Two approaches to overdrawn accounts

When a customer makes a transaction that overdraws their bank deposit account without a corresponding overdraft plan, they are, in essence, asking the bank for an unsecured loan. Community banks can and do return overdrawn payments—a practice that can be costly and embarrassing for customers.

There are two primary methods banks employ to protect customers from the return of payments and the associated fees. The first is an overdraft line of credit account, and the second is overdraft coverage by funds swept from another deposit account of the customer to cover the deficit in the overdrawn account. Although both methods resolve the overdrawn account, they are very different products and require specific disclosures and handling.

Overdraft lines of credit

A consumer-purpose overdraft account is an open-end credit account covered by Federal Regulation Z and the Truth in Lending Act (TILA). Business-purpose overdraft lines of credit are not covered by Regulation Z; however, community banks should manage business-purpose overdraft lines of credit to ensure the programs are sound, operate appropriately and meet all applicable regulatory standards, such as those of the Unfair, Deceptive, or Abusive Acts or Practices Act (UDAAP).

When a transaction causes a customer’s deposit account to become overdrawn and the customer has contracted for an overdraft line, the bank draws on the line of credit and deposits the funds into the overdrawn deposit account. The balance created on the overdraft line then begins to accrue interest as specified in the account contract and operates similarly to other lines of credit. Like other consumer-purpose open-end lines, an overdraft line of credit requires TILA open-end credit disclosures, including those for account opening (§1026.6(b)), the periodic statement (§1026.7(b)), transaction identification (§1026.8(a)), payment crediting (§1026.10(a)) and advertising (§1026.16). Consumer-purpose overdraft lines are subject to compliance with TILA billing error resolution procedures (§1026.13).

Sweeping funds for overdraft protection

The second type of overdraft program uses funds swept between bank deposit accounts to resolve overdrafts. Many community bank customers maintain more than one deposit account, and, generally, a customer will maintain some type of account on which checks or other requests for payments may be presented routinely (for instance, a checking account), and an account classified as a savings deposit (generally, a savings account or money market deposit account).

When a transaction causes a customer’s deposit account to become overdrawn and the customer has contracted for sweeps, the bank draws on the savings deposit designated in the sweep agreement and deposits the funds into the overdrawn deposit account. For this method, no credit account is created, and the sweep arrangement is not covered by Regulation Z or the Truth in Lending Act.

Banks that offer a sweep-based overdraft protection program need to be aware of restrictions on transfers from savings deposits. Federal Reserve Board Regulation D—Reserve Requirements of Depository Institutions governs the classification of various types of bank accounts. It also imposes uniform reserve requirements on all depository institutions with transaction accounts or nonpersonal time deposits, and it defines those deposits. The classification of accounts primarily affects two things: the reserve requirements that financial institutions must pay against the accounts they maintain and how those accounts are reported, such as how they are reported on Consolidated Reports of Condition.

What does this have to do with overdrawn checking accounts? If the bank is using a sweep arrangement for its overdraft program, plenty.

When funds are swept from a savings deposit as defined at 12 C.F.R.§204.2(d)(1) and (2), which includes savings accounts and money market deposit accounts, and the sweeps or other debit transactions exceed the limits allowed by the definitions in Regulation D, the accounts may become ineligible to be classified as savings deposits, and that may affect reporting and reserve requirements. This problem can affect both compliance and safety and soundness examination results.

To satisfactorily manage sweep-based overdraft programs and maintain the integrity of savings deposits, community banks must either prevent transactions from exceeding the limits on transfers of funds from savings deposits or monitor the debits to savings deposits, so customers who do exceed the limits on restricted transfers are notified. If necessary, community banks should also help customers change their savings deposits to an account type more suitable for their financial practices, such as a negotiable order of withdrawal (NOW) account, which has no transfer limitations.

Other compliance requirements

There are additional compliance requirements for sweep arrangements that are different from those of overdraft lines of credit. The basis of the overdraft sweep arrangement is contractual. The community bank should enter into a written agreement with the customer that discloses how the sweep arrangement will be triggered, in what increment funds will be swept between accounts, and any fees that the customer may incur for the sweep service.

Federal Regulation DD and the Truth in Savings Act cover certain aspects of overdraft services. Section §1030.11(b) of Regulation DD specifies advertising requirements for overdraft practices that are offered or conducted for overdraft programs not covered by Regulation Z. Regulation DD (§1030.11(a)) requires disclosure of the total amount of overdraft fees on the customer’s deposit account periodic statement, and the disclosure of total overdraft fees includes fees assessed when items are paid and for items returned unpaid. Fees for transferring funds from another deposit account of the consumer to permit the payment of items without creating an overdraft are not included in this disclosure, even if a fee is charged for the transfer. Similarly, fees imposed under an overdraft line of credit agreement covered by Regulation Z are not included in the total overdraft fees.

Overdraft services continue to be of regulatory interest. According to one study, 18 percent of Americans have overdrawn their checking account in the past year, 24 percent of account holders were enrolled in an overdraft protection plan, and 64 percent of customers overdrawing their accounts had an annual income of less than $30,000. The Consumer Financial Protection Bureau (CFPB) reported in August 2017 that Americans paid $15 billion in fees for bouncing checks or overdrawing their bank accounts in 2016. The 2017 CFPB study was the third report issued by the agency on overdraft services.

In recent years, studies of or guidance on overdraft programs have been issued by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. Regulation E—Electronic Fund Transfers Act rules require specific disclosures and actions if an institution that holds a consumer’s account will assess any fee or charge on a consumer’s account for paying an ATM or one-time debit card transaction as part of the institution’s overdraft service.

Community banks compete on a very crowded playing field. The availability of technology to support product management has allowed community banks to offer products and services commensurate with larger institutions, including overdraft protection programs. Continued regulatory scrutiny and the demands of customer service dictate strong compliance measures to ensure those products meet every requirement.