The Case for Regulation, 2: Overdraft, Consumer Banking

Matt Yglesias writes a good post I’d normally agree with, Kevin Drum responds. I responded on interchange here, and will talk about overdraft here.

Overcharge

I was at a book event for Gary Rivlin’s Broke USA, which I’m reading and is fantastic so far, and I was talking with several other financial style writers (I got to meet Mark Gimein, of the walking away posts I quote a lot), and we were discussing payday lending.

My general opinion is that I am for payday lending in theory but against it in practice. A short-term unsecured loan to someone functionally off the real economy’s grid is going to be an unpleasant loan. What I don’t like is the “sweat box” model, the type of lending that is equivalent of throwing a net onto someone already at risk and when they can cut their way out they are done. You see this with the requirement in many payday lenders to have to pay off the entire loan in order to end it; you see this with toy models we’ve built at this blog of things like fix pay with credit cards, where if you can charge usury rates, your goal is no longer to get paid off but to not get paid off right away. Not necessarily wanting to get paid off right away creates all kinds of incentive and informational problems.

My ideal solution is public option style “vanilla products”, with a relatively deregulated market floating around that. Require that a certain type of product that is non-explosive be sold by financial dealers, and then whatever else people want to sell go have fun. This is a model that works for auto insurance companies, by the way. The fact that it is clear how the auto insurance model works isn’t a state of nature or natural market outcome – the government is involved with that.

Because if you dig down into some microeconomic models with a little bit of behavior theory, you can see why this gets broken. I spend some time thinking about what it means for markets to have “informed” and “uninformed” participants. The neoclassical story is that the most informed drive the market into equilibrium that is best for all, and that the uniformed piggy-back, through consumer welfare, onto their information. Markets as information aggregators.

But maybe it doesn’t work that way all the time. Maybe it works so that the informed can subsidize themselves off the wealth of the uninformed, and that firms will actively look to exploit this. I want to draw everyone’s attention to a paper by Gabaix and Laibson, “Shrouded Attributes and Information Suppression in Competitive Markets” (MR has a copy of a layman’s overview). If you speak Micro, it’s just a fascinating paper about how markets clear with naive investors and fees (one of my favorite papers).

It’s a look at markets where there are low cost, high hidden fee firms, and how competition from medium cost, no fee firms will lose. What’s interesting about this is it is generalizable to a wide variety of favorable market conditions (zero-cost advertising, for instance). And luring sophisticated consumers away won’t work as they are cross-subsidized by the naive consumers paying fees. Another way of saying this is that it is very difficult to break this equilibrium once it is in place, and it’s especially difficult to break this if the person who is “uninformed” is really just “broke.” And I think the evidence is clear that this cross-subsidy, persistent bleeding equilibrium of banking is what our current consumer financial system has ended up in, and I don’t think we’ll break out of it anytime soon.

Participation

And I think Steve Waldman had it best back during the vanilla option debates:

Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic “lemons” problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don’t take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.

The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try travelling with only cash for plane tickets, hotel rooms, and car rentals. People will “voluntarily” participate in markets rigged against them for the privilege of being normal. And we do, every day…

Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.

If people do stupid things with consumer products it is, in general, a their problem. But to see people exploited on what is a pre-condition to full participation in the modern economy should make us believe they are exploited through and through. If it’s part of a liberal vision that people need to have their basic ability to participate in the economy in order to pursue wealth, contracts and happiness, and access to the financial space is part of this basic ability (and it is), it should be offensive that people can’t get a checking account without being bled dry.

That said, I’m not sure what the solution is. A government-public-option postal savings account mechanism strikes me as much better than trying to micro-manage these firms. I wonder if just letting Wal-mart become a bank would solve this problem. Micro-managing is difficult if only because those on the other side are smart and, frankly, quite willing to exploit. They’ll always be one step ahead, so a pure regulation response is difficult to do. But this is what motivates my case here.

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4 Responses to The Case for Regulation, 2: Overdraft, Consumer Banking

  1. Pingback: Matthew Yglesias » A Public Option for Consumer Finance

  2. Franklin says:

    Interesting paper by Gabaix and Laibson.

    An exception to the rule might the Southwest Airlines “No Fees” for baggage ad campaign. So perhaps there’s an exception to the rule in the case where a competitor already has a cost advantage over competitors on base price.

    SWA is protecting its turf by essentially saying: “yes, they have lower prices now, but we still have the LOWEST price. (Of course even SWA has the “overflow/fat fee”).

    Otherwise, Gabaix and Laibson’s reasoning seems to hold true.

    With respect to naive consumers in banking (not touched on in the paper), one part of the story here is that banks likely try to create conditions under which the fee trigger kicks in.

    e.g. from personal experience a new bank bought out my old bank a few years ago. I was assured by the tellers that things weren’t changing, just the name of the bank. Of course, I probably should have run for the hills at that point.

    New bank is slower to credit deposits and tends to sit on debits making it harder to track the daily available balance. The printed monthly statement is less transparent about daily balances. When I call in to check on available balance over the phone there is absolutely no indication of recent debit purchases (which seems ridiculous in hindsight since these are electronic changes which could be reflected instantaneously). It can take two or three days to credit a charge. The monthly statement no longer indicates a running tally of the balance during the month any time a credit or debit is made — just a number at the bottom of the monthly statement indicating the balance on the first and last day of the month. NSF’s start kicking in.

    I switch to a smaller bank with more transparent fees, faster processing times for both credits and debits, and a more transparent accounting system. No NSFs kick in.

    Applying the shrouded cost idea to banking, you have a situation where it’s more than just informational disadvantages that are driving the fees.

    Table IX-11 in “the Death of Free Checking” seems to suggest this possibility (e.g. at all income levels there are customers who trigger the NSF; however, the frequency is much higher at lower income levels. Someone with high levels of discretionary income and a larger account balance may be completely oblivious to charges associated with the NSFs; the person can be perfectly oblivious to the fee and do just fine, because the probability of triggering the fee is lower; whereas every low-income customer likely needs to be aware of the fees upfront in order to avoided getting burned. And even then . . .). Maybe this is obvious.

    It’s also worth adding that companies are continually finding new ways to work in add-on fees. So a sophisticated consumer today might be a naive consumer tomorrow.

  3. chris says:

    It’s also worth adding that companies are continually finding new ways to work in add-on fees. So a sophisticated consumer today might be a naive consumer tomorrow.

    That’s the real driving force behind financial innovation. Finance doesn’t make anything, so *every* economic profit has to come from ripping someone’s face off.

  4. Pingback: Staying ahead of the liberal curve «  Modeled Behavior

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