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All that talk in Washington about holding banks accountable for hefty overdraft fees is finally turning to action.

Last week, Sen. Christopher Dodd, the Senate Banking Committee Chairman, proposed tough new legislation that goes way beyond what banks like Chase (Stock Quote: JPM), Citi (Stock Quote: C) and Bank of America (Stock Quote: BAC) have already promised to do about cutting overdraft fees. Here’s the brand new proposal, and what it means for banks and customers.

While Washington has been whispering for weeks about new bank consumer protection rules, up until now nobody has put any numbers or specifics on the table. The Dodd bill does so by pinning down banks on the number of times overdraft fees can be levied as well as taking dead aim at the size of the overdraft fees.

Congress isn’t happy with banks these days. Many financial institutions were bailed out by taxpayers, only to turn around and raise consumer overdraft fees — or, as the banks called them, overdraft protection programs.

Particularly irksome to consumers is the way that banks prioritize overdraft penalties. Banks can make more cash by green-lighting larger checking account withdrawals first, thereby draining bank accounts and leaving less money to cover other purchases. By law, banks don’t have to let customers know that their accounts are overdrawn. Bank consumers don’t realize it until they check the account and see the dreaded minus sign to the left of their account balance, along with both the checking account overdraws and the accompanying fee deductions.

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Congress has a knack for pushing the law of unintended consequences, but it might be on to something here. The new legislation, called the Fairness and Accountability in Receiving (FAIR) Overdraft Coverage Act, seeks to give bank customers more flexibility in avoiding “fee-shock” scenarios where consumers wake up to see hundreds of dollars removed from their bank account.

According to Sen. Dodd’s Web site, the new legislation:

  • Requires banks to get a customer’s consent before enrolling them in an overdraft protection program for ATM and debit card transactions;
  • Limits the number of overdraft coverage fees banks can charge to one per month and six per year;
  • Requires fees to be proportional to the cost of processing the overdraft;
  • Stops institutions from manipulating the order in which they post transactions in order to rack up extra fees,
  • Requires customers be notified when they overdraw their account and be given the option of being notified by e-mail, text or traditional mail; and
  • Requires that customers be warned if an ATM or branch teller transaction will overdraw their account, and be given the chance to cancel the transaction.

Banks have tried to get in front of this issue by promising to curb overdraft fees. But with the new legislation on tap from Sen. Dodd, it looks like Congress isn’t about to wait — or isn’t too impressed with what banks are offering to customers.

Either way, look for banks to create new revenue streams. If the legislation passes in Congress, they’ll need them to replace a good chunk of the $38 billion in overdraft fees the industry charges every year.

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