Improving Consumer Finance by Regulation

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In a pioneer study, scholar offers advice on how to regulate consumer finance.

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To financial regulations, banks often say “Bah! Humbug!”—as the fictional money lender Ebenezer Scrooge said to Christmas traditions.

According to a paper by law professor Natasha Sarin, this is exactly how financial institutions reacted to legislative efforts to mitigate the subprime mortgage crisis effects of 2008. In her paper, she revisits the banking activity with the “ghosts of the past, present and yet to come,” as Scrooge faced in his journey, to instigate change in financial institutions operating in the consumer finance market.

In this saga of consumer finance redemption, Sarin offers empirical contributions on the leading reforms to the financial services sector enacted after the crisis. Sarin uses the available data, produced in the 10 years following the recession, to provide advice on how to improve the consumer finance market.

Sarin demonstrates that, of the three major regulations in this market, only two worked as intended. The Durbin Amendment failed in meeting its goal—and in fact harmed a considerable number of consumers. The other two rules—the CARD Act and overdraft policy changes—effectively corrected the target market problems and benefited consumers.

The Durbin Amendment required the Federal Reserve System to establish rules limiting debit interchange fees by capping the rates, intending to lower consumer prices by decreasing products’ final presented costs. Interchange fees are fees that banks collect from a merchant for processing card transactions. These fees used to be so high that they were the “second-highest cost of operating after labor,” Sarin states.

Sarin argues that the outcome of this well-intended regulation was twofold. First, the interchange fee dropped substantially after the amendment came into effect—as expected. Nevertheless, by increasing other consumer fees, such as reducing free checking accounts offered to consumers, banks managed to recover almost all of the loss due to the regulation—an unexpected substitution of revenue, Sarin argues.

Second, Sarin contends that, contrary to what defenders of the amendment expected, the regulation did not enable small businesses to lower product costs offered to consumers. This frustration occurred because small merchants that already had deals with low interchange fee rates saw their bank agreements change as banks had to comply with a new rate cap with a higher floor of what they used to pay.

In contrast to the Durbin Amendment, the CARD Act and overdraft policies generally succeeded, as Sarin shows.

The CARD Act banned abusive contract terms that charged clients high credit back-end fees without their knowledge or permitted banks to increase clients’ interest rates without their consent. Sarin contends that this regulation reformed the fundamentals of credit card business by guaranteeing consumer security when engaging in credit purchases, in turn limiting bank’s offerings of inconspicuous contract terms by restricting repricing policies.

In effect, Sarin demonstrates that, since the enactment of this regulation, interest rates for these bank services did not increase, demonstrating the satisfaction of the intended regulatory goal. Sarin shows, however, that banks raised other unregulated fees less salient to consumers as a direct response to the CARD Act. But even with these increases, rates were not as high as before.

The overdraft policy changes aimed to protect low-income consumers from constantly incurring overdraft fees. Overdrafting occurs when individuals withdraw amounts exceeding the available funds in their bank accounts, incurring high penalties if the amount is not replenished in a determined timeframe.

According to Sarin, overdrafting typically occurs with low-income consumers, who then suffer a greater impact from the exorbitant default fees. This type of consumer is also usually less financially savvy, and almost all consumers who overdraft were unaware about their financial condition, writes Sarin.

The overdraft regulation adopted an opt-in policy, in which banks can only charge overdraft fees if consumers actively opt into overdraft transactions. The default plan blocks any exceeding transaction from being completed. As a result, Sarin indicates that banks’ overdraft revenue decreased substantially after the enactment of the regulation. The institutions seem not to have yet recovered these losses, suggesting a permanent positive outcome for consumers.

Considering the outcome of these major regulations that sought to mitigate consumer financial issues, Sarin offers some guidance to financial regulators on how to improve their rules in the “yet to come.”

First, regulators should target hidden prices and non-salient terms of bank services, as consumers tend to ignore less obvious fees, incurring exorbitant penalties for simply not paying attention, as Sarin explains.

Second, Sarin argues that regulators should intervene to prohibit “inequitable cross-subsidization,” the economic phenomenon in which low-income consumers pay higher values in services so that banks may lower prices for high-income consumers. Sarin explains that all three regulations analyzed featured cross-subsidization in some measure.

Finally, Sarin contends that regulators and scholars should pay more attention to what banks and financial institutions do, instead of what they say or demand. The influence of big banks in the regulatory process tends to impact negatively the efficacy of regulations. Too often scholars simply accept unrealistic claims made by financial institutions, she notes.

Sarin believes that valuable lessons may be gained from studying how regulation has worked in the debit, credit and overdraft markets. Such experience should be taken into account to pave the way for regulation that better protects consumer welfare in winters to come.