A Delicate Balance: Regulation, Stability, and Bank Rates

It’s understandable that last year’s banking crisis should spark a renewed drive for financial regulation. It’s unfortunate that the legislative responses so far seem to be barking up the wrong tree.

As promised (or threatened, depending on how you look at it) Senator Christopher Dodd introduced legislation designed to limit banks’ ability to charge overdraft fees. It seems a piece of well-meaning legislation — no one wants to pay a $30 fee for overdrafting an account by a few dollars. However, trying to micromanage a business via legislation can have unintended consequences.

Right now, customers have a clear choice if they don’t like overdraft fees — they can avoid overdrafting their accounts. This is not a Herculean feat — it just requires responsible recordkeeping and spending. Just about everyone overdrafts their account at some point, but most recognize this for what it usually is — their own mistake. They can learn from the experience and avoid repeating it.

However, if you reduce the penalty for overdrafts, will some customers be encouraged to act irresponsibly? Overdrafts cost banks money. If they can’t recoup that cost via overdraft fees, they will make it up somewhere else. They may have to offer lower bank rates, such as savings account interest rates and CD rates.

Alternatively, they could be pushed further away from making their fundamental banking businesses profitable, and resort to relying more on speculative investments. We’ve seen that movie before — trading profits look great when everything is going well, but they are fundamentally unstable. As last year demonstrated, they significantly leverage up the risk level of the banking system.

Consumers have choices that can reduce or even eliminate overdraft fees. Better to make them responsible for exercising those choices than to incur the unintended consequences of micromanaging via legislation.