High-to-Low Overdraft Charging Now in Danger at Community Banks, Too

As community banks adjust to big rule changes on overdraft fees, a new threat looms in the courtroom.

Recent lawsuits could stop community banks in at least two states from deliberately processing the largest transactions first — a method that triggers additional overdrafts and thus higher fees — after a California judge ruled against Wells Fargo & Co. last month.

The Wells decision may prompt regulators to prohibit the practice altogether, KBW Inc.'s Keefe, Bruyette & Woods Inc. warned in a study released Tuesday.

The case "could raise the whole issue of high-to-low service charges and its benefit or negative impact on consumers," said Jefferson Harralson, a KBW analyst and one of the study's authors. It's unclear who "will pick up the torch and continue to carry it, but the practice is laid out for review."

It's tough to predict how wide-reaching the effect of such a ban would be, Harralson said. In 2008 the Federal Deposit Insurance Corp. found that nearly 25% of banks surveyed process debit and check transactions from largest to smallest; of the surveyed banks with assets topping $1 billion, more than 53% used the practice.

Community banking companies that process transactions highest-to-lowest include the $3.6 billion-asset Renasant Corp. in Tupelo, Miss.; the $10.5 billion-asset Citizens Republic Corp. in Flint, Mich.; the $13.7 billion-asset Susquehanna Bancshares Inc. in Lititz, Pa.; the $6 billion-asset First Commonwealth Financial Corp. in Indiana, Pa.; and the $8.5 billion-asset Hancock Holding Co. in Gulfport, Miss.

Many banks that KBW surveyed would not disclose information about their processing practices. Several declined to comment when reached by a reporter, or did not return calls seeking comment.

It's also difficult to predict how a ban on the practice would affect community bank revenue, though the study said the Wells case is a good indicator.

In his decision in August, U.S. District Judge William Alsup ordered Wells to repay $203 million in fees — about 15% of the service fee income generated since it began processing transactions from high-to-low. The company is appealing the decision.

The study said other banks could face a similar hit, although Harralson noted that smaller banks may be somewhat less exposed, because they tend to focus more on commercial business while overdraft fee income tends to come from retail customers.

Nessa Feddis, a vice president and senior counsel at the American Bankers Association, said she expects regulators will eventually consider changes to rules affecting the order of processing. But she noted that the issue has been the subject of debate and litigation for decades, and said a Federal Reserve study found that customers want important payments — such as rent, mortgage or other bills — processed first, and they're willing to pay for it.

"I think it will be addressed, but it's a complicated issue," she said. "Consumer preferences vary, individual consumer preferences can vary based on the transaction or the day. So that's the tricky part."

Yet Harralson said the judge's decision in the Wells case was unusually critical of the practice, and unusually descriptive of the way the process works, providing a road map for future legal or regulatory action.

Since that ruling, a Minnesota woman filed a lawsuit against TCF Financial Corp. in Wayzata, Minn., for posting biggest-dollar transactions first, hoping to turn the case into a class action lawsuit. And a similar suit — also seeking class action status — was filed against the $16.6 billion-asset Bank of Oklahoma in Tulsa. Neither company returned calls seeking comment on the lawsuits.

Customers aren't the only ones who have taken action since the ruling. Umpqua Bank in Roseburg, Ore., sent a letter to customers last week saying that it would change its practice and process the smallest transactions first, rather than the largest ones, The Oregonian reported. A spokesman for the $10.8 billion-asset bank could not be reached for comment.

Meanwhile, other community banks remain focused on the changes to overdraft fee rules. Typically, they are upbeat about the number of customers opting in to overdraft protection while the bank looks for ways to recoup lost fee income, analysts said.

Matthew Kelley, an analyst with Sterne, Agee & Leach, said most of the bankers he has spoken with have reported that 70% to 90% of customers have requested overdraft protection since the changes started taking effect July 1 requiring them to opt in.

"Once a customer realizes what's at stake and what they could lose by not selecting that overdraft protection, most of them want to stick with [it]," Kelley said. "The tough thing is actually getting a customer to make a decision."

Harralson said banks have been fairly aggressive in contacting customers after a check or debit transaction has been declined, and have been highly successful in persuading those customers to enroll in overdraft protection.

Jeff Rulis, an analyst with D.A. Davidson Co., said bankers' biggest worry concerning the regulations — that their fee income would disappear — seems to be unfounded thus far.

Third-quarter results will paint a clearer picture, but so far most banks have reported higher than expected opt-in rates. And analysts said most community banks will be able to make up for lost fee income through other means.

"No one's really signaled that that is just going to fall off completely, in terms of the income side," Rulis said. "We've actually been pleased by the initial wave of people participating."

While some community banks are focusing on implementing the changes, others are considering further shifts in their overdraft programs.

TCF, which earns 25% of its operational revenue from fee income, has discussed the possibility of charging a fee for accounts with a negative balance of more than $5, rather than a separate fee for each overdraft charge, a method the KBW study said would buffer some of the revenue losses.

The study also noted another example: The $2.6 billion-asset City Holding Co. in Charleston, W.Va., has switched to "real-time" software that processes ATM and debit card transactions right away, while automatic drafts are processed at the end of the day. The company estimated a 12% to 15% reduction in service charges as a result of these changes, along with the other new regulations.

Analysts said bankers are still adjusting to the new rules, and are setting their sights next on changes to debit interchange rates and other regulations that could be issued by the new Consumer Financial Protection Bureau.

Kevin Fitzsimmons, an analyst with Sandler O'Neill & Partners LP, said most bankers would not be surprised by further changes to overdraft fees. "For a few quarters now, the overdraft issue has been a source of scrutiny," he said. "It's been an area where they know the regulators were going to come in and look at changes."