Senator Chris Dodd (D-CT) is likely to unveil highly-anticipated financial reform legislation in the coming week. This news comes a few days after Republican Senator Bob Corker announced his plan to partner with Dodd on financial reform. Until that point, the two political parties had been unable to see eye-to-eye on this topic. A bi-partisan agreement would likely include stronger government oversight of Wall Street, but not a new financial protection agency for consumers (a sticking point for Senator Corker).
But in their efforts to hammer out a compromise and gird our country against future financial crises, our representatives should be mindful of the history of unintended consequences that resulted from poorly thought-out government financial intervention.
One consequence reared its head late last year, following the passage of the Credit CARD Act of 2009. Among other provisions, this legislation placed limits on the fees that some card providers could charge to their customers, capping them at 25 percent of the card’s total credit line. Fees like this were targeted because they were considerably higher than normal card fees, and sometimes “hidden” in the small print of a card’s agreement.
Congress’ actions may sound reasonable, until you consider that many consumers with poor credit histories relied on these high-fee cards as their only source of credit.
For the majority of Americans who don’t have a spotty credit history, getting a credit line with few fees attached is no big deal. However, for those who have made poor spending decisions in the past, a card provider generally charges a higher up-front fee to compensate for the higher risk that the borrower will skip out on the bill.
But with those fees capped, the card companies have two options: they can stop providing cards to customers with lower credit scores, or they can raise interest rates. One card issuer, called First Premier, chose the latter option: they lowered their annual fee to $75 (from a previous $256), and raised interest rates to an unheard-of 79.9 percent. That’s nearly seven times the APR of an average credit card.
Some news stories blamed First Premier for bilking consumers, but this ire is misdirected. A credit company can’t remain in business long if they’re always lending and never being repaid. Whether it’s through higher fees or higher interest rates, the company has to be compensated for the greater risk of lending to those with poor credit histories. And if well-intentioned legislators decided to cap both fees and rates, companies like First Premier would find themselves out of business – and many Americans would find themselves out of any credit at all.
You can see another example of regulation-run-amok in our storied “laboratories of democracy” across the nation. Many state legislators have voted to limit short-term (or “payday”) lenders, either through an outright ban or through caps on the interest rates the lenders can charge. This industry has no shortage of critics, and new regulations have been popping up all over the country.
But, again, legislators have neglected to consider unintended consequences. “Payday” lenders play an important role for millions of people who may not have access to a traditional line of credit. If, for instance, a prohibitive rate cap forces these lenders out of a state, consumers in need of credit seek funds from riskier sources (e.g. loan sharks) or end up defaulting on their financial obligations. It’s no surprise that a study by the Federal Reserve Bank of New York found that states that have banned payday lenders – including Georgia and North Carolina – saw an increase in bounced checks and higher rates of bankruptcy.
The moral of the story isn’t that every government regulation is bad; it just means that the world isn’t as cut-and-dried as our political talking points make it out to be. Corruption on Wall Street and spiraling consumer debt are both serious problems that need real solutions. But if policy decisions are based on emotional arguments instead of economic facts, ham-fisted government interventions are more likely to create new problems than to fix the old ones.