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Will 'Operation Choke Point' Regulations Choke the Banking System?

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The following is a contribution from a friend of the site, Art Carden. Art is an Economics Professor at Samford University's Brock School of Business, a research fellow at multiple research and public policy institutes, and a regular contributor to Forbes.com and the Washington Examiner. Here he shares his perspective on the Justice Department’s "Operation Choke Point."

Bankers, electronic payment processors, and the trade associations that represent them are in a lather over the effects of the Justice Department’s "Operation Choke Point," which ostensibly attempts to clamp down on fraud within electronic payments systems by investigating banks that might be doing business with scammers. Some have speculated that Chase’s recent wave of account closures for people in the pornography industry is related to Operation Choke Point, and others accuse the Obama administration of using the Department of Justice—and the cover of "we’re only going after the bad guys"—to close down the politically-unpopular payday lending industry. From my reading, some conservatives and libertarians are overreacting to a Justice Department attempt to identify and punish money launderers and scammers. The potential for abuse suggests that wary, discerning, and skeptical eyes are still important.

Some of the controversy stems from a 2011 publication from the FDIC that outlines some of the risks financial institutions face in dealing with third-party payment processors and that lists a number of industries in which scams might be especially prevalent, including ammunition sales, cable box de-scramblers, dating services, escort services, firearms sales, get rich products, travel clubs, payday loans, pornography, and Ponzi schemes. I’ll quote language from the FDIC publication at length as this may clarify some of the ways financial institutions and regulators identify scammers:

"(o)ne of the more telling signs [of heightened risk in a payment processor relationship] is a high volume of consumer complaints that suggests a merchant client is inappropriately obtaining personal account information; misleading customers as to the quality, effectiveness, and usefulness of the goods or services being offered; or misstating the sales price or charging additional and sometimes recurring fees that are not accurately disclosed or properly authorized during the sales transaction. However, this may be somewhat difficult to determine in that it may be almost impossible to know if consumers are submitting complaints directly to the payment processor or the merchants. One way financial institutions and examiners can determine if consumers are making their complaints or voicing their dissatisfaction is to review certain Web sites, such as those for regional Better Business Bureaus, or blogs intended to collect and share such information to alert other consumers.

Another indication of the potential for heightened risk in a payment processor relationship is a large number of returns or charge backs.

Another warning sign is a significant amount of activity which generates a higher than normal level of fee income.

One reading some reports on account cancellations for porn stars and industry reactions to Operation Choke Point might get the impression that it’s a concerted effort to target politically- and morally-unpopular industries like firearms, payday lending, and pornography. The FDIC’s report is not a "hit list" for regulators; rather, it is a list of the industries in which fraudulent payment processing is and has been most likely. Given the target audience for get-rich-quick schemes advertised on late-night TV, it is hardly surprising that some of the firms involved are of less-than-unassailable virtue and financial propriety. According to the Huffington Post, the "DOJ subpoenas records to review whether the banks know they are working with scammers" when they see an outsized number of returned payment claims.

It’s not the case, though, that there’s nothing to see here and that we should move along. In the Wall Street Journal, American Bankers Association CEO Frank Keating argues that Operation Choke Point effectively deputizes the banking industry and "is asking banks to identify customers who may be breaking the law or simply doing something government officials don’t like." He notes that this is an especially dubious strategy because the Justice Department is targeting bankers who are providing services for firms that are not charged with any wrongdoing.

There is another potential problem, as well. We don’t have free markets in banking or free markets in credit services, which is likely why the much-vilified payday lending industry came into being in the first place. Usury laws and other regulations made it more difficult (and less profitable) for banks to meet the wants and needs of potential low-income customers, and this opened the door for payday lenders, pawn shops, and other organizations to fill the gap in the credit market. Clamping down on these organizations will likely make matters worse: as a January 24 Investor’s Business Daily editorial notes, fighting payday lenders restricts the market for small amounts of short-term credit and pushes small borrowers into the clutches of back-alley loan sharks. Paying high interest rates isn’t fun, but it’s probably better than having one’s thumbs broken by a loan shark.

While we hardly have anything resembling a competitive, free-market banking system, Operation Choke Point would most likely be redundant if we did. Processing payments for scammers exposes payment processors and financial institutions to potential liability and, at the very least, perhaps a greater reputational hit than the one that would come from people knowing that the bank processes transactions for porn stars.

Banking regulation constitutes a pretty dizzying tapestry of rules, all of which encourage some activities and discourage others. From a long-run economic growth point of view, they change the incentives so as to encourage and reward people who are good at coming up with ways to skirt regulations.

When we take a higher-level view and see this as more than just a specific regulatory solution to a specific problem in the electronic payments sector, an important picture emerges. That picture is the pattern of market and regulatory responses to information problems, fraud, and…regulation. People respond to incentives, and laws and regulations can have unintended consequences. Banking regulation constitutes a pretty dizzying tapestry of rules, all of which encourage some activities and discourage others. From a long-run economic growth point of view, they change the incentives so as to encourage and reward people who are good at coming up with ways to skirt regulations. This is a lot of human capital that presumably could have been used elsewhere. It also reduces the transparency of the banking system writ large: when there are hundreds if not thousands of rules and regulations and a small army of regulators to whom financial institutions are answerable, we can stifle innovation in financial services.

Regulating a market is a lot like squeezing a balloon: when you clamp down on one part of the balloon, the air in the balloon moves to a different spot. If you clamp down on that spot, the air moves again. If you keep finding ways to clamp down on each new bump on the balloon, the balloon will eventually pop.

While it might at first look like the Operation is going to root out the bad guys, we can be pretty sure they’ll pop up somewhere else—and it isn’t at all clear that producers and consumers of financial services will be better off because of it.

I’m not convinced that Operation Choke Point is part of a nefarious conspiracy to punish people who do things the Obama administration doesn’t like. From what I’ve read, it’s more innocuous than some commentators and officials would have us believe. That certainly isn’t to say it’s a good idea. Deputizing the banking system sets a dangerous precedent and opens us up to the kind of abuses feared by Operation Choke Point’s critics. I also suspect that a lot of innocent people are going to get choked by the Department of Justice. With as many transactions as they are handling and with the relative security of the payments system, there are bound to be a lot of completely innocent false positives. Finally, we have to be cautious about how people will respond to the new incentives Operation Choke Point will create. While it might at first look like the Operation is going to root out the bad guys, we can be pretty sure they’ll pop up somewhere else—and it isn’t at all clear that producers and consumers of financial services will be better off because of it.

photo credit: Bjoertvedt



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8 Comments.
Comment #1 by Anonymous posted on
Anonymous
"Deputizing the banking system sets a dangerous precedent and opens us up to the kind of abuses feared by Operation Choke Point’s critics" 

Agreed. This feels like it has the potential for quite the slippery slope. Very difficult to find a black and white line of where the government's power stops over one's banking assets/activities once it starts basing its actions on the justification of a percentage of illegal operators in a given category. The potential extensions of this approach are quite unpleasant for anyone that finds himself or herself on the opposite end of the (often un-elected) government officials' ever-evolving social initiatives.    

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Comment #2 by Shorebreak posted on
Shorebreak
Enter the Electronic Transaction Association (ETA), a trade group that recently released industry guidelines to keep payment processors on their toes and prosecutors off their backs. The guidelines read like a best-practices manual, calling for such things as background checks on merchants and periodic reviews of their businesses.

The 100-page document is essentially an olive branch, a way of showing authorities that the payment industry is just as concerned about rooting fraud out of the system. "Because of our shared interest in getting fraudulent merchants off the payments system we've asked law enforcement to work cooperatively with us, as opposed to targeting us," said Jason Oxman, chief executive of ETA, which represents companies, who offer electronic transactions for processing products and services. 

Oxman and his team met with Justice and all of the regulators who have a stake in the payment system, including the Federal Trade Commission and Federal Deposit Insurance Corp. FTC staff offered suggestions and even took a gander at drafts of the guidelines, Oxman said. But even input from government agencies on the guidelines is unlikely to persuade Justice to dial back its operation.  

http://www.washingtonpost.com/blogs/wonkblog/wp/2014/04/16/operation-choke-point-the-battle-over-fin...

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Comment #3 by Anonymous posted on
Anonymous
First they came for the pornographers and I did not speak out-- Because I was not a pornographer.
Then they came for the payday lenders and I did not speak out-- Because I was not a payday lender.
Then they came for the firearms dealers and I did not speak out-- Because I was not a firearms dealer.
Then they came for me--and there was no one left to speak for me.

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Comment #4 by Anonymous posted on
Anonymous
Banks have for many years been instrumental in alerting authorities to money laundering, people stealing from parents, grandparents accounts, altered signatures, stolen and fake checks, counterfeit money, marked money.  Many small businesses and any business that deals with cash are watched. 

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Comment #5 by Anonymous posted on
Anonymous
Banks are getting to be a little bit too nosey.  I make a 1.00 deposit to an account (less than 500.00 balance) just to keep it active and they ask why am I doing this?  All I'm doing is following their policies on inactive accounts!

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Comment #6 by bulldog (anonymous) posted on
bulldog
Having lived in Birmingham for a few years, I had a generally positive opinion of Samford University.  After reading this article, not so much.

The author asserts at least three times that we do not have a competitive, free-market banking system.  He does absolutely nothing to substantiate these statements.  No evidence is provided, nor is any reasoning provided that would lead us to that conclusion.  Simply repeating an assertion does not make it true.  How does a professor not know this fact?

What in the world does a laughable rant about the payday lending business have to do with an article on choke point regulations in the banking industry?

There is massive potential for abuse within our financial payments systems.  The banking industry is in a unique position to monitor suspicious activity.  I'm all for making it more difficult for bad actors to commit crimes.  I also think the Justice Dept. should be more aggressive prosecuting banks that knowingly facilitate illegal cash laundering and tax cheats.  IMO, the slap on the wrist given to HSBC for laundering billions for narco-terrorists is sickening.  They should have lost their license to do business in the United States.

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Comment #8 by Anonymous posted on
Anonymous
I think he addressed it pretty well:

We don’t have free markets in banking or free markets in credit services, which is likely why the much-vilified payday lending industry came into being in the first place. Usury laws and other regulations made it more difficult (and less profitable) for banks to meet the wants and needs of potential low-income customers, and this opened the door for payday lenders, pawn shops, and other organizations to fill the gap in the credit market.

Not that all of these regulations are bad, but they do prevent banks from being more flexible with high risk loans, which is why we have these other businesses filling that role.  His point is that higher regulation will force the customers they're driving away to these other services which are far worse.

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Comment #9 by JonQPublic (anonymous) posted on
JonQPublic
Why are they sanctioning legal businesses and individuals while they systematically ignore the financial institutions who flagrantly break the rules? For instance, look at how they flat out refused to prosecute HSBC for laundering money for drug cartels and terrorists. They'd rather go after businesses that follow the rules simply because there is some abstract potential for breaking them. Never mind due process... They might as well give us all speeding tickets just because the cars we drive can potentially go over the speed limit.

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