Imagine that it is the last day of the month and you have $20 in your checking account. Your $2,000 salary will be automatically deposited into your bank later today.  You walk down the street and buy yourself a $2.95 ice cream cone. Later you also buy yourself a copy of Predictably Irrational for $25.95, and an hour later you treat yourself to a $2.50 cup of café latte. You pay for everything with debit card, and you feel good about the day – it is payday, after all.

That night, sometime after midnight, the bank settles your account for the day.  Instead of first depositing your salary and then charging you for the three purchases, they do the opposite – qualifying you for an overdraft fee.  You would think this would be enough punishment, but the banks are even more nefarious. They use an algorithm that charges you for the most expensive item (the book) first.  Boom, you are over your available cash and charged a $35 overdraft fee.  The ice cream and the latte come next, each with its own $35 overdraft fee.  A split second later, your salary is deposited and you are back in the black – only $105 poorer.

Overdraft plans connected to checking accounts are common at most major financial institutions, and the Center for Responsible Lending estimates that this practice costs consumers about $17.5 billion in fees every year. Given these numbers, it is perhaps not very surprising that most financial institutions currently enroll their account holders into this expensive method of covering overdrafts without the customer’s consent or knowledge and that when consumers try to get out of these programs they find it incredibly difficult.  When I called the few banks I have accounts with last week and tried to un-enroll from these programs, the most common response I got was that it was impossible. Similarly, one New Jersey columnist reported that his own daughter was charged a $35 overdraft fee for a debit card purchase of less than $2, even when he had accompanied her to open her account and asked that transactions that would overdraw the account be denied. (Paul Mulshine, ‘Courteous’ bankers in for a rude awakening, The Newark Star-Ledger, June 7, 2007, at 15)

With the current financial challenges, I suspect that the people at the lower Social Economic Status (SES) are carrying a large part of the general financial crisis in terms of jobs and housing, as well as a large part of the overdraft fees related to overdraft protection plans.  Given this, it is a good sign that the Feds are finally looking at this issue.  The first thing that the policymakers are considering is whether to require banks to let their customers opt-out of the default overdraft system.  This sounds like a no-brainer.  A far better version of the rule would require banks to obtain explicit permission from their customers before enrolling them in this program, the “opt-in rule”. So when you sign up for a bank account, you are not enrolled in this program unless you decide that you want the bank to approve debit purchases you make even if you have no money in your account.  Given what we know about defaults and behavioral economics (that most people adapt the default option as their choice, and they see it as an implicit recommendation), I suspect that with the opt-out requirements, the vast majority of consumers will become part of the program and will keep on paying these high penalties, while the opt-in approach would make consumers much less likely to join these programs. Presumably, the banks know this, which is why they are arguing for the right to put all their customers into this expensive system of overdraft coverage without asking.

But of course, this is just the first step. In addition to the pending Federal Reserve regulatory proposal, Representative Carolyn Maloney (D-NY) has introduced legislation that, in addition to requiring that banks get explicit “opt-in” permission, would require warnings at the checkout counters and ATMs to allow customers to cancel a transaction before incurring a fee. It would also stop banks from clearing transactions from the highest to the lowest in order to increase their fees.  These are useful reforms that are much needed to prevent banks from taking advantage of their customers.

The banks of course are very worried about losing this income stream, but I suspect that changing the bankers’ mindset from business as usual to one where they are actually going to start seeking their customers’ trust and products that would actually appeal to their clients is in everyone’s best interest.  Adopting such programs might in fact push the banks to further improve their overdraft protection programs so that they are truly valuable for their consumers.  For example, banks might start giving consumers better access to competitively priced short- term loans, better connections between saving and checking accounts, or at least they can start alerting consumers using SMS when they are in danger of overdrawing their account. In the meantime, the Federal Reserve Board’s “opt-in” rule would be a step in the right direction.