By James Kwak
As banking scandals go, Wells Fargo opening millions of new accounts for existing customers so that it could pump up its cross-selling metrics for investors is about as clear-cut as it gets. It’s up there with HSBC telling its employees how to get around U.S. regulations in order to launder money for drug cartels, or traders and treasury officials at several banks conspiring to fix LIBOR.
Holding Wells responsible, however, was a bit trickier. The bank agreed to restitution (i.e, refunding the fees it had collected from its customers for the phony accounts) and a paltry $185 million in fines. When customers sued for damages, however, Wells hid behind its mandatory arbitration clauses, which were so broadly written that they even applied to accounts that the customer never intended to exist and that the bank had fraudulently created. Wells eventually reached a settlement with the class of plaintiff customers, but the settlement amount was no doubt influenced by the bank’s ability to compel arbitration.
The Consumer Financial Protection Bureau has proposed to eliminate the Wells Fargo defense by prohibiting class action waivers—clauses that take away customers’ right to participate in class action lawsuits—in arbitration clauses of financial contracts. (Class actions are crucial to deterring and punishing systematic fraud against consumers, because the harm to any single person will not be worth the expense of pursuing a lawsuit; without a class action, no one will sue, and the company will escape unharmed.)
Republicans, not surprisingly, are opposed to the proposed CFPB rule because … markets! The argument against regulations such as a ban on class action waivers is simple and elegant. A class action waiver is just a contract term open to negotiation. The waiver clause is bad for the consumer; therefore, its existence in the contract implies that the consumer must have gotten something else in exchange for that clause—lower fees, free checking, a lower interest rates, whatever. In a free market, customers have a choice: those who want the right to pursue a class action can pay a higher price for it, while those who don’t care about that right can trade it in exchange for a lower price. When a big, bad regulator like the CFPB comes along, and bans waivers altogether, it harms the latter group, who now must pay a higher price for a right they don’t want in the first place.
As law professor Jeff Sovern points out in a new paper, this is just a classic example of economism. Courts love making deductions from first principles of introductory economics; see, for example, Frank Easterbrook in IFC Credit Corp. v. United Bus. & Indus. Fed. Credit Union: “As long as the market is competitive, sellers must adopt terms that buyers find acceptable; onerous terms just lead to lower prices.” The problem is that the conclusions they arrive at are often simply not true in the real world. Sovern, who has done empirical research on arbitration clauses, points out what should be no surprise to any actual human being: few people understand them, which makes it difficult to see how they could be getting anything in exchange for agreeing to them. In one study, Sovern and his co-authors showed hundreds of people a contract that included a class action waiver in ALLCAPS; afterward, four times as many people thought they could still participate in class actions as realized that they could not.
A variant on the argument above is that, in a free market, banks will treat their customers well because it’s good for business. That is, when customers complain, banks will correct any errors they have made, because otherwise the customer will close her bank account or credit card. This argument is so preposterous that it doesn’t even warrant the ten-point rebuttal that Sovern gives in his paper. As anyone who has ever been a customer of any large company could point out, this still gives banks the incentive to rip off their customers unless they know that 100% of those customers will notice and take the effort to complain.
It’s unlikely that anyone actually believes that consumers understand arbitration clauses and take them into account when making buying choices. These arguments aren’t meant to be taken seriously. They are air cover for banking executives who like taking advantage of customers and politicians who want to do favors for the financial lobby. That’s the purpose of economism, and why it continues to be so influential.