In this episode, Jaret Seiberg, Cowen Washington Research Group financial services policy analyst, explores progressive and convervative viewpoints on risk-based pricing for financial services and how the sector would be impacted by results from the upcoming election. Press play to listen to his insights.
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Jaret Sieberg: Welcome to What Would Hamilton Think, our monthly look at financial policy. I am Jaret Sieberg of Cowen’s Washington Research Group. This is part of our Street Cred podcast series, looking at the latest out of Washington. Alexander Hamilton was not just our first treasury secretary, and he didn’t just have ideas that resembled the Central Bank system that we have today. But to quote from a certain musical, he also was in the room where it happened, that the nation’s Capitol ended up in what we today call Washington DC. So it seems only appropriate that our monthly financial policy chat should be named in honor of Hamilton. Fear not, I won’t be singing like in the musical, but we will deep dive into various policy challenges that the financial sector is confronting. It shouldn’t be a surprise that our attention this month turns to the November 3rd election.
Financial policy is not front and center of this campaign. We may have an economic crisis, but it is not the same as the financial crisis of 2008. The election proposals are about how to better combat COVID-19, and how to better revive the economy. Is not about overhauling the regulatory regime for banks. Yet underneath the surface, there is a real battle brewing between progressive Democrats and conservative Republicans over the provision of financial services. In many ways, this fight is linked to the broader battle over social justice and Black Lives Matter. At it’s crux, the issue is whether risk-based pricing for financial services at its most basic level is fair. We’re going to spend the next couple of minutes trying to answer that question.
So risk-based pricing is not the norm in society. The person making 30,000 a year with two kids and the person making 500,000 a year with two kids can walk into that same supermarket and pay the exact same price for a gallon of milk and a box of lucky charms and a bunch of bananas. The same is true if we walk into a hardware store. A hammer or the light bulb or the recycling bags costs the same, regardless of whether you have a lot of wealth or a little wealth. Walk into the land of financial services and things are very different.
At its most basic level, those with the most pay the least for a financial services, and those were the least pay the most for financial products. So let’s look at checking accounts. If you have a lot on deposit, you generally don’t pay fees. By contrast, those who lack the means to keep large deposits with the bank, perhaps because they’re living paycheck to paycheck, face overdraft fees if they lack the funds in their account to cover withdrawal, as well as ATM fees each time they use the machine. Or how about the need for short-term money? If you have means you have a credit card, it may even offer a reward for using it. You can collect that reward, even if you pay off that balance each month. By contrast. Those with less wealth are less likely to pay off the credit card each month. That means interest charges. And if they are late with a payment it means fees. And if they don’t have a credit card it means payday loans, which can have interest rates, that on an annualized basis, exceed 300%.
And then there are mortgages. Those with the most wealth and best credit pay less for their mortgage. By contrast, those with the least income and the more checkered credit histories pay more. And of course our retirement accounts, the last of the four categories that we’re going to look at for our chat today. The tax benefits of retirement accounts favor those in the highest income tax bracket. In addition, the wealthy are more likely to pay for a registered investment advisor who has a fiduciary duty to provide the advice that is in the client’s best interests. By contrast, less wealthy people are more likely to deal with advisors who are paid on commission. Which raises questions about what is motivating their financial advice.
These differences exist for a simple reason. It’s not nefarious. It’s not inappropriate. It’s not wrong. It’s basic business fundamentals. Financial firms want to make a profit. They have owners who expect that return. In many cases, those owners are mutual funds and pension funds that hold everyone’s retirement savings. Financial firms adjust their pricing and policies to ensure that profitability. So let’s take those checking accounts. A bank has fixed costs for each checking account. If you keep enough funds with the bank, then the bank can lend that money out and earn a profit despite those fixed costs. To encourage big depositers to keep their cash with the bank, the bank offers incentives like free ATM use. By contrast, the bank has a problem if the customer doesn’t keep much on deposit. That means there’s less to lend out, which may mean that the fixed costs exceed the profit from lending out those deposits.
Fees on overdrafts or ATM’s help cover that gap. Or credit cards. Banks get paid an interchange fee each time a card is used. So those wealthy customers can still make money for the bank if they transact at a high dollar rate each month. Those with less often have to borrow, which means the bank is incurring longer term credit risk. That comes at a cost, which is reflected in the interest rate. And payday borrowers pay the most and there’s a high processing fee and credit risk for very small dollar transactions. Even with mortgages, it’s all about compensation for taking more credit risk. That is why the FHA program is more expensive than conventional loans, as the FHA program deals with a riskier clientele. It means a higher default rate.
That’s also why Fannie and Freddie use loan-level pricing adjustments, so those who pose the least risk of default, pay less than those who pose the biggest risk of default. And for retirement savings, more wealth means you pay more upfront. And it means you get more value from the tax advantage. This has been the case for decades in financial services. Financial firms don’t price everything the same. They are not supermarkets, they’re not hardware stores. The supermarket has no exposer after you buy that canvas suit. It’s a one-time transaction with no recourse. By contrast, there is a risk of loss for a financial firm. The greater that risk, the more the bank wants to get paid. Again, there’s nothing wrong with that. And that’s where we swing back to the election.
There are progressive Democrats who see this situation as fundamentally unfair. To them it makes no sense that those who can afford the least end up paying the most. And because they pay so much, it makes it harder for them to stay current on their loans or avoid future fees. That means they can end up paying even more. It is why we believe one outcome from the election, if Joe Biden wins, will be a real effort to flatten pricing. It won’t eliminate risk-based pricing. That’s too ingrained and too helpful to the system. But we believe progressive Democrats want to cut the cost for financial products for lower income consumers. And they are on board with the idea that wealthier consumers should subsidize financial services for those with less needs.
This could play out in many different ways. Let’s go back to our four broad categories of services that we’ve talked about a couple of times already in our chat. For checking accounts, this means banning and account maintenance fees and fees that banks use for using ATM’s. It also means sharp limits on overdraft fees, including giving borrowers the ability to repay the overdraft over time so the repayment of one overdraft does not trigger a second overdraft. For credit cards and payday loans, it’s about imposing a usury cap. That way there’s a limit to how much a consumer has to pay for credit. For mortgages, it’s about cutting the price of the FHA program and flattening the loan-level pricing adjustments for Fannie and Freddie so there is less difference between what someone with an 820 credit score pays, versus someone with a 680 credit score. And for retirement savings, it’s about capping the tax deduction benefit so the wealthy do not benefit more than the less wealthy. And it’s about giving all those who save for retirement the protections that come with a fiduciary duty standard of care.
To make this agenda work, Democrats would need to rely upon aggressive use of the fair lending laws. Otherwise companies could simply focus on the wealthy and cut off services to lower income consumers. Or new entities could emerge to poach wealthy customers by offering pricing that doesn’t include that subsidy for lower income consumers. This of course won’t be easy to achieve. As I said a couple of times during our chat, the current approach to pricing is ingrained in how businesses operate, and the government does not often dictate how private industry prices its products. Yet, as I discussed earlier, progressive Democrats do have plans that would flatten pricing and increase cross-subsidies. So what does that really mean overall for policy in the financial services and for the market overall? We believe this could lead Democrats to seek postal banking, which has long been a priority for the progressive wing of the party.
Consumers could have transaction accounts and receive short-term installment loans through the postal service, by going to their local post office. It also could lead to a related requirement that the federal reserve provide every American with a transaction account from which they can receive electronic payments and make electronic payments. It also could mean trying to repeal the 2005 changes to the Consumer Bankruptcy Code. Those changes required those with income to try to repay some unsecured debt before they could discharge all of it in bankruptcy. The changes were seen as positive for credit card lenders, by making it harder for someone to max out their credit cards then walk away from their debts. And it means bringing back the fiduciary duty role, with the threat of class action liability, to ensure that all investors get advice that is in their best interest, even if they pay for that advice via commissions.
Now of course not all of this is politically possible. Just because progressive Democrats are seeking it, does not mean they can get it. The Senate map is what the Senate map is. Even with of a blue wave, Senate Democrats are probably only going to have a couple of seat majority. And those majorities are made up of moderates who are unlikely to fully buy into this election. And there is opposition to some of these ideas on a more narrow basis, even from some Democrats. Postal banking is not broadly endorsed, for concerns that the postal service simply can’t handle the added burden. And the Consumer Bankruptcy Reform passed in 2005 with the support of moderate Democrats, who saw it as a way of convincing credit card lenders to extend their services to lower income borrowers. And even the class action liability provisions of fiduciary duty role have its critics.
They believe that it could make it harder for those with less income to get any investment advice. So with that opposition, does this matter? I think the answer is really yes, because the idea of flatter pricing, of less risk-based pricing, and of more quality of services is a philosophical mantra coming from the progressive side of the Democratic party. And that’s the side that’s on the rise. This doesn’t have to be, however, a mantra that’s negative for banks. And as a result, it’s not necessarily negative for those who invest in banks.
What it will do is require the market to identify which financial firms are able to most quickly adapt to the new pricing regime versus those that lose out because they take too long to accept the new reality.
So what would Hamilton think about all this? The very idea that every consumer has a right to a financial product would probably be a foreign concept, but I think he’d appreciate the exercise of political power that comes from winning. And if there is a blue wave, then the Democrats will have shown that they do deserve to be in the room where it happens. With that. This is Jaret Seiberg of Cowen Washington Research Group. Look for our next installment shortly after the November 3rd election.
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