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Our friend and University of Chicago law professor, Omri Ben-Shahar, fresh off a run participating in our credit card interchange fee symposium, has penned a guest post following up on our ongoing discussion of annual fees:

There is no annual fee for shopping at Wal-Mart, but there is an annual fee for shopping at Sam’s Club. Is there a consumer protection problem here?

Some people think that credit card issuers are acting badly by not charging annual fees, thus luring consumers into services that involve back end costs. By this logic, should retail stores like Wal-Mart be condemned for NOT charging annual membership fees, luring customers in, and making profit at check out lines? In fact, some stores probably charge a “negative” fee.  High-end retailers (Whole Foods, Neiman Marcus) provide a pleasant shopping experience and free samples. Low-end retailers distribute discount cards. They all charge these negative “membership fees” because they surely make up for it at the cashier. Should these retail techniques be regulated to protect consumers?

I find it puzzling why some retailers and service providers charge annual membership fees and others don’t. Why, for example, do wholesale clubs like Costco and Sam’s Club charge memberships while retail department stores do not? I am sure there is much to be learned from finding the answer to this puzzle, but I don’t think it has anything to do with consumer protection. Consumers are doing quite well in either format, and if there are problems of deception they are independent of the annual fee dimension.

Will reduction in interchange fees help or hurt consumers? Two posts yesterday made the conjecture that a reduction in one category of fees would only increase other fees, and that the overall sum of fees will not change. This is the fee-neutrality claim. Todd Zywicki writes:

The mathematics of the situation is inescapable: card issuers would have to increase the revenue generated from consumers from either interest payments or higher penalty fees.

And Josh Wright agrees:

It would be unwise from a consumer protection policy standpoint to assume that [reduction in interchange fees] represent the free lunch legislators have been looking for after all these years – or that those fees will not simply be reinstated in other guises elsewhere.

As a logical claim, I tend to agree with this “neutrality” conjecture. Indeed, the Australian experience can be explained in a way that is consistent with this dynamic, as Joshua Gans noted:

The interchange fee reduction causes merchant fees to fall but issuer fees to rise (or loyalty schemes to be curtailed) but otherwise does not impact on the consumer’s choice of payment instrument.

The question, though, is what are the implications of fee neutrality. Zywicki and Wright conclude, I believe, that in light of fee neutrality, it is pointless to try to help consumers by capping one component of the overall fee. It will not help, and might introduce an inefficiency.

My claim in this post is that the normative implications are not necessarily as Zywicki and Wright suggest. Fee neutrality, as I understand, applies only to the average cost of using credit cards. That is, consumers who use credit cards end up paying on average the same economic cost, regardless of the division of fees.  But when we consider other measures of consumer welfare, the neutrality claim no longer holds.

First, consumers who use credit cards as payment device and not for borrowing would benefit from the fee substitution. For them, the lower product prices when interchange fees decline are not offset by higher finance charges, because they don’t pay finance charges. So even if the neutrality proposition is correct on average, limits on fees have a distributive effect. This effect could also change the relative uses consumers make. Buying things becomes cheaper, borrowing becomes more expensive, and so we can predict some shift in primary conduct, which, again, violates the neutrality conjecture.

Second, even if for a given consumer the increase in finance and other charges exactly offsets the reduction in interchange fees, it is plausible to expect that a reduction in fees would lead to a reduction in prices of products and change the consumer’s purchasing decisions. Imagine that the interchange fee were to drop, in a hypothetical economy, from 5% to 0.5%. Do we think that product prices will drop accordingly? In response to a comment I posted yesterday, suggesting that such a price decline would occur, Todd Zywicki correctly responds that not all the saving will be rolled over to consumers. It depends on cross-elasticities of demand and supply. But at least in competitive markets, where prices equal marginal cost, the bulk of the savings in interchange fees would be enjoyed by consumers. It may be that nominal prices would display some stickiness, but it’s hard to imagine that in the long run consumers will be deprived of this benefit. One has to have very little faith in markets to imagine that the cost reduction will be enjoyed in its entirety by merchants, through higher profits.

If caps on interchange fees cause a non-trivial effect on prices, this regulation has the potential to reach far beyond the credit card market. It now affects primary decisions regarding the composition of consumption.

It is true that some of the increased demand due to lower prices is offset by the higher cost of credit. To buy these cheaper products with borrowed money would be just as costly, according to the neutrality claim. But it is important to unbundle the overall price into its two pure costs—the cost of the product and the cost of the credit. The potential efficiency of fee limits is in achieving an unbundled price, where the product component and the price component are priced separately.

Omri Ben-Shahar is the Frank and Bernice J. Greenberg Professor of Law at the University of Chicago.

I will focus my blog post on one of the proposals for reducing interchange fees: the requirement that the fees be disclosed to consumers. I am not sure how seriously this option is taken by the GAO report. Indeed, the report concedes that mandated disclosures in this context are not very likely to be effective, because “consumers are likely to disregard this kind of information.” But I will not be surprised if, of all the regulatory options discussed in the report, in the end it will be the disclosure rule that is enacted.

I am sure that readers of this blog don’t need a long explanation why disclosures would be futile in this area. Numerous studies have documented the failure of mandated disclosures in other areas of consumer credit, ranging from TILA, through other financial accounts such as depository, savings, and mutual funds, and extending to disclosure by financial brokers, investment advisers, credit reporting agencies, and even pawnshops. These mandated disclosure rules fail to inform people, to improve their decisions, or to change the behavior of the financial institutions. The fail because ordinary people can read them, can’t understand them even in the most simple format, don’t know what to do with the information even it were understood, and face way too many such disclosures in their every day lives

I recently conducted a study looking at the entire body of mandated disclosure statutes that people encounter, reaching beyond financial transactions.  (You can view a talk based on the study here). Mandated disclosures are a routine regulatory device found in insurance law, health care, informed consent doctrine, Miranda warnings, IRBs, and hundreds of product- and service-specific enactments. My study concluded that none of these disclosures do anything to help people, and many of them backfire. One of the features that runs through all these scattered disclosure statutes is how easy it is politically to enact them. When lawmakers respond to a particular problem that requires intervention—much like the one we are now discussing, interchange fees—there is often debate what rules would work, how deep the intervention ought to be, and whose interests to prioritize. But there is very little debate or opposition to disclosure mandates. Everybody supports them. The perception is that more information is always better: it helps people improve their decisions, it “bolsters their autonomy” as some like to put it, and it perfects market competition. At worse, disclosure believers think, the information will not help much, but it surely will not do any harm, and disclosure regulation involves very little budgetary allocation.

Here is a case in point. Just last month, the Federal Reserve regulated overdraft fees.  After much thought and consultation, the Fed found a solution to the problem of high overdraft fees for ATM and debit card transactions. Recognizing that many consumers would prefer that money withdrawal would be declined rather than pay a sizeable overdraft fee, the rule enacted by the FED prohibits banks from charging overdraft fees unless consumers opt in to the overdraft fee option. Sounds sensible: give people choice, and set the default rule to induce information dissemination.

But here is the catch. How, according to the legislation, would consumers learn about the size of the overdraft fees and choose, if they care, to opt in? By establishing mandated disclosure requirements! That is, to make sure that the notice is “meaningful”, the Fed, with the support of consumer advocates, mandated a new form—which they call a “segregated disclosure”—a separate sheet consumers will receive from the bank providing them “a meaningful way to consent and thus to providing meaningful choice.” The ingenious advance here, which ensures “informed choice,” is to have a separate form, with a separate notice, and a separate signature. This, supposedly, will prevent “inadvertent” consent.

Like any other technical financial disclosure, this format is unlikely to help, especially the least sophisticated consumers—those most likely to carry overdrafts. Whether it is one form of separate forms, one notice or separate notices, one signature or separate signatures, this will not change the ineffectiveness of this disclosure paradigm. Consumers will get yet another pre-printed boilerplate page, with another dotted line at the bottom, which they will happily not read.

The point is that, when all is said and done, nothing much happened. There was a moment of significant public and media attention to the problem of overdraft fees, but in the end they were not regulated. Another meaningless disclosure was added to people’s lives, already swamped with hundreds and thousands of disclosures. Politically, the Fed finished its job and the problem is now “solved.” This is a familiar pattern: a disclosure rule provides an excuse to refrain from a real solution.

Now back to interchange fees. The GAO report lists several possible policy options, from direct regulation of the fees to restrictions on the terms imposed by issuers and how they are negotiated. These are controversial options that would likely lead to substantial political wrestling. There is also much uncertainty, even among the most sophisticated of academic experts, as to the effects of these measures. Perhaps other entries to this blog will shed more clarity as to the right regulatory direction. But as long as these difficulties remain, and as long as interest groups exert pressure on lawmakers, disclosure rules will once again surface as a safe, unopposed, but unfortunately useless regulatory device.