The CFPB has proposed a long-anticipated rule targeting overdraft fees.  Billed as part of its effort to rein in “junk fees,” the proposal could have a significant effect on the nature and availability of overdraft protection and the market for deposit products. Here are answers to key questions we have received. 

What’s the headline? 

Banks and credit unions with over $10 billion in assets won’t be able to make money when providing overdraft protection. 

The CFPB proposes to amend Regulation Z, which implements the Truth in Lending Act (TILA). The proposal would subject overdraft services provided by banks and credit unions with more than $10 billion in assets (hereafter “large banks”) to the disclosure and substantive provisions that apply to consumer credit cards – but only if their fees for honoring overdrafts exceed their direct cost of providing the service, including any associated charge-offs. 

Smaller banks can continue offering overdraft protection in its current form and without any regulatory limitation on the fee they charge their customers who overdraft.

Notably, neither the current laws that regulate overdraft nor Regulation Z generally set different rules for banks or creditors of different sizes.

The CFPB suggests this change could result in the reduction of overdraft fees at large banks from an estimated average of $32.50 to as low as $3 per overdraft. The CFPB’s press release suggests that the changes “may save consumers $3.5 billion or more in fees per year,” but its more detailed economic assessment acknowledges that the rule could “lead to evolving industry dynamics with uncertain benefits and costs.”^[1]

How are overdraft fees currently regulated?

Overdraft products and services generally have been exempted from regulation as consumer credit. Since 1969, when the Federal Reserve Board issued Regulation Z implementing TILA, charges imposed by banks for honoring overdrafts have not been considered a “finance charge” unless the bank has agreed in writing to honor the overdrafts in return for a fee.^[2]  The exemption from Regulation Z has been supported to date by language in deposit agreements that provide banks with discretion to pay or not pay an overdraft, which distinguishes overdraft fees from “finance charges.”  As a result, honoring an overdraft does not make a bank a “creditor” with respect to that discretionary transaction, subject to Regulation Z.  Regulation Z also makes clear that debit cards are generally not “credit cards,” even if their use results in an overdraft, and that banks that allow consumers to overdraw their account with a debit card and honor that overdraft are, therefore, not “card issuers” subject to additional provisions of Regulation Z.^[3]

Instead, overdraft has traditionally been regulated as a feature of a transactional deposit account under Regulation DD (implementing the Truth in Savings Act) and Regulation E (implementing the Electronic Fund Transfer Act).  Regulation DD requires disclosures regarding the fees a depository institution charges for honoring an overdraft in advertisements, account opening disclosures and periodic statements.^[4]  Regulation E requires disclosures and consumers “opt-in” to an overdraft service before a bank can charge fees when consumers overdraw their account through an ATM or one-time debit transaction – but these requirements do not apply to other types of transactions that result in overdrafts.^[5]  It also exempts credit extended pursuant to an “overdraft credit plan” from the generally applicable prohibition on conditioning the extension of credit on the consumer’s agreement to repay by preauthorized electronic fund transfer.^[6]

In 2016, the CFPB amended Regulation Z to provide that prepaid accounts that paid overdrafts were generally subject to Regulation Z’s rules governing credit cards.^[7]  Its rationale at the time presaged much of its rationale for this proposed rule: the historical reasons that the Federal Reserve Board exempted ad-hoc coverage of overdrafts – almost always from checks – from Regulation Z did not apply to prepaid products, which (unlike checks) could be declined by merchants on the spot when there was an insufficient balance and therefore generally would not result in NSF fees, fees from merchants and even potential criminal liability for passing bad checks.^[8]

Finally, overdraft services are – and will remain – subject to state and federal prohibitions on unfair, deceptive and abusive acts and practices, which recently has been the regulators’ principal tool for policing overdraft practices.

How would large banks be able to avoid coverage under Regulation Z for their overdraft services?

Under the proposed rule, a large bank’s overdraft fees would not be considered a “finance charge” and would therefore not trigger coverage under Regulation Z if the fees do not exceed the average direct costs and charge-off losses associated with providing the overdraft service.^[9]  The bank could calculate this permissible fee in one of two ways:

• It could calculate the fee on its own, by adding together all the direct costs (including its cost of funds and direct operational costs of providing the service) and charge-off losses from the previous year, and then dividing that amount by the number of overdrafts it honored in the past year for which it charged a fee.^[10]
• A bank could rely on a “benchmark” fee (i.e., a safe harbor fee), established by the CFPB.The proposed rule sets fourth four possible benchmark fees -- $3, $6, $7 and $14 – arrived at using different methodologies.The CFPB specifically requests comment on whether to provide this exemption from its proposed amendments to Regulation Z, and if so, the appropriate thresholds for fees.^[11]

If a large bank charged “above breakeven” fees for overdrafts, what regulatory obligations would be imposed?

If a large bank charged more for honoring an overdraft than its average costs and charge-off losses, the charge would be considered a “finance charge,” and honoring the overdraft would be regarded as an extension of “covered overdraft credit.”^[12] 

The proposed rule would require the bank to create a separate “covered overdraft credit account” from which it would extend “covered overdraft credit.” The proposed rule would prohibit the bank from treating any overdraft as a negative balance on a linked checking or other asset account.^[13]  Covered overdraft credit would be subject to Regulation Z’s rules for open-end credit, such as its disclosure obligations.^[14]

If the financial institution allowed consumers to use a debit card to incur overdrafts (as is typically the case now), the card would be considered a “hybrid debit-credit card” subject to Regulation Z’s rules governing credit cards,^[15] including:

• Limitations on:
  • Fees a consumer is required to pay during the first year.^[16]
  • Finance charges imposed as a result of the loss of a grace period.^[17]
  • Fees for over-the-limit transactions.^[18]
  • Penalty fees, which the Bureau interprets as prohibiting the imposition of non-sufficient fund fees or other fees when a financial institution declines a debit or ACH transaction on a hybrid debit-credit card.^[19]
• The requirement to analyze a consumer’s ability-to-repay before opening a “covered overdraft account.”^[20]
• Provisions regarding allocation of payments.^[21]
• Rules restricting increases in APR or finance charges on outstanding balances.^[22]
• The right to assert claims and defenses against a card issuer.^[23]
• Additional reporting and disclosure requirements specific to credit cards.^[24]

In addition, the financial institution would be prohibited from offsetting amounts due on the covered overdraft credit account with amounts in a consumer’s deposit account.^[25]

Significantly, these obligations would apply to existing overdraft lines of credit accessible through a debit card that are currently subject to Regulation Z, but currently not subject to rules governing credit cards.

The CFPB also proposes to amend the “compulsory use provision” of Regulation E to prohibit large banks from requiring consumers to agree to repay any balance on a “covered overdraft credit account” through a preauthorized electronic fund transfer.

Finally, the CFPB acknowledges that its proposed amendments to Regulation Z, if adopted, would trigger additional compliance obligations.  Specifically, “covered overdraft credit:”

• Would no longer be considered “incidental credit” and would therefore become subject to additional notice and record keeping requirements under Regulation B.^[26]
• Would trigger obligations under the Military Lending Act when offered to active duty members of the military, their spouses or dependents.^[27]
• Could become newly subject to state laws, including usury limits, that apply to credit transactions.

On the other hand, “covered overdraft credit,” now subject to TILA and Regulation Z, would no longer be subject to provisions of Regulation E and Regulation DD concerning overdraft services.

Simply put, covered overdraft credit obtained through a hybrid debit-credit card would be regulated like any other credit card.  The only difference is that it could only be used to cover overdrafts from a linked asset account.

Why is the CFPB only applying the new rules to large banks?

The CFPB says that large banks account for 80% of consumer deposit accounts and approximately 68% of overdraft charges as of December 2022.  The CFPB believes the proposed rule would benefit consumers of these banks, but it does not propose to extend the protections to consumers at smaller banks and credit unions, notwithstanding their proportionately higher rate of charging overdraft fees “[i]n light of the different circumstances smaller financial institutions may face in adapting to the proposed regulatory framework.”^[28]

The CFPB does not elaborate upon these different circumstances or explain how this non-statutory differential treatment is consistent with its mandate to promote fair competition in the markets for consumer financial products and services.^[29] Rather, it says it plans to monitor the market’s response to the rule before deciding whether to extend it to smaller institutions.^[30]  Smaller banks should consider whether to comment on the proposed rule, even if not currently applicable to them, as the CFPB may be less likely to change its substantive requirements if it does ultimately decide to extend them to smaller banks.

If this size distinction in the proposed rule is adopted and maintained, it will be interesting to see how it affects deposit offerings by different sized banks. Will large banks that cannot profitably impose overdraft fees set higher minimum deposit amounts, restrict “free checking” to larger customers or develop other stratagems?  Will smaller banks continue current practices or follow the practices of banks subject to the rule?

Did the CFPB follow the Small Business Regulatory Enforcement Act (SBREFA) process before proposing this rule?

No.  SBREFA imposes additional procedures on the CFPB before it proposes a rule that would have a significant economic impact on a substantial number of small entities.  The proposed rule would not apply to banks with less than $10 billion in assets, and because only banks with less than $850 million in assets are considered “small entities,” the CFPB has determined that it was not required to comply with SBREFA.

What’s next?

The CFPB requested comments by April 1.

^[1] Proposal at 157.

^[2] This exception, as slightly amended in 1981, is currently codified at 12 CFR 1026.4(c)(3).

^[3] See 12 CFR pt. 1026, Comment 2(a)(15)-2.ii.A.

^[4] See 12 CFR §§ 1030.4, 1030.6, 1030.11.

^[5] 12 CFR § 1005.17

^[6] 12 CFR § 1005.10(e)(1).

^[7] See, e.g., 12 CFR § 1026.61.

^[8] 81 Fed. Reg. 83934, 84158 (Nov. 2016).

^[9] Proposed 12 CFR §§ 1026.4(c)(3), 1026.62(b)(1), (d).

^[10] See Proposal at 68.

^[11] Proposal at 74-75.

^[12] Proposed 12 CFR §§ 1026.4(c); 1026.62(b).

^[13] Proposed 12 CFR § 1026.62(c).

^[14] See, e.g., 12 CFR §§ 1026.5, 1026.6(b)

^[15] The CFPB proposes to amend Regulation Z to make clear that a hybrid debit-credit card could not be considered a “charge card” even if it does not utilize a periodic rate.

^[16] 12 CFR § 1026.52(a).

^[17] 12 CFR § 1026.54.

^[18] 12 CFR § 1026.56.

^[19] 12 CFR § 1026.52(b); Proposal at 100-103.

^[20] 12 CFR § 1026.51.

^[21] 12 CFR § 1026.53.

^[22] 12 CFR § 1026.55.

^[23] 12 CFR § 1026.12(c).

^[24] See, e.g., 12 CFR §§ 1026.57, 1026.58, 1026.5(b)(2)(ii)(A), 1026.6(b)(2)(i)(F), 1026.7(b), 1026.9(c), (g); 1026.10; 1026.11; 1026.60.

^[25] 12 CFR § 1026.12(d)(1).

^[26] 12 CFR § 1002.3(c).

^[27] See 10 U.S.C. § 987; 32 CFR pt. 232.

^[28] Proposal at 33.

^[29] 12 U.S.C. § 5511.

^[30] Proposal at 7, 33.