offered overdraft protection in one form or another for centuries. It’s a practice almost as old as banking itself. But banking customers have changed, as has the nature and use of credit. In the early history of banking, and in fact well into the 20th century, bank accounts, especially checking accounts, were for people of means. Ordinary people paid in cash.

People of means were thought to be better at handling money because they were the only ones who had any of it. They were generally considered better credit risks, too, because they usually owned some property that could be seized by the bank to make good on any unpaid debts. The widespread extension of credit to the rest of us, however, quickly demonstrated what a risky business, and economic disaster, that could be. So regulation was born.

Consumer protection laws, rules and other regulations cover many aspects of loans by banks and virtually everybody in the money lending business – except perhaps the mob. But as extensive as these regulations are, they don’t cover overdraft protection. That’s why the substantial increase in these services essentially slipped in under the radar screen. It wasn’t until banks began aggressively marketing the services that both bank regulators and consumer groups became concerned.

Banking rules and regulations do not cover services provided voluntarily – that is, without any sort of contractual commitment. And that is what, historically, overdraft protection has been. Banks provided this service as a courtesy to their best customers. Generally speaking, the bigger and older the account, the larger the overdraft a bank would cover. But they aren’t obliged to do so, and that is a significant difference under the law.

Besides the legal distinction, bank regulators really didn’t have any real reason to pay much attention to overdraft protection. It was a minor part of banking, an almost accidental part of the business.

But recently, banks have become jealous of the market developed by the nonbank, payday loan industry, which aims at providing short-term loans to people who “run out of money before they run out of month.” And some of them began aggressively marketing overdraft protection as a way to capture that market from competitors.

This market development raises a number of concerns, but two of them stand out from the others.

The first is whether getting into this market raises the overall credit risk of the bank. After all, people who are chronically short of money are not the best credit risks in the world, and banks do not generally evaluate the credit risks of individual customers using overdraft protection because it is too expensive to do so.

The second has to do with consumer disclosure and fairness. The fees and interest rates associated are high – which is why banks were attracted to the business – and the disclosure rules don’t always apply. And there are questions of fairness when these costs are loaded down onto a group of people least able to afford them – maybe driving them into even bigger trouble, just like those guys in the cartoon.

In situations like this, there is always the risk of overregulating, but it does seem that the banks should reconsider their moves into this market. Their entry will legitimize, and thereby encourage, consumers to live even closer to the edge. There is already an extraordinary level of consumer credit outstanding, and we have to wonder whether this high-risk end of the market is the place where our commercial banking system, so critical to our economic growth and prosperity, should be deploying its resources.

James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101,” which appears monthly in The Snohomish County Business Journal.