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Banks are set to rake in £1.3bn after being given permission to delay offering refunds to millions of customers hit with unfair overdraft fees.

The news follows a decision by City watchdogs relating to a long-running court case over the legality of rip-off overdraft fees.

The Office of Fair Trading (OFT) is taking the banking industry to court on the basis that charges of up to £38 a time for bouncing a cheque are unfair and excessive.

It has won an initial judgment that should ensure refunds are paid to millions of people.

However, the banks are dragging out the case through the appeal courts with the result that payments are being delayed.

The City watchdog, the Financial Services Authority (FSA), has allowed the banks to put the handling of complaints and refunds on hold until the case is settled.

This so-called waiver was first introduced in July last year and was due to run out this month - a year in which the banks will have collected £2.6billion in overdraft fees.

The FSA said it would allow the waiver to run another six months, until January 2009, allowing the banks to collect another £1.3bn.

There is every chance the banks will appeal the case through to the House of Lords, which could delay any compensation for customers until well into next year.

The delays mean the banks can continue to generate billions of pounds from what the OFT believes are illegal charges. This money is coming straight out of the pockets of some of the poorest people in the country.

The FSA said the delay in resolving the situation will not affect the ability of bank customers to claim refunds of charges going back to 2001, once the case is finally settled.

And while a general waiver for dealing with refunds has been established, the banks will be required to handle complaints involving customers suffering real financial hardship.

Martin Lewis, founder of MoneySavingExpert.com, said: 'For all its talk of consumer protection, the FSA's decision to extend the hold on reclaiming bank charges is a kick in the teeth to the millions of people trying to reclaim them.

'The original hold was installed as the test case was announced, because of apparent "inconsistencies," even though the enormous majority of people were being paid out by the banks.

'Yet now, a year on, the test case decision is out and there's a legally binding, precedent-setting court decision that bank charges are governed by fairness rules, so why not allow people the chance to ask for their money back?'

Director of retail policy at the FSA, Dan Waters, explained the decision saying: 'The FSA continues to work closely with the OFT and banks in reaching a resolution on the fairness of unauthorised overdraft charges.

'Our objectives continue to be certainty over this complex issue, and a fair and consistent resolution of consumer complaints about unauthorised overdraft charges.

'The FSA has reviewed the prevailing circumstances and has decided to offer firms a new waiver. The waiver will be for six months, when we expect to have a decision from the Court of Appeal.'

The watchdog has the power to lift the waiver if it believes the banks are dragging out a resolution of the case unnecesarily.'

The consumer group Which? said extending the waiver for another six months appears to be the least worst option.

Its head of campaigns, Louise Hanson, said: 'The waiver is a necessary evil.

'Scrapping it won’t get people their money back – only the banks can do that by conceding defeat and paying up instead of continuing to string out the process.'

Which? is concerned that banks have been changing their terms and conditions in recent months in a bid to get around any crackdown on unfair overdraft fees.

Miss Hanson said: 'People in financial difficulty need greater clarity and banks must be prevented from moving the goalposts with detrimental changes to their terms and conditions.'

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A student has been landed with bank charges of £800 - after going just eight pence overdrawn.

Laura Gibson, 20, has been threatened with legal action by Lloyds TSB if she does not pay the extortionate charges.

The fees mounted up after Laura unwittingly went 8p overdrawn on her current account.

Despite paying back £300 the penniless student has been unable to keep ahead of the spiralling charges and still owes £515.18.

She claims the bank piled on daily fees of up to £20 plus a monthly fee of £15 for having an unplanned overdraft.

By the time Laura realised what was going on, the costs had spiralled out of control.

'I can't cope with it,' said Laura.

'The bank staff can see I'm not in a situation to pay yet they carry on telling me I have to or they will take me to court.

'They didn't contact me saying I had gone overdrawn. They just keep putting more and more charges on your account.

'The first charge was in the region of £80 but it goes up and up the more you go overdrawn.'

Laura, of Monkscroft, Cheltenham, Gloustershire, said it was hard to keep track of the situation while she was ill with a nervous breakdown.

'I had nothing to live on because it was swallowing up my benefit money.

'I tried to leave the bank in February but they told me I couldn't until I had paid the charges.'

The student, who is enrolled to start a course at the Gloucestershire College in September, found herself being charged £20 a week after getting overdrawn.

Once her debts topped £100, the bank started charging her £20 a day.

Laura's bank statement shows she was £180.97 overdrawn on May 1 but by July 1 it had increased to £515.38.

'I've now paid more than £300 in charges to them,' she said.

Laura now has a part-time job and has opened an account with another bank but says she is still unable to pay all the charges.

A spokeswoman for Lloyds TSB said they would investigate the case now they had been alerted and would contact Laura to discuss her account.

Last week an investigation by finance website Moneynet.co.uk reported that Lloyds TSB was worst offender for punishing customers who fall briefly into the red.

Those with the Lloyds TSB Classic Plus account - which Laura has - who exceed their agreed overdraft limit by £50 for two weeks are charged £165.

A damning report by the Office of Fair Trading (OFT) said that banks rake in more than £8.3 billion from current account charges.

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Banks yesterday threatened an end to free current accounts after they were accused of dirty tricks, ripping off customers and imposing stealth charges.

The warning of the death of free banking came after the Office of Fair Trading criticised practices that earn them £8.3billion a year from the accounts.

The Government watchdog said customers were actually paying an average of £152 a year for banking services in the form of excessive overdraft and penalty charges.

It has warned banks to change how they charge for services.

But they have hit back by threatening monthly charges for basic services if they have to cut fees.

It is feared they will retaliate by introducing fees of between £5 and £20 for a current account.

Industry leaders hint that customers may also face extra charges to use a cash machine, write a cheque or pay a direct debit.

Angela Knight, chief executive of the British Bankers Association, said: 'It is important that this model, which is what customers have asked for - free for their normal banking, does remain.

'We are worried that the OFT seems to be challenging that.

'Do you really want to pay for ATM use, pay for statements, pay for direct debits in this country?'

The OFT yesterday launched what consumer groups called a 'devastating critique' of how banks charge for current accounts.

The biggest earner relates to the fact that banks pay very low or no interest on current account balances. But they invest the money in customers' accounts at much higher rates of interest to make a profit of £4.1billion a year.

The OFT wants banks to give each customer an annual statement showing the value of this lost interest. Separately, they make £2.6billion a year from excessive overdraft charges, which have risen by 17 per cent above inflation in four years.

Four million people are paying more than £200 a year in overdraft charges, with 1.4 million of them handing over more than £500.

The watchdog made it clear that profit margins on overdraft penalty fees, which can be £38 for bouncing a payment, are excessive.

It said the nation was overdrawn by an average of £680million a day in 2006. However, bank fees and interest on this sum amounted to £1.5billion, a return of 220 per cent.

The OFT identified dirty tricks where banks have secretly pushed up penalty charges to subsidise other products brought in to attract new customers.

It said finance industry claims that they look after customers by providing 'free banking' were bogus.

OFT chief executive John Fingleton described the lack of interest on current accounts as a 'stealth charge', adding: 'There is a systemic problem. All of the banks have moved towards charging us more and more for things we can't see. Banking is not free, it is costing us £150 a year. Because we can't see how much it costs, we can't compare and switch properly.'

The OFT complained vulnerable groups such as pensioners were suffering. It said: 'There is significant potential for slight errors in financial management to result in hundreds of pounds of charges.'

It also pointed out that a customer going overdrawn with one bank might not be charged, while another would have to pay £260.

The OFT says customers should be able to get interest on their current accounts without paying monthly charges.

Philip Cullum, of the National Consumer Council, said: 'The OFT has delivered a devastating critique of this market, which has too long failed consumers.'

Andrew Hagger, of the website MoneyNet, said: 'If and when the decision is made to cap unauthorised overdraft fees, it is inevitable that we will move towards paying monthly fees for personal banking.'

When First Direct imposed a current account charge of £10 a month for 200,000 of its customers last year, 20,000 closed their accounts.

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One of Britain's biggest high street banks has slashed its overdraft charges in a move which is set to spark a battle for current account customers among other major banks.

Barclays announced today that it will launch two new accounts that charge a flat fee of just £8 for each transaction once a customer goes beyond the agreed overdraft limit, compared with the current £35 fee.

It comes after high street banks lost the first stage of a High Court battle over the legality of hefty overdraft and other fees. The banks are said to be reviewing fees after the ruling, which they are appealing.

Customers opting out of having the buffer zone will see payments over an agreed limit bounced, but will still only have to pay the reduced £8 charge.

Barclays said that it had been able to reduce its charges as a result of breakthroughs in its handling systems, with a far greater automated service.

But it is likely to be seized upon by campaigners who have long claimed that fees of up to £35 are unfair and does not represent the actual cost to banks - which they believe could be as little as £2.50.

In April, the Office of Fair Trading won a High Court ruling over the issue, when a judge said fees were subject to "unfair contract" rules.

It paves the way for a further hearing to decide whether charges are unfair and, if so, what a fair charge should be. Banks have since lodged an appeal over the High Court ruling.

Barclays' £8 charge could lead to other banks scrambling to play catch up in an industry that faces being forced to lower fees.

It is part of a new overdraft service for customers that will also include the launch of "Personal Reserves" on August 18.

These buffer zone, typically of around £250, can be used as often as the customer needs without repeat charges.

But if a customer fails to pay off the additional balance within five working days, they will be liable to pay another £22 fee.

According to the bank, the system will "significantly reduce" charges and give customers certainty about when their payments will be met and when they will be bounced.

Crucially, current account users can opt out of having the buffer zone - and therefore not be liable to the £22 charge - but still only face £8 for bouncing a payment.

Mark Parsons, managing director of current accounts at Barclays said: "We have listened to our customers and acted on this feedback by completely revamping our unauthorised overdraft service, replacing it with the new Personal Reserve.

"Our customers wanted a simple, clear way of managing payments when they go beyond agreed limits."

He added: "Our new approach has been tested with consumers extensively over the last two years and we are confident that our products will promote account switching to Barclays."

The bank also announced that from June 1 it is to scrap credit interest on standard current accounts. Research found that customers do not value the 0.1 per cent payment - which works out about 2p a week to the typical account holder.

And from June 2, interest on overdrafts will go up from 15.6 per cent to 17.9 per cent.

Mr Parsons added: "The overall package of changes we are making for new and existing customers provides a simple, clear choice and improved value, marking a step change in current account banking in the UK."

The bank's 11 million current account customers will receive a letter in the coming weeks informing them of the changes

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The major high street banks have so far paid out more than £550 million in refunds to customers who complained about unauthorised overdraft charges.

The payouts, which total £559 million, were revealed in the annual results of the majority of the banks that are involved in the High Court test case over the issue of whether the charges are fair.

But the actual total will be higher as both Abbey and Nationwide Building Society declined to disclose how much they had refunded.

The HBOS group, which includes Halifax, has faced the biggest payout to customers who complained the charges were unfair, refunding a total of £122 million.

Royal Bank of Scotland Group, which includes high street bank NatWest, has paid out £119 million to date, while Barclays has paid out £116 million and HSBC has refunded £115 million.

Lloyds TSB refunded £76 million to customers before the test case began and Clydesdale and Yorkshire Bank said claims and costs, as well as provisions for future administrative costs relating to the issue, totalled £11 million.

The banks are currently awaiting the judgment from the test case which could pave the way for a ruling on how much they can charge people who go into unauthorised overdraft or breach their agreed limit.

The case was bought jointly by the seven banks and Nationwide and the Office of Fair Trading to settle the issue after consumer began to reclaim millions of pounds through the courts.

The recent case concerns whether unauthorised overdraft charges come under the scope of the 1999 Unfair Terms in Consumer Contracts Regulations.

If the judge rules that this is the case, the court will decide at a separate hearing later this year whether the charges are unfair and give guidance on what a fair fee should be.

The banks, who argued that consumer contract rules do not apply to the charges and that, even if they do, the fees are not unfair, have been given permission to put any new or ongoing refund claims on hold until the outcome of the test case is known.

HSBC said yesterday that in the worst case scenario total refunds could reach £303 million if it loses the court case.

The other banks involved declined to predict the total liability they would face if they lost the case, but if, like HSBC, total payouts would be more than double what they have refunded so far, banks could collectively face a bill of more than £1.1 billion from the issue.

Banks are thought to make between £2 billion and £3.5 billion a year in fees charged when customers go into unauthorised overdraft.

These fees can be as high as £39, but campaigners claim that the actual cost to banks is as little as £2.50.

Commercial lawyers have warned that, if the charges are scrapped or drastically reduced, it will mean an end to free banking and all customers will have to pay a monthly current account fee.

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High Street banks claimed yesterday that overdraft charges which rake in billions of pounds a year are not subject to normal 'fairness' rules.

In the first day of a long-awaited legal battle, the banks insisted they have the right to charge the fees that can be as high as £38 even if a customer has slipped only a few pence into the red.

Campaigners claim the actual cost to the bank is as little as £2.50.

Experts estimate that banks make about £3.5billion a year from unauthorised overdraft fees.

The case, which follows a two-year Daily Mail "Fair Play on Charges" campaign, could force banks to pay billions of pounds in compensation.

An army of 60 legal advisers representing seven banks - Abbey National, Barclays, Clydesdale, HBOS, HSBC, Lloyds TSB and the Royal Bank of Scotland - and the Nationwide building society were in court yesterday for what has been described as the biggest commercial legal case for more than 20 years.

Laurence Rabinowitz QC, for Royal Bank of Scotland, told the court that the outcome is "eagerly awaited up and down the country".

Customers have launched a 'torrent of claims' against banks following a "deluge of complaints" about charges, Mr Rabinowitz told the court.

The Office of Fair Trading, representing consumers, claims that the overdraft charges are unlawful and too high.

The case is about whether unauthorised overdraft fees are subject to the Unfair Terms in Consumer Contracts Regulations.

The banks argue that customers agree to overdraft conditions, including charges, when they open an account.

They deny accusations that the conditions are not written in "plain, intelligible" language.

Mr Rabinowitz argued the OFT was partly responsible for the consumer revolt after "ill-informed" comments made following an earlier ruling about credit card charges.

He told Mr Justice Andrew Smith: "A hornet's nest had been disturbed and something had to be done."

The case was sparked by an extraordinary consumer backlash against bank charges.

Millions of people have won back thousands of pounds from their banks after complaining about excessive charges.

But many other complaints have been put on hold for almost a year pending the outcome of this crucial case.

Experts warned that if banks are forced to scrap, or reduce, their fees, they will try to make money in different ways from their customers.

This is most likely to include axeing 'free' current accounts.

If they lose, it is almost certain that the banks will appeal.

Marc Gander, of campaign website Consumer Action Group, said: "This is just the first part in what could be a very long process."

The hearing, at the International Dispute Resolution Centre in Central London, is expected to last three weeks.

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High street banks accused of making customers pay inflated overdraft fees could be forced to reduce their charges following a test case beginning today.

The High Court challenge, brought by the Office of Fair Trading (OFT) against seven leading retail banks and the Nationwide building society, was beginning formally with reading of legal papers.

But the hearing is not expected to open until Wednesday.

The regulator will argue in the case opening this week that the overdraft charges come under the scope of the 1999 Unfair Terms in Consumer Contracts Regulations.

If the judge rules that the charges come under this legislation, the High Court could then decide at a separate hearing at a later date on what a fair charge should be.

"It means (if we win) that we can go back to the court with new evidence from our banks market study and start to talk about whether and what a fair amount should be," a spokeswoman for the OFT said.

Bank customers can incur the charges for taking out an unauthorised overdraft or breaching their authorised limit.

Charges can also be levied if customers make a payment but have insufficient funds in their account to cover it or if banks stop a payment because the account holder does not have enough money.

Banks are thought to make between £2 billion and £3.5 billion a year in fees charged when customers go into unauthorised overdraft.

The fees charged to customers can be as high as £39, but campaigners claim that the actual cost to banks is as little as £2.50.

The hearing is an attempt to resolve the legal issues at the heart of the wave of mass litigation which swept the country during the past two years.

In November, the OFT accused banks in the past of charging customers more for unauthorised overdrafts than it cost to provide them.

It has also claimed the charges meant customers were given credit on "uneconomic terms" in which the fees were "disproportionate" to the amount of money borrowed.

It has said that the terms relating to the charges are not written in "plain, intelligible language", were not "clear and transparent" and in some cases they were even "liable to mislead customers".

But it stopped short of saying the charges were unfair, saying it had not yet concluded its investigation and assessment of the fairness of them.

Defenders of the charges have argued that if they are scrapped it would mean an end to free banking and all customers would have to pay a monthly fee.

The banks have sought to justify the charges by claiming they reflect a service the bank provides to the customer, namely considering whether to grant them an overdraft.

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Big banks are raking in up to £3.5 billion a year from punishing overdraft charges with more than half believed to be pure profit.

The income estimates come from the Office of Fair Trading(OFT) which believes millions of customers have been ripped off through unfair penalty fees.

The figures suggest the bank's profits from the fees are likely to range from £1.5billion to £2 billion a year.

The OFT is locked in a legal battle with banks in an effort to have the charges, which can be as high as £39 for busting an overdraft limit, brought down.

The banks are fighting the OFT and have issued dark threats that any clampdown will see the introduction of monthly fees on current accounts, so ending free banking as we know it.

The court case is due to start in January, however there are fears that beligerent banks could drag out any resolution of the case for many years.

The OFT first signalled that it believed high overdraft charges were likely to be an unfair penalty, because they are way above the bank's real costs, in April last year.

Since then, tens of thousands of people have lodged complaints and claims for the refund of penalties, plus interest, going back over a six year period.

The big banks have so far paid out more than £400 million to these customers, despite insisting that their fees are legally applied and perfectly fair.

The banks have been swamped by complaints and refund claims bringing suggestions the final bill could well top £1 billion.

The court case involving the OFT and the banks is supposed to produce a final resolution to the question of whether the charges are unfair and can be reclaimed.

The OFT's handling of the case is being led by Cavendish Elithorn who put an official estimate on the bank income from the charges for the first time.

He suggested it would be up to £3.5 billion a year. Mr Elithorn would not say how much of this is profit however it is thoughtly likely to be more than 50per cent.

The real cost of sending a customer an overdraft charges letter is thought to be less than £3, however the bank will generally charge more than £25 in those circumstances.

Mr Elithorn rejected industry threats that a crackdown on the overdraft fees would bring the end of free banking and annual account fees of up to £300.

He said there would be 'no excuse' to impose such new account fees.

He suggested the banks, which have posted record profits for two years in a row, could easily swallow any loss of income without the need to impose new charges.

"I would say there is no excuse at all for banks to introduce charges on the vast majority of customers in relation to the work that we are doing," he said.

"We have no control over the core pricing of banks, nor should we... But we believe that a lot of banks will continue to offer free services to those in credit.

"Personally, I don't see the need for new monthly account charges."

Mr Elithorn say the banks have rejected the OFT's case. They insist the charges are fair and that the OFT has no jurisdiction over what the banks should charge.

The court case is due to begin in January and could run for up to five months. If the banks lose, they could appeal the case, dragging out any conclusion into 2009 and beyond.

That would be disastrous for the thousands of people seeking refunds. Currently the banks have frozen offering any payments pending the outcome of the case.

Mr Elithorn admitted:

"It could be more than one year. There are strategic reasons why some banks would want to drag it out, but there are also strategic reasons why some banks would want to see a quick resolution to this."

The British Bankers Association(BBA) insisted the charges are legal.

A spokesman said:

"These payments are not charges, they are fees for a service, which is the overdraft facility.

"It is perfectly simple for customers to avoid having to pay them, either by arranging an overdraft first of keeping within an agreed limit.

"The banks maintain that these fees are fair in that people know they exist and they know what they are. They also notify people in advance before they are levied.

"Clearly, if the OFT is correct then we are into a different ball game."

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Bank customers have been ripped off by an average of £742 in "illegal" penalties in the past six years, according to a new report.

Four in ten UK customers have been hit by fees for "breaches" including unauthorised overdrafts, bounced cheques and unpaid direct debits since 2001, a new study has shown.

It found that many faced huge penalties of up to £230 a year from major High Street banks.

The report comes as Britain's biggest banks prepare for a High Court battle in January which will determine whether they have a legal right to deduct the charges.

According to the poll of more than 4,000 consumers, the worst offender was Abbey, where the average charges for customers added up to £1,376 - or £230 a year.

That compared to average penalties of £800 at Lloyds TSB, £731 at Barclays and £585 for HSBC and First Direct over the last six years.

In total 16.8 million current account holders have incurred penalty charges since 2001, with the average fees adding up to £742 over that period.

The charges of up to £39 a day were mainly for going overdrawn or beyond an overdraft limit without permission, but it also covered fees for bouncing cheques and other administrative tasks.

Eddie Weatherill, spokesman for the Independent Banking Advisory Service, said: "As an average £742 might sound relatively reasonable. But I'm dealing with a case at the moment of someone who was charged £300 in a month and a half.

"One would expect to pay something for a basic service but if you're penalised for a poor service that's a different ball game."

According to the figures from the polling company YouGov, carried out on behalf of uSwitch, UK banks have profited by £12.4 billion from bank charges since 2001.

But the report have been dismissed as "nonsense" by the British Bankers Association.

Chief executive Angela Knight said: "It is an audited fact that 80 to 85 per cent of people get their banking completely free."

Recently hundreds of thousands of customers have been refunded charges after threatening to take banks to court.

But banks have refused to accept that automatic charges for going into the red are unfair - as the Office of Fair Trading believes they are.

Now all outstanding claims - thought to be worth £713 million - have been frozen pending the outcome of the court case being brought by the OFT.

If the banks win, consumers will have to accept the charges or be forced to leave their bank. If they lose, the banks could face a multi-billion pound payout to customers.

A victory for consumers could also, however, spell the end of free banking.

Experts fear that banks will simply seek to recoup the money elsewhere, perhaps by imposing monthly current account charges.

In the first six months of this year the "big five" banks made joint profits of nearly £4 billion from their UK branches.

Banks are only allowed to recoup costs when customers break bank account terms, but campaigners have argued that the charges are unfair as the actual costs of dealing with an unauthorised overdraft are estimated to be as little as £2.

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Banks have been accused of lying to customers to deter them from claiming refunds on unfair overdraft penalties.

In a hard-hitting letter to bank bosses, the Financial Services Authority said it had uncovered serious "weaknesses" in how they are handling the consumer backlash against exorbitant charges.

Giving out misleading information, closing or threatening to close accounts as a "punishment", and failing to respond properly to complaints are among the failings highlighted by the FSA.

The roasting came as the Office of Fair Trading launched a court case against the major banks to establish whether their overdraft charges are unfair.

The OFT, which has been investigating the charges since March, lodged papers with the High Court after eight high street banks agreed to the test case to settle the issue.

The biggest banks are estimated to have paid out £200million this year to customers claiming back charges.

But the FSA criticisms indicate what a struggle it is for many to persuade the banks to cough up.

Tens of thousands of consumers have complained about the charges, which are levied when they go over an authorised overdraft limit and which can be as much as £39 for a single bounced payment.

While it has never been revealed how much an unauthorised overdraft actually costs banks, some experts have estimated it could be as little as £2.

In its letter to the chief executive officers of all firms providing current account services, the FSA listed its criticisms.

It said: "Some firms appear to have been making false or misleading statements to prospective or actual complainants, including representing that no refund or goodwill payment will be made when they are in fact making payments to other customers with identical complaints.

"This is likely to have the effect of deterring customers from making or persisting with complaints.