Overdraft Protection: New Practices, New Rules

When the lifeguard says it's not safe to go into the water, it is generally a good idea to stay out - and dry. Unfortunately, when the bank regulatory agencies told banks to avoid jumping into overdraft protection programs, the banks ignored the warnings and jumped in as fast as they could. Now there are proposed guidelines and regulations and banks have no-one to blame but themselves.

There are several elements in the overdraft protection program that should have been warnings. First, third party vendors thought this up as a way to make money - for themselves. Profit motives keep capitalism going, but there are times when profit should not be the sole motive. Second, this was marketed by appealing to greed - fee income to increase the bottom line. And third, the vendors of the product gleefully explained that the product had been oh so carefully designed to avoid the grasp of Regulation Z and all those nasty disclosures.

What the participating banks failed to ask is what new service or product would be offered to earn the new fee income. The answer to this question is fundamentally nothing. The overdraft protection programs are simply a technique for billing more and faster for what is essentially the same old service.

Moreover, it isn't nice to fool Mother Nature and it also isn't nice to try to fool your regulator. Both Mother Nature and your regulator have the ability to make you pay. And the regulators are now telling you how they expect you to pay up.

Two developments occurred simultaneously. The FFIEC agencies proposed joint guidelines on overdraft or bounce protection programs and the Federal Reserve proposed amendments to Regulation DD.

Storm Warnings
The language in both proposals contains some clear signals. The industry would be wise to heed them. For example, the overdraft protection is touted as a product that is not credit subject to Regulation Z. It avoids Regulation Z using mere technicalities. The agencies are not impressed. In fact, in the background discussion to the proposed Guidance, the agencies call overdraft protection a "credit service." In fact, the documents states that when "overdrafts are paid, credit is extended." The disclosures are not currently triggered because the product is designed so that the overdraft fees are not finance charges.
The document also states that regulators have concerns related to the marketing, disclosure and implementation of some of these programs. These concerns go directly to the fairness, accuracy, and disclosures that would be required by Truth in Lending and Truth in Savings. Since unfair or deceptive trade practices are a front burner concern at the moment, the marketing and disclosure issues should be a leading concern for the institutions offering overdraft protection.

Safety and Soundness
Much of the explanation to the guidance involves risk - both legal and safety and soundness. As a first step in managing these risks, the agencies will look for strong policies and procedures to manage the product and the risks associated with it. No matter how you look at it, this means no free lunch.

Legal risks involve careful attention to and compliance with all applicable federal and state laws. To manage this risk, you cannot rely on the representations of the product's vendor. You must make your own determinations.

Closely related to legal risks are the marketing and communications of the product. The regulatory agencies advise institutions to avoid any representations that mislead the customer or that encourage the customer to overdraw the account. For example, consumers may assume from the marketing materials that the overdraft will always be paid and act accordingly.

The agencies also raise a significant safety and soundness concern. With each overdraft allowed, the institution accepts the risk that the overdraft may not be paid. For this reason, the guidance includes instructions on how to treat overdrawn balances and recommends strict time limits for which the account may remain overdrawn.

This concern is compounded by the fact that the institution typically performs little or no analysis of the consumer's creditworthiness. This lack of underwriting is of concern to regulators. They will look for "prudent risk management practices" that include well defined standards of eligibility and clearly documented dollar limit decision criteria. The regulators also expect ongoing monitoring of the customer's use of the product to identify customers who may be "excessively reliant" on overdrafts.

Accounting practices also clearly concern the regulators. The proposed guidance would require institutions to treat overdrafts in the context of credit management. There should be charge off collection practices in place. There should be a clear point at which an unpaid overdraft becomes a loss and any subsequent collection of it reported as a recovery.

If the institution advises the customer about the available amount of overdraft protection - thus encouraging the customer to make use of it - the available amounts should be reported as "unused commitments."

Regulatory Concerns
The interagency guidance lists a variety of regulatory concerns, including Regulations Z, B, and DD. The agencies warn that written agreements to repay overdraft balances would be covered under Regulation Z and should be careful to comply with that regulation's disclosure requirements.As for Regulation B, not only do discrimination prohibitions apply to the overdraft product, but so do notification requirements. Certain actions will trigger adverse action notices under ECOA and potentially under FCRA.

Regulation DD also weighs in on this product. Fees in connection with the product must be disclosed together with the conditions under which the fee may be imposed. Finally, if the customer can use an ATM or point-of-sale transaction to trigger the overdraft, Regulation E enters the compliance equation. This means disclosures, terminal receipts, and periodic statements.

The agencies have outlined best practices for institutions.

Regulation DD
First there is the advertising concern. Regulation DD prohibits misleading advertising and the use of the term "free" when fees or conditions are actually imposed. Marketing is raised as the core concern of this proposal. The FRB points out that what tends to distinguish the in-house programs from the vendor plans are the marketing plans that appear to encourage customers to overdraw their accounts.

Having reviewed programs and their marketing materials the FRB has concluded that "consumers would benefit from more uniform and complete information about the costs and terms of overdraft services not covered under TILA, including in advertisements." That statement is a justification for regulation if ever there was one.

The Board is concerned that consumers may not have adequate information about the overdraft protection and that some marketing information is actually deceptive. So the Board is proposing a remedy for these concerns - more regulation.

First, there will be new disclosures. Account opening disclosures would have to include the overdraft protection fees and the circumstances when they would be imposed. On top of that, periodic statements would contain two new disclosures: the amount of overdraft protection fees charged in that statement cycle, and the cumulative total amount of overdraft protection fees charged during the year.

Then there would be advertising disclosures - trigger terms, if you will. These would include the fee for the payment of each overdraft item, the types of transactions covered, the time period for repayment and the circumstances under which the institution would not pay the overdraft. Fine print, anyone?

In addition to the inclusion of terms, the regulation would specifically prohibit misleading advertisements. Do you want your examiner evaluating not just the accuracy of your marketing materials but also whether they are misleading?The bottom line here is clear: there is a price to pay when you invent or introduce a new product for the primary purpose of making money without regard to whether there is actual value to the product.

ACTION STEPS

If you are offering a form of bounce protection, review your program very carefully against the agency guidance. Be sure your program meets all concerns.
If you are considering bounce protection, review the program elements carefully and compare them to the agency guidance.
Review your marketing materials for clarity and the information they provide to consumers. Avoid any deceptive marketing.
Whether you are offering traditional overdraft lines of credit or the newer bounce protection, look at your offering very carefully for benefit to the consumer relative to the cost paid.