The Lie Banks Use To Protect Their Late-Fee Profits

In response to new federal rules capping outrageous credit card late fees, big banks say they need to find other ways to bilk consumers to ensure profits don’t take a hit. But as celebrated economist Hal Singer notes in today’s featured story, this “conservation of ill-gotten gains” argument is pure nonsense — and hints at a market failure that hurts consumers and businesses alike.

Rock the boat.

(AP Photo/LM Otero)

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Much of modern economics borrows from physics. Some of these appropriations, like how the scientific concept of maximum energy has influenced the study of consumer behavior, proved immensely valuable. But somewhere along the way, neoliberals and economic pundits misappropriated a physics concept — the conservation of energy — to fend off any attack on hidden fees or ill-gotten profits. 

Physics holds that energy is neither created nor destroyed but merely changes form. When interpreted through economics, this new conservation theory implies that any attempt to tamp down on profits from one illicit 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. I have named this theory the “Conservation of Ill-Gotten Profits” fallacy, admittedly a mouthful. Duncan Bowen Black, an economist who blogs under the pseudonym Atrios, has named it the “Lump of Profits” fallacy, inspired by the more common “Lump of Labor” fallacy in economics.  

The Lump of Profits fallacy is peddled by economists in every domain, but 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 — claim they will raise a fee, charge someone else more money, or take away some benefit. 

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In February, when the Consumer Financial Protection Bureau proposed capping credit card late fees — which cost consumers an estimated $14 billion annually — 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.” (The $8 cap went into effect earlier this month.) 

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 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 Consumer Financial Protection Bureau’s cap on late fees? 

Third, while there are economic models 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 are optimally set.

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, up front, 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 — banning a range of abusive fees that obscured the real cost of credit — despite warnings by the bank lobby. 

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.

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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. And they are facing the prospect of limits on high-cost loans offered in the form of overdraft fees, which has generated the usual warnings of all the good things that will be lost. 

It’s a great theory 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. 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. In other words, excessive and often unfair pricing by banks in one area hasn’t slowed excessive and often unfair 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’ loyalties. 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, lost innovation, and lost economic activity 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 any firm in the economy is automatically entitled to the same profits that it could 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.

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