A friend called to my attention an essay by Harold Pollack that was posted on Vox last week, “How new regulations saved consumers billions in credit card fees.” P0llack is apparently a professor of social service administration with a primary expertise in public health and crime, but has written a brand-new book on personal finance. The focus of Pollack’s article is the effects on consumers from the enactment of the Credit Card Accountability and Disclosure (Card) Act of 2009, which codified existing regulatory limits on the ability of credit card issuers to adjust credit card terms in light of changes in consumer risk (such as limiting the ability to raise interest rates) and placed price controls on certain behavior-based fees, such as over-the-limit fees and others.

According to Pollack, the effect of the Card Act essentially was a free lunch to consumers:

My favorite finance paper published last year makes clear that struggling with credit cards is not unusual. The study examined 2008–2012 data from a mammoth database of 160 million credit card accounts at America’s eight largest banks to analyze the practical impact of the Credit Card Accountability Responsibility and Disclosure (CARD) Act, which Congress passed in 2009. The authors found that the CARD Act was a triumph of financial regulation.

“The CARD Act did two main things,” according to Neale Mahoney, a co-author of the study and my cross-campus colleague at the University of Chicago. “First, it restricted a number of credit card fees. Second, it required credit card issuers to provide information on annual statements that was designed to ‘nudge’ consumers into making larger monthly payments on their cards.”

Mahoney and his co-authors found that the legislation saved consumers $11.9 billion per year, largely by reducing fees imposed on the least sophisticated consumers who have the lowest credit scores.

And unlike other sorts of credit regulation, the CARD Act seems to have produced few offsetting unintended consequences. “We don’t find any evidence that card issuers offset the reduced fee revenue by increasing interest rates (or other fees not targeted by the law) or by reducing access to credit,” Mahoney told me.

Most of the savings came from eliminating fees credit card companies used to charge when customers went over their credit limits.

The paper that Pollack identifies as his “favorite finance paper published last year” is this one, “Regulating Consumer Financial Products: Evidence from Credit Cards” by Sumit Agarwal, Souphala Chomsisengphet, Neale Mahoney and Johannes Stroebel. The theory of their paper rests in the idea of so-called “shrouded fees,” a theory from behavioral economics that rests on the idea that certain price or quality elements of consumer contracts (including consumer finance contracts) essentially escape the notice or understanding of consumers when they enter into contracts and as a result consumers can be exploited on those margins (it is rarely specified whether this results in a transfer of rents to lenders or simply a cross-subsidization among consumers in a zero-profit equilibrium world where any supposed rents are competed away). The theory, roughly put, is that these fees are “not salient” to consumers, and as a result most consumers do not notice them when they shop for credit cards (again, the statement of the theory is ambiguous, in that it is rarely specified whether it is “most” or “all” or “enough” consumers, which are all important issues for the theoretical models to be specified). And since consumers don’t notice them and shop on those margins, it is argued, they are serving no particular risk-based pricing function and as a result if we wipe those fees out, then there should be no harm to consumers in the form of offsetting price adjustments (such as in interest rates or other fees) and no reduction in access to credit, especially for higher-risk borrowers. And so this is why Pollack touts the supposed consumer-friendly aspects of the law, in that, according to the paper he discusses, the law supposedly eliminated or restricted these fees and since they were “shrouded” or “non-salient,” there supposedly were no offsetting adjustments in terms of higher interest rates (or other fee adjustments) and no reduction in access to credit for higher-risk borrowers. And let me stress at the outset that I admire and respect these economists and I don’t see anything wrong with the economics in the article.

The problem is not the economics, but the law: The entire paper rests on a fatal flaw in the authors’ understanding of the regulatory regime they examine. Moreover, this error is fatal, in the sense that the error in understanding the regulatory regime is so profound that it negates their findings entirely. Moreover, once the error in the regulatory regime is corrected, the consumer-friendly finding that there is a regulatory free lunch here is turned on its head. Allow me to explain.

The following is a discussion of an article that Tom Durkin, Greg Elliehausen and I published last summer in the Supreme Court Economic Review entitled “An Assessment of Behavioral Law and Economics Contentions and What We Know Empirically About Credit Card Use by Consumers,” 22 S. Ct. Econ. Rev. 1 (2014). A non-final working paper version of the article is available here (I will be quoting from the as-published version of the article which is substantively similar to the working-paper version but also included some final page proof edits that are not included in the working paper version).

The Card Act was passed by Congress in April 2009 and the regulations implementing the Card Act went into effect beginning February 2010. So in order to test the effects of the Card Act, the authors constructed a database of credit card accounts beginning March 2008 and then traced those through to December 2011 (once they make various adjustments) to supposedly get before and after snapshots of the effects on consumer accounts. They narrow the analysis of the “pre-Card” period still further by starting the collection of FICO scores at April 2008. They conclude that the Card Act reduced fees paid by consumers for over-the-limit fees and other similar fees but that there were virtually no unintended consequences in terms of offsetting interest rate or fee adjustments and no restriction in access to credit.

Here’s the problem — the Card Act was not written on a blank slate. The Card Act largely codified existing regulations that were virtually identical to what later was enacted as the Card Act. The Federal Reserve regulations were formally proposed in May 2008, and the final rules were adopted in December 2008 (moreover, they had been discussed substantially before then and the substance was anticipated as early as 2007). As we write in our our article:

Recent federal regulation and legislation provides further opportunity to examine the economic significance of risk-based fees. In May 2008 the Federal Reserve Board proposed and then in December 2008 adopted final rules that regulated credit card contract terms, although those new rules were not scheduled to go into effect until July 1, 2010. In 2009 Congress passed the Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (the “CARD Act”), which legislated many of the terms of the Fed’s regulation, thereby superseding the Fed’s action. In August 2010 the Federal Reserve issued its rules implementing the CARD Act. Thus, even though the final regulations were not implemented until August 2010, banks were aware by May 2008 at the latest (and presumably by 2007 or early 2008) of pending regulation governing credit card terms.

Both the Fed’s regulations and the Card Act apply significant limitations to terms of the credit card agreement that BLE proponents claim to be non-salient. For example, except for introductory rates and variable rate cards, issuers are required to provide forty-five days’ notice before increasing interest rates and fees and prohibited from increasing interest rates on existing balances unless the account falls deeply in arrears. Such rate increases then must be reevaluated every six months. These provisions limit risk-based penalty pricing, which credit card issuers have used to help manage accounts on which risky behavior was observed. The rules also placed price ceilings on the size of penalty fees, requiring them to be reasonably proportional to the cost to the issuer. In short, the Fed’s rules implementing the Card Act substantially restricted the ability of card issuers to raise interest rates, to adjust contract terms, and to assess back-end behavior-based fees on credit card contracts (the ones alleged to be non salient).

And here’s where the problem with the Agarwal et al. paper comes in: The writers treat the entire pre-Card Act period as their “pre” period. In fact, it is telling that their article makes no mention at all of the Federal Reserve regulations that were promulgated in May 2008 and anticipated before then. Thus, their article rests on the assumption that the period early 2008 was a pure “pre” period because the Card Act wasn’t enacted until 2009 and the regulations didn’t come on line until 2010. But their baseline period was in fact already distorted by the adjustments made by credit card lenders to the Fed regulations, which the Card Act largely just codified. Again, the article makes no mention of the Federal Reserve regulations much less make any effort to control for their effects.

And it turns out that this error is important because once you extend the event window to include the Fed regulations, the free lunch for consumers touted by Pollack disappears. (Pollack also ignores multiple studies that have found an adverse effect for consumers from just the Card Act itself.) Most notably, the finding that there was no reduction in access to credit cards by higher-risk borrowers and offsetting impact on other fees disappears. We discuss several studies in our article that do actually include the effects of the Federal Reserve regulations and which uniformly find an adverse effect on access to credit cards from the combined effect of the regulations and Card Act, especially for higher-risk borrowers:

This failure to consider the anticipatory effects of the Federal Reserve’s regulations turns out to be important, as shown by Jambulapati and Stavins.[1] Examining data from the Consumer Financial Monthly survey, Jambulapati and Stavins reviewed the effect of the CARD Act on the supply of credit card credit and credit card terms. Moreover, they examined not just the period preceding the effective date of the CARD Act’s rules (February 2010) but also the earlier period of the Federal Reserve’s rulemaking. Between May 2009, when the CARD Act was signed, and February 2010, they found that banks reduced credit limits but did not close accounts at a higher rate than previously. When they expanded their inquiry to consider the possible preemptive effects of the Federal Reserve’s earlier rulemaking, however, they found that a higher fraction of accounts was closed immediately following adoption by the Federal Reserve of its rules in 2008. They also found evidence that the reduction in credit lines began during that period as well. Thus, once the Federal Reserve’s earlier rulemaking is taken into account, the two waves of regulations were associated with a reduction in both access to credit cards and credit lines, as would be predicted by the standard economic model.

In addition to identifying a reduction in lending, Jambulapati and Stavins found that average interest rates rose almost two percentage points in the period preceding the effective date for most of the CARD Act’s rules. Taking into account the market responses to the Federal Reserve’s regulations as well as the Credit CARD Act, they also found reductions in credit supply, both in terms of fewer accounts and lower credit limits.

Santucci also examined the effect of the CARD Act on credit limits, comparing initial credit lines for new credit card accounts in 2005 versus 2011.[2] Santucci found that the average initial credit line for a new card fell by 60% (from $5,000 to $2,000) and fell even further for the riskiest quartile of accounts, by 66.7% (to $500). Thus, as predicted by standard economics, restrictions on the ability to adjust interest rates and other risk-based pricing practices resulted in a reduction of initial credit lines for consumers.

Han, Keys, and Li further examined the effect of the CARD Act on access to credit by reviewing the volume of new account solicitations before and after the CARD Act became effective.[3] Focusing on a pool of consumers who had filed bankruptcy, they sought to identify the access of those high-risk borrowers to credit and the impact of the CARD Act on their access to credit.

They found that after the CARD Act became effective, the number of offers for new accounts to higher-risk borrowers fell sharply, suggesting a substantial decrease in the supply of credit available to riskier borrowers. Moreover, they found a substantial deterioration in the quality of the cards offered to those borrowers when compared to the pre–CARD Act period. “Before the financial crisis, the offers to [bankruptcy] filers are more comparable with those to nonfilers; but, in the post–CARD Act period, on balance, filers tend to receive much less favorable offers.” In particular, following the enactment of the CARD Act, lenders offered riskier borrowers much lower credit limits than before the act. Offers were less likely to have low introductory teaser rates or rewards. Moreover, following the enactment of the CARD Act, riskier borrowers were more likely to be offered cards with an annual fee, and the spread between the cost of funds and the APR widened substantially. In fact, while the interest rate spread for those who filed bankruptcy and those who did not was similar prior to the enactment of the CARD Act, subsequently the spread was 175 points wider for those who had filed bankruptcy than those who had not. As they observed, “Thus, although filers continue to receive credit card offers, lenders who extend credit to them apparently engage in a different business strategy—keeping credit limits low to mitigate default risk and levying fees to boost profit from such borrowers.” Although they found the largest effects for riskier borrowers, they found that the interest rate spread increased for all borrowers, including even those who had not filed bankruptcy.

What this means is that if one were to calculate the actual economic impact on consumers from the Card Act (and the Federal Reserve regulations) one has to include in the analysis the impact on the large number of consumers who lost access to credit cards as a result of the Card Act and thus instead were forced to turn to high-cost alternatives such as payday loans, which is the next-best alternative for many consumers who saw their credit lines slashed or lost access to credit cards entirely.

Although this paper has a fatal flaw in its understanding of the law that negates its findings, I want to emphasize that I am an admirer of the economics work of the co-authors on this paper. For example, a couple of them teamed to write one of the most important papers that tests the behavioral economics hypothesis that consumers would be predicted to systematically underestimate the likelihood that they will revolve credit card balances. For those who are interested, they find that contrary to the BE hypothesis, a majority of consumers choose the cost-minimizing contract, that most consumers correct their errors, and that consumers do not appear to systematically underestimate their likelihood of revolving and that errors are not systematically biased, i.e., consumers act in a manner that is consistent with the idea that they are as likely to overestimate their likelihood of revolving as to underestimate it — in fact, according to their data collected under the particular constraints they impose on their field experiment, they actually find that consumers are much more likely to err in a manner that is consistent with the idea that consumers are unduly “underoptimistic” about their likelihood of paying off their balances without revolving. We suggest in our paper that result is explained by standard rational choice models of consumer behavior that the costs of overoptimism vs. underoptimism are asymmetrical in the experiment, in that the costs of being underoptimistic are bounded by the size of the annual fee whereas the costs of overoptimism are essentially unbounded. You can read the discussion in the paper.

But as for the CARD Act, I believe Mr. Pollack might do well to adopt a new “favorite” finance article if he really wants to know what is going on (I’d recommend ours).

A final word — one interesting lesson from all this is to be cautious in the belief that that peer review is a panacea for the ailments associated with student-edited law reviews. I have been extremely critical of several prestigious law reviews that have published hand-waving behavioral economics articles that ignore the available economic literature, such as on the use of overdraft protection by consumers. But this article was published in an extremely prestigious economics journal and subject to presumably rigorous peer review. One suspects, however, that the peer reviewers were knowledgeable about the economics covered in the article but not the full legal and regulatory framework and so presumably the reviewers and editors were also unaware of the existence of the Federal Reserve regulations that predated the Card Act.

[1] Vikram Jambulapati and Joanna Stavins, The Credit CARD Act of 2009: What Did Banks Do?, Public Policy Discussion Paper, Federal Reserve Bank of Boston,  No 13-7 (Oct 2013), online at http://www.bostonfed.org/economic/ppdp/2013/ppdp1307.htm.

[2] Larry Santucci, A Tale of Two Vintages: Credit Limit Management Before and After the CARD Act and Great Recession, Philadelphia Federal Reserve Bank of Philadelphia Payment Cards Center Discussion Paper (Feb. 2015); see also Joshua Ronen and Tiago da Silva Pinheiro, Unintended Consequences of the Credit Card Act (Aug. 2014) (concluding that the CARD Act likely was welfare reducing for many consumers).

[5] Song Han, Benjamin J. Keys, and Geng Li, Unsecured Credit Supply over the Credit Cycle: Evidence from Credit Card Mailings, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Working Paper 2011-29 (2011), online at http://www.federalreserve.gov/pubs/feds/2011/201129/201129abs.html.