Risks of a dynamic limit strategy

Any overdraft or courtesy pay program these days faces an intense level of scrutiny. On the one hand, you have regulators calling for overdraft reform and increased focus on overdraft practices during exams. The CFPB published two reports on the subject in December of 2021 – one emphasizing financial institutions’ reliance on overdraft fees and the other assessing the impact on consumers. The CFPB said in the accompanying press release that it will be “enhancing its scrutiny of banks that are heavily dependent on overdraft fees.”

And on the other hand, you have consumer demands for transparency. They don’t want to be handed a brochure of fine print or be surprised by fees that they don’t understand. It is increasingly easy to change financial institutions, so consumers that feel that their financial institution has opaque overdraft practices may look for an alternative.

While community financial institutions should routinely evaluate their overdraft programs, one practice, in particular, introduces an increased level of risk: dynamic limits. Credit unions should strongly consider if that risk is worth any potential benefits that such a program may provide.

The rise of dynamic limit strategies

Historically, most community banks and credit unions have favored fixed overdraft limits, where consumers are assigned a limit at account opening, and the limit rarely changes.

Dynamic limits use variables such as the age of the account, overdraft history, account holder relationship, and consumer behavior to change the limits over the overdraft. The limits may also change periodically, as frequently as daily.

In the past, such programs were too complex for many community financial institutions to manage; however, technological advances in AI-driven models have increased their prevalence. Financial institutions can rely on algorithms to assign a dynamic limit based on the pre-determined variables.

The argument in favor of dynamic limits has been that such programs provide more personalized service to borrowers. Limits may be assigned based on a borrower’s ability to repay, for example. In theory, this also complies with the FFIEC’s Joint Guidance on Overdraft Protection Programs, which states that “institutions should monitor these accounts on an ongoing basis and be able to identify consumers who may represent an undue credit risk to the institution.”

While dynamic limit programs may have had some appeal in the past, in today’s environment they don’t hold up against the combination of regulatory and consumer pressures.

Regulatory and legal scrutiny increase

In its March 2022 publication Consumer Compliance Supervisory Highlights, the FDIC devoted a section to automated overdraft programs and the conversion from static to dynamic limits. Citing Section 5 of the FTC Act for deceptive acts or practices, the FDIC found in consumer compliance examinations that several institutions had failed to disclose the key changes when moving from a static to a dynamic limit. Specifically, the FDIC wrote that “changes in overdraft coverage without adequate disclosure resulted in consumer harm.”

Additionally, there has been an increase in overdraft-related class action lawsuits against financial institutions of all sizes. While lawsuits themselves are nothing new, the tactics have shifted. Previously, plaintiffs focused on violations of the consumer’s account agreement. Now, they’re focusing on unfair and deceptive practices — where the institution benefits from the increase in how fees are assessed.

Between the potential regulatory and legal issues, it’s clear that community financial institutions need to tread lightly when considering a dynamic limit program.

Risks outweigh benefits

The FDIC’s commentary in the Highlights publication indicated that financial institutions could mitigate the risks of a dynamic overdraft limit by “disclosing changes to overdraft limits in real time to consumers, as these vary, with the opportunity for consumers to adjust their behavior.”

While this may seem to resolve the issue, implementing such notifications may be challenging. By their very nature, dynamic limits can change daily and consumers may not receive the disclosures with enough time to adjust – particularly since such notifications assume that consumers are consistently checking email or in-app banking notifications.

Furthermore, such notifications may be confusing to consumers who may not understand why the limits have changed. Without explaining the complexities behind the algorithm, consumers may be caught off guard or feel that they can’t make spending decisions without knowing their overdraft limit. And if an explanation is provided, it opens the door for potential litigation as a discriminatory practice against lower-income account holders.

Any financial institutions considering a dynamic limit strategy — including those that have already implemented one — would do well to evaluate the potential risks. Between regulatory scrutiny and heightened consumer awareness, all institutions should be emphasizing transparency and consumer benefits in their overdraft programs.