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The Three Consumer Banking Systems

posted by Adam Levitin

For the past couple of years we've heard a lot about shadow banking versus traditional banking. But this dichotomy treats the traditional banking system as a unitary whole. That's hardly the case for consumer banking. The United States currently has three consumer banking systems. They have somewhat separate regulation and market segments, but they are fundamentally in competition with each other. 

The first system is the too-big-to-fail commercial banks. They are almost all structured as national banks, regulated by the Office of the Comptroller of the Currency. The second system are the community banks and credit unions.  They tend to be regulated by the FDIC and NCUA, but also by the Fed or state banking supervisors.  And the third system are the nonbank finance companies (payday lenders, title lenders, even pawn, etc).

Despite the competition between these sectors, they have cooperated to a surprising degree recently, particularly community banks and credit unions with commercial banks. For example, on both bankrutpcy cramdown and the Durbin Amendment, there were carve-outs for small institutions (<$10B net assets), but the small banks still fought furiously despite being exempted. I'm frankly puzzled why they are willing to carry water for the big boys (do they want to be part of the club?). Maybe someone will explain in the comments. But below the break I'll lay out the case for why the smaller banks should actually be strongly supportive of recent consumer finance regulatory initiatives. 

The community banks and credit unions have two major disadvantages vis a vis the big banks. First, they lack economies of scale. And second they lack the too-big-to-fail funding premium.  One would think that this would make them want to level the playing field. They can't offer the fancy products and bells and whistles of the big boys, and they can't do as sophisticated data analysis that supports those products.  Instead, their advantage is that their leadership is in the communities they serve, and they can offer better customer service.

The problem for community banks and credit unions is that it is hard for straight-forward, clean, no-tricks products to compete against products that have lots of bells and whistles meant to hide the total cost of the product (what Gabaix & Laibson term "shrouded pricing"). The clean, simple products might actually be cheaper or at least competitive once one figures in better service, but that isn't apparent to consumers because of the way product pricing is structured by the big banks (e.g., splitting up the cost in many separate price terms so apples-to-apples comparisons are impossible). Shrouded pricing lets the big banks offer products that appear to be much more competitive than they actually are. 

The best thing that could happen for community banks and credit unions is a regulatory regime that encourages transparent pricing so that consumers can do apples-to-apples comparisons. Such a regime would go a long way to leveling the playing field for smaller financial institutions. 

Price transparency is likely to be a major focus of CFPB activity, which means that the CFPB could be the small banks' best friend. I hope that community banks and credit unions will recognize this. I've been arguing for a couple of years that a lot of recent regulation that they have opposed actually helps them more than it hurts them (see here too). The regulatory burdens of the Credit CARD Act, for example, are much more severe for banks that relied on risk-based repricing models, and those tended to be the big banks. Likewise, the CARD Act is likely to force greater price transparency, which benefits the smaller banks. 

A similar story exists for the Durbin Amendment. The large banks have economies of scale, particularly in the card space, that the smaller ones will never match. Moreover, the large banks currently get special "rebates" from the card networks in addition to interchange fees (meaning interchange really isn't a one-size-fits-all fee for the issuer banks). First Bank of Springfield isn't getting a rebate from Visa. The Durbin Amendment limits the large banks' ability to lure in customers via rewards programs that the small banks can't match. It also will likely end the rebates (depending on regulatory interpretation). And it would likely leave the small banks (<$10B net assets) with a separate and higher interchange fee schedule

Yet small banks and credit unions are in a tizzy about any sort of regulatory changes. Part of this is that they are simply in a bad state in general and are worried about any sort of change. And par tof it is because regulatory costs might be harder to amortize for smaller institutions--they lack regulatory compliance economies of scale. I suspect this makes compliance easier; smaller is nimbler, but that's just conjecture. There's no question that regulations like the CARD Act and the Durbin Amendment might reduce revenue for small banks. But these regulations hit the big banks much, much harder, and that's to the small banks' advantage. And if one is worried about the too-big-to-fail problem (both because of the systemic risk and because of the political power problems it creates), then this sort of leveling of the playing field is a good thing. 

All of which brings me back to a really bizarre point that the US Chamber of Commerce has been raising in its Congressional testimony about the CFPB of late. The Chamber is expressing concern that there might be "regulatory capture" of the CFPB--that the CFPB will regulate in the interest of the consumer finance industry, rather than the public interest. This concern is particularly weird coming from the Chamber, whose central mission is to capture regulators. I couldn't believe that the Chamber's representatives could express concern about capture with a straight face.  

But who does the Chamber fear will capture the CFPB?  It can't be multitude of well-financed consumer groups or seniors or military families. And consumer finance just isn't an agenda topping issue for civil rights groups. The plaintiff's bar is the anti-Christ to the Chamber, but the CFPB doesn't have the power to create private rights of action, so it's unlikely to be a tool of the plaintiff's bar any more than the FTC is. Businesses will be able to see UDAAP rulemakings coming a long way off, which will give them plenty of time to ensure compliance. 

So this has left me puzzled for a while. But now I'm thinking that if the community banks and credit unions have any sense, they should make it their mission to try and capture the CFPB. And maybe that's what the big banks that back the Chamber are really worried about. 

[Update: a reader with experience in the banking sector says that the economies of scale stop once the bank hits between $5-$10B in assets. If anyone has thoughts on this, I'd be very keen to hear them.]



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