Overdrafts: When Markets, Consumers, and Regulators Collide
There is a fierce debate in the United States about whether to regulate overdrafts and, specifically, about whether to limit their use or cap their prices. Proponents of regulation claim that overdrafts are not marginally priced and cause financial harm, particularly to those already facing financial hardship. Opponents of regulation claim that capping overdraft prices will harm consumers by limiting access to overdraft credit and causing transactions to be rejected. This paper conceptually unpacks some of these claims, while comparing the overdraft markets in the United States, the United Kingdom, and Israel. First, I argue that overdrafts can fulfill three different functions: (1) unintentional overdrawing and insurance against the rejection of transactions, (2) short-term “emergency” credit, and (3) long-term revolving credit lines. This distinction sheds light on why overdrafts are priced differently in each country, and how they compete with products such as payday lending and credit cards. Thus, while prices in the United States may be non-marginal when compared to short-term high-cost credit such as payday loans, competition with credit card companies might explain why overdrafts in the United States aren’t provided as long-term revolving credit at significantly lower prices, as is the case in Israel and the United Kingdom. Next, I offer that regulatory intervention must be tailored to each of these functions, addressing the unique market failures and cognitive biases associated with each of them. Inadvertent overdrafts can be mitigated with the use of technology and real-time notifications, and must coincide with the regulation of insufficient-funds charges. When overdrafts are used as emergency, short-term funds, they should be equated to other short-term high-cost credit, such as payday loans. Since banks have significantly lower overhead and risk-based costs, this indicates banks may be charging excessive prices, while exploiting consumers’ biases. Finally, while consumers in the United Kingdom and Israel may benefit from lower prices for inadvertent overdrafts and long-term credit, the design of overdrafts in these countries might reduce consumers’ welfare by limiting their ability to devise self-control mechanisms, exacerbating overconsumption and leading to high, chronic, and persistent levels of debt.
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