Regulation E: Are the problems with overdraft protection properly addressed?

I. Introduction

                In 1984, in the earliest days of the debit card, legal commentators were already considering the need for the legislature to curtail the banking practice of “Insufficient Fund Check Charges,” now colloquially referred to as overdraft fees. [1] The battle against overdraft fees failed in the 1980s when the courts largely agreed that overdraft fees were a competitively-priced "service" and therefore not subject to rules against unconscionability or penalties. [2] The battle against such fees, however, is ongoing. Twenty five years later, the latest battle in the war against overdraft fees came to a victorious end when the Federal Reserve Board, at the behest of President Obama, created a new regulation limiting the practice in significant ways. [3] This article will begin by summarizing the overdraft protection scheme typically used by banks. It will then consider the arguments against these practices, and finally, consider whether the Federal Reserve Board regulation addresses these arguments and problems.

II. How it works

                As it currently stands, the system relies on a scheme known as overdraft protection, which has the banks protecting consumers from bouncing checks and transactions for a fee. The effects of overdraft protection on consumers and consumer checkbooks are exacerbated by a practice known as high-to-low check posting, in which banks post checks and transaction to customer accounts in the order that will lead to the highest number of charges possible. 

               A. Overdraft Protection

                Overdraft protection, often called bounce protection, is a "service" offered by banks.  If a bank consumer with overdraft protection overdraws on a checking account, the bank will pay the money owed for the consumer; the consumer will then be charged a fee for this service.[4] Oftentimes, consumers are enrolled in these programs automatically, and are not aware of their ability to opt out. [5]

                This operates to mean that overdraft protection is a lending scheme. The bank makes a small loan for every overdrawn transaction to prevent consumers from bouncing checks or having declined card purchases.[6] However, these "loans" are not considered to be lending as such and therefore not subject to the Truth in Lending Act. [7]

                The Truth in Lending Act was passed in 1968 as an attempt to protect and inform consumers in credit transactions. [8] Particularly, the act requires the disclosure of the key terms and costs of lending agreements.  [9] Lenders and creditors are required to provide consumers with a standardized accounting of the real costs of their lending arrangements. [10] This is done through APR, annual percentage rate, which includes not only interest but all the associated costs of a loan to determine the annual cost as a percentage of the original loan. [11] Simplified, this means that if a lender lent $100, with $20 in interest, with a $5 fee, that lender is required to inform the customers that while the interest rate is 20%, the actual costs of the loan actually amount to 25%. However, overdraft protection is not currently covered under this act. [12] This means that banks are not required to present consumers with information regarding the effective cost of borrowing through overdrafts. Customers are therefore not informed of the true cost of the loan the bank makes when they overdraw.

                Before the new regulations, consumers were typically automatically enrolled unless they affirmatively chose to opt out. [13] Banks offered overdraft protection to consumers, ostensibly under the theory that nearly all consumers would want to avoid the embarrassment of having a transaction denied or a check bounced. [14]

                B. High-to-Low Check Posting

                One of the practices of banks that has a very significant effect on overdraft protection is what is typically known as high-to-low posting.[15] High-to-low posting is a method of posting checks and transactions to accounts from highest to lowest amount.[16] Posting method has little effect on the average consumer. However, when the consumer has written a check that will overdraw his account, high-to-low posting can serve to maximize the number of overdraft transactions [17], and therefore the number of itemized fees collected by the banks.

                In practice, this means an increase in overdrafts. Because checks and electronic transactions are not immediately posted to an account, but in fact posted at the end of the business day, banks have discretion in choosing the order in which they are posted. Going from highest to lowest generates the highest amounts of overdraft.

                For example, if an account has $100 in it, and 4 checks are written for $10, $16, $48, and $92, there could be as many as three overdraft transactions, or as few as one. If the checks are processed from lowest to highest, there is $26 left in the account when the $92 check is posted, and the account overdraws a single time, incurring one fee. If the $92 check is posted first, the account will overdraw when each of the subsequent checks are posted, leading to three transaction fees.

                This means that the banks purposely chose a posting order that would maximize overdraft transactions, and therefore fees and profits. Some have suggested that this practice is unfair and unjustly punishes consumers much more than necessary for overdrawing their accounts. [18]

III. Arguments against Overdraft Fees

                There has been much writing on the issue of overdraft fees. The appearance of the debit card as a "check-like" device created some legal challenges in the 1980s. The recession and recent credit crisis has led to a renewal of critical interest in overdraft practices, leading to a new body of academic thought on the issue.

                A. The 1980s and the Contract Argument

                In the 1980s, several legal challenges were brought against overdraft fees as the advent of debit cards made the fees much more economically relevant. [19] The legal arguments turned on points of contract law, with the opponents of overdraft fees claiming that the fees were either unconscionable, unenforceable, or punitive and therefore barred by contract law. [20]

                Legal commentators noted that the contracts that banks used to charge overdraft fees were questionably enforceable.[21] In part, they charged the banks with forcing contracts of adhesion on clients while unfairly surprising them with fees that were not disclosed up front and that were generally excessive, thereby creating an issue of unconscionability. [22]

                 Furthermore, they argued that the overdraft fees were penalties for breach rather than any sort of recuperation for the bank. [23] The belief was that the fees were being unlawfully charged as a penalty because banks incurred costs believed less than a dollar for each overdraft and yet charged much, much more. [24] The courts, however, disagreed, voicing the opinion that the overdraft was not a fee but rather a service, where banks charged a fee to honor consumer transactions instead of declining them out right. [25]

                B.  The 2000s and the Misinformation Argument

                More recently, commentators have focused on overdraft fees from a different angle. Several have focused on the misinformation surrounding overdraft practices. A significant recurring argument is one that centers on overdraft protection's omission from Truth in Lending disclosure requirements. [26]

                 Critics argue that banks operate overdraft protection at great profit by misinforming their consumers. [27] Particularly, they believe, the unavailability of APR figures prevents consumers from understanding the true costs of overdraft protection. [28] One commentator noted that the average consumer with average bank fees would, in the average repayment period of two weeks, incur what works out to an 884% annual percentage rate. [29] This same commentator further notes that many ATMs have been known to list the bounce protection limit of an account as available funds, thereby fooling consumers into bouncing checks and transactions. [30]

                 Other academic arguments center not on whether banks have been misinforming customers, but rather on what banks should need to tell consumers about these fees. [31] Their debate is largely framed in light of the new rules regarding the advertising of overdraft services and whether or not they are sufficient for consumers to make fully informed decisions.[32]

                Others still argue that high-to-low check posting itself constitutes misinformation because it is done without clear notice to consumers and against their basic expectations. [33] They further contend that it is perpetrated against the consumers in bad faith, for the sole purpose of collecting profits. [34] For example, the Texas State Bar Committee has suggested that it is unlawful for a bank to implement high-to-low posting simply for the purpose of collecting more fees. [35]

IV. The New Rule 

               The new rule by the Federal Reserve Board, Regulation E, provides that, on July 1, 2010, all overdraft protection schemes are to be opt-in only, rather than opt-out. [36] The rule will further require that banks broadly explain the terms of overdraft protection and the fees associated with it. [37] It also provides that a consumer’s choice not to take part in overdraft protection cannot be cause for different account terms, such as different interest rates. [38]

                The new regulation does not put overdraft fees under the requirements of the Truth in Lending Act. It also does not control overdraft fee amounts, or the effective interest rate and APR of the loans made by the banks under the guise of overdraft protection. Finally, it does not control any overdraft-related bank activities such as high-to-low check posting.

                By making overdraft protection an opt-in proposition, the arguments made in the early days of the fees, in the 1980s, are generally addressed. Consumers will now be willingly entering into a contract for overdraft protection with the banks and will therefore be forewarned of the possibility of fees. However, the later arguments are not addressed by this regulation. Exclusion from Truth in Lending disclosures means that consumers may not have a clear idea of the actual cost of overdraft protection. Furthermore, the allegedly unfair check posting practices that maximize these potential fees continue to exist. As such, only part of the problems previously identified have been rectified.

IV. Recommendation

                The new Federal Reserve rule regarding overdraft fees remedies in great part the biggest and most obvious flaw with overdraft fees: misinformation. By forcing consumers to actively seek overdraft protection, and therefore overdraft fees, and by forcing to fully inform consumers as to the terms of such an agreement ahead of time, consumers are now forming informed contracts with their banks. However, some problems remain.

                First, the amount of the fees remains unchecked. Banks argue that they use fees to incentivize consumers to act prudently vis-a-vis their checking accounts. However, it is unclear whether the amount charged is optimal to incentivize good consumer behavior. If lower fees would create the same incentives, they should be put in place. Banks and consumers have entered a contract. Breach by the consumer in the form of an overdraft cannot and should not, according to contract law, lead to punitive damages and a windfall for the bank. If the banks are not incurring damages of a magnitude similar to that of the fees, and if their fees are not necessary to incentivize consumers to practice good banking, then it may be the case that the Federal Reserve should revise their regulations to control the amount charged in fees.

                Second, banks are still allowed to continue other practices that have generally been regarded as unfair, unnecessary, or ill-advised. The new regulations only requires consumers to be aware that they are agreeing to overdraft protection, but it does not provide with more information as to how it actually works. Particularly, they are still not fully informed as to the terms because overdraft protection is not subject to Truth in Lending disclosures. As such, the Federal Reserve's rules fail to fully account for the problems created by overdraft fees and new regulations should be put in place to require disclosures for overdrafts, by either including overdraft protection in the Truth in Lending Act provisions, or creating a similar regulation tailored more specifically to overdraft protection.

                Thirdly, the practice of high-to-low check posting has not been addressed under this new regulation. While giving the banks their autonomy in such practices is important, the current methods of check posting seem to be designed solely for the purpose of maximizing overdraft fees. The Federal Reserve Board should at least consider the effects of potentially altering this practice. If the banks can maintain a healthy level of profit without it, the practice should be outright eliminated. If not, it should be scaled back and more closely monitored and controlled to prevent abuse of the system.

V. Conclusion

                The Federal Reserve Board has taken a great step towards informing the general public about the finer points of overdraft practice with their new rule. By forcing banks to require active approval of overdraft protection, the rule forces banks to educate their clients. It further requires clients to actively agree and therefore eliminates the possibility of being blind-sided by overdraft fees. However, some of the arguments brought up against overdraft fees in the past remain unaddressed. The regulation is a fair start in addressing the obfuscation in the realm of overdraft policies, but it is not a coup-de-grace against what legal commentators describe as deceitful banking practices.

[1] Daniel K. Weiss, Insufficient Fund Check Charges: The Need for Legislative Action, 45 Ohio St. L.J. 1003 (1984).
[2] See e.g. Shapiro v United Cal. Bank, 133 Cal. App. 3d 256 (1981).
[3] Stephen Labaton, New Rules Would Restrict Overdraft Fees on Debit Cards, N.Y, Times, Nov. 12, 2009.
[4] Sarah Tennant, Bounce Protection Plans: Consumer Convenience or Disguised Deception? 21 Loy. Consumer L. Rev. 540, 540 (2009).
[5] Id.
[6] Id.
[7] Id. at  543.
[8] See generally Comptroller of the Currency, Truth in Lending: Comptroller's Handbook (Oct 2008) available at
[9] Id
[10] Id
[11] Id
[12] Id
[13] Id.
[14] Id.
[15] Willie E. Spruill, The Exploitation of Bank Charges and Undermining of Consumer Protection: Exploring the Realms of High-to-Low Check Posting, 13 NC Banking Inst. 433 (2009).
[16] Id.
[17] Id.
[18] Id.
[19] Weiss, supra note 1.
[20] Id.
[21] Id.
[22] Id.
[23] Id.
[24] E. Robert Wallach, Banks Fight Class Actions on Surcharges, 3 Cal. Law. 14, 15 (Jan. 1983).
[25] See e.g. Perdue v Crocker Nat'l Bank, 141 Cal. App. 3d 200, 209 (1983).
[26] See e.g. Tennant, supra note 4; Jennifer S. Martin, How your $4 coffee can cost you $39 or more if you use your debit card! Federal level consumer protection and modern payments transactions, 39 U. Mem. L. Rev. 805 (2009).
[27] Id.
[28] Id.
[29] Tennant, supra note 4, at 543.
[30] Id. at 543-44.
[31] See e.g. Carolyn M. Gillikin, Overdraft Protection Programs: Consumers Still in the Dark after Regulation DD, 10 N.C. Banking Inst. 231, 234 (2006).
[32] Id.
[33] Spruill, supra note 11, at 439-42.
[34] Id.
[35] Tex. Bus. & Com. Code Ann. §4.303 (2007).
[36] Press Release, Board of Governors of the Federal Reserve System (November 12, 2009) (available at
[37] 12 CFR §205 (2009)
[38]  Id.