Over the last year, more and more community banks and credit unions have come to realize that fixed overdraft limits just don’t work anymore. Part of the sea change was precipitated by the Office of the Comptroller of the Currency’s (OCC) proposed Guidance on Deposit-Related Consumer Credit Products. As I pointed out in a July 2011 article for BAI Banking Strategies, we do not believe that the overdraft service is really a credit product and think that it is dangerous to categorize it as such. However, the OCC’s guidance and the realities of risk management do impose responsibilities akin to managing credit that cannot be met with fixed overdraft limits.
Many community banks and credit unions currently use a fixed overdraft limit, $500, for example, that applies to all accounts and often becomes available after the account is open for a set period of time; e.g., 30-90 days. This limit often is raised to a higher number, say, $800, after the account has been open for a certain period of time, typically one year. Most of these institutions never really actively review these limits once they are set – essentially, it’s “set-it-and-forget-it” – and the chargeoffs are allowed to fall where they may.
Such fixed limits create two major problems. First, the same limit is not right for everyone and, second, they create significant additional risk for the institution.
An Issue of Limits
Account holders who push more deposits through the account and have a history of repaying overdrafts deserve a higher limit. Consumers who have lower deposits or a history of not paying back overdrafts should not get the automatic $800 overdraft limit discussed above just because their accounts have been open for more than a year.
Consider a consumer – let’s call her “Sally” – who makes around $20,000 per year and gets paid twice a month. The $800 overdraft limit is going to be more than the after-tax payroll that Sally receives. It’s going to take a very long time for Sally to clear up overdrawn items out of the dollars deposited if she gets behind. On the other hand, Sally’s boss, the small business owner who makes $200,000 annually and overdraws the account but always brings it current, is being poorly served with an $800 limit.
Larger institutions have known this for years. They do not advertise the limit, lest the consumer think that this is a dollar amount of credit that is being promised. An overdraft program is a discretionary service, meaning that the bank will strive to pay items that would overdraw the account, they do not commit to pay them. These larger institutions set limits individually on an account-by-account basis and also monitor activity more closely than smaller institutions and are able to adjust the overdraft limits as factors change.
The regulatory world is changing to the point that we think overdraft limits that shift based on activity (“dynamic limits”) are ultimately going to be required for all financial institutions, large and small. For example, the OCC’s proposed guidance calls out those banks that are administering overdraft programs “without proper attention” to their risks. The OCC notes: “In some cases, these program weaknesses are strikingly apparent.” The OCC further says that “changes in customer usage should be regularly monitored to identify risks. Appropriate action should be taken to address any risks that are identified, including excessive usage and nonperformance, such as … adjusting credit terms, fees or limits….”
The guidance expects, for example, the bank to “detect … potential changes to repayment capacity with respect to the overdraft product.” If Sally, our consumer in the example above, always gets that semi-monthly direct deposit of $800 but on the first of this month didn’t receive the deposit, then she has either gotten fired or has fired you as her bank. Either way, this certainly is a sign of a change in “repayment capacity.” So, continuing to authorize Sally’s debit card transactions up to an $800 overdraft limit, in our opinion, wouldn’t comply with the OCC’s “appropriate action” requirements such as “adjusting credit terms, fees or limits” – for example, lowering Sally’s limit to $80 instead of $800 and ideally making this limit change the day after the regular deposit isn’t made.
The OCC’s proposed guidance also expresses concern over “failure to ensure adequate risk management” of overdraft protection programs. In our opinion, failure to pay attention to your checking accounts and their repayment capacity on a frequent basis and failure to re-set overdraft limits accordingly is a failure to ensure adequate risk management of your overdraft protection program.
Ultimately, it’s becoming clear: fixed overdraft limits just don’t work anymore.
Mr. Leonard is president of Wilmington, N.C.-based Velocity Solutions, Inc., a provider of fee income enhancement, checking account acquisition and overdraft management strategies to community and regional banks and credit unions. He can be reached at firstname.lastname@example.org.
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