How Much Protection Does Overdraft Fee Rule Provide?

The Federal Reserve this week issued anew rule requiring banks to allow customers to decide whether they want the automatic "courtesy" overdraft protection, that covers debit card purchases when they overdraw their accounts, but nicks them with a hefty fee.

Under the new Fed rules, bank customers must be allowed to "opt-in" for this protection. It addresses a longstanding consumer complaint that paying the overdraft fees is much worse than having a purchase denied due to insufficient funds.

While the new rule should go a long way in mitigating this consumer complaint, some think it doesn't go far enough. Rep. Carolyn Maloney (D-NY) has drafted legislation that also allows bank customers to "opt-in" to overdraft protection.

"I'm glad that the Federal Reserve has recognized the need to address outrageous overdraft policies by requiring a strong affirmative opt-in to debit-card overdraft plans, and I commend Chairman Bernanke for taking the regulators in this direction," Maloney said. "The Fed's rule is an endorsement of the need for more overdraft protection for consumers."

But Maloney said Congress still needs to act on the issue. She says there are shortcomings in the new Fed rule that her bill would address.

"The Fed still allows institutions to charge an unlimited quantity of overdraft fees, would do nothing to make fees proportional to the amount of the overdraft, and would not address the manipulation of posting order of charges to accounts," Maloney said. "Under the Fed's new rule, a $5 cup of coffee could still become a $40 cup of coffee after an overdraft fee is added!"

Maloney says her bill, H.R. 3904, caps the quantity of fees at one per month or six per year, requires that fees be reasonable, and prohibits posting-order manipulation, and includes all transactions, not just debit cards. She says her bill has wide support, including from House Financial Services Chairman Barney Frank, who is a co-sponsor.

But as with the credit card reforms passed earlier this year, some in the financial industry warn of unintended consequences. They point out that banks will likely respond to rule changes - that remove billions from their revenue lines each year - with some rule changes of their own.

For example, Tim Smith, CEO of Probity Financial Services and the former President of a nationwide bank consulting firm, says nothing in the new Fed rule or the Maloney bill requires banks to keep customers.

What will banks do when a consumer hits the six overdraft fee maximum in a year? Smith says the most likely outcome will be to close their accounts, just as credit card companies have been closing many cardholder accounts in the wake of the credit card reform bill.

Smith cites an FDIC study of bank overdraft programs to suggest more than one in ten checking accounts would fall into this category. He says these consumers may be forced to turn to check cashing services and prepaid debit card services to meet their spending needs, both of which are likely to be just as expensive as bank's overdraft programs.

"Banks can and should adapt to limitations placed on their aggressive overdraft policies…But, let's be honest, if Congress establishes a limit on the number of overdrafts a bank can charge in a given year, there is a very real possibility that millions of consumers will be forced out of the banking system," Smith said. "This is a classic case where the intentions are good, but the outcome will likely be very different than what Congress envisions."