Financial Privacy: The Economics of Opt-In vs. Opt-Out
CRS Report for Congress
Financial Privacy:
The Economics of Opt-In vs Opt-Out
Updated February 12, 2004
Loretta Nott
Analyst in Economics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress
Financial Privacy: The Economics of Opt-In vs Opt-Out
Summary
Rapid financial sector restructuring and accelerating technological change over
the past decade have propelled the issue of financial privacy to the forefront of the
legislative agenda. Recently, the 108th Congress addressed concerns regarding the
sharing of consumer information among affiliates of the same corporate group with
the enactment of the Fair and Accurate Credit Transactions Act of 2003 (FACT).
Under the FACT Act, financial institutions are prohibited from sharing information
for the purpose of marketing unless the consumer has been notified and provided an
opportunity to opt out.
Economic theory suggests that there are distinct benefits to information sharing.
In a perfect market, theory holds that competitive forces will deliver an economically
efficient outcome. However, this conclusion is contingent upon several assumptions
that underlie the theoretical model. If one or more of these assumptions are absent,
then the market can be said to have “failed.” In these cases, public policy can play
an important role in promoting economic efficiency.
In the market for financial information, the two most relevant types of market
failures are externalities and imperfect information. If externalities exist and
transaction costs are zero, economic theory indicates that an efficient allocation of
information sharing will occur when “property rights” over information are well
defined. Opt-out effectively assigns the property rights to financial institutions, while
opt-in awards ownership to consumers. In terms of economic efficiency, theory
holds that it is irrelevant who owns the property rights to the information. However,
if there are significant transaction costs, then an economically efficient outcome can
still be achieved when costs are minimized. In this case, an opt-out policy would
more likely deliver an efficient allocation of information sharing.
In a world with imperfect information, economic theory asserts that an opt-out
policy will fail to produce the most efficient outcome since financial institutions will
receive the economic gains from information sharing without paying consumers its
true value. Therefore, theory predicts that an opt-in policy would promote a more
economically efficient outcome. If financial institutions have to obtain the explicit
consent of their customers, then they will have an incentive to offer some sort of
compensation to their customers for the use of their information.
This report will be updated as events warrant.
Contents
In troduction ......................................................1
Background ......................................................1
The Economics of Financial Privacy...............................3
The Economic Value of Information ..............................3
Economic Efficiency...........................................4
Market Failures...............................................5
Ex ternalities ..............................................5
Imperfect Information......................................6
Thin Margins and Transaction Costs...............................7
Conclusion .......................................................8
Financial Privacy:
The Economics of Opt-In vs Opt-Out
Introduction
Rapid financial sector restructuring and accelerating technological change over
the past decade have propelled the issue of financial privacy to the forefront of theth
legislative agenda. Recently, the 108 Congress addressed concerns regarding the
sharing of consumer information among affiliates of the same corporate group with1
the enactment of the Fair and Accurate Credit Transactions Act of 2003 (FACT).
Under the FACT Act, information used for marketing purposes may not be shared2
unless the consumer has been notified and given the opportunity to opt out. Prior
to the enactment of the FACT Act, which amends the Fair Credit Reporting Act
(FCRA), consumers could only opt out of having non-transaction, non-experience
information shared.
During the FACT Act debate, the financial industry argued that there are
numerous consumer benefits to the free flow of information, thus advocating for
information sharing policies to remain opt out. Meanwhile, consumer groups argued
for an opt-in policy that would require financial institutions to obtain a consumer’s
explicit consent before sharing certain information with their affiliates. This report
examines the economics of financial privacy in the context of the opt-out/opt-in
debate and considers the implications of both policies.3
Background
According to the Federal Reserve, Americans made 71.5 billion non-cash retail
payments in the year 2000.4 Each one of those payments created valuable
1 P.L. 108-159.
2 P.L. 108-159 § 214.
3 This report will examine financial privacy in the context of economic theory. For the legal
perspective, see CRS Report RS21449, Fair Credit Reporting Act: Preemption of State Law
and CRS Report RS21427, State Financial Privacy Laws Affecting Sharing of Customer
Information Among Affiliated Financial Institutions. Also see CRS Report RS20185,
Privacy Protection for Customer Financial Information, and CRS Report RL31666, Fair
Credit Reporting Act: Rights and Responsibilities, by Angie A. Welborn. For general
information on privacy issues, see CRS Report RL30671, Personal Privacy Protection: The
Legislative Response, by Harold C. Relyea.
4 Non-cash retail payments include checks, and debit and credit card transactions. For more
information, see Geoffrey R. Gerdes and Jack K. Walton II, “The Use of Checks and Other
(continued...)
information. Every financial transaction, whether withdrawing money from an ATM
or settling a purchase with a credit card, generates an electronic information trail as
a byproduct. These data are collected by financial institutions and may be compiled
into consumer profile databases that potentially may be shared among corporate
affiliates and other third parties.
In order for any non-cash financial transaction to be completed, consumers must
willingly release their personal information to the other parties involved. For
example, purchasing groceries with a credit card requires the release of financial
information to the grocery store, the credit card company, and the financial
institution. But then the critical question becomes, who owns the rights to that
information once the transaction has been completed?
In this regard, there are several federal laws pertaining to a consumer’s right to
financial privacy, including the Fair Credit Reporting Act (FCRA), which regulates
the collection, use and disclosure of consumer credit information.5 The FCRA
excludes the communication of certain types of information from the definition of a
consumer report, including information shared among affiliates of the same corporate
group.6 The law distinguishes between “transactions or experiences” information
and “other” information.7 Transactions or experiences information between an
institution and a consumer may be shared with affiliates. Non-transaction, non-
experience information obtained from third parties or from consumer applications
may not be shared unless the consumer has been notified and given the opportunity
to opt out from having such information shared. The recently enacted FACT Act
amends the FCRA to also prohibit the sharing of information for the purpose of
4 (...continued)
Noncash Payment Instruments in the United States,” Federal Reserve Bulletin, Aug. 2002.
5 There are five federal privacy laws that pertain to a consumer’s right to financial privacy:
the Electronic Fund Transfer Act (15 U.S.C. §§1693a-1693r), the Right to Financial Privacy
Act (12 U.S.C. §§3401-3422), the Telephone Consumer Protection Act (47 U.S.C. §§227),
the Gramm-Leach-Bliley Act (15 U.S.C. §§6801-6809), and the Fair Credit Reporting Act
(15 U.S.C. §§1681-1681t).
6 15 U.S.C § 1681(d)(2)(A). The FCRA states that the definition of a “consumer report”
excludes any “(i) report containing information solely as to transactions or experiences
between the consumer and the person making the report; (ii) communication of that
information among persons related by common ownership or affiliated by corporate control;
or (iii) communication of other information among persons related by common ownership
or affiliated by corporate control, if it is clearly and conspicuously disclosed to the consumer
that the information may be communicated among such persons and the consumer is given
the opportunity, before the time that the information is initially communicated, to direct that
such information not be communicated among such persons.”
7 The FCRA does not provide any guidance as to what types of information may be
included in the term “transactions or experiences.” Furthermore, none of the federal bank
regulators nor the Federal Trade Commission have promulgated regulations regarding the
definition of “information solely as to transactions or experiences” or what information may
be included in such.
marketing unless the consumer has been notified and given the opportunity to opt
out.8
The financial industry favors federal privacy laws that leave the responsibility
to consumers to opt out from having certain types of information shared. In support
of the opt-out view, financial services providers argue that there are numerous
consumer benefits to the free flow of information, including enhanced customer
service and better financial product design. In addition, there is evidence to suggest
that these benefits are monetary as well. In a study conducted for the Financial
Services Roundtable (FSR), a prominent industry lobby group, Ernst and Young
estimated that the practice of information sharing saved $17 billion per year for the
customers of the FSR members.9 Thus, the financial industry argues that an opt-out
policy ensures that consumers will receive these benefits, even if they do not realize
they exist.10
However, many consumer advocacy groups have voiced concerns about the
potential erosion of financial privacy associated with information-sharing activities
among corporate affiliates. In contrast, consumer advocacy groups claim that
financial privacy should be protected by restricting such information-sharing
activities.11 These groups argue that advances in information technology have caused
an erosion in consumer privacy, leading to more junk mail and telemarketing calls,
as well an elevated risk of identity theft. Thus, consumer groups advocate an “opt-
in” policy that would require financial institutions to obtain a consumer’s explicit
consent before sharing certain information among their affiliates.
The Economics of Financial Privacy12
The Economic Value of Information
Economic theory suggests that there are benefits to information sharing. For
example, producers might be able to expend fewer resources on marketing and
product development when they have access to detailed consumer information. That
translates into lower prices and enhanced consumer choices. Similarly, consumers
will spend less time searching to identify products that meet their demands at a
8 P.L. 108-159 § 214.
9 This estimate captures savings from both affiliate and non-affiliate information sharing.
For more information, see Cynthia Glassman, “Customer Benefits from Current Information
Sharing by Financial Services Companies,” an Ernst and Young study conducted for the
Financial Services Roundtable, Dec. 2000.
10 For a perspective on how opt-in restrictions could affect the financial industry, go to the
American Bankers Association web site,
[www.aba.com/Industry+Issues/GR_PR_Opt-in.htm], visited Feb. 12, 2004.
11 For information on the concerns voiced by consumer advocates, visit the Privacy Rights
Clearinghouse web site, [www.privacyrights.org/financial.htm], visited Feb. 12, 2004.
12 The theoretical arguments outlined in this section are applicable to both affiliate and non-
affiliate information sharing.
competitive price. Therefore, information sharing can play a positive role in
economic transactions.
To illustrate this point, suppose one wants to buy a new car. The dealer has
many different types of cars on the lot, ranging from economy to luxury. It is in
one’s own interest to let the salesman know what type of car is desired. Search costs
are reduced since the salesman can immediately direct the buyer to that type of car
on the dealer’s lot. Thus, the transaction is made more efficient by releasing detailed
information about one’s preferences to the salesman.
The same rationale can be applied to the market for financial services. For
consumers, junk mail is equivalent to the car salesman presenting a sales pitch for
every single vehicle on the lot. In other words, there exist excess search costs
because a seller has too little information about the buyer’s preferences. If a financial
institution knows whether a customer is interested in purchasing insurance or
applying for a new credit card, then the financial institution can make better decisions
on whether or not to supply that customer with informational materials. Just like the
car example, it is in the best interest of both parties to have the seller know the
customer’s preferences. Therefore, consumers have an incentive to provide this
information to financial institutions, and financial institutions have an incentive to
solicit this information from consumers.13
Economic Efficiency
Although financial information sharing can generate economic benefits,
consumer valuations of these benefits might differ depending on each individual’s
preferences over privacy. Some consumers might not feel comfortable sharing their
personal information with financial companies, either due to a concern of identity
theft or a dislike of intrusive solicitation, while other consumers are less opposed to
giving up a degree of financial privacy in exchange for improved products or
services.
Similarly, the magnitude of economic value generated by information sharing
could differ across financial institutions. Thus, it might be more costly to some
financial services providers to offer a greater degree of privacy to their consumers
since it means forgoing potential economic gains.
Under the traditional economic model, competitive market forces will generally
deliver an economically efficient outcome. Applying this theory to the market for
financial information suggests that an efficient amount of information sharing will
occur up to the point where the economic benefits of information sharing are
balanced against the associated costs. Specifically, if the economic value created by
information sharing exceeds the value derived from financial privacy, theory
maintains that the economically efficient outcome would be to share information.
13 For a more detailed explanation of this economic argument, see Hal R. Varian, “Theory
of Markets and Privacy,” in Privacy and Self-Regulation in the Information Age
(Washington, DC: U.S. Department of Commerce, June 1997); online
[www.ntia.doc.gov/reports/privacy/privacy_rpt.htm], visited Feb. 12, 2004.
In contrast, if the economic value generated by financial institutions from access to
consumer information does not exceed the consumer benefit from financial privacy,
then economic efficiency dictates that information not be shared.
Market Failures
The conclusion that competitive markets will produce an efficient allocation of
information sharing is contingent upon the assumptions that underlie the theoretical
model. The conditions for a market to deliver an efficient outcome include freedom
of entry and exit of producers, the absence of external effects, or “externalities,” and
perfect information. However, economists agree that these conditions often do not
exist in practice. For instance, economic actors usually do not share symmetrical and
complete understanding about the market, including the economic impact of law or
the market value of financial information. The absence of one or more of these
conditions is said to result in a “market failure,” that is, the market fails to deliver an
economically efficient outcome. In these cases, a prudent mix of government
legislation and market-oriented policies can approximate the forces necessary to
produce an efficient allocation of information sharing. In the market for financial
information, the two most relevant types of market failures are externalities and
imperfect information.14
Externalities. An externality occurs when transactions impact third parties
without due compensation. For example, when your neighbor paints the exterior of
his or her house, this action in turn raises the property value of your own home. This
is an example of a favorable externality to you since you incur an economic gain
without having to compensate your neighbor for the expense of the improvements.
Some economists have argued that there are no externalities in the market for
financial privacy since the information sharing that occurs between consumers and15
financial institutions does not affect other parties. However, this view does not
consider the benefit financial institutions receive from accessing the information that
is shared between consumers and non-financial companies. Recall the example of
a consumer purchasing groceries with a credit card. In order to settle the grocery bill,
the consumer must share credit card information with the store clerk. But in today’s
technology-driven world, every financial transaction generates an electronic
information trail. Financial information is a byproduct of non-cash transactions, and,
when compiled into databases, generates value for financial institutions when shared
among their affiliates. Therefore, the economic benefit accrued to financial
institutions is analogous to the benefit you receive when a neighbor paints his or her
house. Since financial institutions do not purchase this information, they are
14 Public goods and imperfect competition are also often referred to in economics literature
as market failures. However, financial information is “excludable” so it cannot be
considered a public good. Furthermore, since there are few regulatory restrictions on entry
and geographic expansion, the financial services industry is often considered to be
competitive.
15 For more information on this view, see Jeffrey M. Lacker, “The Economics of Financial
Privacy: To Opt Out or Opt In?,” Economic Quarterly, Federal Reserve Bank of Richmond,
Volume 88/3, Summer 2002.
receiving a favorable externality from being able to access and use the financial
information.
When market externalities exist, economic theory dictates that an efficient
allocation can still be reached when “property rights” are well defined.16 Public
policy effectively assigns the property rights over information through the choice of
opt out or opt in. Under the current opt-out policy, financial institutions have the
right to share certain types of information about a consumer with their affiliates.
Consumers will choose to opt out when the value of their financial privacy exceeds
the value derived from information sharing. In this case, competitive financial
institutions will have an incentive to compete for those depositors by bidding up
compensation for the use of their information. Similarly, under the alternative opt-in
policy, consumers effectively hold the property rights to their information. In this
event, financial institutions will have an incentive to purchase this information up to
the point where the economic gain to them equals the cost of compensating
consumers. Therefore, regardless of how property rights are assigned, the market can
still deliver an economically efficient outcome.17
Imperfect Information. Under the Gramm-Leach-Bliley Act, all financial
institutions are required to send customers an annual privacy policy statement.18 This
document includes a detailed description of a financial company’s policies related to
information sharing among affiliates.19 Therefore, many economists would argue that
all parties have full and complete information.
But some consumers claim that privacy notices are confusing and complex, and
consumers might therefore be inadequately informed about their financial privacy
rights. Further, it is possible that consumers do not fully understand the potential
market value of their financial information to the same extent as financial
institutions. That may explain why surveys reveal that a majority of consumers place
a high value on their financial privacy, yet banking industry estimates show that20
opting-out rates “hover around 5 percent.”
16 The economics literature commonly refers to this result as the Coase theorem, named after
the Nobel Prize-winning economist Ronald H. Coase, who first proposed this idea. The
term “property rights” is a general concept used in economics to represent ownership or
control over a good, and should not be interpreted literally as a legal definition of an
individual’s property rights.
17 Note that this argument depends upon the assumption that transaction costs are zero. The
next section will show how the existence of transaction costs could affect the assignment
of property rights.
18 P.L. 106-102, Title V; 113 Stat. 1436-1450; 15 U.S.C. §§6801-6809. For more
information, see CRS Report RS20185, Privacy Protection for Customer Financial
Information.
19 The statements also describe an institution’s policy about sharing financial information
with other non-affiliated third parties.
20 W.A. Lee, “Opt-Out Notices Give No One a Thrill,” American Banker, July 10, 2001.
Federal Reserve economist Jeffrey Lacker dismisses this view. He suggests that
the reason for the inconsistencies between consumer privacy preferences, as
identified in surveys, and their opt-out rates is because “the value they place on
financial privacy does not exceed the inconvenience of exercising their right to opt
out.”21
Lacker’s argument raises an interesting point, but it remains possible that not
all consumers are fully aware of their right to opt out. Therefore, financial
institutions could be benefitting from asymmetric information about the “rules of the
game,” as well as the market value of consumers’ financial information. In either
case, the economically efficient outcome would not be realized. If consumers do not
fully understand the market value of their financial information, then they might not
opt out even when given the opportunity, and financial institutions could be receiving
economic gains from sharing this information without paying consumers its true
value.
If there is imperfect information, public policy might promote an efficient
allocation of information sharing by assigning property rights to the consumer
through an opt-in policy. Competitive financial institutions would presumably
compete for depositors’ information by bidding up the compensation for financial
information to its true economic value. In this environment, an opt-in policy largely
obviates the need for consumers to understand the actual market value of their
information. Simply put, if a financial institution has to obtain the explicit consent
of its customers, then it will have an incentive to offer compensation to its customers
for the use of their information.
Thin Margins and Transaction Costs
Although it is important to identify the types of market failures that may prevent
an efficient allocation of information sharing, there are other important factors to
consider when deciding upon the optimal policy solution. For example, if thin
margins exist between the economic benefit to financial institutions from sharing
information and the cost of doing so, then an opt-in policy will cause the market for
financial information to unravel. The additional cost required by financial
institutions to compensate consumers might eliminate the economic surplus from
collecting and sharing financial information. As a result, value would be lost as
financial institutions ceased to share information. That would be a detriment to
financial sector profits, as well as to consumers who might not receive the benefits
of better choice in financial products and services. In this event, the effective control
of financial information would more efficiently remain with the financial institutions
by retaining the opt-out restriction as provided in the current law.
Another example is transaction costs. In the previous section on externalities,
it was shown that in terms of economic efficiency, the assignment of property rights
is irrelevant. However, this conclusion assumes that negotiation and transaction
costs are zero, which might not always be true in practice. There could be costs, in
terms of inconvenience and time, to consumers who want to opt out. Similarly,
21 Lacker, “The Economics of Financial Privacy: To Opt Out or Opt In?,” p. 11.
financial institutions could find it costly to solicit permission from every customer
in order to use their information. If there are significant transaction costs, then
economic theory suggests that an efficient allocation would be one in which the costs
are minimized. If transaction costs are likely to be greater for financial institutions
than consumers in this case, theory holds that the current opt-out policy would
deliver the most economically efficient outcome.
Conclusion
Economic theory suggests that there are distinct benefits to information sharing.
In a perfect market, competitive forces will generally deliver an economically
efficient outcome. However, this conclusion is contingent upon several conditions
that underlie the theoretical model. If one or more of these conditions are absent,
then the market will fail to deliver an economically efficient outcome. In these cases,
public policy plays an important role to promote an efficient outcome.
In the market for financial information, the two most relevant types of market
failures are externalities and imperfect information. If externalities exist and
transaction costs are zero, then economic theory indicates that an efficient allocation
of information sharing will occur when property rights are well defined. Opt-out
effectively assigns the property rights over information to financial institutions, while
opt-in awards ownership to consumers. In terms of economic efficiency, it is
irrelevant who owns the property rights to the information. However, if there are
significant transaction costs, then an economically efficient outcome can still be
achieved when costs are minimized. In this case, economic theory suggests that the
opt-out policy would more likely deliver an efficient allocation of information
sharing.
In a world with imperfect information, an opt-out policy will fail to produce an
economically efficient outcome since financial institutions will receive the economic
gains from information sharing without paying consumers its true value. Therefore,
an opt-in policy could promote a more economically efficient outcome. If financial
institutions have to obtain the explicit consent of their customers, then they will have
the incentive to offer compensation to their customers for the use of their
information.