laws
Overdraft Fees, Credit Card Late Fees, and the Lump of Profit Fallacy
Predetermined profit margins and prices hidden in the back end of a transaction are really just market failures.
Introduction
In January 2024, the Consumer Financial Protection Bureau (CFPB) proposed to limit fees charged for overdraft credit when that credit is not offered in compliance with the price disclosures and other requirements of the Truth in Lending Act (TILA).[1] In particular, the rule would limit high fees when they are used as a back-end profit center, and it would require compliance with TILA if the banks want to charge fees higher than those limits.
The CFPB’s overdraft proposal was met with swift resistance by bank lobbyists and economic columnists. The American Bankers Association (ABA) quickly released a statement in opposition to the CFPB proposal, claiming that the proposed overdraft fee rule “would make it significantly harder for banks to offer overdraft protection to customers.”[2] Washington Post columnist Megan McCardle made a similar argument with respect to capping overdraft fees: “It seems possible banks would look to limit their losses by getting rid of those customers or making up the revenue somewhere else—or possibly both.”[3]
Banks are fighting a rule in a different CFPB rulemaking that would stop predatory credit card late fees charged on the back end to avoid price competition through annual percentage rates (APRs) on the front end. Lindsey Johnson, president of the Consumer Bankers Association, asserted a parade of horribles: “[T]his is going to increase costs, and it’s going to reduce access to credit. It just is.”[4] We refer to the claim that any attempt to regulate fees in one area will automatically result in higher prices in some related area as the “Lump of Profit” fallacy.
In this essay, we explain that CFPB’s rules for overdraft fees and credit card late fees are based on sound economic theory. This essay highlights two points in support of our central thesis: (1) a market intervention is warranted in this situation and will protect vulnerable consumers and improve competition; and (2) the reaction to the rule will not be to simply rearrange prices and price consumers out of bank accounts.
I. A Market Intervention Is Warranted
The CFPB estimates that banks collect about $9 billion annually in overdraft fees, and customers who pay overdraft fees pay about $150 on average every year.[5] Overdraft fees averaged $35 per event in recent years, and a bank can assess multiple fees for one overcharge episode whenever multiple payments result in an overdraft. These checks do not bounce; instead, the banks pay them and then charge the customer an overdraft fee.
Moreover, banks have engaged in practices that induce overdrafts (or greater fees), such as engaging in “high-to-low reordering” (processing a large debit before smaller transactions, even if the latter are posted earlier),[6] inducing people to opt in to overdraft fees on debit and ATM transactions, and using different balance calculations (ledger balance or available balance) to decide whether a transaction has overdrafted. While banks extend large amounts of overdraft credit, they use technicalities to avoid complying with protections for borrowers including disclosure of the annual percentage rate (APR), flexibility on how to repay credit, and underwriting for the ability to repay.
The CFPB’s proposed rule would give banks choices. They could continue to ignore credit laws if they can justify their overdraft fees on the basis of the bank’s incremental costs. If the banks could not do so, however, then the fee would be regulated between $3 and $14. Alternatively, the banks could price the overdraft credit at a higher amount, but they would have to provide APR disclosures and comply with the Truth in Lending Act.
The rule would apply to large banks only, which some commentators have pointed out misses some of the worst offenders.[7]
A. Vulnerable Aftermarkets
Economists recognize that market forces are especially weak when it comes to disciplining the price of ancillary or aftermarket services.[8] The classic teaching example is movie theater popcorn. Customers do not have the price of popcorn on the top of their minds when choosing among theaters; the movie choice and the drive time are paramount. And when they arrive at a theater, customers are not likely to reverse their ticket transaction and find a new theater in response to sky-high popcorn prices: the switching costs would be too steep. The same is true for the price of other common aftermarket services, such as movie rental in hotels, and printer cartridges.
Overdraft protection can be understood as an ancillary service to standard checking account services. As one economist at the Federal Reserve put it, “Most bank fees represent an example of add-on or aftermarket fees.[9] Aftermarkets can be found in many industries such as printers (for toner), computers (software), razors (blades), and many others.” When someone is shopping around for where to set up their checking account, they will primarily consider the bank’s reputation and geographic footprint, the proximity of a physical office and ATMs to their home or office, and the interest rate offered on savings. Overdraft fees and the complicated ways in which banks provide overdraft coverage and determine fees likely are not top of mind, and even if they were, the bank won’t prominently display its overdraft fee on its webpage. Moreover, customers have limited attention (as implied by economic experiments showing that sending repeat messages to customers with a propensity to incur an overdraft fee was effective in changing their behavior).[10]
Indeed, even though Bank of America has one of the lowest overdraft fees among very large banks, one of the authors learned of Bank of America’s overdraft fee ($10) only by invoking the help tab on its website, and then looking through several documents that contained the term “overdraft.” The fee is buried in a document titled “Personal Schedule of Fees.”[11] Given the high costs of switching banks, when a customer is hit with an exorbitant overdraft fee, there is little chance the customer will terminate the relationship—that is, the traditional forces that discipline supra-competitive prices are absent.
The ABA quickly released a statement in opposition to the CFPB proposal, claiming that the proposed overdraft fee rule “would make it significantly harder for banks to offer overdraft protection to customers.”[12] This would only be true if the cap were set below the incremental cost of providing the service and if banks were not given the option of charging more by complying with TILA. In support of its opposition, the ABA cited a Morning Consult survey, showing that 88 percent of respondents “find their bank’s overdraft protection valuable,” and 77 percent who have paid an overdraft fee in the past year “were glad their bank covered their overdraft payment, rather than returning or declining payment.”
There’s no doubt bank customers value overdraft protection and detest the notion of having rent or other important payments bounce. The relevant economic question, however, is whether market forces can be counted on to supply competition in how overdraft fees and practices are set, to affect the choice of bank, and to price overdraft protection at competitive levels (i.e., near marginal costs). So this survey was a bit of misdirection.
A more relevant survey, by contrast, would ask bank customers whether they considered a bank’s overdraft fee and overdraft practices when choosing with which company to bank, and whether it would be easy to switch banks upon learning of the bank’s high overdraft fee after choosing a bank. If the answer to both questions is no, then bank customers are vulnerable to back-end pricing on overdraft protection without the benefits of competition.
A consumer who wishes to compare bank accounts today would find it very difficult to assess differences in overdraft practices. Most large banks charge approximately the same $35 fee. But there are a variety of complicated practices that can affect when and how often that fee is charged.[13] Most consumers would have no idea of those differences and no easy way to compare them.
B. Who Bears the Burden Matters
The typical customer who bears the burden of excessive overdraft fees is low-income, which means a policy of tolerating overcharges here is highly regressive. Consumer Reports notes that eight percent of bank customers, mostly lower-income, account for nearly three-quarters of revenues from overdraft fees.[14] According to a CFPB survey released in December 2023, among households that frequently incurred overdraft fees, 81 percent reported difficulty paying a bill at least once in the past year, another indication of poverty.[15] The CFPB survey also notes that “[w]hile just 10% of households with over $175,000 in income were charged an overdraft or an NSF fee in the previous year, the share is three times higher (34%) among households making less than $65,000.”
When deciding whether to regulate how overdraft fees are charged, the economic straits of the typical overdraft fee payor is important. Economists recognize that customers in aftermarkets are generally vulnerable to high, back-end prices, but do not counsel an intervention in each of these markets. A middle-class family that overpays for popcorn at a movie theater does not engender much sympathy: if the price is too high, then can abstain without much consequence. Similarly, learning that an upper-class family overpaid for in-room dining at a boutique hotel does not tug at the heartstrings. But a low-income family that pays $35 overdraft fees could be missing out on important things like meals. And they are in no position at the time that a bank processes an incoming payment to tell the bank whether they do or do not want to have the payment bounce. A family that overdrafts a lot also could have trouble finding another bank, and probably does not have the cushion necessary to handle the complicated switch from one bank to the next.
C. The Element of Surprise
In addition to the weak market forces disciplining the price of aftermarket services, bank customers are particularly vulnerable to exploitation given their lack of knowledge about the fees. The same CFPB survey mentioned above showed that, among those who paid an overdraft fee, only 22 percent of households expected their most recent overdraft fee[16]—that is, for many customers, the overdraft fee came as a surprise. In discussing the fairness of surprise fees, Nobel prize winner Angus Deaton notes in his new book, Economics in America, that “If you need an ambulance, you are not in the best position to find the best service or to bargain over prices; instead you are helpless and the perfect victim for a predator.” Neoliberal economists might ignore these teachings, and instead trust the market to deliver competitive prices for ambulance services and overdraft fees. But anyone with a modicum of understanding of power imbalances (e.g., frictions leading to lack of outside options) and information asymmetries will quickly recognize that an intervention here is well grounded in economics.
II. The Overdraft Rule Will Not Price Consumers Out of the Market
Opponents of the CFPB rule have constructed a new economic theory that implies that any attempt to tamp down on profits from one activity will automatically lead to a newfound source of profits elsewhere.
Under this highly convenient theory for monopolists and their hangers-on, profits are like the air in a balloon; squeeze one side and the balloon expands on the other. One of us has named this theory the “Conservation of Ill-Gotten Profits” fallacy, admittedly a mouthful.[17] Duncan Bowen Black, an economist who blogs under the pseudonym Atrios, has named it the “Lump of Profits” fallacy,[18] inspired by the more common “Lump of Labor” fallacy in economics.
Although the Lump of Profits fallacy is peddled by economists in every domain, it is particularly prevalent in the banking industry. Whenever there is a proposal to deal with an aspect of bank activity that seems unfair or deceptive, bankers—or their surrogates in the press[19]—claim they will raise a fee, charge someone else more money, or take away some benefit.
Banks are fighting a rule in a different rulemaking that would stop predatory credit card late fees charged on the back end to avoid price competition through APRs on the front end. The CFPB estimates that credit card late fees cost consumers an estimated $14 billion annually.[20] That rule was finalized on March 5,[21] and the ABA and others immediately sued to overturn it.[22] In February, Lindsey Johnson, president of the Consumer Bankers Association, asserted the fallacy with no evidence: “[T]his is going to increase costs, and it’s going to reduce access to credit. It just is.”[23] In January, Washington Post columnist Megan McCardle made a similar argument with respect to capping overdraft fees: “It seems possible banks would look to limit their losses by getting rid of those customers or making up the revenue somewhere else—or possibly both.”[24]
In other words, banks will find a way to replicate the profits from today’s hidden or abusive fees indefinitely. Nothing can be done to change that. Changes only force them to seek profit elsewhere. It’s profit predestination. This pseudo-economic theory fails for myriad reasons.
First, no company is morally entitled to a predetermined level of profits. If the source of a company’s profits is a violation of antitrust, consumer protection, unfair pricing, or labor law, then the disgorgement of those ill-gotten profits restores consumers or workers to their rightful place absent the violation. That’s the end of the story.
Second, a threat to raise the price of a related service in retaliation to some intervention strains credulity, as it suggests a company charitably kept prices of another service artificially low, rather than optimizing all prices for profit. What services, exactly, were banks underpricing prior to the CFPB’s cap on late fees?
Third, while there are economic models[25] that spell out the conditions under which the price of an ancillary product acts as a subsidy for the primary product — movie-theater popcorn, for example, subsidizes the price of movie tickets — we shouldn’t assume that every ancillary product or service subsidizes the price of its corresponding primary product or service. Companies should back up threats to raise the price of related offerings in response to price regulation by empirically demonstrating that such subsidies are necessary. In the absence of rigorous proof, regulators should assume there is no subsidy required and the price of related services is optimally set. Moreover, to the extent that overdraft fees do subsidize the cost of bank accounts, it is a highly regressive subsidy, charging the least able so that wealthier people can have free checking.
Fourth, just because banks can get away with high fees when they’re hidden on the back end, that does not mean that competitive forces will allow them to charge those same high prices when they are forced to do so transparently, upfront, in a way that allows consumers to easily comparison shop.
Indeed, in the realm of banking services, there is good evidence that contradicts the Lump of Profits theory. Back in 2009, Congress passed a comprehensive reform of the credit card market[26]—banning a range of abusive fees that obscured the real cost of credit—despite warnings by the bank lobby.[27] In 2013, initially skeptical researchers dug into the data and found that the policy worked: The market was more transparent, with borrowers being charged annual percentage rates that reflected actual cost, and credit access was unimpeded by the changes.[28]
Banks and their surrogates are fighting tooth and nail against greater competition in the payment system by warning that lost profit will destroy card-reward programs[29]—programs which, like overdraft fees, are likely highly regressive, charging the least able so that wealthier people can have credit card rewards.
The Lump of Profits theory is a great one to believe in, if you are a bank. It turns out that average net profit margins for money center banks (banks situated in economic hubs) and regional banks are about 31 percent, more than for any other industry in America.[30] You might think that industries like pharmaceuticals (15 percent net margins) or wireless telecom (nine percent net margins) were blessed, but apparently, neither of them were picked to automatically get profits as high as the big banks.
As their leading net profit margins suggest, the banks just aren’t leaving any money on the table—or, per the Lump of Profits fallacy, they aren’t eschewing untapped profits that could be seized in response to regulation.
Another episode highlights the Lump of Profits fallacy. As banks have hit consumers with higher interest payments, late fees, overdraft fees, and more, they have also hit businesses with higher swipe fees.[31] In other words, excessive pricing by banks in one area hasn’t slowed excessive pricing in other areas. Instead, all of these revenues have increased alongside each other for years. In other words, it’s just the opposite of what banks assert with their profit-predestination argument.
The U.S. economy wasn’t built on predetermined profit margins or hidden prices. Instead, it was based on robust, transparent, free-market competition. In a competitive market economy, businesses need to work to earn customers’ loyalty. When they do that by providing better products, services, or lower prices—that is, when they compete on the merits—everyone wins. The business makes money, consumers get value, and the economy grows.
Predetermined profit margins and prices hidden in the back end of a transaction are really just market failures. They only can happen when there is collusive or monopolistic behavior, or when companies act in deceptive ways. Economists have long shown that such market failures lead to degraded products and services,[32] lost innovation,[33] and lost economic activity[34] overall. In short, if you accept that excess profits are destiny, everyone loses.
Because the Lump of Profits fallacy is so destructive to the foundational principle of open markets, it’s important to stay vigilant against the idea that market corrections should be rejected because any firm in the economy is automatically entitled to, and will be able to charge, the same profits that it can achieve using anticompetitive or deceptive measures. That belief strikes at the heart of the free-market system and is a license for everyone to keep getting ripped off. No one should fall for it.
Notes
[1] https://www.cbsnews.com/news/b...
[2] https://www.aba.com/about-us/p...
[3] https://www.washingtonpost.com...
[4] https://punchbowl.news/archive...
[5] https://www.consumerfinance.go...
[6] https://papers.ssrn.com/sol3/p...
[7] https://www.reuters.com/breaki...
[8] https://www.semanticscholar.or...
[9] https://papers.ssrn.com/sol3/p...
[10] https://papers.ssrn.com/sol3/p...
[11] https://www.bankofamerica.com/...
[12] https://www.aba.com/about-us/p...
[13] Only some of those practices are described in CFPB, Overdraft/NSF metrics for Top 20 banks based on overdraft/NSF revenue reported during 2021 (Dec. 6, 2022, partially updated May 22, 2023). Other practices that vary by institution are payment reordering, fees for authorize-positive-settle-negative, and use of the ledger balance or available balance to assess overdraft fees.
[14] https://www.cbsnews.com/news/b...
[15] https://www.consumerfinance.go...
[16] Id.
[17] https://twitter.com/HalSinger/...
[18] https://twitter.com/HalSinger/...
[19] https://www.washingtonpost.com...
[20] https://www.cnbc.com/select/cr...
[21] https://www.consumerfinance.go...
[22] https://news.bloomberglaw.com/...
[23] https://punchbowl.news/archive...
[24] https://www.washingtonpost.com...
[25] https://en.wikipedia.org/wiki/...
[26] https://www.gsb.stanford.edu/i...
[27] https://ourfinancialsecurity.o...
[28] https://www.nytimes.com/2013/1...
[29] https://thepointsguy.com/news/...
[30] https://pages.stern.nyu.edu/~a...
[31] https://www.wsj.com/finance/vi...
[32] https://www.investopedia.com/ask/answe...
Rethinking Drug Laws: Theory, History, Politics – review
In Rethinking Drug Laws: Theory, History, Politics, Toby Seddon analyses drug control policy and argues for a paradigm shift that decentres the West and recognises China’s historical and contemporary influence. Unpacking the complexity of drug law as a regulatory system, Seddon’s well-argued, insightful book calls for more inclusive, evidence-informed and democratic policymaking, writes Mark Monaghan.
Rethinking Drug Laws: Theory, History, Politics. Toby Seddon. Oxford University Press. 2023.
Based on forensic archival research, Rethinking Drug Laws: Theory, History, Politics by Toby Seddon is beautifully written and deeply insightful. Its central thesis is that we must decentre the West, especially when thinking about the origins of drug policy. Viewing drug policy from a Western vantage point is a blip because, as Seddon shows, China has long been a key player on the global stage, but drug policy analysis, with some exceptions, has not always recognised this. In this way, drug policy analysis has fallen into the trap of Occidentalism, providing a distorted view of the West’s prominence. Seddon sets out to show the folly of this and succeeds. Furthermore, he demonstrates that there are signs of regression toward the mean as China once again is becoming a primary global player, particularly through the belt and road initiative.
In drug control, inanimate objects – drugs – are not banned, but transactions that would otherwise constitute lawful economic activity are criminalised.
A defining feature of Seddon’s writing is the remarkable capacity for distilling complex historical narratives into an easily digestible schema. We see this clearly in the introduction, where he proposes a tripartite structure of race, risk and security arcs as ways to think about the origins of what has only recently become known as the “drug problem”. We are also introduced to another key idea that drug laws function through controlling the circulation of goods, ie, they are regulatory systems. In drug control, inanimate objects – drugs – are not banned, but transactions that would otherwise constitute lawful economic activity are criminalised. This is about the control of personal property rights. The right to personal property is not explicitly eroded through prohibition, but some transactions in relation to them become impermissible and there is no legal recourse for the right to conduct these transactions. In outlining this, the entire premise of drug control shifts from one of a struggle between the forces of prohibition and legalisation to understanding legalisation and prohibition within a broader system of regulation.
Seddon refers to regulatory systems as ‘exchangespace’. […] The basic premise of exchangespace is that ‘market behaviour and regulation are not separate realms but two sides of the same coin’.
Seddon elaborates on this over the following chapters and in doing so demonstrates a depth of research and scholarship that is genuinely cross-disciplinary, bringing in economics, sociology, history, political economy as well as insights from criminology, regulation theory and socio-legal perspectives. There is, however, method to this, which shapes and is shaped by the development of a new conceptual framework. Drawing on the work of Clifford Shearing and others, Seddon refers to regulatory systems as “exchangespace”, and this is painstakingly outlined in Chapter Two. The basic premise of exchangespace is that “market behaviour and regulation are not separate realms but two sides of the same coin”. The dimensions of exchangespace can be summarised as:
- Regulation operates in networks consisting of multiple dimensions and participants.
- Nodes are a key element of networks and facilitate communication across them. Analysis of networks should, therefore, look at the nodes because these are the locus within a system where various resources are mobilised in order to govern effectively.
- Not all nodes exert the same amount or kind of power in the network. The most economically powerful nodes can distort the smooth operation of the entire system.
- Networks adapt overtime. Consequently, policy does not stand still, it evolves and emerges in often unpredictable ways.
Seddon encourages us to focus on the network conditions that led to increasing control of certain substances (what we know as drugs), whilst permitting or at least freeing the trade in others (coffee, alcohol and tobacco) and to view these as complex systems.
Seddon encourages us to focus on the network conditions that led to increasing control of certain substances (what we know as drugs), whilst permitting or at least freeing the trade in others (coffee, alcohol and tobacco) and to view these as complex systems. In complex systems, the outcomes of policy depend on understanding where the starting point is. However, identifying starting points is almost impossible, not least, as Seddon contends, because we don’t yet have the theory and methods at our disposal to do so. The best we can do, then, is to try and understand elements of the wider network; that is, which nodes are exerting power in which contexts while acknowledging that these systems are unpredictable and constantly changing. Seddon uses this framework to explain the origins of Cannabis Social Clubs in Catalonia and the complex politics behind the patchy implementation of Heroin Assisted Treatment. In this way, we can start to explain the ways in which, for example, overdose prevention centres have been established in some locations and not others, or why and how drugs were decriminalised in Oregon, a decision that may now be reversed.
Seddon demonstrates how the origins of the current system can be traced to colonialism […] in the nineteenth century, even if we cannot pinpoint the exact starting point.
A complex system like drug policy can never revert to an earlier stage of development. Oregon’s post-decriminalisation society will not be the same as its pre-decriminalisation society. Fortunately, however, complex systems do have path dependency, and so it is possible, as Seddon does in Part II (Chapters Four and Five), to outline the chain of events that has led to the contemporary global drug regulatory system. Seddon demonstrates how the origins of the current system can be traced to colonialism (the race arc) in the nineteenth century, even if we cannot pinpoint the exact starting point. The key lesson here is that we need to look East rather than West to understand this. Here, the Opium Wars of the nineteenth century are a key reference point.
Taking an exchangespace perspective we see that the Opium Wars (1839-1842) were more than just about one country (Britain) establishing a right to export its products (opium) to a large market (China). More accurately, they represented a military contestation that focused on the boundaries between legal and illegal trade – a contestation that lies at the heart of drug control. The burgeoning temperance movement proved a powerful node alongside increasingly powerful US economic interests, which contributed to the realigning of opium in the late nineteenth and early twentieth centuries as a product requiring control. The Opium Wars also represent – in the form of the second opium (Arrow) war – the first moment that drug control (as opium control) became a multinational affair. In this way we can draw a direct line from the Opium Wars to global drug prohibition fifty years later.
In Part III (Chapters Six and Seven) Seddon turns to the political nodes of the regulatory network, focusing on “what is at stake when drug laws and drug policy become a matter of political contestation”. The idea here is that within exchangespace, it is impossible to stand outside of politics, as the system is inherently political. Politics is a powerful node. This section draws heavily on Loader and Sparks’ conception of public criminology and the strategies that can be used to add coolant to heated debates.
To hand over decision making to experts is to abandon any hope for democratic politics as it replaces one system of domination (populist politics) with another (experts).
For Seddon, this should not simply mean that populist ideas – such as the “war on drugs” – are replaced with technocratic, evidence-based decisions. To hand over decision making to experts is to abandon any hope for democratic politics as it replaces one system of domination (populist politics) with another (experts). Arguably, that is why it has become more commonplace to speak of evidence-informed or evidence-inspired policy. However, Seddon provides a way out of that impasse by stating that “better politics” is required more than better evidence. This has two dimensions. First, we need a more careful analysis that focuses not only on the impact or harms of current drug policies (eg, criminalisation, stigmatisation, racist stereotyping) as they occur, but considers in depth and precision how the arcs of race, risk and security perpetuate this system. Secondly, on a practical level, a more cosmopolitan, comprehensive and inclusive deliberative democracy is required which can yield discernible change. Reforms in Catalonia and Oregon point to how this can be done, but also its precarity. Scaling it up and bringing in the voice of people who use drugs as part of a social movement is essential.
The text brings us almost full circle to how a better politics might lead to a more sophisticated, fairer form of market regulation.
Seddon points to the success of prison reform movements in France in the 1970s or the radical politics of mental health campaigning organisations which sought to foreground the voices of survivors of the psychiatric system as providing a blueprint. To this we could add decades of campaigning by disability rights activists, which have shown how positive change can occur with these strategies. There is no reason why drug policy should be any different. In this way, the text brings us almost full circle to how a better politics might lead to a more sophisticated, fairer form of market regulation. Ultimately, for Seddon, this means shifting the focus of social and political science away from the way the world is, towards the deeper thinking on the kind of world we want. This is the book’s challenge. It is us up to us to deliver.
Note: This interview gives the views of the author, and not the position of the LSE Review of Books blog, or of the London School of Economics and Political Science.
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