With New Rules In Place, Old Overdraft Gimmicks Under Fire

photo:  Joshua Davis

On August 15, new overdraft rules went into effect, preventing banks from imposing overdraft fees on debit and ATM card transactions unless the customer actively opts in to have that feature.

The new rules have been largely hailed as consumer-friendly, with one caveat: they did not address the practice of reordering how multiple debit-card and check transactions post to one’s bank account. Many banks post transactions not in the order in which they were made, but from largest to smallest in terms of dollar amount. That practice, according to consumer advocates, effectively causes many people to overdraw their accounts sooner – and more often.

Consider this example: you only have $100 in your account and in one day you charge $5 at the coffee shop, $25 at a bookstore and an $80 at the supermarket. If the bank debited those transactions in the order you made them, you would overdraw your account just once and be charged one overdraft fee. But if it reordered those transactions from largest to smallest, you would overdraw your account twice and be charged two overdraft fees.

Now, a federal judge in California has taken issue with that practice. Last week, just as the media was getting busy reminding consumers of the new overdraft rules, Wells Fargo (WFC) was ordered to pay more than $203 million in compensation to customers who were charged overdraft fees thanks to reordering transactions in this way.

Wells Fargo collected nearly $1.8 billion in overdraft fees in California from 2005 to 2007. The bank plans to appeal the court decision.

If the decision is upheld, consumers have a lot to win, says Ed Mierzwinski, Consumer Program Director for the U.S. Public Interest Research Group. “Reordering checks is a gimmick banks use to increase overdraft fee revenue,” he says.

Even if the ruling is overturned, however, Mierzwinski expects that new Consumer Financial Protection Bureau that starts in 2011 will ban the practice.

In the meantime, consumers should set up low-balance email or text-message alerts from their bank, Mierzwinski suggests, and link their checking accounts to a credit line or a savings account, so that if they do withdraw their account the bank would make a transfer for a much lower fee.

The bigger question is, of course, how this court decision may affect the industry. With this practice now in the limelight, could other big banks take the lead and abandon it preemptively?

Greg McBride, a senior financial analyst at Bankrate.com, says he doesn’t think that’ll happen. Consumers have actually expressed preference that their largest payments are honored first because they are typically more important. “It’s cheaper for them to pay a $35 overdraft fee than pay a late fee on their mortgage payment,” he says “What they don’t want is to pay a $35 fee on a $3 transaction for a bagel and coffee and it’s important consumers are given that choice.”

Still, McBride adds, the frequency with which consumers encounter this practice will go down as a result of the new overdraft rules.

Jim Sinegal, associate director of equity research at Morningstar says this court decision will at the very least cause more people to focus on the fairness of overdraft fees.

“It just doesn’t make sense to charge a $35 fee for a potentially $1 dollar loan,” he says. “I think we are going to see a lot more pressure on those fees.”

As a result of the new overdraft rules – and, potentially, of this latest development with reordering transactions — banks might not be able to charge as much in overdraft fees. But, as usual, they will find other ways to make money. “Banks will find a way to pass some of these costs to their customers in different ways,” Sinegal says.