Economic Analysis and Competition Policy Research

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Last week, the Consumer Financial Protection Bureau and the Biden White House proposed to limit prices on overdraft protection by banks. This is smart policy and is backed by sound economics.

While inflation ran hot in 2022 and 2023, talk of price controls bubbled to the surface, even in economic circles. University of Massachusetts economist Isabella Weber pointed out that price controls were used successfully during World War II, and deployed effectively by Germany more recently to handle spiraling natural gas prices. Health policy professors interviewed last week by the New York Times noted that other countries, including Canada and France, use price controls to limit inflation in pharmaceuticals. Just a few years ago, price controls were a dirty word in economics—the only imaginable exception being for natural monopolies, where a price cap was set in a way to permit a normal rate of return.

Given the shifting attitudes towards price controls, the CFPB’s overdraft-fee proposal is likely to receive a friendlier reception among economists. The financial watchdog estimates that banks collect about $9 billion annually in overdraft fees, and customers who pay overdraft fees pay about $150 on average every year. Overdraft fees averaged $35 per event in recent years, and a bank can assess multiple fees for one overcharge episode whenever multiple checks bounce due to the overdraft. Moreover, banks engage in practices that induce overdrafts (or greater fees), such as refusing to deposit a check without a ten-day hold or engaging in “high-to-low reordering” (processing a large debit before smaller transactions, even if the latter are posted earlier).

The CFPB’s proposed rule would require banks to justify their overdraft fees on the basis of the bank’s incremental costs; if the banks could not do so, then the fee would be regulated at some price between $3 and $14. The rule would apply to large banks only, which some commentators have pointed out misses some of the worst offenders.

Vulnerable Aftermarkets

Economists recognize that market forces are especially weak when it comes to disciplining the price of ancillary or aftermarket services. The classic teaching example is movie theater popcorn. Customers do not have the price of popcorn on the top of their minds when choosing among theaters; the movie choice and the drive time are paramount. And when they arrive at a theater, customers are not likely to reverse their ticket transaction and find a new theater in response to sky-high popcorn prices; the switching costs would be too steep. The same is true for the price of other common aftermarket services, such as movie rental in hotels and printer cartridges.

Overdraft protection can be understood as an ancillary service to standard checking account services. As one economist at the Federal Reserve put it, “Most bank fees represent an example of add-on or aftermarket fees. Aftermarkets can be found in many industries such as printers (for toner), computers (software), razors (blades) and many others.” When someone is shopping around for where to set up their checking account, they will primarily consider the bank’s reputation and geographic footprint, the proximity of a physical office to their home, and the interest rate offered on savings. Overdraft protection likely is not top of mind, and even if it were, the bank won’t prominently display its overdraft fee on its webpage. Economists have learned through experiments that sending repeat messages to customers with a propensity to incur an overdraft fee was effective, consistent with customers having limited attention.

Indeed, I learned of Bank of America’s overdraft fee ($10) only by invoking the help tab on its website, and then looking through several documents that contained the term “overdraft.” The fee is buried in a document titled “Personal Schedule of Fees.” Given the high costs of switching banks, when a customer is hit with an exorbitant overdraft fee, there is little chance the customer will terminate the relationship—that is, the traditional forces that discipline supracompetitive prices are absent.

The American Bankers Association (ABA) rushed out a statement in opposition to the CFPB proposal, claiming that overdraft fee caps “would make it significantly harder for banks to offer overdraft protection to customers.” (This would only be true if the cap were set below the incremental cost of providing the service.) In support of its opposition, the ABA cited a Morning Consult survey, showing that 88 percent of respondents “find their bank’s overdraft protection valuable,” and 77 percent who have paid an overdraft fee in the past year “were glad their bank covered their overdraft payment, rather than returning or declining payment.”

There’s no doubt bank customers value overdraft protection and detest the notion of bouncing checks to multiple vendors. The relevant economic question, however, is whether market forces can be counted on to price overdraft protection at competitive levels (i.e., near marginal costs). So this survey was a bit of misdirection.

A relevant survey, by contrast, would ask bank customers whether they considered a bank’s overdraft fee when choosing with which company to bank, and whether they would consider switching banks upon learning of the bank’s high overdraft fee. If the answer to either of those questions is no, then bank customers are vulnerable to excessive pricing on overdraft protection.

Who Bears The Burden Matters

The typical customer who bears the burden of excessive overdraft fees is low-income, which means a policy of tolerating overcharges here is highly regressive. Consumer Reports notes that eight percent of bank customers, mostly lower-income, account for nearly three quarters of revenues from overdraft fees. According to a CFPB survey released in December 2023, among households that frequently incurred overdraft fees, 81 percent reported difficulty paying a bill at least once in the past year, another indication of poverty. The CFPB survey also notes that “[w]hile just 10% of households with over $175,000 in income were charged an overdraft or an NSF fee in the previous year, the share is three times higher (34%) among households making less than $65,000.”

When deciding whether to impose price controls of the kind contemplated in the CFPB proposal, the economic straights of the typical overdraft fee payor is important. Economists recognize that customers is aftermarkets are generally vulnerable to high prices, but do not counsel an intervention in each of these markets. A middle-class family that overpays for popcorn at a movie theater does not engender much sympathy; if the price is too high, then can abstain without much consequence. Similarly, learning that an upper-class family overpaid for in-room dining at a boutique hotel similarly does not tug at the heartstrings. But a low-income family that pays a $35 overdraft fee could be missing out on other important things like meals, and is in no position to refuse the service; refusing to comply might jeopardize their credit or banking relationship.

The Element of Surprise

In addition to the weak market forces disciplining the price of aftermarket services, bank customers are particularly vulnerable to exploitation given their lack of knowledge about the fees. The same CFPB survey mentioned above showed that, among those who paid an overdraft fee, only 22 percent of households expected their most recent overdraft fee—that is, for many customers (almost half), the overdraft fee came as a surprise. In discussing the fairness of surprise fees, Nobel prize winner Angus Deaton notes in his new book, Economics in America, that “If you need an ambulance, you are not in the best position to find the best service or to bargain over prices; instead you are helpless and the perfect victim for a predator.” Neoliberal economists might ignore these teachings, and instead trust the market to deliver competitive prices for ambulance services and overdraft fees. But anyone with a modicum of understanding of power imbalances and information asymmetries will quickly recognize that an intervention here is well grounded in economics.