Why is your checking account "free"?

I am currently reading an amazing book on behaviorial finance "Predictably Irrational" by a Duke professor Dan Ariely. Harper published a revised and updated version of the book in 2009. It includes a new chapter on the financial meltdown from a behaviorial finance perspective. He uses an interesting illustration to point out how insurance and banks operate in a way to take advantage of those who are already at financial risk.

"Think, for example, about the 'perk' of free checking that the banks so generously provide us. You might think that banks lose money by offering free checking, because it costs them something to manage the accounts. Actually, they make huge amounts of money on mistakes: charging very high penalties for bounced checks, overdrafts, and debit card charges that exceed the amount in our checking accounts. In essense, the banks use these penalties to subsidize the 'free checking' for the people who have sufficient amounts of cash in their checking accounts and who are not as likely to bounce a check or overdraw with their debit cards. In other words, those living from paycheck to paycheck end up subsidizing the system for everyone else: the poor pay for the wealthy, and the banks make billions in the process.

Now does the usary of the banks end there. Imagine that it is the last day of the month and you have $20 in your checking account. Your $2,000 salary will be automatically deposited into your bank today. You walk down the street and buy yourself a $2.95 ice cream cone. Later you also yourself a copy of the book Predictably Irrational for $27.99, and an hour later you treat yourself to $2.50 caffe latte. You pay for everything with a debit card, and you feel good about the day - it is payday, after all.

That night, sometime after midnight, the bank settles your account for the day. Instead of depositing your salary and then charging you for the three purchases, the bank does the opposite and you are hit with overdraft fees. You would think this would be enough punishment, but the banks are more nefarious. They use an algorithm that charges the most expensive item (the book) first. Boom - you are over your available cash and are charged a $35 overdraft fee. The ice cream and the latte come next, each with its own $35 overdraft fee. A split second later, your salary is deposited and you are back in the black - but $105 poorer."