November 9, 2011

The Economics of Overdraft Protection Regulations

Todd Zywicki

Senior Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics
Summary

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Since the Federal Reserve changed the rules in 2009 to require banks to let customers “opt-in” to overdraft protection on their debit card purchases and ATM withdrawals, few have taken a comprehensive look at overdraft protection and the effects of regulating it. Todd Zywicki, senior scholar with the Mercatus Center at George Mason University, has done just that, releasing a paper that seeks to understand who uses overdraft protection, why they use it, and what the effects of regulation have been for bank customers.

“Most justifications offered for regulating overdraft fees fall into one of two categories,” Zywicki said.

“Either they are an attempt to fill a perceived information gap for consumers (based on the assumption that decisions about financial products often require information unavailable to the average consumer) or as a means of paternalism (based on the assumption that consumers would not make the ‘right’ choice about financial products even with perfect information),” he added.

Unfortunately, according to Zywicki, these assumptions can be wrong, or based on misleading statistics.

“When the Federal Reserve began exploring overdraft protection regulation in 2009, they based their conclusions on the responses of a survey of only six individuals, and made no determination of the relative cost of an opt-in versus an opt-out system for overdraft protection,” Zywicki said.

Zywicki also noted that common assumptions about who uses overdraft protection, why they use it, and the effects of regulating it are often somewhat misguided.

“There is no evidence, for instance, that those who use overdraft protection are unaware of the cost or otherwise use overdraft protection foolishly or unknowingly,” Zywicki said.

“In fact, overdraft protection can maintain short-term liquidity needs better, is sometimes less expensive, and can be more convenient than alternatives like payday lending, bounced checks, or dishonored payments,” added Zywicki.

Data indicates that consumers are also willing to take action to keep their overdraft protection, according to the study. At various large banks, 60-80% of customers opted-in to debit card overdraft protection when given the option.

“Overdraft protection fills a unique need in the consumer credit marketplace,” Zywicki argues.

“It provides a convenient, flexible line of credit accessible 24-hours a day on demand anywhere in the world. If access to overdraft protection is taken away, where will consumers who count on it turn?’