Why a Variable Limit Overdraft Program Hurts Your Bottom Line

Variable limit programs are primarily focused on reducing risk – essentially, reducing charge-offs.  Of course, having fewer charge-offs is a good thing but there’s just one problem.  The charge-off line item on the overdraft program P&L is the last line item to be worried about!  That might sound like heresy to most bankers, but it’s really just simple economics.

The table below shows a simple P&L for an overdraft program.  Overdraft protection is by far the most profitable service we offer in terms of return on capital.  In fact, it’s about 100 times more profitable than most loan portfolios!

This P&L assumes industry average overdraft fee income per account and a typical loss rate of 4% of total fees.  Clearly, I think we all would agree that writing off $32,800 to earn $787,200 in fee income is a pretty good deal!  Unfortunately, too often we get so focused on reducing the charge-off number that we lose sight of the other impact that action will have on the overdraft program.  When you think about it, how high would charge-offs have to be before you would consider the overdraft program’s financial performance to be poor?  The answer is the charge-off rate would have to be huge!  And the notion that we can have our cake and eat it too – i.e. lower charge-offs plus the same level of fee income is just a fantasy.

The fundamental concept behind variable limit overdraft programs is to adjust the overdraft limit based on account activity.  Usually, activity measures used to do this are average daily balance, deposit frequency and volume, times overdrawn or NSF, age of account, volume of POS debit card, ATM and ACH payments.  Fundamentally, low balances and deposit volumes result in low limits, higher measures result in high limits.  Here’s the problem – if you are a consumer with high average daily balances, high deposit amounts and fairly significant transaction volume you probably don’t overdraw your account much…if ever.  If you are a consumer with low average daily balances, low deposit amounts and less significant transaction volume you may be more likely to overdraw.  If you are the first consumer, what do you need a high overdraft limit for if you never use it?  If you are the second consumer you are far more likely to use your limit.

Why does this matter?  When it comes to overdraft fees, about 8% of consumer generate almost 80% of fees.  And these consumers tend to be low to moderate income – which means they likely have lower average balances and lower deposit volume.  If I reduce – or possibly even eliminate the limit on these consumers I am cutting off the largest source of fee income to the overdraft program – the line item that really matters!  Here’s the real kicker too – generally variable limit software solutions are very expensive.  So, you pay more to earn less.

In the table below we look at what would happen to the P&L outlined in the first table if we were to eliminate 10% of the overdraft activity – all from accounts that fall in the ‘8% group’ – those consumers who generate almost 80% of fee income.  We also assume – probably very optimistically – that this will reduce charge-offs by a whopping 50%.  This massive reduction in risk ends up reducing overall program profitability by almost $50K.

There’s another challenge with variable limit programs.  The consumer’s limit can change periodically based on account activity which makes it very hard for the consumer to know their limit at any given point in time.  Knowing the limit has been proven to be a key driver of usage, resulting in higher fee income.

If you want to maximize profitability of your overdraft program – ditch the variable limit system!  By definition, the consumers who drive usage – and the revenue – of an overdraft program are the consumers that represent the highest risk.  Why would you want to limit their usage or chase them away from your program?