Algorithm-based overdraft protection lacks disclosure transparency

There’s no doubt that algorithms can reach levels of analysis that humans alone can’t make. In banking, AI might identify fraudulent activity or improve fair lending practices — both of which ultimately offer benefits.

At a recent industry event, CFPB Director Rohit Chopra said that the rapidly changing payments landscape, particularly Google and Apple Pay, is changing the way consumers engage with money, which presents challenges, especially for smaller financial institutions. The challenges have contributed to a shift from relationship banking toward algorithm banking, which can have detrimental effects.

When it comes to overdraft protection programs, algorithm-based models have their limitations.

Because algorithms often have murky calculations when it comes to overdraft protection, they can damage your member relationships.

The negative impact of AI-driven models

Financial institutions turn to AI-driven models of overdraft protection most frequently when they’re implementing a dynamic limit strategy. Rather than applying a fixed overdraft fee structure, an algorithm uses variables such as overdraft history and consumer behavior to change the limits of the overdraft.

Undoubtedly, the payments landscape has changed dramatically. Accessibility and convenience have pushed digital wallet purchases to more than 48 percent of global e-commerce transactions in 2021, according to The Global Payments Report by FIS. With your members relying heavily on digital payments, both online and in-store, it can be hard for them to understand their account balances and even harder if they don’t understand how your overdraft program works.

Think of the scenario where a member doesn’t understand their dynamic limit. They contact their financial institution and ask for an explanation. It’s unlikely that an employee would be able to specifically answer “why” when the overdraft limit is determined by an algorithm.

Overall, this lack of transparency is not a relationship-first approach and can create distrust among your members.

Reduce risks with transparent disclosures

When asked about overdraft program rulemaking at the event, Chopra said, “We are looking at a host of issues, and it’s a complicated rule. We know that it’s going to involve some costs for institutions trying to report the data. We’re working on the contours and hope to get this completed within three to five months.”

Even though the CFPB says it will scrutinize overdraft programs, it has talked about rulemaking for years and that has never come to fruition. Still, community financial institutions can look to the bureau’s recent policy statement and other regulatory guidance around overdraft programs — and disclosure transparency as a key pillar.

The Consumer Compliance Supervisory Highlights released by the FDIC in March of 2022 found several shortcomings in disclosures from banks that had implemented an algorithm-based overdraft program. Specifically, the FDIC emphasized that overdraft programs must “comply with all applicable Federal law and regulations, including the FTC Act, which prohibits unfair or deceptive acts or practices.”

If account holders don’t understand the overdraft program, it can constitute a violation under the FTC Act. Transparent disclosures that inform the consumer exactly when and how fees will be assessed allow them to make a more informed decision. Moreover, transparency is aligned with the relationship-first approach: credit unions are financial partners for their members.

Overdraft protection remains a valuable service

While some financial institutions have opted to eliminate overdrafts rather than appease the regulators, it remains a service that consumers depend on. According to a survey conducted by Morning Consult on behalf of the American Bankers Association, 61 percent of consumers think it’s reasonable for financial institutions to charge a fee for overdrafts. The number jumps to 74 percent when overdraft fees ensure that large payments like rent or mortgage are paid on time.

As shown by this survey, the majority of consumers appreciate access to overdraft protection. To continue providing this service while reducing risk, credit unions would do well to stay abreast of industry trends and ensure that their disclosures meet regulatory guidance.

To learn more about how JMFA can assist with implementing a compliant and pro-consumer overdraft service, contact your local JMFA representative.