The Consumer Financial Protection Bureau (CFPB) announced a final rule last week to impose price controls and onerous disclosure rules on overdraft fees charged by those banks and credit unions with assets of more than $10 billion. At first glance, such interventions might seem like a win for consumers, particularly those with low incomes who are more likely to run into short-term liquidity problems. In practice, however, the new regulations will almost certainly backfire.
Making overdraft services less profitable to lenders or more cumbersome for them to administer will yield the likely response of banks scaling back services to precisely those lower-income customers who need them most. The end result: fewer people getting access to mainstream financial products, hindering both financial inclusion and upward mobility.
CFPB explains its rule as follows:
The final rule makes several key updates to federal regulation governing overdraft fees for financial institutions with more than $10 billion in assets.
These institutions would have to choose one of the following options when charging for overdrafts:
- Cap their overdraft fee at $5: Under this simple option, covered banks and credit unions could simply cap their fee at $5, which is the estimated level at which most banks could be able to cover their costs associated with administering a courtesy overdraft program.
- Cap their fee at an amount that covers costs and losses: For banks that wish to offer overdraft as a convenient service rather than as a profit center, the final rule allows financial institutions to set their fee at an amount that covers their costs and losses.
- Disclose the terms of their overdraft loan just like other loans: For financial institutions that wish to profit from overdraft lending, they may do so by complying with the standard requirements governing other loans, like credit cards. This would include giving consumers a choice on whether to open the line of overdraft credit, providing account-opening disclosures that would allow comparison shopping, sending periodic statements, and giving consumers a choice of whether to pay automatically or manually.
Before looking at the proposed price controls’ effects, let’s briefly consider the disclosure option. On its face, this may seem reasonable. But anyone who has ever gone into overdraft accidentally will see the flaw immediately: it requires the bank to give the consumer a choice as to whether to open the line of overdraft credit in advance.
Even assuming consumers have sufficient foresight to know that they will likely go into overdraft, this requirement would add costs, thereby ensuring that those banks that implement this option will increase fees. Meanwhile, consumers who overconfidently predict they will not go into overdraft and thus reject the option may find themselves paying much higher charges to the bank and creditors when checks and automatic debit payments are rejected.
This last effect highlights one of the fundamental problems with price controls: they distort the underlying economic calculus. Overdraft fees serve two important—if sometimes misunderstood—functions.
First, they allow banks to accommodate customers who need a little short-term breathing room—e.g., individuals who may be waiting for a paycheck to clear, juggling the timing of bill payments, or weathering an unexpected expense. By agreeing to cover these shortfalls, banks expose themselves to risk: the possibility that the customer may not repay. Overdraft fees help to offset that risk. The fees also compensate the institution for the administrative costs associated with extending short-term credit, monitoring account activity, and managing defaults.
But second, they create incentives on the part of bank customers to avoid overdrawing their account. If the CFPB’s price caps come into effect, customers at covered banks will have less incentive to avoid overdrawing their account and will therefore do so more frequently. That will increase banks’ costs. Meanwhile, those banks will lose an important revenue stream that helps to offset the risks they face.
To remain viable and profitable, covered banks would be forced to adjust their product offerings. They might raise the minimum balance requirements for free checking accounts, impose monthly service charges, or simply refuse to open accounts for individuals who seem likely to overdraw. That is exactly what banks did when the Federal Reserve imposed price controls on debit-card interchange fees under the Durbin amendment.
The irony is that numerous banks already offer fee-free overdraft facilities. They are able to do so by being more selective about their customers’ risk profiles and/or by covering those costs through other fees. Of course, not all consumers will qualify for such accounts because their credit risk would be too high.
Thus, to a significant degree, banks have naturally assorted in accordance with customer risk. Imposing price controls on overdraft fees charged by larger banks would interfere with this assortment. Customers of covered banks who would impose an excessive credit risk will be debanked. To put it bluntly, when profitability diminishes, banks become choosier about whom they serve.
Those debanked customers may then seek accounts at smaller banks and credit unions, who would be exempt from these rules. If they are successful in gaining access to smaller lenders, they will likely drive up such institutions’ average credit risk, ultimately forcing them to increase their fees.
But not every debanked customer will find an accommodating alternative home; instead, they may remain unbanked. And who are these higher-risk customers? In many cases it is low-income consumers who are likely to be the first to be excluded.
In the long run, losing access to a checking account can be profoundly detrimental. Without a stable foothold in the mainstream financial system, it is harder to save money, harder to build credit, and ultimately harder to climb the economic ladder. In other words, the CFPB’s rule would likely disproportionately affect precisely the individuals it claims to be helping.
If the CFPB and policymakers more generally truly wish to help low-income Americans, they should resist the temptation to impose clumsy top-down solutions like price controls or increasingly burdensome disclosure mandates. A better approach would be to remove existing harmful regulations, such as the Durbin amendment, and thereby foster competition among banks, encouraging innovation.
Ultimately, ensuring that underserved communities have robust banking options is about lowering barriers, not raising them. In the effort to deliver short-term political wins, we must not forget the long-term harm caused by well-intentioned but ultimately counterproductive regulations.
