Making Consumer Finance Work

In early 2009, with the financial crisis still raging, progressive policymakers successfully passed legislation upending the credit card industry. This legislation precluded card issuers from changing interest rates without sufficient warning or charging exorbitant late fees. Congresswoman Carolyn Maloney, who sponsored the legislation in the House, deemed it ‘historic’ protection for consumers from deceptive bank practices. Conversely, Jamie Dimon, CEO of JP Morgan, postulated that restrictions on repricing would cause his bank to end credit provision for 15% of its customers.

A few months later, the Federal Reserve amended its rules to disallow the levying of overdraft fees on consumers unless consumers affirmatively opted-in to banks’ overdraft programs. Again, consumer advocates celebrated a ‘long-overdue’ victory for ordinary Americans while banks promised that consumers would bear the brunt of this intervention.

The next year, in May 2010, Senator Dick Durbin successfully amended the Dodd-Frank Act (the Durbin Amendment, or ‘Durbin’) to require that the Federal Reserve promulgate rules to restrict the costs of debit interchange (the fees merchants pay to card issuers for processing debit transactions). He celebrated the reform as allowing ‘small businesses and their consumers … to keep more of their own money.’ Large banks promised that following Durbin, consumer costs would rise, not fall.

These three examples underscore a general trend: the Great Recession prompted a wave of consumer-oriented reforms that provided both the necessary political capital for intervention and new authorities (including the newly formed Consumer Financial Protection Bureau) to act. These reforms were simultaneously celebrated as welfare-enhancing by progressive consumer advocates and attacked as counterproductive by the financial sector.

How to determine who got the better of these debates? Did sweeping regulatory changes ultimately limit abusive bank practices or instead needlessly burden financial markets and limit consumers’ access to beneficial products? In my article, ‘Making Consumer Finance Work’, I address these questions.

To do so, I analyze the incidence of three significant post-crisis consumer reforms in the debit, credit, and overdraft industry. Each of these reforms involved exactly the same financial institutions. Each involved exactly the same kind of reform—a price regulation to limit banks’ fee revenue. Each was celebrated by consumer advocates, each decried by regulated firms. And yet despite these similarities, these interventions had varied efficacy: the data reveal that banks offset losses only from debit interchange regulation, and not from decreases in credit card and overdraft revenue.

The empirical evidence leads me to three concrete lessons to guide future regulators. First, banks regularly exploit consumers’ behavioral limitations. We are inattentive (so don’t read complex contracts) and overly optimistic (so we underestimate our likelihood of bearing penalty fees). As such, we do not factor in the cost of hidden—or ‘non-salient’—prices when making choices about financial products. Regulators should restrict price-shrouding. At the very least, consumers will then better appreciate the true costs of financial products. But as reforms in the overdraft and credit card market illustrate, it is also possible that affected firms will choose not to change other prices to recover the revenue they lose when non-salient prices are regulated.  In these cases, the result of intervention is an overall increase in consumer welfare.

Secondly, consumer financial markets regularly feature inequitable cross-subsidization by the low-income of their higher-income counterparts. This is true in each of the settings I study. There are two reasons for this. First, wealthier consumers are less likely to bear hidden penalty fees mechanically because they have more money in their bank accounts (and so, e.g., are less likely to overdraw) and because they tend to be more attentive. Second, wealthier consumers have access to the most attractive products, like credit cards with generous rewards. Policymakers must address the regressive nature of these markets. The result of intervention may be higher prices for the wealthy, who are benefited by the status quo. That is a feature of well-designed regulation, not a bug.

Thirdly, policymakers should heed what firms do, not what they say. Affected institutions will always discourage intervention by saying that it will leave them with no choice but to raise prices for consumers or restrict the services they provide. This leads many, even well-informed academics, to be pessimistic about the efficacy of regulation (see Barr et al). Some even suggest the inevitable failure of behavioral policies, which they argue will inevitably be offset by sophisticated financial firms (see Willis, and Bubb and Pildes). My article shows that these skeptics are wrong and that heeding banks’ cautions about regulatory incidence is unwise.

Natasha Sarin is Assistant Professor of Law at University of Pennsylvania Law School and an Assistant Professor of Finance at The Wharton School.