Overdraft

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"I warn you, Sir! The discourtesy of this bank is beyond all limits. One word more and I – I withdraw my overdraft!"
Cartoon from Punch Magazine Vol. 152, June 27, 1917

An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be "overdrawn". If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate. If the negative balance exceeds the agreed terms, then additional fees may be charged and higher interest rates may apply.

History[edit]

The first overdraft facility was set up in 1728 by the Royal Bank of Scotland. The merchant William Hog was having problems in balancing his books and was able to come to an agreement with the newly established bank that allowed him to withdraw money from his empty account to pay his debts before he received his payments. He was thus the first recipient of cash credit from a bank in the world.[1] Within decades, the advantages of this system, both for customers and banks, became apparent, and banks across the United Kingdom adopted this innovation into service.

With the onset of industrialization, new businesses needed an easy form of credit to jump-start their activities, without having to take out loans on securities they didn't necessarily have. The importance of this new financial innovation was recognized by the philosopher David Hume who described it in one of his essays as 'one of the most ingenious ideas that has been executed in commerce'.[2]

Reasons for overdrafts[edit]

Overdrafts occur for a variety of reasons. These may include:

United Kingdom[edit]

Overdraft protection in the UK[edit]

Banks in the UK often offer a basic overdraft facility, subject to a pre-arranged limit (known as an authorized overdraft limit). However, whether this is offered free of interest, subject to an average monthly balance figure or at the bank's overdraft lending rate varies from bank to bank and may differ according to the account product held.

When a customer exceeds their authorized overdraft limit, they become overdrawn without authorization, which often results in the customer being charged one or more fees, together with a higher rate of lending on the amount by which they have exceeded their authorized overdraft limit. The fees charged by banks can vary. A customer may also incur a fee if they present an item which their issuing bank declines for reason of insufficient funds, that is, the bank elects not to permit the customer to go into unauthorized overdraft. Again, the level and nature of such fees varies widely between banks. Usually, the bank sends out a letter informing the customer of the charge and requesting that the account be operated within its limits from that point onwards. In a BBC Whistleblower programme on the practice, it was noted that the actual cost of an unauthorised overdraft to the bank was less than two pounds.

Amount of fees[edit]

No major UK bank has completely dropped unauthorized overdraft fees. Some, however, offer a "buffer zone", where customers will not be charged fees if they are over their limit by less than a certain amount. Other banks tend to charge fees regardless of the amount of the level of the overdraft, which is seen by some as unfair. In response to criticism, Lloyds TSB changed its fee structure; rather than a single monthly fee for an unauthorized overdraft, they now charge per day. They also allow a 'grace period' where you can pay money in before 3.30pm (Mon - Fri) before any items are returned or any bank charges incurred (with exception from Standing Orders which debit at beginning of working day). Lloyds TSB allows their customers, if they have gone into an unplanned Overdraft on a Friday for example, to pay money in before 10am on Monday morning and the daily fees for the weekend (Saturday and Sunday) to be waived. This, however, does need to be cleared funds. Alliance & Leicester formerly had a buffer zone facility (marketed as a "last few pounds" feature of their account), but this has been withdrawn.

In general, the fee charged is between twenty-five and thirty pounds, along with an increased rate of debit interest. The charges for cheques and Direct Debits which are refused (or "bounced") due to insufficient funds are usually the same as or slightly less than the general overdraft fees, and can be charged on top of them. A situation which has provoked much controversy is the bank declining a cheque/Direct Debit, levying a fee which takes the customer overdrawn and then charging them for going overdrawn. However, some banks, like Halifax, have a "no fees on fees" policy whereby an account that goes overdrawn solely because of an unpaid item fee will not be charged an additional fee.

Legal status and controversy[edit]

In 2006 the Office of Fair Trading issued a statement which concluded that credit card issuers were levying penalty charges when customers exceeded their maximum spend limit and / or made late payments to their accounts. In the statement, the OFT recommended that credit card issuers set such fees at a maximum of 12 UK pounds.[4]

In the statement, the OFT opined that the fees charged by credit card issuers were analogous to unauthorized overdraft fees charged by banks. Many customers who have incurred unauthorized overdraft fees have used this statement as a springboard to sue their banks in order to recover the fees. It is currently thought that the England and Wales county courts are flooded with such claims.[5] Claimants tend frequently to be assisted by web sites such as The Consumer Action Group.[6] To date, many banks do not appear in court to justify their unauthorized overdraft charging structures and many customers have recovered such charges in full,[7] However, there have been cases where the courts have ruled in favor of the banks and alternatively struck out claims against customers who have not adequately made a case against their bank.[8]

United States[edit]

Consumer reporting & account denial[edit]

In the United States some consumer reporting agencies such as ChexSystems, Early Warning Services, and TeleCheck track how people manage their checking accounts. Banks use the agencies to screen checking account applicants. Those with low debit scores are denied checking accounts because a bank can not afford an account to be overdrawn.[9][10][11]

Overdraft protection in the US[edit]

Overdraft protection is a financial service offered by banking institutions primarily in the United States. Overdraft or courtesy pay program protection pays items presented to a customer's account when sufficient funds are not present to cover the amount of the withdrawal. Overdraft protection can cover ATM withdrawals, purchases made with a debit card, electronic transfers, and checks. In the case of non-preauthorized items such as checks, or ACH withdrawals, overdraft protection allows for these items to be paid as opposed to being returned unpaid, or bouncing. However, ATM withdrawals and purchases made with a debit or check card are considered preauthorized and must be paid by the bank when presented, even if this causes an overdraft.

Ad hoc coverage of overdrafts[edit]

Traditionally, the manager of a bank would look at the bank's list of overdrafts each day. If the manager saw that a favored customer had incurred an overdraft, they had the discretion to pay the overdraft for the customer. Banks traditionally did not charge for this ad hoc coverage. However, it was fully discretionary, and so could not be depended on. With the advent of large-scale interstate branch banking, traditional ad hoc coverage has practically disappeared.

The one exception to this is so-called "force pay" lists. At the beginning of each business day, branch managers often still get a computerized list of items that are pending rejection, only for accounts held in their specific branch, city or state. Generally, if a customer is able to come into the branch with cash or make a transfer to cover the amount of the item pending rejection, the manager can "force pay" the item. In addition, if there are extenuating circumstances or the item in question is from an account held by a regular customer, the manager may take a risk by paying the item, but this is increasingly uncommon. Banks have a cut-off time when this action must take place by, as after that time, the item automatically switches from "pending rejection" to "rejected," and no further action may be taken.

Overdraft lines of credit[edit]

This form of overdraft protection is a contractual relationship in which the bank promises to pay overdrafts up to a certain dollar limit. A consumer who wants an overdraft line of credit must complete and sign an application, after which the bank checks the consumer's credit and approves or denies the application. Overdraft lines of credit are loans and must comply with the Truth in Lending Act. As with linked accounts, banks typically charge a nominal fee per overdraft, and also charge interest on the outstanding balance. Some banks charge a small monthly fee regardless of whether the line of credit is used. This form of overdraft protection is available to consumers who meet the creditworthiness criteria established by the bank for such accounts. Once the line of credit is established, the available credit may be visible as part of the customer's available balance.

Linked accounts[edit]

Also referred to as "Overdraft Transfer Protection", a checking account can be linked to another account, such as a savings account, credit card, or line of credit. Once the link is established, when an item is presented to the checking account that would result in an overdraft, funds are transferred from the linked account to cover the overdraft. A nominal fee is usually charged for each overdraft transfer, and if the linked account is a credit card or other line of credit, the consumer may be required to pay interest under the terms of that account.

The main difference between linked accounts and an overdraft line of credit is that an overdraft line of credit is typically only usable for overdraft protection. Separate accounts that are linked for overdraft protection are independent accounts in their own right.

Bounce protection plans[edit]

A more recent product being offered by some banks is called "bounce protection."

Smaller banks offer plans administered by third party companies which help the banks gain additional fee income.[12] Larger banks tend not to offer bounce protection plans, but instead process overdrafts as disclosed in their account terms and conditions.

In either case, the bank may choose to cover overdrawn items at their discretion and charge an overdraft fee, the amount of which may or may not be disclosed. As opposed to traditional ad hoc coverage, this decision to pay or not pay overdrawn items is automated and based on objective criteria such as the customer's average balance, the overdraft history of the account, the number of accounts the customer holds with the bank, and the length of time those accounts have been open.[13] However, the bank does not promise to pay the overdraft even if the automated criteria are met.

Bounce protection plans have some superficial similarities to overdraft lines of credit and ad hoc coverage of overdrafts, but tend to operate under different rules. Like an overdraft line of credit, the balance of the bounce protection plan may be viewable as part of the customer's available balance, yet the bank reserves the right to refuse payment of an overdrawn item, as with traditional ad hoc coverage. Banks typically charge a one-time fee for each overdraft paid. A bank may also charge a recurring daily fee for each day during which the account has a negative balance.

Critics argue that because funds are advanced to a consumer and repayment is expected, that bounce protection is a type of loan.[14] Because banks are not contractually obligated to cover the overdrafts, "bounce protection" is not regulated by the Truth in Lending Act, which prohibits certain deceptive advertisements and requires disclosure of the terms of loans. Historically, bounce protection could be added to a consumer's account without his or her permission or knowledge.

In May 2005, Regulation DD of the Truth in Savings Act was amended to require that banks offering "bounce protection" plans provide certain disclosures to their customers. These amendments include requirements to disclose the types of transaction that may cause bounce protection to be triggered, the fees associated with bounce protection, separate statement categories to enumerate the number of fees charged, and restrictions on the marketing of bounce protection programs to deter misleading advertisements. These disclosures are already provided by larger banks which process overdrafts according to their terms and conditions.

Transaction processing order[edit]

An area of controversy with regards to overdraft fees is the order in which a bank posts transactions to a customer's account. This is controversial because largest to smallest processing tends to maximize overdraft occurrences on a customer's account. This situation can arise when the account holder makes a number of small debits for which there are sufficient funds in the account at the time of purchase. Later, the account holder makes a large debit that overdraws the account (either accidentally or intentionally). If all of the items present for payment to the account on the same day, and the bank processes the largest transaction first, multiple overdrafts can result. Another problem for the consumer can occur when a large deposit and a larger debit occur on the same day; for example, a customer with $700 in their account who deposits a $600 paycheck and later pays an $800 rent check on the same day will be charged an overdraft fee, despite having more than enough money in their account to cover the check.[citation needed]

The "biggest check first" policy is common among large U.S. banks.[15] Banks argue that this is done to prevent a customer's most important transactions (such as a rent or mortgage check, or utility payment) from being returned unpaid, despite some such transactions being guaranteed. Consumers have attempted to litigate to prevent this practice, arguing that banks use "biggest check first" to manipulate the order of transactions to artificially trigger more overdraft fees to collect. Banks in the United States are mostly regulated by the Office of the Comptroller of Currency, a Federal agency, which has formally approved of the practice; the practice has recently been challenged, however, under numerous individual state deceptive practice laws.[16]

Bank deposit agreements usually provide that the bank may clear transactions in any order, at the bank's discretion.[17]

Opt-in regulation[edit]

In July, 2010 the Federal Reserve adopted regulations (revisions to Regulation E) which prohibited overdraft fees resulting from one time debit card and ATM transactions unless the bank customer had opted into overdraft protection. Research by Moebs Services released in February, 2011 showed that as many as 90% of customers had chosen overdraft protection resulting in the projection that United States banks would post record profits from overdraft fees.[18]

References[edit]

  1. ^ "A short history of overdrafts". eccount money. 
  2. ^ "World's first overdraft authorisation, 1728". Royal Bank of Scotland. 
  3. ^ Yates, Jon (8 December 2011). "Bank fees that overdraw teen's account have mom seeing red: Daniel Ganziano went from having $4.85 to owing more than $200". Chicago Tribune. Retrieved 10 December 2011. 
  4. ^ "Your reporter: Unauthorised overdraft fees". BBC News. May 2, 2006. 
  5. ^ Pollock, Ian (July 20, 2006). "Sue for money using the internet". BBC News. 
  6. ^ The Consumer Action Group
  7. ^ "Accountant sues bank over charges". BBC News. March 15, 2006. 
  8. ^ BBC article
  9. ^ New York Times
  10. ^ Bank Account History, cnn.com
  11. ^ CFPB Credit Reporting
  12. ^ Appendix - Bounce Protection
  13. ^ http://www.house.gov/apps/list/hearing/financialsvcs_dem/htfeddis071107.pdf
  14. ^ U.S. PIRG Consumer Blog: Bounce protection loans/debit cards under committee microscope
  15. ^ USA Today: Banks' check-clearing policies could leave you with overdrafts
  16. ^ [Scott J. Kreppein, Dissent of Man Law Blog, "Potential Tide Turning Victory in The Battle Against Illegal Non-Sufficient Fund and Overdraft Fees: Bank of America Settles Closson Class Action," http://kreppein.blogspot.com/2009/02/california-class-action-against-bank-of.html] [See also Kreppein, Dissent of Man Law Blog, "The UK Takes Steps to Curb Illegal Overdraft Fees, But US Efforts Have Not Been So Well Received," http://kreppein.blogspot.com/2007/08/uk-takes-steps-to-curb-illegal.html]
  17. ^ Bank of America Deposit Agreement
  18. ^ Kapner, Suzanne (February 23 2011). "Americans choosing to pay overdraft fees". The Financial Times. Retrieved February 23, 2011.