Payday lenders have long been viewed as villains for charging consumers exorbitant interest rates, leaving borrowers who live paycheck to paycheck struggling to repay their loans. But conventional banks are equally guilty of using fees to penalize consumers, which hurts low-income customers the most, research shows.
Despite the scrutiny of overdraft fees during the financial crisis more than a decade ago, some banks are still reorganizing checking account debits so that the largest amounts, rather than the first debits posted, are withdrawn first. Harvard Business School researchers have found that this practice can lead banks to charge consumers multiple overdraft fees rather than just one, draining significant cash from people living on the edge of their means at a time when the inflation further reduces their purchasing power.
“The misconception is that checking accounts are vanilla products that don’t fool people.”
“The misconception is that checking accounts are vanilla products that don’t fool people,” says Marco Di Maggio, Ogunlesi Family Associate Professor of Business Administration at HBS. “Well, overdraft fees are a form of credit. The bank lends you money for a very, very short time. This, I think, escaped the regulatory net.
Imagine a checking account with $400. A bunch of debits posted, and the bank goes through the biggest one first, a $500 rent check. This triggers an overdraft fee of $35. Two checks for $50, which technically arrived before the larger check, then pass, bouncing around and charging the account an additional $70 in overdraft fees.
Failure to pay these multiplying fees can lead to the bank closing accounts, a stain on a consumer’s record that can have lasting ramifications. ChexSystems, the main consumer reporting agency used by banks, records a bank’s account closures, which often occur if a customer fails to repay overdraft fees and other outstanding balances for two months. This black mark can prevent a consumer from opening a bank account elsewhere for up to five years, the authors write, limiting a customer’s ability to obtain credit, write checks or use convenient banking products and services, such as debit cards and direct deposit.
Di Maggio reviews the practice, known as “top-down ordering,” with HBS assistant professor Emily Williams and doctoral student Angela Ma in a working paper titled In the Red: Overdrafts, Payday Loans and Underbanked.
“Overdraft fees can be much more expensive than even payday loans. We’ve always seen the banks as the good guys and the payday lenders as the bad guys,” says Williams. “We say it’s not as simple as that. The banks look a bit like the bad guys here.
Banks make billions from overdraft fees
The bank’s rationale for decreasing orders is that the largest bills, which are often the largest, are paid first under the system.
But banks are also reaping the rewards. In 2018, overdraft fees accounted for $33 billion in bank revenue and two-thirds of deposit account fees collected by banks, according to the researchers, citing data from Moebs Services. About half of the top 50 banks organized deposits in descending order in 2016, according to a report by Pew Charitable Trusts.
“We’ve always seen the banks as the good guys and the payday lenders as the bad guys.”
At least a quarter of U.S. households are classified as unbanked or underbanked, the authors note, quoting 2017 figures of the Federal Deposit Insurance Corporation. Consumers without bank accounts often say bank fees are too high, according to the FDIC. In fact, the data suggests that low-income people pay three times what others pay just to maintain their checking accounts.
When fees stop, consumers’ financial health improves
Researchers looked at the link between top-down orders and payday lenders and found a direct relationship between the two.
They compiled data from alternative credit bureau Clarity Services, which covers 1 million people who use lenders like payday services, and data from Equifax, a major consumer credit bureau that offers information on installment loans for low-income borrowers. They supplemented this data with hand-collected information about the top-down reorganization lawsuits that ultimately spurred the banning of the practice at 23 banks.
The researchers found that when lawsuits forced banks to end the top-down practice, consumers benefited. As a result of the bans, payday loans fell 16%, or about $84 per borrower per quarter. Installment loans fell 6%, or about $200 per borrower, the researchers found.
Consumers’ overall financial health has also improved. Two years after top-to-bottom replenishment bans, borrowers’ balances in good standing have increased by about $431, credit card limits have increased by $190, and their FICO scores have risen significantly. These results suggest that the overdraft practices implemented by banks could have serious consequences for consumers who live from paycheck to paycheck.
About 14% of bank customers incur five or more overdraft fees a year, according to the FDIC. The researchers estimate that 4.2 million customers benefited from the bans. Sued banks that had to stop the top-down reorganization saw their overdraft revenue decline by $1.3 billion a year, translating into savings of $330 per customer, the researchers estimate.
“The message is, ‘Check your individual bank and look at the fees, and make sure you know what you’re getting into. “”
One of the unintended consequences of the ban is that once traditional banks are ordered to stop using the top-down practice, they often close branches in neighborhoods where people with low income live. low income, according to research. This finding suggests that these fees are somewhat necessary to make it attractive for banks to serve this less affluent segment of the market.
How consumers can protect themselves
For consumers, the message is clear: make sure you know your bank’s policy on how and when overdraft fees are charged.
“Community banks do it too,” says Di Maggio. “In fact, overdraft fees could represent a larger portion of their overall income. So the message is not, “You should go to your credit union instead of Wells Fargo. The message is: “Check your individual bank and review the charges, and make sure you know what you’re getting into.”
Banks should find other ways to make a profit rather than charging exorbitant fees on low-income checking accounts, the researchers say. They should “focus on cutting their costs instead,” Williams says.
Additionally, policymakers should take a closer look at which financial services best meet the needs of low-income consumers, rather than striving for everyone to have access to the traditional banking system, the authors suggest.
“A general push for people to become banked may not be the policy response that will be most effective in helping these consumers,” Williams says.
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