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.
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.
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