In May 2016, the federal Consumer Financial Protection Bureau (CFPB) published a proposed rule that would prohibit arbitration clauses in consumer financial contracts that foreclosed class-action remedies. The CFPB based this decision, in part, on its finding that individual dispute-resolution mechanisms are insufficient to enforce consumer protection, as evidenced by “the relatively small number of arbitration, small claims, and Federal court cases” brought over consumer finance claims.
In its analysis justifying its proposed rule, the CFPB acknowledged that financial institutions have market incentives to refund fees to customers who complain; but it worried that “if two consumers bring the same dispute to a company, the company might resolve the dispute in favor of a consumer who is a source of significant profit while it might reach a different resolution for a less profitable consumer.” Class-action litigation, the CFPB found, not only transfers more dollars in the aggregate to consumers but also “benefit[s] consumers not included in a particular class settlement because, as a result of a class settlement, companies frequently change their practices in ways that benefit consumers who are not members of the class.” In reaching the latter conclusion, the CFPB explicitly pointed to a federal court decision in the Northern District of California, Gutierrez v. Wells Fargo, which changed the bank’s nationwide overdraft practices.
This report argues that the CFPB is correct that arbitration cases are relatively rare, that financial companies have incentives to—and often do—resolve fee disputes according to customer profitability, and that class-action litigation affects company behavior. Where the report disagrees with the CFPB is in the latter’s conclusion that prohibiting contractual clauses that preclude class-action litigation benefits consumers. The CFPB’s finding, like the Gutierrez court’s decision, rests on a fundamental misunderstanding of banks’ and other institutions’ economic framework for consumer finance products and how that framework intersects with consumer welfare.
After looking in some depth at the actual fee structure that financial institutions use, as well as the overdraft litigation in Gutierrez upon which the CFPB relied, the report performs an economic analysis examining how a financial institution’s overall objective of maximizing profits influences its discretion in determining whether to waive or impose a transaction-based fee on a consumer. This model suggests that the market incentive to retain a customer’s business generates substantial incentives for financial institutions to forgive fees to complaining customers. Thus, the relative infrequency of arbitration over consumer finance disputes makes sense: under the model, the firm’s market-driven incentive to avoid loss of business is stronger than the incentive created by a costless and perfectly accurate arbitration regime.
Moreover, the model suggests that financial institutions have strong incentives to invest in information about customer profitability—as determined by average bank balances and propensity to borrow on overdraft lines or engage in other costly fee-triggering transactions—in deciding whether to waive fees. This investment in information benefits some customers while harming none: it satisfies the Pareto criterion for improving social welfare by making some people better-off while making none worse-off.
The report then applies the model to class-action litigation, which mandates broader fee forgiveness not according to contractual language but due to other norms, such as state consumer-protection laws. Such litigation unbundles the tailored regime of fee forgiveness based on account information, so that banks can no longer use customer profitability information in a way that maximizes profits—lessening the incentive to gain such information. Because class-action liability amounts to involuntary lessening of transaction fees that banks would otherwise collect from low-balance, high-transaction-volume accounts, customers must have higher balances or pay other fees to be profitably maintained. Thus, class-action liability is likely to harm the customers it is supposed to help, as banks respond competitively by raising minimum-balance requirements or otherwise modifying fee structures and fee-forgiveness programs.
In fact, large financial institutions have responded as the model would suggest. Free checking accounts have now become a thing of the past. More precisely, major banks now charge monthly fees for checking accounts that are waived only if customers maintain a minimum daily balance.
Jason Scott Johnston is the Henry L. and Grace Doherty Charitable Foundation Professor at the University of Virginia Law School.