Price Regulation in Two-Sided Markets: Empirical Evidence from Debit Cards (with Vladimir Mukharlyamov)

January 16, 2025

Accepted, The Journal of Financial Economics

 This paper provides empirical evidence of a well-known theoretical concern that market failures in two-sided markets are hard to identify and correct. We study the reactions of banks, merchants, and consumers to Dodd-Frank’s Durbin Amendment that lowered interchange fees on debit card transactions. Banks recouped a significant portion of their losses by charging consumers for products that they previously provided for free on the subsidized side of the two-sided market. The accelerated adoption of credit cards with higher interchange fees likely diminished—if not eliminated—merchants’ savings. These effects impede the regulation’s stated objective of enhancing consumers’ welfare through lower retail prices.

Presentations: AFA, NBER SI Household Finance,  Booth Conference on Financial Regulation*, NYU Stern Women in Finance, Philadelphia Federal Reserve Consumer Finance Conference, Consumer Financial Protection Bureau, Society for Empirical Legal Studies (Theodore Eisenberg Prize), Brookings Institute

What Private Equity Does Differently: Evidence from Life Insurance (with Divya Kirti)

July 14, 2023

The Review of Financial Studies 37.1 (2024): 201-230.

This paper studies how private equity creates value and its consequences for consumer welfare in the insurance industry, where PE investments grew tenfold following the financial crisis. PE firms add value through regulatory and tax arbitrage that increases profits relative to their non-PE counterparts. Crucially, the impact on consumer welfare is nuanced: in the short run, consumers benefit from more favorably priced products. But the arbitrage strategy also exposes them to more risk, as annual expected losses scaled by capital buffers rise by 50 percentage points. This creates the possibility of consumer harm in the event of a downturn.

Presentations: NYU/Penn Law & Finance Conference, IMF Annual Conference*, European Financial Association*

Dynamic Regulation

July, 2021

Southern California Law Review 94.5 (2021): 1005-1082.

There is widespread consensus that the Great Recession did not have to be as Great as it was: Had regulators acted earlier, its consequences would have been less severe. Two explanations are typically offered for early inaction. The first is that crises occur unexpectedly, so there is little time to respond aggressively. The second is that even regulators who suspected a downturn was imminent lacked the legal authority to intervene. This Article disputes these myths. First, empirical evidence demonstrates that there was over a year between the first tremors in financial markets and the crash. Second, legal analysis illustrates that regulators had at their disposal significant authority to bolster banks. In fact, they used this authority with respect to small banks, but not large, systemically important firms.

There is an alternative explanation for the tepid initial response to the crisis. Regulators’ default is inaction until regulatory measures of bank health signal distress. These measures are slow to update—in many cases, the day before banks failed, their regulatory capital measures suggested no cause for concern. In the absence of significant change, regulators will inevitably be fire-fighting future financial crises ex-post; rather than successfully policing financial markets ex-ante. The next crisis can be prevented. But to do so will require an overhaul of the financial regulatory regime. This Article proposes a way forward. It advocates for automating aggressive action when financial markets indicate that distress is likely. Such reform will finally make costly bank failures a relic of the past.

Presentations: Duke Law & Economics Seminar, Michigan Law & Economics Seminar, Georgetown Law & Economics Seminar

Making Consumer Finance Work

October, 2019

Columbia Law Review 119.6 (2019): 1519-1596.

The financial crisis exposed major fault lines in banking and financial markets more broadly. Policymakers responded with far- reaching regulation that created a new agency—the Consumer Financial Protection Bureau—and 19changed the structure and function of these markets.

Consumer advocates cheered reforms as welfare enhancing, while the financial sector declared that consumers would be harmed by interventions. With a decade of data now available, this Article examines the successes and failures of the consumer finance reform agenda. Specifically, it marshals data from every zip code and bank in the United States to test the efficacy of three of the most significant postcrisis reforms: in the debit, credit, and overdraft markets.

The results are surprising. Despite cosmetic similarities, these reforms had very different outcomes. Two (changes in the credit and overdraft markets) increase consumer welfare, while the other (in the debit market) decreases it. These findings run counter to prior work by prominent legal scholars and encourage reevaluation of our (mis)conceptions about the efficacy of regulation.

The evidence leads to several insights for regulatory design. First, banks regularly levy hidden fees on consumers, obscuring the true cost of financial products. Regulators should restrict such practices. Second, consumer finance markets are regressive: Low-income customers often pay higher prices than their higher-income counterparts. Regulators should address this inequity. Finally, banks tend to discourage regulation by promising their costs will be passed through to consumers. Regulators should not be overly swayed by their dire warnings.

Presentations: University of Pennsylvania Law, University of Virginia Law, Northwestern Law & Economics Seminar, Texas Law & Economics Seminar, Stanford Behavioral Law Workshop, Berkeley Law and Economics Seminar

Understanding Bank Risk through Market Measures (with Lawrence H. Summers)

September 10, 2016

Brookings Papers on Economic Activity 2016.2 (2016): 57-127.

Since the financial crisis, there have been major changes in the regulation of large banks directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress-testing has sought to further assure safety by raising levels of capital and reducing risk-taking. Standard financial theories predict that such changes would lead to substantial declines in financial market measures of risk. For major banks in the United States and around the world and for midsized banks in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, price–earnings ratios, and preferred stock yields. To our surprise, we find that financial market information does not bear out the predictions of financial theory. Measures of volatility and risk premiums today are no lower and perhaps somewhat higher than they were prior to the financial crisis. We examine a number of possible explanations for our findings. While financial markets underestimated risk prior to the crisis and regulatory measures of capital are flawed, we believe that the most important explanation for our findings is the dramatic decline in the franchise value of major banks. We highlight that the ratio of the market value of common equity to assets on both a risk-adjusted and risk-unadjusted basis has declined significantly from the precrisis period to the current period for most major banks. As a consequence, banks are more vulnerable to adverse shocks. We argue for taking a dynamic view of capital that recognizes future profits as a source of capital, and urge approaches to financial regulation supervision that will reliably force rapid capital replenishment in difficult times—something that did not take place in the United States in 2008 and is not taking place in Europe today.

What’s in Your Wallet (and What Should the Law Do About it?)

March, 2020

Chicago Law Review 87.2 (2020): 553-594.

In traditional markets, firms can charge prices that are significantly elevated relative to their costs only if there is a market failure. However, this is not true in a two-sided market (like Amazon, Uber, and Mastercard), where firms often subsidize one side of the market and generate revenue from the other. This means consideration of one side of the market in isolation is problematic. The Court embraced this view in Ohio v. American Express, requiring that anticompetitive harm on one side of a two-sided market be weighed against benefits on the other side.

Legal scholars denounce this decision, which, practically, will make it much more difficult to wield antitrust as a tool to rein in two-sided markets. This inability is concerning as two-sided markets are growing in importance. Furthermore, the pricing structures used by platforms can be regressive, with those least well-off subsidizing their affluent and financially-sophisticated counterparts.

In this Article, I argue that consumer protection, rather than antitrust, is best suited to tame two-sided markets. Consumer protection authority allows for intervention on the grounds that platform users create unavoidable externalities for all consumers. The Consumer Financial Protection Bureau (“CFPB”) has broad power to curtail “unfair, abusive, and deceptive practices.” This authority can be used to restrict practices that decrease consumer welfare, like the anti-steering rules at issue in Ohio v. American Express.

Presentations: Chicago Antitrust Symposium, UPenn Faculty Workshop

The Deregulatory Deception(with Cary Coglianese, Stuart Shapiro) 

Regulation and Governance, forthcoming

President Donald Trump and his supporters like to point to the positive economic trends the United States experienced prior to the COVID pandemic. They argue that these positive conditions stemmed from the President’s policies, especially his emphasis on deregulation. But what has the Trump Administration really accomplished when it comes to regulation? The answer is much less than the Administration has claimed—and much less than probably most members of the public would surmise. We compare the claims the Administration has made about its deregulatory accomplishments with what the evidence can sustain. Drawing on an original compilation of data on federal regulation from over the last four years, we find three new completed actions appear in agencies’ regulatory agendas for every one that is labeled deregulatory. When we look at just economically significant actions, even on assumptions favorable to the Administration, we find only one deregulatory action for every one action labeled as regulatory. Overall, we find that every claim we examine about the Trump Administration’s deregulatory efforts is either wrong or exaggerated. The reality is that the Trump Administration has done less deregulating than regulating, and its deregulatory actions have not achieved any demonstrable boost to the economy. 

Media: The Regulatory Review, Bloomberg

On Market-Based Approaches to the Valuation of Bank Capital (with Lawrence H. Summers) 

Handbook of Financial Stress Testing, 2022

In this paper, we build on our prior work to highlight four points. First, stress tests are dependent on regulatory measures of bank capital, which appear to not be a good proxy for economic capital measures that more accurately indicate the risk of insolvency. Second, stress tests have almost come to be seen as a panacea for resolving crises based on the successes of SCAP. We point out that while crisis stress tests were clearly valuable, it is hard to disentangle the role they played in stabilizing the financial sector from other factors like extraordinary fiscal interventions and good fortune. Third, banks perform far worse on a naive market-based stress test than they do on the annual regulatory exercise, which provides suggestive evidence that the regulatory tests are not painting a full picture about financial stability. Finally, we provide some early thoughts on the COVID-19 experience. The disparity between the optimistic view of bank health in recent stress tests and the reality today provides additional evidence that the current exercise is lacking.

Corporate Crime and Punishment: An Empirical Study (with Dorothy Lund)

Texas Law Review, 2021

For many years, law and economics scholars, as well as politicians and regulators, have debated whether corporate punishment chills beneficial corporate activity, or, in the alternative, lets corporate criminals off too easily. In this paper, we take important first steps in addressing these questions. Specifically, we proxy for corporate crime using three novel sources: the Financial Crimes Enforcement Network (FinCEN) Suspicious Activity Reports (SARs), consumer complaints made to the Consumer Financial Protection Bureau (CFPB), and whistleblower complaints made to the Securities and Exchange Commission (SEC). Each source reveals an increase in complaints or reports indicative of corporate misconduct over the past decade. We also examine levels of public company recidivism and find that they are also on the rise. And we document a potential explanation: recidivist companies are much larger than non-recidivist companies, but they receive smaller fines than non-recidivist companies (measured as a percentage of market capitalization and revenue). We conclude by offering recommendations for enforcement agencies and policymakers. In particular, our results suggest that enforcers are unlikely to achieve optimal deterrence using fines alone. Enforcement agencies should therefore consider other ways of securing deterrence, such as by seeking penalties against guilty individuals and the top executives who facilitate their crimes. 

Presentations: Corporate Law Academic Series, Yale Law & Economics Seminar*

Media: Corporate Crime Reporter, Columbia Blue Sky Blog

Who Do Credit Cards Reward?

Journal of Policy Analysis and Management 44.3 (2025): 1090-1098

Regulating payments markets is a complex task because these markets are two-sided: a successful network requires adoption by consumers who transact with cards but also merchants who accept cards. That creates the possibility of anticompetitive action on either side of the network: Consumers can be harmed by actions taken by card companies that lower the number of card offerings available for them to choose from and artificially inflate prices, and similarly merchants can be harmed by the lack of ability to shop around for transaction fees that are more competitively priced. The nature of these two-sided markets has created challenges for the court and made it difficult to evaluate the winners and losers of the payment system, to identify market failures, and to make the case for government intervention.

In this short essay, I seek to make four points. First, the credit card industry is highly profitable and the mechanics of the market that create those profit opportunities is not well understood. Second, the credit card market creates a host of regressive cross-subsidies such that high-wealth, rewards card users airline miles are subsidized by those at the bottom of the distribution who are more likely to transact with cash. Third, new technology and payments systems outside of the United States suggest that these issues may resolve themselves in the future as today’s credit card market becomes a thing of the past. Fourth, regulatory interventions are challenging given the complex nature of this market. But recent focus on making it easier for merchants to make clear to consumers the costs that they bear when consumers shop with rewards cards with high processing fees is worthwhile. Overall, I suspect that—due primarily to technological innovation, but also because of potential policy changes—the payments market of the future will evolve to become faster, safer, and cheaper to the consumers and merchants who interact with it.

Stressing the Stress Tests (with Til Schuermann)

January 15, 2025

Spring 2023 saw Silicon Valley Bank, Signature Bank, and First Republic experience failure due to predictable rate hikes by the Federal Reserve. Despite the clear success of stress testing as a crisis and peacetime risk management and capital adequacy tool, the series of bank failures and resultant turmoil in the banking system revealed flaws in the stress testing regime that today governs the regulatory capital regime. It’s clear from these recent events that the current stress testing system is ill-suited to mitigate risk associated with the banking system, especially when looking at smaller regional banks that aren’t subjugated to annual stress testing. Stress testing as a regulatory tool is also exposed to significant legal risks following recent Supreme Court jurisprudence that draws into question the viability of the status quo.

Today, regulators and other interested parties must change tacks to craft a stress testing regime that is fit for purpose. This Article seeks to inform that debate by laying out key features of a successful stress testing program against which we assess the current regime in the US. Based on this analysis, wemakefourspecificrecommendations:1) using multiple scenarios to allow exploration of a wider set of risks; 2) disclosing(stressed) fair value for the assessment of all securities held on banks’ balance sheets; 3) stress testing of funding and liquidity risk; and 4)subjecting more banks to the stress tests. Taken together, these reforms would usefully improve the dynamism of the financial regulatory regime.

Presentations: Yale Law School, Columbia Law Banking Conference, Yale Program on Financial Stability Conference