Originally published on CBInsight.com, March 29, 2017
It is probably safe to assume that every reader of this article recalls from their youth the story of Goldilocks and the Three Bears.
Let’s forget for a moment that Goldilocks was a trespasser who rudely helped herself to the bears’ food and furniture and, instead, concentrate on the upside of her decision-making abilities. For all of her faults, Goldilocks knew how to make a decision that was exactly right for her (“Not too cold, not too hot… but, just right,” etc.). The same philosophy is applicable to how your institution sets its overdraft limits for your customers. A fixed limit, of say $500 for a certain type of checking account, may be too high for one customer, too low for another, or perhaps just right for some–based on their ability to repay the overdraft and fees at any given time. This “set-it-and-forget-it” limit-setting strategy can lead to service nightmares as customers (who deserve and appreciate the additional protection) are denied coverage when they attempt to pay for necessities when they inadvertently fall short of funds. Worse, it can leave some customers with limits far beyond their ability to repay, putting the institution at risk for higher charge-offs.
The safer and more customer-focused solution is to adopt Goldilocks’s decision-making strategy by adopting dynamic limits, which are ‘just right’ for each customer, as they more accurately align with the customer’s ability to repay. Using dynamic limits, you strive to pay more overdrafts for those who have the ability to repay, while paying fewer for those who do not. The strategy requires you to more diligently monitor an individual’s ability to repay their overdrafts and adjust limits for each customer as his/her situation changes.
Dynamic limits based on automated matrix-driven software have been around for over a decade, although community-sized banks have more often utilized fixed limits because of the previous high cost of developing or purchasing dynamic limit-setting matrices. That has changed, however, due to the availability of modern overdraft systems that calculate daily limits using advanced algorithms based on a myriad of account holder data points. The information gleaned helps to not only adjust overdraft limits, but alert you to suspend the service, suggest counseling, etc.
Right Decision. Right Reason.
While Goldilocks was seemingly more concerned about her own comfort than in obeying the law, your institution cannot be quite so cavalier. Federal regulatory guidance requires that financial institutions monitor the credit risk of each account holder.
As stated in the Federal Financial Institutions Examination Council (FFIEC) 2005 Joint Guidance on Overdraft Protection Programs: “Institutions also should monitor these accounts on an ongoing basis and be able to identify consumers who may represent an undue credit risk to the institution. Overdraft protection programs should be administered and adjusted, as needed, to ensure that credit risk remains in line with expectations.”
Employing dynamic overdraft limits helps your institution manage this risk and meet compliance demands by consistently applying the same risk factors (such as duration of account or relationship, related balances and deposit activity) to each and every customer, every day. While customers may receive different limits, those limits are the most appropriate for them at the time and are easily justifiable to regulators.
Not too much. Not too little. Just right.