By Ray Birch
LAKE FOREST, Ill.—Overdraft fees are dominating the financial news at present, but they go a long way back.
As CUToday.info has extensively reported, overdraft fees are under fire from consumer groups, have drawn new scrutiny from the CFPB, and have become a new point of competition among the biggest banks and some credit unions, which have either eliminated fees for not having enough money on hand to cover their checks, or sharply reduced them.
“A quick history of overdrafts can really help people understand the origins of the overdraft business and put into perspective the need for the service,” said Michael Moebs, economist, and CEO at Moebs $ervices. “Looking back, it is very interesting to see how this service, now used by 60-million Americans, has evolved, eventually leading to the offerings we see today—and the dramatic changes we are experiencing now.”
Moebs explained his research shows the roots for today’s overdraft programs actually were forming in 1478 when Franciscan Friar Pacioli invented double-entry bookkeeping to track wine and food consumption, since some friars had become overweight.
“Checks started shortly thereafter,” said Moebs. “Yet, it wasn’t until about 1728 when the Royal Bank of Scotland established the first overdraft facility for business—consumers did not have access to checking accounts for another 200 years.”
The ’Commonfolk’ Get Involved
The usage of checks and the new concept of being overdrawn didn’t really start becoming a reality for average Americans until the end of World War I when “commonfolk” started using checking accounts, which were previously a service reserved for the wealthy and businesses, according to Moebs.
“Around the same time the Federal Reserve entered the picture, proving to be a fly in the checking ointment,” said Moebs. “Prior to the Fed, checks cleared on a non-par basis, or in lay terms, the payor bank had to pay a small fee for each check cleared, something like interchange today. Consumer checking started off as unprofitable and remains so today.”
A decade later, in 1924, J. Edgar Hoover became director of the FBI and introduced forensic methods to identify checking fraud from kiting and overdrafting, Moebs said.
“To avoid the criminal aspect of transactions or kiting—writing checks on two separate financial institution transaction accounts each with no money—check writers started to overdraw their accounts,” said Moebs. “Consumer overdrafting is only about 100 years old and got off to a shaky start. Today, about 60 million working Americans overdraw once or more yearly, while 90 million working Americans kite every year.”
A Lack of Interest--Literally
The next decade brought another big change with the introduction of the 1933 Banking Act, which prohibited interest on checking, Moebs explained.
“This government regulation really curtailed overdraft usage since the Great Depression was happening and interest had been allowed for over 20 years on checking accounts,” noted Moebs. “It took World War II to stimulate checking, and to some extent overdrafts. Until after WWII, payroll was done with pay envelopes filled with currency and coin along with pay vouchers, and definitely no paychecks.”
From the 1940s and 50s, and up until the Vietnam War in the 1960s, banking had social stigma on its side, said Moebs.
“‘Overdrafting is evil’ was heard from the pulpit on Sunday morning,” said Moebs. “This prompted banking to view overdrafting as a penalty for spending more than a consumer had on balance. Therefore, ‘Punish these overdraft sinners by penalizing them with a fee.’”
The Post World-War II Era
From 1946 to the early 1960s, consumers got away with a few overdrafts.
“But standard banking practice was to return checks for non-sufficient funds,” said Moebs. “When the consumer did not have enough money to cover the check, 95% of the time it was returned NSF. If banks paid an overdraft, then they seldom charged a fee for the service since few were allowed and only for established, profitable customers. OD limits were rare and never over $100.”
In the early 1960s, the “suburban banks,” a chain of small community banks in the Northwest suburbs of Chicago started to charge for ODs and simultaneously stopped returning many checks NSF, Moebs explained.
“Volume went to about 80% for overdrafts and 20% for NSFs. This change was quickly adopted nationwide,” he said. “The fee charged was slightly less than $10 per transaction overdrawing a checking account. Some banks charged up to $20 for the service, but this was one charge per day based on the end of day negative balance.”
Later that same decade, the federal government stepped in in 1968 when Congress passed the Truth-In-Lending Act.
“The Federal Reserve took this law as an opportunity to formalize overdrafting,” said Moebs. “There were several challenges to the Fed’s definition of overdrafts, but by 1974, these disputes had been settled and ‘overdrafts as credit but not a loan’ became the Fed’s official definition,” he said.
Credit Unions Get Involved
The business of overdrafts started with credit unions in the late 1970s when credit unions—after significant effort on their part and over the equally significant objections of the banking industry—were finally given the OK to offer share draft accounts.
“The 1970s also saw the introduction of free checking, and this was a key stimulus for banking, credit unions, and consumers to expand overdrafting,” said Moebs. “Overall total OD revenue was less than $1 billion in 1970.”
According to Moebs, the death of checks began with the 1978 Electronic Funds Transfer Act.
“This act of Congress was really the birth of the debit card. Paper checks in 1978 were over 35% of the payment system’s volume. Today checking is 7% and debit cards over 40% of payment system transaction volume,” said Moebs. “Prior to this, overdrafting was a form of kiting using processing time, or float, to extend credit by the consumer. The debit card would eliminate check float and truly make overdrafting an error process and not a penalty process. Overdrafting had become socially acceptable.”
End of Prohibition 2.0
In 1980, Congress passed legislation ending the prohibition of interest on checking accounts and overdrafts took off again, since all checking account types could offer overdrafts.
“In 1991, Congress passed the Truth-In-Savings Act. This legitimized and endorsed overdrafting. Depositories were required to disclose ODs and prices in a systematic way,” said Moebs. “Consumers received monthly information on the number of ODs and NSFs, as well as year-to-date. Overdrafts took off. Prices had changed from $10 per transaction in 1980 to $15, and OD total revenue was $11.6 billion in 1991,” Moebs explained.
From 1991-2003, overdraft prices increased from $15 per transaction to $25. Limits moved from less than $100 to $500.
“For the first time in this period, overdrafts exceeded overdraft limits offered by payday lenders,” explained Moebs. “The cost of doing a checking account also increased and checking accounts continued 75 years of unprofitability with only a very few depositories making money with checking the service. In the ’90s the Fed incorporated the checking profitability and cost of overdrafts in the Federal Reserve’s Functional Cost Analysis (FCA).”
‘No More Paper Checks’
With the passage of the 2003 Check Clearing for the 21st Century Act (Check 21), Congress said, “No more paper checks,” Moebs noted.
“The Fed set out to eliminate processing time, or float, in the payment system. By 2007, float went from over $10 billion daily to less than $100 million—a reduction of 99%,” said Moebs. “Debit cards dominated the payment system including overdrafts. ODs significantly moved from check processing time to debit card authorization time starting in 2003.”
Also in 2003, the Fed eliminated the FCA, thus eliminating checking and overdraft cost analysis.
“Moebs $ervices took over the FCA. In 2003, the OD price was $25 and total OD revenue $28.1 billion, and OD limits were still at $500,” said Moebs.
In response to the Great Recession, Congress in 2010 passed the Wall Street Reform and Consumer Protection Act.
“This Act substantially curtailed interchange fees, or swipe fees, for big banks,” Moebs said. “The unintended consequence was an increasing OD price to a new all-time median high of $30.”
Act is Amended
Michael Moebs
In 2009, the Federal Reserve, recognizing the dual proliferation of debit cards and overdrafts in the payment system, amended the Electronic Funds Act (Reg E) by requiring the consumer to opt in for debit card overdrafts. Banks and credit unions were prohibited from charging a fee for debit card overdrafts unless the consumer explicitly provided consent. In 2010, total overdraft revenue fell to $33.1 billion from an all-time high of $37.6 billion in 2008. Overdraft limits still remained at $500.
From 2010 through 2011, overdraft revenue fell and rose three times each. The high was $34.8 billion, the low was $30.1 billion, and the median was $32.4 billion. Overdraft limits stayed the same at $500. OD price remained at $30.
Moebs emphasized that in the second quarter of 2021, two significant overdraft changes occurred.
“For the first time in 24 years, OD limits increased from $500 to $600. Then, Walmart dropped its OD price from $25 to $15, and Bank of America’s OD price fell to $10 from $35,” Moebs pointed out. “Walmart and BofA have 31.1% of all 525 million checking accounts in U.S. In 2021 OD Revenue increased to $33.4 billion, or an increase of 3%. Lowering the OD price increases OD revenue.”
A Century of Events
A century later, Moebs summarized how today’s overdraft is far different from where it was when started about 100 years ago by noting:
- The 1968 Truth-In-Lending Act legitimized ODs and gave the action a legal definition
- The Electronic Funds Transfer Act in 1979 is the origin of the modern transaction account existing today, which is driven by debit cards, not checks and ruled by OD limit which allows authorization of OD transactions
- The 1991 Truth-In-Savings Act gave Congress’ endorsement of ODs, smoothed the edges of transaction disclosure and overdraft prices, and formalized the process of overdrawing
- Congress passing Check 21 eliminated paper checks and payment processing float time ended quickly
It All Adds Up
“Each of these Congressional Acts formed the overdraft of today by the use of information ranging from definition to process,” said Moebs. “These acts provided a structure for financial institutions offering transaction accounts along with consumers and small business using the overdraft service.”
In 2010, Congress authorized the creation of the Consumer Financial Protection Bureau.
“From its start in 2011, the CFPB is still finding its approach to consumer protection and deals with many unsettled issues,” concluded Moebs. “Why does the CFPB report to the President while other depository U.S. agencies do not? Is the CFPB an information agency? Or is the CFPB a policy making agency? Finally, what is the role of the U.S. Treasury, Federal Reserve and CFPB? Time will sort these questions out…Overdrafts have become like seatbelts on a car—they are a necessary financial safety feature.”