Sizing NSF-Related Fees

By Bill Stoneman

Everyone has a say in how financial institutions protect customers from bouncing checks — and earn fee income in the process. How big can NSF fee income be? And at whose expense?

Even on such an acrimonious topic, it is possible to start at a point where there's some consensus: When a customer writes a check (or pays with a debit card or draws funds from an ATM) for an amount that exceeds the account balance, he runs the risk of penalty. Few will debate this.

How his or her bank responds to the overdraft will depend on myriad factors, including the customer's relationship with the bank, an implicit or explicit understanding with the customer, the bank's non-interest income objectives, the size and technological acumen of the bank and — increasingly, the regulatory environment. The consumer experience can vary widely, and that has regulators edgy.

What's an appropriate response to bad checkwriting? The NonSufficient Funds (NSF) revenue to be earned and how it's earned and even the secular direction of NSF fee income all are up for discussion as various factions seek a role in sculpting NSF-related fees as an income source.

NSF Maximizers

Banks traditionally levied a fee when customers overdrew their checking accounts. They honored checks on occasion, depending upon their comfort that the customer was good for the funds. And they waived fees reasonably often in the interest of maintaining good customer relationships. Banks have also long offered overdraft lines of credit and covered checks through linked-account services, though neither product has enjoyed broad popularity.

This relatively passive approach didn't arouse attention until the early 1990s when large banks began to simultaneously clamp down on fee waivers but begin to honor more checks.

The result: An increase in NSF fee income. At the same time, banks automated the process of deciding whether to pay or reject each check, freeing branch managers for other work.

The deliberate decision to stop fee waivers, pay overdrafts and collect $5, $10 and $15 per has yielded significant income streams. Sheshunoff Management Services Inc., a bank consulting firm based in Austin, Texas, estimates that financial institutions collected $22 billion in overdraft fees in 2003. Annually, it amounts to about 2.9% of non-interest income, according to a 2003 report by Celent Communications, a Boston-based financial services research and consulting company. Industrywide, NSF-related fees can amount to up to 50% of total consumer checking account revenue.

It can be a significant contributor at some institutions. TCF Financial Corp., one of the few banking companies to even hint at the subject in its shareholder communications, says it generates $230 in non-interest income per consumer checking account. About half of that is from NSF fees, says Jason Korstange, spokesman for the Wayzata, Minn.-based company.

The group of institutions that seek to maximize NSF-related fee income includes a few subgroups — the large and the small and those divided on the subject of whether to expressly communicate overdraft protection as a product. Large institutions tend to say little about their willingness to pay on overdrawn checks beyond, perhaps, in the fine print of account agreements. Their expectation is that customers will learn through experience that their checks will be paid and some will adjust their behavior accordingly.

(Consultants say that a fairly small group of consumers willingly pay substantial NSF fees on one condition — that their bank pays their overdraft items rather than return them. And so one of the secrets to generating more NSF revenue may be to pay most overdraft items.)

But while large institutions have established practices regarding NSF fees and overdrafts, few are marketing the existence of something called "overdraft protection." According to Ken Patrick, executive vice president for revenue enhancement with Dallas-based Carreker Corp., "Most of our clients would say the term 'program' does not apply to them."

Many larger institutions rely on internal systems that automate their overdraft management decisions based on their own customer data and experience. By contrast, smaller institutions tend to use programs created by third parties, and they're more inclined to position them as a benefit. Customers are told about overdraft protection at the time the account is opened and then reminded with letters 60 or 90 days later. Customers are frequently told the limit up to which they can overdraw.

Why the difference in the approach? Consultants say that large institutions are more sensitive to the possibility that someone would find grounds for a lawsuit if they seem not to fulfill a promise that they make.

"A class-action lawyer isn't going to go after a $5 billion bank," says Jim Henschel, a managing director with Carreker.

Program Providers

Third-party providers of overdraft protection programs can demonstrate the programs' effect in generating income. In a July 2004 statement praising the proposed rules, Houston-based John M. Floyd & Associates provided the numbers: The typical fee charged on an NSF check is $17 to $35, with $22.50 the average in 2003. Studies indicate the average accountholder writes about 3.4 NSF items per year. The opportunity to collect an additional $75 on half of all checking accounts can be irresistible to institutions. There are a total of 2,500 programs in existence, according to Floyd.

One possible measure of their ubiquity: The number of returned checks dropped from 240 million in 2000 to 189 million in 2003, according to the 2004 Federal Reserve Payments Study, for a compounded annual decline of 7.7%. That compares to a compounded annual decline of 4.3% in checks written overall. Though the Fed did not examine consumer behavior or the thinking behind decisions to either pay items or return them when accounts are overdrawn, Richard Oliver, senior vice president and retail product manager with the Federal Reserve Bank in Atlanta, says it stands to reason that overdraft protection programs are at least part of the explanation.

"Something is happening at the check writer's bank that is causing the item not to be returned," Oliver says.

Several providers serve the industry. Each program is based on the proposition that financial institutions without a plan are leaving money on the table — which is not to suggest that the programs' intent is to encourage overdrafts. In fact, key to most programs' value propositions is the assurance to institutions that a plan will keep them on the right side of the law.

Program providers part ways, though, on whether mere disclosure of overdraft protection is a step on the road to "marketing" the protection. Marketing and promotion are at the top of the list of what critics find objectionable about overdraft protection programs.

"My feeling is that if you're going to give a customer an overdraft limit, you need to tell them," says John M. Floyd, president of John M. Floyd, adding that his clients notify customers about the service in a first-class letter before it starts.

Joseph Gillen, chief executive officer of Pinnacle Financial Strategies, an overdraft protection program consultant also in Houston, says customers who would relish using the service will never learn about it unless their bank tells them.

Sheshunoff Management Services disagrees.

"There is no reason to market NSF programs because it is very difficult for anybody to create primary demand," says managing director Robert Giltner. Institutions should simply provide good service to customers who overdraw their accounts, letting them know that their check was covered because their business is valued, he says.

Consumer Advocates

In the eyes of groups such as the Consumer Federation of America and the National Consumer Law Center, overdraft protection makes an implicit promise that leads consumers to unwittingly borrow money at steep interest rates. (For the record, the same NSF fee is usually levied whether the check is honored or returned. And, proponents say, the payment isn't promised but is made in the interest of good service.)

Covering an occasional accidental overdraft is one thing, but paying checks regularly is something else altogether, consumer groups contend. Even worse, they argue, is extending the same courtesy to customers who overdraw their accounts at ATMs or when they make purchases with debit cards. While financial institutions aren't expected to be able to prevent consumers from accidentally overdrawing their account with a check, they are believed to be able to prevent it from happening in an online transaction.

The intentional overdraft effectively turns the checking account into a credit instrument, but without credit underwriting or disclosure of an interest rate, the consumer advocates say. What's more, this undoes the original purpose of the debit card as a payment tool for consumers who don't want the freedom to overspend that a credit card offers.

If banks are going to lend money, they say, it should be with a formal agreement. Moreover, the cost of credit should be fully disclosed, enabling consumers to shop around.

"Banks should not be loaning money to consumers without their knowledge and informed consent," said Jean Ann Fox, director of consumer protection for the Consumer Federation of America, What banks regard as standard NSF fees should be presented to customers in interest rate terms, Fox insists.

The Government

The practice of extending overdraft protection is being deliberated by the federal government. A May 2004 proposal by the Federal Reserve Board to amend Regulation DD, which implements the Truth in Savings Act, and a separate May 2004 proposed inter-agency guidance on overdraft protection programs raise a host of operational issues that conceivably will constrain all depository institutions.

While these initiatives have been in the works for a few years, the effect of Check 21 in promoting quicker clearing is fanning the flame. Prior to Check 21's October 28, 2004, implementation date, Consumers Union and the Consumer Federation of America called for a two-month suspension of bounced check fees to give consumers time to adjust. In December, overdraft protection was included in the scope of post-Check 21 consumer legislation proposed by U.S. Rep. Carolyn Maloney (D-NY). Maloney's bill seeks to prohibit fees for "bounce protection" unless the customer opts in.

The availability of multiple check clearing options, as made possible or otherwise prompted by Check 21, raises some interesting questions for the consumer, says Steve Mott. Mott, principal of BetterBuyDesign, a payment system consultant in Stamford, Conn., asks: "Can consumers really expect banks to execute the various types of check-clearing options in any cogent, predictable way? Some banks could be proficient with imaging and be able to zap the account right away; others will struggle for years. Worse, all will be dependent on the capabilities of other banks from an end-to-end perspective. So, do we tell the consumer — assume that the moment you write the check that it will clear — just like a real-time debit in order to spare those who will lose the float entirely to efficient C21 operators?…Or do we let consumers navigate through four to five years of check-clearing efficiencies bouncing all over the place?"

Regulators use very guarded language on the subject, but clearly are sympathetic to the consumer groups' concerns.

Unfortunately, bankers and program providers say, 20 pages of discussion by the Fed about proposed amendments to Regulation DD and 15 pages of proposed guidance from the Federal Financial Institutions Examination Council fall short of clarifying which account disclosures or marketing campaigns are objectionable.

At the minimum, the effect of these discussions in Washington, D.C., has been to chill promotion of overdraft protection. Billboard advertising is no longer done, for example. But few if any concessions are being made to existing overdraft plans. Program providers picked at some provisions in the regulatory drafts but generally commented that they will be able to work within what's proposed.

One of the more critical dissents to the inter-agency guidance came from Cliff McKee, executive managing director for Profit Technologies Corporation, an earnings enhancement consultant based in Davidson, N.C. McKee called the proposed best practices a "misguided paternalism to consumers of financial services. This recommendation is tantamount to Wal-Mart suggesting what type of groceries a consumer should buy or the cable company telling the consumer what television programs are appropriate for viewing. Financial institutions are not formed for the purpose of providing financial counseling services to consumers. In a free market economy where rule by Adam Smith's invisible hand should be paramount, the responsibility for fiscal soundness should rest with the individual consumer."

Although specifics and timetable are in question, many observers expect federal regulators to make substantial revisions to their first draft efforts before formally adopting any new rules. Few think it's likely that regulators will stop institutions from paying NSF checks.

Ken Patrick of Carreker says, "I think right now it is impossible to predict what the outcome will be. Trying to predict scenarios and how banks would be impacted by various scenarios would be very difficult."

Payments Strategists

Finally, here's the view of payments strategists, who urge institutions to think beyond the NSF income opportunity. One of the first to comment on the subject was Celent Communications' Gwenn Bezard whose March 2003 report said, "NSF fees are less a cash cow than a mad one. The head of retail banking must commit to designing tactics to make the organization less dependent on punitive NSF fees and more dependent, for instance, on overdraft lending."

At the time of his report, Bezard expected the transition from checks to electronic payments would result in reduced NSF revenues. He had envisioned banks rejecting online bill payment and debit card payments initiated on overdrawn accounts, thereby eliminating the opportunity to charge fees on those transactions. Increasingly, Bezard now notes, banks are providing funds on such transactions and then charging customers an NSF fee.

In fact, electronic transactions are part of the reason for the doubling in overdraft volume in the past 10 years, says Sheshunoff's Giltner, who is optimistic that fees will continue to climb. "As velocity increases, as things clear faster," he says, "customers are not able to respond as fast on the deposit side as they are on the transaction side."

But consultant Mott looks at the very same rise in electronic payments and says, "The NSF party is ending." Consumers are "looking for a better deal than banks offer," which often leads them to electronic payments, where they can better time their last-minute payments, says Mott.

Mott challenges institutions to approach their NSF-paying customers in a different way. As much as one-half of all checking accounts get overdrawn at least once a year, with 95% of them being the "occasional goof-up or delay in deposits clearing," according to Mott. The fee assessed on those occasions can be the last reason a customer needs to walk out the door, he says. Frustration with NSF fees may underlie a portion of the growing account churn that large banks in particular experience year in and year out. "Consumers in unprecedented fashion are moving from bank to bank because they feel like they're getting a raw deal," Mott says.

Five percent of overdrawn customers, Mott continues, are the "recidivists" on whom building a fee income strategy might be ill-advised. "While paying a bank $25 to make good on a check to the credit card company is a good idea for one month, it's just a palliative for folks caught in a downward draft, where punitive fees — no matter who applies them — pushes them further down into the hole," Mott says. High fees assessed by financial institutions are different from late fees on utility bills or car loans, where consumers put up $2.50 to $5 to make last-minute payments.

Mott encourages institutions to think about ways to nurture rather than penalize customers. In the case of the recidivists, he says as an example, the credit card could be converted to a secure card and the customer could be offered a debit-lite service charge-free account to help with cash flow management.

"I think the better, long-term instinct would be to want to help your customers," Mott says. "A lot of banks are figuring this out, and are finding ways to provide real value that the consumer is willing to pay for —instead of playing 'gotcha!' They're the ones increasing their deposit base — especially with the highly profitable electronic consumer who just wants to transact efficiently and painlessly."

Questions or comments about this article? Post them at the Banking Strategies blog.

Mr. Stoneman is a freelance writer based in Albany, New York.

Copyright © 2005 by Banking Strategies, published by BAI.

back to top