Congress is now turning its attention to the enormous $27 billion bank overdraft market and is considering legislation to alert customers when they are about to overdraw an account. Banks are fighting back, since overdraft fees are a big component in their business and profitability.

The overdraft market is an enormously profitable piece of a bank's revenue. According to a NY Times article on overdraft fees, banks make more on overdrafts than they do on penalty fees from credit cards. I can confirm this importance from my banking days. I remember sitting in meetings where potential changes to overdraft policy were discussed very gingerly because of its importance to the bank's revenue. Banks know that overdrafts diminish customer satisfaction but at the same time they are addicted to this "easy revenue."

Several pieces of overdraft reform are working through the Fed and Congress. The Fed is considering requiring banks to get customer permission before enrolling them in an overdraft program. And Representative Carolyn Maloney from New York has introduced legislation that would require banks to alert customers if a transaction is going to overdraw an account.

The banking industry is painting a dire scenario. From the Times article:

“Michael Moebs, an economist who advises banks and credit unions, said Ms. Maloney’s legislation would effectively kill overdraft services, causing an estimated 1,000 banks and 2,000 credit unions to fold within two years. That is because 45 percent of the nation’s banks and credit unions collect more from overdraft services than they make in profits, he said.

“Will they be able to replace it with another fee?” Mr. Moebs said. “Not immediately and not soon enough.”

Banks say that without overdraft fees, they may have to start charging for free rewards checking accounts. Bankdeals makes the case that reward checking accounts may not be profitable for banks without the funds from overdraft/NSF fees.

“This marketing brochure from BancVue compares the NSF revenue from free checking and reward checking. It shows that NSF revenue is actually a little higher for reward checking than for free checking. In both cases, NSF revenue is much higher than revenue from debit cards.”

To add another wrinkle, banks have been slapped for trying to “game” how transactions settle, potentially increasing the number of overdraft fees. Bank of America reached a settlement last year for allegedly changing the order in which transactions settled in order to increase overdraft fees.

Much of the discussion over this will come down to personal responsibility versus the bank’s responsibility to be fair. Those that advocate personal responsibility will say that consumers should know how much they have in their account and that if they are overdrawing it is their fault.

Others, such as one commenter on Bankdeals will make the case that:

“a lot of banks aren't really in the banking business at all - they're in the Gotcha Fee Collection business.”

My feeling is that if a consumer does not have money in their account, the transaction should not go through. Debit card transactions clear differently from a written check. When writing a check, a merchant is taking it on faith that there are funds in the account to prevent it from bouncing. The check is cashed after the goods have been exchanged. If the check bounces, the bank has to reverse the transaction and potentially deal with the merchant who was never paid for the service or good they sold.

But debit cards don’t work that way. The card can be checked before the exchange is made to ensure there are sufficient funds. It’s at that point that the bank should terminate the transaction if sufficient funds don’t exist. In that case, the merchant is not out of the good and the bank does not have to reverse a transaction. There is no bounced check.

Obscuring a lack of funds is like a gas company from hiding the gas low indicator in a car and then charging $100 for an emergency tank fill when the car stalls. It may be good for the income statement, but it’s a terrible way to build customer loyalty.

See savings rates here.

Even as the economy continues to show signs of firming and the stock market continues its upward trend, the rate on savings accounts and many CDs continue their downward movement. It's clear that until the Fed raises the Fed Funds rate, money markets, cds, and savings accounts will pay low yields. The only consolation is that inflation remains low, meaning the actual inflation adjusted return is higher.

As the chart below shows, savings as well as 12-month and 36-month CD rates moved down again last week to their lowest levels since we began tracking rates. The slope of the decline has slowed and is now more like a slow downward drift. It seems that like the economy, that we have probably hit bottom, or are close to it. The average savings rate according to the BestCashCow rate tables has fallen from 3.64% APY last year to 1.77% APY today. The rate you'll have find at your corner bank is probably a good deal lower.

There's no significant change to report in the spread between savings rates and 36-month CDs. The spread ticked up a bit but nothing that isn't within the normal range of the past few months. Notice that the spread between savings and 3-year CDs that we saw widen in the spring is still there, a sign that the economy is poised for expansion. One wonders who will blink first: will longer term CD yields come down in the absence of any sign of inflation, or will short term savings and CD accounts rise as the economy strengthens?

I still think that the bias is towards rate increases later in the year so I would stay short-term and wait. An improving economy will force the Fed to eventually raise rates, and that will cause yields to start rising.

The spread between the average BestCashCow savings rates and 36-month CD rates remains steady as the economy stabilizes and investors, banks, and consumers wait to get the next read on where the economy is going.

August 17, 2009 Update

I wrote the following back in June, before the lazy days of summer:

"Individual bank rates may fall a bit from here but for the most part rates seem to have bottomed, as shown by the chart below. Even savings accounts, the most liquid and sensitive to the Fed Funds Rate (currently at 0%) has flatlined and is no longer on its steep downward slope. Indeed, we've even seen a few banks increase their rates."

Ah, if only that were true. Savings and CD rates continued to drop over the summer even as the stock market went on one of its longest winning streaks in history, shooting above 9,000 and getting giddy analysts to call for it to rise above the 10,000 mark before long.

As the chart below shows, there was nothing to be optimistic about from a savings or cd rate perspective. The average savings account rate according to the BestCashCow rate table is paying 1.8% APY. And those are the top rates in the country! If you walk into Bank of America or Chase, they'll ask you to pay them - practically. Last year at this time, the average savings rate was 3.6% APY. Nothing to write home about but still a lot better than today. The story is much the same with CDs.

The average 12-month CD rate is only slightly better than the savings account rate at 2% APY and banks will pay you 3.22% APY to lock your money in for 5 years.

As the chart below shows, the spread between savings rates and 36-month CD has remained fairly steady over the summer - both have gone down!

So what's a saver to do? With the economy looking like it's on the mend and the Fed and government still pumping trillions, it's hard to justify locking money into a long-term CD. The time to do that was 18 months ago when rates were 5% APY+. For now, I think it's best to stay short-term and wait. An improving economy will force the Fed to eventually raise rates, and that will cause yields to start rising.

The spread between the average BestCashCow savings rates and 36-month CD rates remains steady as the economy stabilizes and investors, banks, and consumers wait to get the next read on where the economy is going.