What's Wrong with Banks

Nearly every Yahoo! Finance article has dozens of reader comments castigating bankers for the damage they have done to the U.S. economy. If this is the common wisdom, and the common wisdom is wrong, then what is the truth?

Theoretically, debit cards save consumers money by reducing their costs of holding cash. At least, this is what the bankers associations believe. But in order to feed their top and bottom lines, over the years bankers got themselves addicted to two kinds of fees: those they would levy on customers who were "bad", which is to say, those who overdrew their accounts; and fees charged to the merchant at the point of sale. Now that the U.S. has regulations curtailing both types of fees, the banks are finding themselves short of many billions of dollars of fees. So they have tried to make up the missing revenue through other fees. Bank of America, for example, is famous for saying that it would levy a $5 monthly fee on debit card users, only to rescind its plans when popular outrage made it clear that the fee would cost them too many accounts.

Let's start counting up the mistakes.

First, a debit card is not an asset, for most customers. Unlike paper cash, which provides a clear signal when it is being expended, debit cards make it much more difficult for the customer to track the drain on their bank balance. It makes overspending much easier. This benefits the merchant, because they can sell more goods, and it benefits the bank, which collects higher fees on the transaction, and which gets a small probability of collecting a penalty fee in the event the customer's account is overdrawn. The banker's theory that a debit card saves money for the customer makes the incorrect assumption that the customer's spending will be the same as when the same customer uses cash. Academic studies show that even savvy credit card holders spend more money when using a credit card than they do when using cash.

Debit cards were introduced as massive trickery in which retailers and banks colluded to induce consumers to overspend while shopping. They reduce time at the register, but by disconnecting the customer's budget sense during the payment process, they cause the customer to lose hundreds and thousands of dollars per year in spending that is unnecessary.

If you have $100 in your wallet and are about to buy an item that costs $40, if you have to use two of the five 20s in your wallet, you might decide to cancel the transaction and not buy at all. If you use a check, you might still compare the amount you are writing on the check with the cash in your wallet, but you will also think "I still have $100 in my wallet," making it feel like you aren't spending of your cash. If you use a debit card, you might not even notice that the total is $40. Hence it is very easy to let the transaction go through, because it barely feels like you are spending money at all.

A number of banking services that evolved between 1995 and 2010 are based on psychological tricks of this type. Customers believe they are rational, and are not. The banks get their services and fee structures approved because everyone, including regulators, assume that customers are rational, and they are not. The services are perhaps designed by the bank with full knowledge of the irrational behavior of customers, or perhaps it is just that some of them get lucky when they try random services, and they keep the profitable combinations, which just happen to have unpleasant side effects on customers.

Now, when I say irrational, I don't mean customers who act against their own best interest, or who are random or perverse. I mean that they act in ways that are chronicled in the psychology literature, things like helping their friends to do worse than they do on critical tests. Also, by not doing arithmetic when considering whether a purchase is in their budget. That's hardly a case of insanity or not. It is simply that rounding off numbers and doing the arithmetic in your head is much harder when using debit cards than it is when using cash. It isn't the bank's "fault" that you don't do this arithmetic. It just happens to be the beneficiary of your laziness.

You could also say that cash is like an automatic computer, because the supply of bills remaining in your wallet always matches the amount of money you have left (!!).

So if the bankers are evil, it is because they have marketeers that use the same tricks that Neiman Marcus, Saks, Wal-Mart, Nordstrom's, Sears, Dollar Tree, Kohl's, Bon Ton, Abercrombie, Safeway, Kroger, and thousands of other retailers and hucksters use to take your money and make you overspend your budget every day.

I've picked on debit cards here, but you can probably make the same case for other financial products, especially mortgages, that permit the customer to make a mistake.

You could go further, and discover that the existence of conservative banks doesn't help, because there will be banks that play at the margins. If the conservative bank turns down a mortgage applicant for a loan, but the bank of marginal behavior offers the same applicant a loan, who is the hero and who is the victim? Many, many community activists at one time or another, and perhaps now, would have castigated the conservative bank for failing to agree to the loan, and praised the marginal player. Where were these activists in the era of 100% loan-to-value? Shouldn't they have been out there trying to stop individuals and families from taking these loans from overly generous banks?

The same thinking applies to all risk-based banking products. Risky bankers ruin it for those with better values. Aggressive and marginal consumers are either taken advantage of by the bank, or taking advantage of the bank (and I don't see that you can make a definite case that one is more true than the other), and they ruin it for the rest of the customers who don't partake of the foolish banks nor present such banks with unusual risks.

Historically, banks have exploded over and over. The system tends to be unstable, with each success at systematizing any part of the process, reducing costs, and making things normal instead causing instabilities that tend to make the industry implode and sometimes take the economy with it. Government regulation has been tried repeatedly, but since this is just another attempt at systematization, it isn't clear that regulation will prevent the problem.

Since I try to write an objective blog, not a normative one, I will not prescribe a "fix" to the banking system or to specific elements, like debit cards. My task, as I see it, is to discover the hidden truths that self-interest and conventional thinking tend to obscure. Hence, my only recommendation is to be very open-minded about future events. Regulation of debit cards could result in their disappearance entirely, or in enormous shrinkage of their distribution. And maybe that would be a good thing for people, who cannot afford a payment mechanism that makes overspending so much easier than cash.