Banking on a timely warning
A United Kingdom-based study led by Associate Professor of Economics Michael D. Grubb found that automatically enrolling bank customers in a text message alert program significantly reduced overdrafts and resulted in massive potential consumer savings.
The field experiment, conducted by a multinational research team, examined transactions at the six largest retail banks in the UK during 2017. Grubb and his colleagues, who report the findings in The Journal of Finance (“Sending Out an SMS: Automatic Enrollment Experiments for Overdraft Alerts”), say the results indicate that low-income customers, frequent overdrafters, and financially vulnerable consumers—all of whom policymakers most want to assist—can significantly benefit from text alerts.
Through the program, overdrafts and unpaid item charges declined by 4 to 19 percent, resulting in an annual, nationwide potential consumer savings range of nearly $213 million to approximately $300 million at today’s exchange rate (the researchers measured the savings in British pound sterling at £170 to £240 million at the time).
Michael Grubb (Lee Pellegrini)
“Bank overdrafts are one of the most common but one of the most expensive forms of consumer borrowing,” Grubb noted. “Automatic enrollment in just-in-time alerts provides a large consumer benefit without offsetting consumer harm.”
An overdraft occurs when a consumer has an insufficient account balance to pay for a transaction, but the financial institution pays it. Typically, a UK bank pays an overdraft transaction by extending overdraft credit—using its own funds and then requiring the consumer to repay.
At the time the study took place, overdrafts in the UK incurred a mix of daily charges, ranging from $6 to $12, and interest rates of 11 to 67 percent, in addition to unpaid item charges of $6 to $31 per declined transaction.
In 2017, overdraft and unpaid item charges in the UK totaled an estimated $3.26 billion (£2.6 billion). In the nation’s poorest areas, the one percent heaviest users spent $468 on average on unarranged overdraft charges in 2016.
Adjusted for default risk, the U.K.’s Financial Conduct Authority (FCA) estimated that the average overdraft mark-ups—the amounts added to the cost to drive profit—are three times higher than those for credit card lending or unsecured personal loans. Additionally, previous studies demonstrated that consumers often have access to lower-cost sources of liquidity at the time of their overdraft borrowing, which they could use rather than incurring overpriced overdraft fees.
According to the researchers, inattention to account balances is the principal theory for overdrafts, so requiring banks to automatically enroll their customers in text message alert programs should reduce overdraft fees, a policy they note was implemented in 2018 by the Competition and Markets Authority—the UK’s principal competition regulator—and extended by the FCA, which expanded the mandate to cover more banks and more overdrafts.
They noted, however, that their examination does not reveal what the banks’ pricing response would be once the alerts were installed across the market.
“Since alert mandates represent a regulated cut in revenues from hidden charges, a natural concern is that banks will raise overdraft fees or other charges to offset the lost revenue,” Grubb said. “Nevertheless, we are optimistic that UK retail banks will respond to the regulated cut in hidden charges similarly to United States retail banks, which did not adjust prices to offset the 2009 CARD Act reductions in hidden credit card charges.” The CARD (Credit Card Accountability, Responsibility, and Disclosure) Act is a U.S. federal law that aims to protect consumers from unfair credit card practices.
The researchers emphasized, however, that text message alerts were not a panacea.
“Bank customers had sufficient financial resources to avoid over 50 percent of the overdrafts by drawing on savings or lower interest credit card accounts,” they noted. “However, text message alerts reduced charges by much less than 50 percent, suggesting that banks can still profit off consumers’ mistakes. While text messages are beneficial, this shows that additional measures are necessary to fully protect consumers.”
In a directly related development, on December 12, 2024, the U.S. Consumer Financial Protection Bureau announced the finalization of its rule addressing overdraft fees. Effective this coming October 1, financial institutions with more than $10 billion in assets can choose to cap their overdraft fees at $5—a steep drop from the average fee of approximately $35 per transaction—or limit the fee to an amount that covers the lenders’ costs or charge any fee but disclosing the loan’s interest rate. [In the wake of the administration change, the rule’s fate is unclear.]
In addition to Grubb, the research team included Darragh Kelly, a senior apps growth manager at Google Ireland; Jeroen Nieboer, a London School of Economics fellow and a data science and machine learning manager at British online food delivery company Deliveroo; Matthew Osborne, an associate professor of marketing at University of Toronto; and Jonathan Shaw, a technical specialist at the FCA and a research associate at the Institute for Fiscal Studies, a London-based independent economic research institute.