Regulatory Interventions Involving Depository Accounts: Pressing on the Balloon

The checking account—aka demand depository account or current account—is one of the most common financial services products. In developed countries almost every household has one of these. Banks provide a plethora of services through these accounts, which enable people to manage their household finances including paying for the sundries of life, managing their weekly pay check, and saving some money.

The checking account is also a frequent subject of regulation by competition authorities, consumer protection regulators, banking regulators, and legislatures.

Just think about interventions in the last five years around the world. The US and UK have both gone after overdraft fees that banks assess when people don’t have enough money in their accounts to meet a payment and the bank advances the money. The European Commission has imposed limitations on the fees that banks can assess on receivers of funds for direct debits – with much more to come. Many countries have imposed limitations on the fees that banks can receive from merchants that are paid by the debit cards they issue to their depository customers. Implementing Congressional legislation, the US Federal Reserve halved those fees in October 2011 while other countries such as Australia have reduced them much more. Of course, there’s been the PPI debacle in the UK. Beyond this, some countries such as France impose a variety of regulations on the fees that banks can charge for checking accounts.

Unfortunately, all of these interventions have knock-on effects. Proponents hardly ever consider seriously these unintended consequences of their regulations. Often doing so would raise serious questions about the wisdom of rules that help some but perhaps harm the many. In the US, for example, the combined effect of overdraft fee regulations and price caps for debit-card interchange fees has resulted in a massive decline in free checking accounts—from 76 percent in 2009 to 39 percent in 2012—as well as an overall increase in fees. That has contributed to an increase in the number unbanked by 821,000 between 2009 and 2011 along.

In my experience regulators fail to recognize, or at least seriously consider, two critical aspects of checking accounts or speak of them. Both should temper their exuberance for interventions. Checking accounts involve bundles of services. They are also multi-sided platforms with several distinct customer groups. These features result in the interests of many different customers being intertwined. Necessarily, they lead to knock-on effects from any regulation of any particular price, offering, or practice.

Depository accounts offer a place to park one’s money. But then they provide a multitude of different payment services. These include debit cards, getting cash from ATM machines or bank branches, checks, mobile bill payment, direct debit, and so on. Often checking accounts provide different services for saving money. Banks provide people with various ways for managing their funds from branches, ATM machines, telephone support, online banking, and mobile banking. They also provide credit—including temporary overdraft protection—and many other services.

Banks incur fixed costs, of varying degrees, for providing these services. That runs from operating bank branches to installing ATM machines to sending out bank statements. They also incur many variable costs. Many of the services they provide are complementary to each other. Like many businesses that offer multifaceted services and that have fixed costs to cover, banks offer bundles of services, they engage in complex pricing strategies in which some services are priced low relative to marginal cost and some high (that is, they price discriminate), and they engage in cross-selling of services. They do this in order to cover their fixed costs and make money. Economists would expect bundling and price discrimination as a matter of theory. In some ways, banks aren’t much different than supermarkets that have to figure how much to charge for the milk, steaks, diapers, and so on to cover their fixed costs and make a profit. Of course, banks also need to use prices to deal with risks such as consumers overextending their accounts and not being able to cover it.

Given these economics and facts, the overall effect on consumer welfare of regulatory interventions involving depository accounts is far more ambiguous than other interventions. When a competition authority busts a cartel, like vitamins, prices fall and consumers are almost certainly better off. When a consumer protection agency goes after false advertising—such as the FTC’s recent attack on “Your Baby Can Read!”—the purveyor is often forced to withdraw the product. Not so with checking accounts. The bank still has to cover its fixed costs, it’s still striving to make money, and so long as it can continue to engage in complex pricing and bundling strategies, it has many degrees of freedom for adjusting things.

Aside from the certainty that they will do something to make the money back, it is very difficult to predict all of the knock-on effects. The demise of free checking was certainly predictable, though. Banks had overdraft fees flowing into their coffers. They competed the profits away in part by offering free checking. People who didn’t overdraw their accounts benefited greatly from this competition. In the end they were subsidized by people, and they were less careless with their finances. The attack on overdraft fees hurt these people. As banks tightened up restriction on accounts in the wake of restrictions, people who used overdrafts in times of need had to turn to other sources of (probably more expensive) credit or go without.

None of these comments is intended to argue, or prove, that these regulatory interventions were poorly conceived. Looking across all banks, and around the world, surely there were, and still are, banks engaging in deceptive practices. The point, though, is that it is simply not possible for the government authorities to ensure that they are working in the interest of the public without looking quite carefully at how other prices and service offerings will change and for whom. Regulators should take their blinders off. Unfortunately, there’s no guarantee that regulation will shift the costs from poor to rich or from dumb to smart. In the real world financial regulation can push lower income and distressed people out of banking services to higher priced and sometimes unsavory alternatives.

The other sources of knock-on effects come from the fact that depository accounts are multi-sided platforms. Checking accounts provide payment services between account holders and receivers of money, and they broker liquidity between those who have some and investors. I’m going to focus on the payment side. (This is well-trod territory which Abel Mateus and I have examined for the EU and Bob Litan, Dick Schmalensee and I have studied for the US. Also see my e-book which has a collection of essays I’ve coauthored on this.) This point is so trivial as a matter of economics that it is nothing short of mind-boggling that policymakers have tried to dismiss it. It isn’t possible to eliminate massive amounts of revenue that banks were earning from the merchant side of the platform without having follow-on effects. Simple economics tells us they have to re-equilibrate their prices. And the facts support this everywhere interchange fees have been slashed. This phenomenon is probably most apparent in the US. As interchange fee revenue in the US grew during the 2000s banks lowered fees, made free checking almost universal, and increased services to depository customers (part of this was also driven by overdraft fees). As those interchange fees (and overdraft fees) were slashed, all this has been put into reverse.

As with bundling, my point isn’t that these interventions are necessarily bad. Rather, government policy makers can’t keep pretending in these complex markets that their interventions necessarily benefit consumers, and don’t have other unintended consequences, without doing serious analysis. It isn’t enough to say that we don’t need to worry about any of this because consumers will get the money back at the point of sale—that depends on the merchant pass-through rate. As the papers I just mentioned demonstrate, the evidence overwhelmingly supports the fact that bank pass-through rates are typically higher than merchant pass-through rates. That implies that consumers are net losers from these interventions. Yet there is no serious analysis of these relative pass-through issues in any of the regulatory interventions involving interchange fees. (The best one gets an assertion that reminds me of the old can-opener joke involving economists—let’s assume that merchants pass through 100%!)

It is easy not to love banks these days and to view everything they do with suspicion. The reality is that they provide nearly every household with depository services that are essential for living in the modern world. Regulators should absolutely be looking at these depository products and services to make sure that they aren’t subject to competition or consumer protection problems. But they should make sure they do their homework so that interventions help rather than harm consumers overall.