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Time to Review Your Overdraft Program Plans

by Andy Zavoina

Many banks have been taking a "wait and see" position on adding or updating their handling of overdrafts, knowing that Washington was about to weigh in on the subject. That guidance has been handed down, and now it's time to make those decisions.

On February 18, 2005, the OCC, FRB, FDIC and NCUA released their final guidance document on Overdraft Protection Programs. The OTS issued its final guidance on February 14.1

Beginning with an OCC Interpretive Letter in September, 2001, the agencies have expressed concern about the operation of Overdraft Protection Programs (ODPs). Bankers with these programs, as well as those considering them, have been in a kind of regulatory limbo since June 2004, when the agencies, including the OTS, issued a proposed guidance document.

There are generally two types of facilities used to cover overdrafts. One is a true line of credit where an agreement exists for a financial institution to transfer an overdraft balance to the line. The terms and conditions are agreed upon in advance by both parties, and the arrangement is subject to Truth in Lending.

The other facility is what has been termed an Overdraft Protection Program (ODP) or "bounce protection." These programs are not officially loans and financial institutions reserve the right to pay or not pay an item. There is no commitment and it is not subject to Regulation Z. An NSF fee may apply for each item presented. That fee would be charged whether the item was paid or returned. Some also charge a daily fee, if allowed by state law, on overdraft balances. The details of these programs vary between financial institutions. Because of the convenience and income these programs can generate, they have become more and more popular. To avoid confusion and misunderstandings, the agencies have issued guidance to help financial institutions as they offer ODPs. Following the agencies' guidance should help both the financial institution and its customers.

The guidance document covers three specific areas:

  1. Safety and Soundness
  2. Legal Risks
  3. Best Practices

Some commenters on earlier agency proposals wanted to draw a distinction between financial institutions which have ODPs and those that pay overdrafts on a case-by-case basis. The Safety and Soundness section of the guidance document expressly applies whether an ODP is in place or not, broadening the scope of this guidance. However, the agencies have applied the document particularly to the handling of overdrafts in consumer accounts.

Safety & Soundness
First and foremost, paying an overdraft is extending credit. This is why it is of interest to all financial institutions. There is exposure to loss and it is usually done without credit underwriting but rather based on circumstances such as the frequency and amount of deposits and the time the account has been open. This presents risk and is an issue that will often be reviewed.

Institutions with an ODP are expected to have policies and procedures in place that address the credit and operational risks associated with paying overdrafts, and any other risks the institution sees. Policies should address the criteria for approving a customer for participation in the program. Reports should be produced allowing the institution to manage the ODP. Specific items to include are the volume of overdrafts, profitability, losses anticipated and a mechanism to identify individual accounts that involve more risk than the institution is willing to accept. Procedures should include a way to exclude identified accounts from the ODP. Budgets should allow for loss estimates and the fact that not all of the fees accessed for overdrafts will be paid. An institution's Allowance for Loan and Lease Loss account may have a specific provision in it for the ODP. Banks should describe in their policies the methodology used for this calculation and continue to verify its validity periodically.

Following the aging of overdrawn accounts is one tool that can be used to manage the ODP. This will allow more responsive collection practices and suspension from the program as well as adjustments to improve profitability.

In response to industry comments, banks do not need to charge these accounts off at 30 days, but can allow them to reach 60 days. Credit unions are still required by 12 CFR ?701.21(c)(3) to not exceed 45 days. If a payment plan is entered into, the 45 or 60 day timeframe still applies unless a true loan is used in the plan. In this case there is credit underwriting and an institution's normal charge-off policy would apply. That policy should conform to the applicable regulator's existing requirements.

Overdraft balances should be reported as loans. Institutions should follow generally accepted accounting principles and report these according to instructions on their Call Reports. If customers are told what their "limit" is -- for example, when they open an account, on a periodic statement, or on an ATM receipt -- this should be considered an "unused commitment" and reported on the Call Report as such.

The agencies have specifically stated that they expect proper risk-based capital treatment of both outstanding overdrawn balances and unused commitments. They also expect that the accounts should be risk-weighted according to the risk-based capital guidelines applicable to the institution. The agencies believe that the ODPs this guidance addresses fall within the meaning of "related plans" as a type of "overdraft checking plan" for risk-based capital guidelines. Consequently, overdraft protection programs that are unconditionally cancelable by the institution would qualify for a zero percent credit conversion factor.

If an institution uses a vendor to assist in its ODP, due diligence is a pre-contract requirement. The interagency guidance contained in the November 2000 Risk Management of Outsourced Technology Services will help in these requirements.

Legal Risks
Financial institutions are reminded that compliance with applicable federal and state laws and regulations is required. Under state laws institutions may have to determine what constitutes credit and when usury rules apply, as well whether any fee limits may be imposed. Criminal laws and rules covering deceptive acts or practices should not be overlooked. For this reason, you may opt to have counsel review your ODP. Because laws and regulations can change, you may want to have this review updated periodically as well. Remember too, that on May 27, 2004, the Fed published a proposal to amend Reg. DD that could affect disclosures for accounts involved in an ODP. That amendment is still outstanding as of the issuance of this guidance. [Editor's note: Read the companion article for a discussion of the final Regulation DD amendment that was later issued.]

Some rules and regulations you may want to pay particular attention to, and address issues in your policy, procedures or risk management documentation, include:

Federal Trade Commission Act/Advertising Rules
In general terms, an act or practice may be deemed deceptive if it is a representation, omission, or practice that is likely to mislead a consumer. There is a lot of emphasis in this guidance and the documents which led up to it on the way ODPs are marketed. Some of these concerns may be addressed in the potential Reg. DD amendments. Institutions should carefully review the advertisements and materials explaining the ODPs they offer to ensure that a consumer would not be confused about the offering and its costs.

Truth in Lending Act
The NSF fee charged on an item is not a finance charge, but could be if a greater fee is charged when an item is paid. Typically ODPs are administered so as to not be subject to Regulation Z, which implements TILA. But often loans are made to convert an overdraft balance into an amortizing loan. These can certainly trigger Reg. Z disclosures.

Equal Credit Opportunity Act
ECOA is implemented by Regulation B. Institutions should review their ODP criteria to ensure there are no overt or covert discriminatory practices, such as "steering" customers on a prohibited basis toward an ODP while offering other >
Truth in Savings Act
Reg. DD implements TISA. Disclosures are required for any fee that is imposed in connection with an account, including the conditions under which the fee will be charged. When an institution changes a disclosable fee or when it will be imposed, advance notice is required if the change is adverse to the consumer. If the fee for a consumer in the ODP is greater than for a consumer who is not, re-disclosure would be required. Reg. DD also has advertising requirements similar to the rules described above in the FTCA/Advertising Rules section. Again there is emphasis on how the programs are displayed and advertised to consumers.

Electronic Fund Transfer Act
The EFTA is implemented by Regulation E. Reg. E provides disclosure requirements at account opening or when EFTs are contracted for as well as requirements for periodic statements. If an ODP may be accessed via an ATM or POS debit, then Reg. E will apply. The requirements for periodic statements and receipts at electronic terminals should be verified for compliance.

Best Practices
"Best practices" are things commonly done in the industry that are seen as beneficial to the consumer and compliant with laws and regulations. Clear disclosures are among the most important things. They promote an understanding of the program itself and will best facilitate responsible use and not encourage abuse. By reducing the potential for confusion, clear disclosures also reduce the chances of a consumer complaint and lower the risks of litigation.

A "best practices" list for institutions with ODPs might include:

  • Do not appear to promote or encourage irresponsible use of the program. This is after all, meant to cover occasional inadvertent overdrafts and not to serve as a continual line of credit.
  • Disclose the parameters of your ODP and any alternatives you may have so that customers may make informed decisions.
  • Train staff to understand the ODP and to explain it and potential alternatives to customers. Employees need to be able to discuss fees and terms as well as how the customer may opt-out of the program. If your employees can't understand it, they can't explain or sell it.
  • Be clear when payment of an item is at the discretion of the institution, to ensure that the customer understands that facet of the program.
  • Do not contribute to any confusion between a "free" account, a service or account feature which is free, and an NSF item that would cause a fee to be assessed.
  • Clearly describe your fees associated with the program. Rather than refer to another document which actually contains, for example, the NSF amount, provide that cost in your program description. If ODP materials are meant to be stand-alone documents, make them complete.
  • Clearly disclose that you include NSF fees owed in the amount of the overdraft balance. This avoids a consumer writing, for example, $300 in checks believing that you will pay them all, only to find out that the six $25 fees use up $150 of the $300 limit.
  • Describe the manner in which you assess fees for the ODP. Avoid confusing consumers, who may believe that there is one flat fee for all the items presented in one day unless you are crystal clear that's not the case. If there are differences based on the number, dollar or a daily fee, clearly describe this.
  • Disclose your item processing policy so consumers don't assume checks are processed in the order in which they are written. Help them understand the order in which you pay and that this may influence the number and amount of fees they may be liable for. This may be as simple as describing that you pay largest to smallest items after priority payments which include items cashed in the branch, ACH/ATM items, etc.
  • Clearly disclose the types of items that may cause an NSF fee to be imposed -- a check, an ATM or POS withdrawal, an ACH debit, etc.
  • Allow consumers to opt-out of the program if they wish and ensure they know about this option, and understand the costs involved in the alternative.
  • Notify customers when possible (such as at your ATMs or teller windows) that a withdrawal they are requesting will cause an overdraft fee to be assessed. This may be possible in electronic or paper form. If transaction notices are not possible, for example, at an ATM, post a notice that transactions might overdraw an account, incurring fees. Consider eliminating the practice of including the available overdraft amount in the balance available for ATM or debit card authorizations.
  • Either present to a customer an actual available balance, separate the amount into what is available and what is allowed in the overdraft or provide the total available and clearly indicate it includes an overdraft limit available.
  • Notify consumers promptly when they are overdrawn. This makes them more informed and may assist the institution in the event of fraud or theft involving the account.
  • Consider limiting the daily amount of fees that will be assessed against an account.
  • Monitor accounts for excessive usage, which may indicate the ODP is being abused, and recommend an alternative credit facility.
  • Do not report negative information to a credit reporting agency when the ODP is being used in accordance with the terms of the agreement and the way it was promoted.

Clearly, the agencies' guidance will serve as a set of expectations that examiners will bring to the table at banks' next round of examinations. There are as many issues raised in the guidance document as are resolved by it. We suggest that a prudent course of action is to begin a careful review of your bank's plans, and to determine which elements of the guidance document will apply to your overdraft approval process.

There will doubtless be parts of the Best Practices list that won't work in your bank for one reason or another. We recommend that you document your decisions and be prepared to justify them in light of the guidance provided by the agencies.

1We have not done a detailed comparison of the two documents, but they appear similar. We have focused our analysis on the joint agency release.

First published on 2/25/05

First published on 02/25/2005

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