New crunch on overdraft fees coming
The Consumer Financial Protection Bureau’s (CFPB’s) new rules for overdrafts (ODs) on checking accounts are scheduled for July of this year. Based on our analysis of the overdraft rules for prepaid issued December 23, 2014, we project the most likely scenario is that the new rules will reduce financial institution revenues from OD revenues by 56% after full implementation in 2016.
This will happen by CFPB rules that essentially eliminate OD fees on consumer debit card transactions. We believe that financial institutions will replace these lost fees through a combination of new account fees, increases in remaining overdraft fees on checks and business accounts and offering new, automated lines of credit. These new credit lines will constitute the key revenue replacement opportunity, contributing nearly half of new revenues. Other fees, such as monthly maintenance fees, will end “free” checking for most consumers as in Canada, where account fees average nearly $15 per month for all accounts and overdraft fees drive only minimal revenue.
Prepaid Card Rules
We begin our analysis with the CFPB’s proposed rules for overdrafts on prepaid cards issued last December. In our view, the CFPB clearly intends for rules for overdrafts on prepaid cards to eventually apply to checking accounts. Their sections concerning overdrafts, Reg Z and Reg E could be easily read as if they were in a document about bank checking accounts.
The agency initially planned to publish rules for financial institution OD services in February, 2015, but deferred this until July 2015. We see this as a savvy move by the CFPB to first document the rules for prepaid cards, which will not get much attention, since most financial institutions do not offer prepaid cards with overdrafts. Indeed, early response confirms that little comment has been made about the prepaid overdraft rules from financial organizations.
Our best estimate is that 56% of OD fees, those related to consumer debit card transactions, would be lost. Under the most adverse perspective, nearly 90% of OD revenues could be lost. The reason that OD revenues will be diminished by the new rules is because the CFPB views overdrafts as an extension of credit. Further, the agency believes that the historical exclusions in Reg Z and elsewhere stating that the OD fee is not part of the annual percentage yield (APR) should be removed, which would make the non-sufficient funds (NSF) fee part of a loan’s APR. The proposed rules for prepaid cards go on to state that any “overdraft” would be considered a loan under Reg Z, the provider would have to evaluate the user’s ability to repay before providing such a loan and that repayment would be based not on the next deposit but on a statement issued every 30 days, with up to 18 days for consumer payment after the statement is issued.
If overdrafts are loans and NSF/OD fees are part of the APR, usury law restrictions will materially reduce the ability of financial institutions to earn OD fees. Even earning 36% interest on a thirty-day loan for $500 brings in less than $15, which could cover approximately 10 overdrafts compared to OD fees of $35 per item, or $350.
We do think the CFPB will face challenges in applying its rules to all OD items. Checks for consumers and businesses represent about one-third of OD fees and fall under the Uniform Commercial Code (UCC) as transaction instruments where significant legal precedent documents fees are acceptable. The charging of a fee by merchants has provided an economic barometer for the legitimacy of check OD fees, and it would be problematic if merchants could charge fees financial institutions cannot. Further, if checks are returned, no loan balance is incurred so an APR cannot be applied to a returned check fee. This may even put a new fee premium on returning items, even if customers would prefer items paid. Finally, even after Check 21, the possibility exists of a gap between a check being issued and clearing.
Debit card transactions, however, are not UCC transactions and provide immediate clearing. The CFPB would find its prepaid rules easily applied to bank debit card transactions, essentially requiring all overdrafts on debit card transactions to be classified as loans. Such lines of credit offered instead of the OD may be configured to be profitable through digital automation of underwriting and delivery. While not as profitable as overdrafts, their profitability will be material, as non-bank digital lenders have shown through efficiencies and consumer appeal, which has been documented by McKinsey research shown in the Economist.
Financial institutions need to begin planning now to replace lost OD revenue. We see three key steps likely. The first is adding account monthly maintenance fees to replace one-third of lost revenue. The second is increasing fees for NSF items for business or returned items to replace about one-fifth. And the third, and most important, is offering new, automated digital lines of credit, as many non-banks are doing, which efficiently can replace nearly half of lost revenue.