Why Have Overdraft Fees Declined?

The rise of digital banking and fintech companies has disrupted traditional banking models.

Before overdraft fees arrived in the 1990s, if you wrote a check that exceeded the amount in your checking account at your bank, the check would “bounce”–and the payment would not be made.

If the payment was for something like your heating bill or your mortgage, you might get charged late fees or penalties as a result. But banks began offering “overdraft protection,” where in exchange for a fee, they would go ahead and make the payment.

These overdraft fees often cost about $35 per transaction. Some banks charged such fees each day until you deposited more money in the account. The fees added up. Pre-pandemic estimates were that banks were getting $15-30 billion per year from such fees. Some large banks were reporting more than $1 billion per year in overdraft fees. There were stories of certain smaller banks making losses in other areas, where the overdraft fees were more than 100% of their profits. A few years back, a bank executive for a mid-sized bank in my home state of Minnesota reportedly named his boat “Overdraft.”

However, it now seems as if these lucrative overdraft fees are declining substantially, and even going away entirely at some banks. Given that big banks are not known for their altruism in cutting fees, there is a minor mystery as to why this is happening. For background, useful starting points are Aaron Klein, “Getting Over Overdraft” (Milken Institute Review, posted October 31, 2022) and Michelle Clark Neely, “Is the Era of Overdraft Fees Over?” (Regional Economist, Federal Reserve Bank of St. Louis, March 8, 2023).

Before sketching the recent trends and possible explanations, it’s useful to be clear on the economic nature of overdraft fees. For a person who overdraws their checking account, the bank is effectively making a short-term loan. This loan was often very short-term, like just a day or two before another paycheck was direct-deposited into the account. Indeed, there have been many cases where an employee had good reason to believe that their paycheck had already been deposited, and then wrote a check, only to find that their personal check was subtracted from their bank account before the paycheck was added–thus triggering the overdraft fee. The $35 “overdraft” fee was, in effect, an interest rate charged by the bank for lending relatively small amounts for very shot times.

As you would expect, the people most exposed to overdraft fees were those with bank accounts hovering around zero: thus, overdraft fees were mostly paid by those with lower income levels. Neely of the St. Louis Fed writes:

A relatively small proportion of bank customers account for the lion’s share of overdraft fees. According to the Consumer Financial Protection Bureau (CFPB), people who frequently overdraft their accounts represented just 9% of bank customers but generated almost 80% of overdraft and nonsufficient funds (NSF) fees in 2017. Consulting firm Oliver Wyman estimates that customers who heavily use overdraft services generate, on average, more than $700 in profit for the bank per year on a basic bank account; customers who don’t use overdraft services produce an average of $57 in profit for the bank per year.

Thus, the overall result of overdraft fees is that a substantial share of profits for many US banks depended on charging high fees to predominantly low-income borrowers for extremely short-term loans–which doesn’t sound like the basis for a healthy banking industry.

Overdraft fees have not gone away by any means. But according to both Klein and Neely, they have dropped by billions of dollars since their peak back in 2019. Klein reports: “The largest banks are planning to cut overdraft fees by about half from 2019 levels.” However, no new regulations or legislation about the fees have been enacted. So why the decline?

One theory is that this is an example where legislators and regulators made sufficiently hostile and growling noises about these fees, so that banks were motivated to back off.

The difficulty with this explanation lies in believing that profit-seeking banks were willing to give up billions of dollars per year in revenue in response to these kinds of warning rumbles–without actual rules or legislation being passed. Klein writes:

Congress and regulators did put pressure on banks to change their ways. Sen. Chris Van Hollen (D-MD) prodded the Comptroller of the Currency, the agency that regulates national banks about overdrafts. Sen. Elizabeth Warren (D-MA) confronted JP Morgan Chase CEO Jamie Dimon, pointedly asking why his institution earns seven times as much in overdraft revenue as comparably sized Citibank. Rep. Caroline Maloney (D-NY) repeatedly introduced legislation that would force sweeping changes to overdraft policy, although it never came close to enactment. Meanwhile, the Consumer Financial Protection Bureau published research highlighting the overdraft bonanza’s magnitude and who’s paying for it. 

The difficulty with this theory is that it suggests that after about three decades of lucrative overdraft fees, banks decided to drop them dramatically over some bad publicity. A complementary theory is that the ongoing evolution of financial markets has increased competition. Neely writes:

Competition—from other banks and nonbank providers such as fintech firms—arguably has affected overdraft practices more than anything else. The growth of online and mobile banking has given customers more choices, and those wishing to avoid overdraft fees are voting with their feet by switching to competitors. In addition to introducing low or no overdraft charges, some fintech firms have created financial management tools for account holders. The digital banking platform Dave, for example, created a bank account in partnership with Evolve Bank & Trust that has no minimum balance or overdraft fees, real-time spend alerts and early access to paycheck deposits.

The difficulty with this theory is that some of the new fintech entrants are still quite small, and it seems unlikely that they are putting a lot of competitive pressure on the fees charged by, say, Citibank or Bank of America.

Of course, one can blend these theories together. Perhaps the warnings of legislators and regulators caused a few banks to shift their practices, and some new competitors entered the market, and the pressures of competition snowballed in a way that pressured other banks to follow along. But at least to me, the reasons behind the abrupt decline in overdraft fees remains something of a mystery. Neely describes the major changes that are taking place like this:

Banks have modified their overdraft programs in response to these factors, with large banks taking the lead. These changes include:

• Lowering the overdraft fee (from $35 to $10, for example)

• Increasing the trigger value (charging a fee only when the overdraft exceeds a given amount)

• Curing (adding a grace period to allow customers to cover the shortfall)

• Reducing the daily maximum number of overdraft fees charged (the average is four to eight)

• No longer charging fees to cover transactions that overdraw linked accounts

• Giving customers early access to their direct deposits …

The research arm of Pew Charitable Trusts estimates that these changes will save customers of large and regional banks more than $4 billion a year in overdraft fees; the CFPB projects half those savings will come from three institutions: JPMorgan Chase, Bank of America and Wells Fargo. Citigroup, the nation’s third-largest bank, has eliminated overdraft fees altogether. By August 2022, 13 of the country’s 20 largest banks had stopped charging NSF fees as part of their overdraft programs, and four more were scheduled to do so by the end of 2022. This represents a dramatic change from a year earlier, when 18 of the 20 largest U.S. banks charged NSF fees. …

Several banks have taken a further step, turning account deficits into small-dollar loans that will cost the customer less than a series of overdrafts. A negative balance can be turned into an installment loan with a fixed rate or a charge based on the amount borrowed, rather than on the number of transactions that overdrew the account. Customers then make regular payments on these loans, allowing them both to avoid overdrafts and build credit. …

As of January 2023, six of the eight largest U.S. banks, ranked by number of branches, offered small-dollar loans. In addition to substituting for overdrafts, small-dollar loans are being touted by consumer groups as less costly alternatives to payday loans, auto-title loans and rent-to-own agreements. Pew estimates that small-dollar loans at four of these large banks—Bank of America, Huntington Bank, U.S. Bank and Wells Fargo—are priced at least 15 times lower than the average payday loan.

Klein describes these kinds of changes as well, and suggests that some additional regulations may be useful. For example, bank regulators might take a much closer look at financial institutions that make an outsized share of their profits from collecting high overdraft fees from low-income household–and ask if that bank is fundamentally stable. Or banks could be required to post the additions to a checking account in a given day before they post the subtractions –rather than the reverse.

The news about declining overdraft fees is generally welcome, but it does raise the question of how banks might try to make up the revenue they are losing. As Neely writes: “The speed at which banks continue modifying overdraft services will depend largely on whether they are able to compensate elsewhere for lower overdraft fee revenue.”