CBA Publications >> CBA Regulatory Compliance Bulletin >> Vol 2005 No.1 March 18, 2005

Vol 2005 No.1 March 18, 2005

Analysis of Federal Overdraft Guidance

In response to concerns over the marketing of overdraft protection programs, sometimes referred to as "bounce protection programs," the federal banking agencies issued guidance on safety and soundness considerations, legal risks, and best practices associated with such programs. The agencies express concern where a program is presented in a manner that appears to encourage consumers to overdraw their accounts, and lead them to believe that overdrafts will always be paid when, in reality, the bank reserves the right not to pay some overdrafts.

The FDIC, OCC, Federal Reserve Board, and NCUA joint guidance is available at the Federal Reserve Board's website at: http://www.federalreserve.gov/boarddocs/press/bcreg/2005/20050218/attachment.pdf. The OTS guidance, which is substantially the same, is available from the OTS website at http://www.ots.treas.gov/docs/r.cfm?480028.pdf (hereafter, collectively referred to as the "Guidance"). This Bulletin does not reiterate all the elements of the Guidance, but rather analyzes some of the potential pitfalls and risks.

The Guidance states specifically that the safety and soundness considerations apply to all overdraft activities, whether or not marketed. Otherwise, it does not specify what applies to marketed programs only and what applies generally, though much of the guidance pertains logically only to programs that are promoted or featured as a service. All banks that charge overdraft fees should review their policies in light of the new guidance.

What is a program. The introduction to the Guidance acknowledges that overdrafts paid on a discretionary basis as an accommodation to the account holder, where the accommodation is not promoted, does not raise significant concerns. Unlike the proposal, the Guidance places less emphasis on whether a program is automated. In its comment letter, CBA pointed out that most banks relied on automation to some extent to screen overdrafts and pay them when pre-determined criteria are met, so it is not a reliable indicator of a marketed program. Unfortunately, in describing programs that are of concern, the Guidance is still less than clear. Programs that the Guidance appear to target are those that affect consumers and incorporate "some or all" of a list of seven characteristics,1 only one of which is that overdraft privileges are promoted as a feature of the account. The remaining six are characteristics that to some extent describe discretionary overdraft activities that the Guidance states are of no concern.2

1) The characteristics of an overdraft protection program are: it is promoted as a service; coverage is automatic for accounts that meet certain criteria; an overdraft limit is set; payment by the bank is discretionary; the service may extend to transactions other than just checks; a flat fee is charged; and some banks offer closed-end loans to consumers to repay balances.

2) The Guidance focuses on consumers, but not exclusively. From the introduction to the Guidance: "This joint guidance is intended to assist insured depository institutions in the responsible disclosure and administration of overdraft protection services, particularly those that are marketed to consumers." (Emphasis added).

Moreover, the Guidance does not specify what activities (presumably, short of paid advertising) constitutes promotion. Apparently, informing consumers of the available "aggregate dollar limit" could constitute promotion. Whether a bank is deemed to promote overdraft protection if it "informs" an account holder of a dollar limit through a provision in the account agreement, overdraft notice, or statement is unclear.

Banks have to decide for themselves what portions of the Guidance, if any, apply to their overdraft activities. If overdraft protection is not promoted, then the risks that are the focus of the Guidance (e.g., inappropriate consumer incentives to mismanage accounts) are largely absent. As to promoted programs, the Guidance does not clarify whether the failure to meet one or more standard indicates an inadequate program.

No Regulation Z coverage for discretionary overdrafts. Where a bank pays an overdraft on a discretionary basis, as contrasted with a payment made pursuant to an overdraft line of credit, overdraft fees are not treated as finance charges under the Truth in Lending Act and Regulation Z.3 So far, the agencies still observe the regulatory distinction that an overdraft fee is not a finance charge if payment of the overdraft were not made pursuant to a written agreement and payable in more than four installments. The Federal Reserve Board notes in the introduction, however, that it has the authority to re-evaluate the exception in the future, if necessary. By limiting banks' ability on the one hand to preserve the notion of discretion while on the other promote overdraft services to its customers, the agencies can be seen as chipping away at the exception as it relates to promoted programs.

3) 12 CFR 226.4(c)(3). Overdraft charges are not finance charges unless the payment of overdrawing items and the imposition of the charge were previously agreed upon in writing.

Safety and soundness. Regardless of whether a bank promotes its overdraft program, it must adopt formal written policies and procedures on all aspects of its overdraft activities (including account eligibility criteria, dollar limits, repayment plans, suspensions, and write-offs) and treat overdrafts as loans for purposes of regulatory reporting and capital standards.

Note that if a bank "advises" account holders of the available amount of overdraft protection, it should report the available amount with "legally binding commitments" for Call Report purposes, and be characterized as "unused commitments." It is unclear whether a bank has so advised an account holder if it also clearly disclosed that it retains the discretion not to pay any overdraft.

In response to strong opposition from CBA and others, the agencies backed away from a 30 day charge off requirement, which is not practicable and highly detrimental to consumers. The Guidance now states that overdraft balances must be charged off when considered uncollectible, but no later than 60 days from the first overdraft transaction.4

4) Note that California Financial Code Section 858 establishes a 90 day rule for state chartered banks.

If in complying with the safety and soundness considerations discussed above the bank has amended its policies and procedures, consider what changes are warranted in the account agreement.

Best practices. The Guidance includes a series of "best practices" aimed primarily at promoted programs, but which can be "useful" for other methods of covering overdrafts. At the top of the best practices list is that banks must not market programs in a way that encourages intentional overdrafts (and account mismanagement). Banks may present the service as a means of covering inadvertent overdrafts, and should go no further. Again, this is no bright line test, and raises the question whether prophylactic disclaimers such as "always manage your account wisely" should be inserted with ads or promotional statement that come close to that line.

If the bank offers more than one type of product, such as an overdraft line of credit, the best practice, when "informing" consumers about its discretionary program, is to inform them about those other services as well. This means advertisements should be reviewed and staff should be trained to provide this information.

Marketing communications regarding overdraft programs will be more lengthy under the new Guidance. Whether a bank is required to furnish these numerous disclosures (that is, whether it has a covered program) becomes all the more important to resolve because the act of making the detailed disclosures, by itself, could be treated as promotion.

Banks would have to explain that they retain the discretion not to pay any overdraft if the program is marketed. A statement to that effect contained only in the account agreement is not likely to make this point "clear" within the meaning of the best practice. Banks should disclose the dollar amount of overdraft fees and any interest rate that may apply, that fees apply against any disclosed overdraft limits (if applicable), and the fact that more than one overdraft fee may be charged in one day. No type size standards or other formatting standards are provided.

These suggested disclosures make another best practice almost academic: overdraft protection should not be promoted in the same advertisement as "free" accounts in order to avoid implying that overdraft protection is provided without charge.

Disclosure of a bank's check clearing policies was a proposal that CBA strongly opposed because the rules for processing checks are replete with exceptions and not as simple as high-to-low or low-to-high. Rather than disclosing its policies, a bank should now explain that transactions may not be processed in the order in which they occurred, and that the bank's policies can affect the amount of fees incurred by the customer. It is not clear whether this particular disclosure may be made only in the account agreement. The OTS Guidance states specifically that a savings association is not permitted to adjust its clearing policies in order to inflate fees.

Operational issues. The Guidance recommends that consumers be given a right to opt out of overdraft protection (or better yet, opt in), which presumably could be offered at account opening and upon request. Banks would be required to provide a "clear consumer disclosure" of this option, but no other details are provided. Remember, however, that it is impossible in all instances for a bank to disallow an account from being overdrawn. An overdraft could occur when a deposited check is returned, or a recurring fee is imposed that brings an account into negative balance. If fees are charged in these situations, consider the appropriateness of any opt out language used.

While banks address details of overdraft and fees charged on monthly statements, and some banks issue notices of overdraft each time an overdraft occurs, the Guidance states that notices should be delivered the same day that an overdraft has occurred. This requirement is, to say the least, operationally challenging and in some instances, impossible, and in spite of comments to that effect, the agencies have adopted this as a best practice.
Banks should reevaluate their consumer reporting practices associated with overdraft activity that while, excessive, is consistent with the terms of a program (i.e., the fees are paid in a timely fashion). The Guidance discourages the filing of a report in such instances if the bank in fact had encouraged such use. Note that if an account is closed for excessive activity, some systems automatically generate a report to credit bureaus.

Legal risks. Neither Regulation Z nor Regulation B (Equal Credit Opportunity Act) applies to discretionary overdrafts per se.5 But Regulation B may apply if any aspect of a program is administered in a discriminatory manner. Pricing policies that have a discriminatory impact on a prohibited basis, and steering of certain classes of customers but not others to more favorable lines of credit programs, are examples.

5) 12 CFR Section 202.3(c)(ii). Regulation B does not apply to "incidental credit," which includes charges for credit that are not subject to a finance charge within the meaning of Regulation Z, 12 CFR 226.4. See footnote 3 above.

The Guidance, even though it is not technically binding as a regulation, has the effect of creating industry standards. A bank that promotes a program falls below the standards at its own peril. In California, banks should be aware that liability exposure exists even if a practice violated no law or regulation (or even the Guidance) if the practice could be considered "unfair" within the meaning of Business & Professions Code Section 17200 (Unfair Competition Law).

If you have any questions, please contact Leland Chan at 916-438-4404 or lchan@calbankers.com.

The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.