Overdraft on a Balance Beam

April 2016: Vol 39 No 4
by Richard H. Gamble

CUs benefitting from this source of non-interest income must carefully follow the rules.

Man walks on balance beamOverdraft protection may need some protecting. CU managers see overdraft fees as an important source of income and a member service. At the same time, the Consumer Financial Protection Bureau is looking at overdraft programs more closely.

CFPB is considering new regulations aimed at identifying overly aggressive overdraft fees and programs. What’s more, a small but growing number of CUs are being sued over overdraft services.

Because of aggressive consumer protection initiatives, overdraft practices at financial institutions have become a legal and regulatory minefield, reports Brian Witt, a partner in the Portland, Ore., law firm Farleigh Wada Witt, who advises CUs on how to stay out of trouble and defends them when they are sued. Those lawsuits are growing, he says, and CU managers need to think defensively on two fronts: pending regulation from the CFPB and potential litigation.

CFPB has been investigating overdraft protection practices for several years and postponed new regulations that were expected last fall, Witt reports. “We don’t know what the new CFPB regulations will say, but we know that they are looking at five practice areas.” These are opt-in features; limits on daily and aggregate fees; posting order; how fees are calculated; and involuntary account closures.

There are no safe harbors, but there are best practices that can offer some degree of protection, Witt adds. He recommends that CUs perform a full risk assessment of their overdraft programs to identify any potential legal and regulatory problems, then update all documentation to be consistent and address litigation trigger points.

He doesn’t say so, but the implication is clear: It’s dangerous to set fees as high as possible and levy them as often as you can. What he does say is that it’s also dangerous to have reasonable fees, but not communicate them clearly.

Coming off meetings with CFPB staff in Washington, D.C., G. Michael Moebs, CPA, economist and CEO of Moebs $ervices, Lake Forest, Ill., reports that reform rhetoric has been toned down as political rhetoric has heated up; he doesn’t expect action before the election. Moreover, complaints to the CFPB about CU overdraft practices are rare.

However, in February, CFPB Director Richard Cordray sent a letter to the 25 largest retail banks, urging them to provide accounts that can’t be overdrawn.

What CFPB is most concerned about, Moebs says, is providing services for the unbanked, and here CUs are well positioned to shine with reloadable prepaid cards with no overdraft features. Such cards are currently offered by 26.8 percent of CUs, compared to 16 percent of banks.

Witt characterizes most of the litigation against CUs as “attorneys trolling for consumers to seek monetary settlements based on technicalities.” More than a dozen CUs have been sued and many more threatened, he notes.

Good Guys

If regulators and litigators are looking for bad guys, they won’t find them at $66 million Tuscaloosa Credit Union in Tuscaloosa, Ala. Members there have two options for overdraft protection if they write a check or authorize a debit that exceeds their balance. The credit union will lend them up to $500 at 18 percent interest to cover the shortfall. Or they can get “courtesy pay,” where the CU pays the check or debit, allows the overdraft on the books for up to 45 days, and charges the member $25 per occurrence.

Members are automatically eligible for courtesy pay after 45 days, and many opt in, reports CEO Tommy Cobb, a CUES member. Courtesy pay overdrafts are limited to a total of $500.

Courtesy pay is by far the more popular option, according to Cobb, and that’s fine with him because the interest the CU earns on the small overdraft loans doesn’t cover the cost of carrying them. “We need to charge a fee to at least cover our cost, and we’re looking into that,” he says.

Tuscaloosa CU members use overdraft protection two ways: A small group uses it to cover emergency expenses, a timing surprise or a clerical error. The other, much larger group uses it regularly, in ordinary situations, to stretch their spending to the next paycheck or benefit deposit.  

And that poses a dilemma for Cobb and for many CU policymakers. Overdraft protection is a valuable service for which banks and CUs charge a fee. It’s certainly possible with smart management to maximize the fee income and improve profitability. But the fees the CU collects mostly come out of the pockets of its poorest, least sophisticated members. What’s good for the CU may be bad for a vulnerable segment of its members and attract regulatory scrutiny.

Compassionate Cobb and Tuscaloosa CU go to the other extreme. He was moved by the plight of one woman who years ago wrote a check to Pizza Hut for $25 that she didn’t have in her account. The check bounced twice, and she ended up being charged $100 in fees by Pizza Hut and the CU and came to the CU to plead for mercy. “That was too much punishment for one bad decision,” Cobb says. “We have to take care of people like that.” So he introduced courtesy pay, and now the penalty, on the credit union side at least, would be capped at $25.

The situation is getting worse, Cobb reports. Chronic overdrafters get in too deep and move on, sticking CUs with charge-offs. That’s why Tuscaloosa CU is about to link account opening to a screening process where they find out up front if a prospective member has a trail of bad credit. “If they have a bad record, we’ll let them open an account,” Cobb says, “but we’ll deny them overdraft protection, at least for a while. Overdraft protection is a good product, but it’s badly used by some people.

Efficient Credit

But that’s not all, urges consultant Richard Crone, San Carlos, Calif. Overdraft protection is not just about poor people struggling to make ends meet. It’s particularly useful to very small businesses—maybe a single practitioner with one office or a home office, a growing segment coveted by many CUs.

“Often these members don’t want the complications of a business line of credit. Overdrafts are the simplest, most efficient way for them to meet short-term credit needs. It’s a transaction-level loan. It’s exactly what they want, and they’re happy to pay the fees.” His point is logical, but may be irrelevant at some CUs. Cobb, for example, doesn’t see members like that at Tuscaloosa CU.

Crone puts protected overdrafts in the context of P2P lending, in which members of a social network lend to each other, he explains. It’s unregulated and a competitive challenge to CUs. Permitting overdrafts for a fee is a valid way for CUs to compete, offering something ultra-convenient and often economical, he argues. Allowing overdrafts and charging a fair price for them is entirely compatible with the values of the credit union movement, he suggests.

In spite of his efforts to help members avoid overdraft fees, Cobb is a strong advocate of using vendors to support ongoing overdraft strategy. Like most of the CUs we talked to, he uses CUES Supplier member John M. Floyd & Associates (JMFA), Baytown, Texas. He gives the firm a lot of the credit for increasing Tuscaloosa CU’s income from overdrafts tenfold.

“They’re the most aggressive partner I have,” he observes. “They’re always pointing out ratios I should notice and challenging me to fix things. If all our vendors were this attentive, we’d be more profitable.”

JMFA brings to Tuscaloosa CU more than profitability coaching. “You could do this yourself, but it’s really best to engage a third party,” Cobb says, “because they really keep up with all the regulations and trends. It’s becoming a complex business.”

When Cobb joined the CU in 1991, it had $8 million in assets, and overdrafts were managed by putting the handful of names and amounts on a wallboard. “We knew the members personally,” he says, “and could make informed decisions about which ones to pay. Now it takes policies and programming.”

Compliance Advice

Not everyone thinks vendors who get paid for increasing overdraft fee income are the best source of compliance advice. “Vendors and consultants are offering CUs programs to increase fee income,” Witt observes. “They are out to maximize profit, not improve service. Compliance is secondary to them. They don’t deal with it well—not even close,” he warns. “A CU needs to put its trust in compliance and legal experts.”

Lisa Burroughs, CME, CCE, CIE, disagrees. She’s chief operations officer of LEVERAGE, the for-profit service corporation of the League of Southeastern Credit Unions & Affiliates, a CUES Supplier member based in Tallahassee, Fla., which resells the JMFA product to credit unions in Florida and Alabama. “It helps them increase fee income, improve operating efficiency and achieve regulatory compliance,” she explains. “JMFA is in tight communication with the CFPB. They make sure their clients are compliant.”

LSCU and the Credit Union National Association, Madison, Wis., also keep in touch with CFPB sources, Burroughs says. “They don’t want to kill the service, but they want full and clear disclosure. They are the voice of the consumer. We are the voice of the credit unions. We talk to them about unintended consequences that could choke off the product. They are listening.”

Like Cobb, Burroughs thinks today’s overdraft protection management is a job for a third party. “When I worked at a CU before, we had a courtesy pay program. It was a great offering, but it was hard to keep up with. Bringing in a third party assures that you will stay aware of evolving best practices and new regulations. You can do it yourself, and many CUs do, but they may miss opportunities that way.”

$150 million Dane County Credit Union, Madison, Wis., was happy to use a vendor—JMFA—to upgrade its in-house program. “We signed with JMFA 10 years ago and renewed our contract again last October,” reports CUES member Shay Santos, chief financial officer.

“We started for compliance reasons, but it has also expanded the range of our product. We now cover debit card transactions. JMFA made a lot of recommendations, and we’ve followed most of them. Clear communication with members has been a big part of the improvements. It’s also helped our retention.”

Building fee income has been part of Dane County CU’s success. “We’ve focused on increasing non-interest income for the past several years, and overdraft programs have helped,” Santos says. “The JMFA people asked for our numbers, analyzed them, made recommendations and it has worked as advertised. We charge for some things that we didn’t before, like offline and below-floor-limit debit card transactions. We had a floor limit before of $50. If a member needed $200, they would attempt four $50 transactions to avoid overdraft fees. Now a $30 overdraft fee is assessed on each transaction—no more sliding under the fence.”

Ratios and Analysis

And now the program is actively managed. “We send JMFA our numbers every month, and they analyze them and show us ratios and how we perform compared to our baseline,” Santos explains. “They point out the consequences of what we are doing and what should happen if we did it differently. Then we decide. Under our contract, we pay them a percent of the increased noninterest income we get from following their recommendations. It was a big list at first.”

The increased fee income from overdraft protection—roughly 20 percent more per year—“lets us do other things that benefit members,” Santos says. “It helps to offset the cost of our debit card program—all that overhead and fraud.” As regulatory attention to fee practices increases, he is concerned about new regulation, but not about compliance. “JMFA helps us take care of that by providing guidance and periodic reviews of our entire process,” he says.

One major change in the Dane County CU policy was to standardize practices. “We had tiers before. Now it’s uniform for all members,” Santos reports. The overdraft cap is $800. “We considered $1,000, but our vendor was uncomfortable with that, so we avoided hassles by sticking with $800.”

Looking forward, there’s a cloud over overdraft practices, but it’s not funnel shaped. Witt has warned that growing regulation and litigation could “strangle” overdraft programs and cause financial institutions to abandon them. He now says that such programs are still viable for CUs and valuable for consumers.

The alternative—bouncing all those payments—would cost consumers more, disrupt services and not benefit financial institutions. “The regulators are in a tough spot,” he observes. “They’re trying to protect consumers but if they over-regulate, they know they could leave consumers worse off than they are now.”

Richard H. Gamble is a freelance writer based in Colorado.

Overdraft Program Parameters
CU practices vary, but most will have a savings-to-checking transfer service as the first line of defense against bounced checks or debits, according to Lisa Burroughs, CME, CCE, CIE, chief operations officer of LEVERAGE. LEVERAGE is the for-profit service corporation of CUES Supplier member League of Southeastern Credit Unions & Affiliates, Tallahassee, Fla., which resells the overdraft protection product from CUES Supplier member John M. Floyd & Associates (JMFA), Baytown, Texas, to credit unions in Florida and Alabama.

CUs will often also offer a line of credit link to make up the shortfall or a courtesy pay service or both, she explains. If members don’t opt in for these services, they could face a non-sufficient-funds event and charges from both the CU and the merchant payee.

Burroughs sees good reason to set the overdraft protection limit high enough. “A member could have insufficient funds to cover an important mortgage payment,” she says. “But it’s a risk decision that’s up to each CU.”

Another variable is how long to allow the overdraft, if it’s not covered by a line-of-credit draw or transfer from savings. Most CUs limit the number of times a month an overdraft can be covered. Some set a consistent policy for all members; others tie it to relationships. The absolutely most important thing, Burroughs emphasizes, is to clearly communicate your policies to members. They have to be clearly informed ahead of time about how an overdraft will affect them.