The Fed’s announcement on Thursday of a new rule prohibiting overdraft fees on debit card and ATM transactions without consumer opt-in is an economic earthquake for retail banks.

The Center for Responsible Lending has estimated that banks make $23.7 billion in overdraft fees annually; the New York Times said this morning that Fed officials had put the total at $25 to $38 billion, including check overdraft fees (which are not covered by the new rules).  In either case, it’s a large amount.  Perhaps of more concern, the CRL’s analysis also indicates that the burden falls disproportionately on the less affluent – just 23% of adults with bank accounts suffer more than five overdrafts per year, and probably account for the lion’s share of the total revenue.  That means that the few (possibly irresponsible, certainly less affluent) are subsidizing the cost of checking for the many.

Retail banks have three principle sources of revenue for checking accounts – net interest income (the value of the balances), debit card interchange, and fees.  Consumers haven’t tolerated much in the way of direct fees, so overdraft fees have been the bulk of fee income.  We calculate debit card interchange as about $22 billion a year – in the same ballpark as overdraft fees.

It will be exceptionally interesting to watch what banks do about this.  Some things to expect:

• Aggressive attempts to get consumers to “opt-in” for the “convenience” of overdraft facilities – with heavy emphasis on the importance of avoiding bounces on mortgage payments and the like.  Don’t expect banks to point out that the rules don’t apply to standing debit card transactions (recurring payments).
• A reduction in the overdraft fees charged.  After all, if you are asking a consumer to “just say yes” to a service, it will have to be priced reasonably.
• An increase in the balance requirements for “free checking” – with hefty fees if the balances aren’t met.
• More pressure on card networks to keep debit interchange high.

Finally, I expect that this will be a shot in the arm for open-loop prepaid card issuers (Wal-Mart Moneycard, etc.).  With balance requirements and fees on traditional banking accounts probably increasing, and the utility of the open-loop cards also increasing, I think more consumers will opt for the non-bank alternative.

At a Kansas City Fed conference on the future of retail payments held earlier this week, Harry Leinonen, an advisor to the Bank of Finland, said that hidden pricing is the main problem with the payments market – that if payments pricing were visible, innovation, efficiency and choice would flourish.  The Fed’s actions seem to be a good step towards less hidden pricing.

We’ve been saying for a while that overdraft fees for bankers are like heroin – they know it’s bad for them (particularly in building the trust relationship with customers that they want), but the revenue just feels so good….  The Fed’s new rules are detox – the rehab period will follow.