Biden Administration Proposes Regulating Bank Overdraft Fees

The Biden administration has proposed regulating bank overdraft fees, which are charges banks levy on account holders when their account balances fall below zero. I’m rarely a supporter of government regulation, but in this case, the idea has merit.

First off, it seems to be consistent with contract law. I’m not a lawyer, so I’ll be happy to hear counterarguments from those more knowledgeable about contract law than I am, but in general, penalty clauses in contracts are not enforceable. Overdraft fees often seem to fit the definition of a penalty.

People do not intend to overdraw their bank accounts. Still, it may be difficult for people to keep track of their bank balances, especially when using debit cards. In any event, account holders will be liable for the charges on their cards, so overdrafts don’t give them free money. And it is reasonable for banks to charge overdraft fees that cover their expenses related to the overdrafts, so I’m not against overdraft fees. I’m saying that those fees shouldn’t be greater than the cost to the bank of servicing the overdraft.

One might argue that depositors agreed to those overdraft fees when they opened their accounts, but this argument is problematic because people do not open bank accounts to overdraw them. Overdrafts (almost always) occur accidentally as account holders lose track of their balances. It’s not like agreeing to buy a good or service. It’s a charge for something the account holder did not intend to have happen when the account was opened. It’s a penalty for the account holder’s oversight, and in general, penalties are not legally enforceable.

Few suggest that account holders facing overdraft charges go to court to fight them on the grounds that they are unenforceable penalties. The amounts are too small to make court battles worthwhile, which is why regulation seems a reasonable substitute.

One might also argue that competition among financial institutions should keep overdraft fees at a reasonable level, but in a world of imperfect information, most depositors won’t know what overdraft fees are charged by their banks until they overdraw their accounts. I’ve never overdrawn my account and don’t know what overdraft fees I would face if I did. Do you know the overdraft fees your bank charges?

If someone intends to make a transaction and signs a contract, those terms should be left up to the contracting parties. But when someone unintentionally violates a contract, as is (almost always) the case with overdrafts, the person should pay the reasonable cost imposed on the other party but not be penalized for an unintentional oversight. That is consistent with contract law in general.

I can envision problems with the proposed regulation, as with any regulation, starting with the issue of how reasonable overdraft fees would be calculated, leading to the possibility that financial institutions will be under-compensated for the costs they bear due to irresponsible depositors. The opposite is more likely to occur: overdraft fees will be set to overcompensate financial institutions.

Still, there is a strong argument for regulating these charges that nobody intends to face when they open their accounts.

Randall G. Holcombe is a Senior Fellow at the Independent Institute, the DeVoe Moore Professor of Economics at Florida State University, and author of the Independent Institute book Liberty in Peril: Democracy and Power in American History.
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