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New Consumer Regulation: Education and Disclosure Is Not Enough

posted by Ethan Cohen-Cole

Elizabeth Warren’s appointment as special advisor to the president was widely hailed as an achievement for consumer advocates. Professor Warren has long been a strong advocate of the middle class and famously compared financial products to flaming toasters.

The creation of a new agency brings new possibilities and new risks for consumer advocates. Most importantly will be the agency’s approach to regulation. In a two-part posting, I will comment on two key aspects of the new agency’s direction. The first revolves around understanding of consumer behavior and the second around firm behavior.

Part 1:

A core component of the CFPB mission is based around the idea that banks provided risky products to consumers that didn’t understand them. There is abundant evidence that consumers didn’t understand the products they bought; however, it’s far from clear that this is a sufficient role for the CFPB. I’ll argue here that in addition to disclosures, education and information, we need explicit regulation of the products as well.

Effectively, this boils down to a simple question: if banks want to offer a risky product (a flaming toaster) to consumers that fully understand its dangers, should the bank be permitted to offer it?

Let’s compare two views of the world:

1. Banks should be allowed to offer risky products to individuals that understand them. The (simplified) argument is that a combination of financial education, disclosure and product standardization will lead to consumers understanding the risks of the products they purchase and, as a result, will prevent 1) predatory lending and possibly 2) future crises.

2.  Banks should not be permitted to do so because

  1. The average consumer is unlikely to be able to fully understand many existing products.
  2. Even in the highly unlikely case that individuals fully understand the products, the products may include personal incentives to use them that have systemic consequences. A recent paper finds evidence to support this. Put another way, the toaster might burn down the neighbor’s house too.

I think it would be very hard to argue that the crisis would not have happened or that individuals would have been better off if they had understood the products completely ex-ante. Similarly, it would be hard to claim that the foreclosure mess we now see not would not have happened.

I point to a few reasons in favor of explicit regulation of products (in addition to consumer information and disclosure).

1) Consider a very knowledgeable individual with a poor credit history. When academic and policy makers think about credit quality, we often assume (incorrectly) that an individual with a high credit score is necessarily one who understands the system and one with a low score is someone who doesn’t understand. To see that this is false, one needs only to look at the literature on causes of bankruptcy. If bankruptcy is even partially due to negative personal events such as divorce, bad health, or unemployment, there must be some low score individuals who previously understood the system and had high scores. This soon-to-unlucky person, is offered a loan that he can afford if he keeps his job and can’t afford if he loses it. If he fails to pay, he loses his house and suffers a cost to his credit score, but gains free rent for the period of time it takes to foreclosure. For example, it take a couple years in Florida to foreclosure on a house (Nice NYT graphic). This creates the very real situation in which individuals have a large private gain to taking a risky product and a large public loss if many do the same. Similarly the bank generally has an incentive to issue the loan, even if it knows some borrowers with default. 

Unfortunately, complete information, perfect financial understanding and standardized products do not prevent this from occurring. Economists refer to this as an 'externality.' The deal works for the borrower and the bank, but at some cost to everyone else. The trick is finding a way to ensure that too many risky loans are not made.

2) The above example is a wildly optimistic one based on the assumption that consumers can correctly calculate the probabilities both that they can repay and the value of the loan (and thus whether they WANT to repay) See, for example. Understanding this, even for the most knowledgeable individuals is not simple. In addition to understanding the product itself, she needs to understand, at the time of the loan, the expected path of interest rates, the distribution of this path, the conditional probabilities of economic outcomes based on these interest rates, their own future job outcomes, etc. As well, the individual needs to understand that the loan will likely be packaged and sold and that the final buyer may have different incentives and policies to pursue foreclosure (see current foreclosure crisis). 

Perhaps this is too much information to expect a consumer to know? I can buy a toaster without worrying about the electrical standards that govern its use; I simply trust that I can use it repeatedly without fear of its catching on fire.

If one stays with disclosure and education alone, we run the risk on going down a path in which consumers must digest complex information about increasingly complex products. As a system, we leave to chance that there are counterbalancing forces that prevent many consumers and banks from entering into mutually-beneficial arrangements that are costly to the economy as a whole.

I personally think that the solution lies is the explicit regulation of products that can be demonstrated to be safe for the individual, the bank, and the system.

The question is then how to approach the product regulation itself?

Comments

Interesting and important post. I wondered though what your answer to just this question is: "if banks want to offer a risky product (a flaming toaster) to consumers that fully understand its dangers, should the bank be permitted to offer it?" Your analysis frequently assumes people can't have perfect information (obviously right), but what about a hypothetical world where consumers have perfect/complete information. Should banks be able to sell risky products in that world?

Thanks for the question:

My interpretation is that perfect/complete information is still insufficient for some products. (I'm careful about wording here because 'risky' to a finance professor means ALL products!)

The reason I make this point is the systemic risk portion. Products that have some potential to contribute to systemic risk transfer economic gain either to the bank or the consumer at the expense of society. I think of this as each sub-prime loan made cost the tax-payer $x. In some cases the borrower gained, in others the bank, in others the real-estate agents, etc.

These need explicit regulation. That regulation could
1. prohibit the product
2. impose higher capital burden on the bank (an insurance mechanism against the systemic risk)
3. impose costs on the borrower or bank (something like a Tobin tax)

My general point is that explaining it to the consumer does not prevent systemic risk.

Ethan --

I think you need to go back and take another look at the BCFP's powers under Title X. It is entirely true, as you suggest, that the original "idea" for the Bureau was similar to that of the NHTSA or CPSC, with ability to ban "unsafe" products, or to regulate the precise form of products. However, as the legislation emerged from the congressional compromise process, the powers of the Bureau were sharply curtailed and are essentially limited to determining that a particular product is unfair, deceptive or absusive. The Bureau does not have the power to impose capital requirements or meaningfully affect pricing. Even the "abusive" standard allows a lender to take "reasonable" advantage of a consumer's imperfect understanding.

It's worth actually reading the statute, or as computer geeks say, RTFM.

HM

Hillary-
I refer to section 1021c and 1022b2B (though I'm aware that the legislative process led to 1022b2B being included because of concerns that consumer protection would reduce profits, it opens the door to the reverse). Also, 1031c is awfully broad.

My regulatory suggestion in the original piece is to curtail specific products.

My comment above about capital is simply to point out that there are alternatives - not to suggest that the BCFP can or should impose them.

This is exactly what I have been saying for the past three years when commenting on this website, ever since the idea of the CPFB or whatever it is named came to be floated. Disclosure-based regulation has failed for decades. If you don't want people to borrow too much relative to their income or at offensively high rates, just pass laws that address the problems directly: a usury law; laws that require meaningful down payments; laws that forbid mortgage lenders with less than X years of complaint-free experience from extending credit to elderly or poor customers. There are all kinds of direct solutions and none of them require a 1000-person agency.

Ethan --

I think your reading of 1021 and 1022 is misplaced. The authority of the Bureau is essentially limited to making regulations that enforce federal financial laws; it lacks the power to make new laws. So, unless the regulation serves to enforce a specific substantive power created in Dodd-Frank or already existing under another federal law (such as TILA), the Bureau is without authority to regulate. (It really is easy to confuse what the "framers" originally intended with what Congress ultimately passed!) I agree with you that 1031(c) is broad, but it's not as broad as 1031(d). Both of these sections have "reasonableness" standards that are an invitation to lenders to beef up their disclosures in order to avoid precisely the kinds of curtailments you propose.

Lets recall that the UL label started out as a voluntary program, and that the insurance companies pushed it to start with. I don't know if today it is illegal sell an electrical device with no UL or equivalent approval, (in fact I suspect it is legal in at least some places having seen christmas lights marketed without it.)
So if a consumer reports type of group came in and gave a seal of approval on products that would meet the goal without the government being involved. In fact there is an interesting opportunity for CR right now, to do just that on credit cards and the like. (I must admit that some mags and journalists do it). What is really wanted is something like the old good housekeeping seal on it. (Not from the Gov but from a truly independent third party).

I agree with MT. All we need to to remove the usury exceptions for banks. If I cannot legally collect more than 10% interest on a loan to my neighbor, why the hell should anybody else be able to do it? Why is the exact same conduct legal for one person and illegal for another?

Yes, I know the conventional answer: that the exempt entities are "regulated" and, therefore, more "professional" than I. Is there anybody today willing to make such an argument? If not, why don't we just tell bankers that they have proven themselves unworthy of the exemption and take it away?

Yes, I know the answer to that, too. And it is extraordinarily depressing.

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