Before and
after enactment of the Dodd-Frank legislation in 2010, concerns were raised
that consumers often lacked the knowledge to evaluate and make informed
decisions about financial services. Some
of the most important involve home mortgages, car loans, asset management,
retirement planning, household credit for major durable purchases and credit
lines for ongoing household expenses, life and nonlife insurance to keep a family
secure, and many more. In the past, the government and employers often made
some of the most important financial decisions on behalf of households - for
example by providing Social Security or defined-benefit employee retirement
plans. Today, households are mostly on their own.
Not such a bad thing, with plenty of financial products and competitors
from all kinds financial firms to choose from. But with time financial products
have become more complex and less transparent, and a there
is bewildering range of options
being pitched. Often financial salespeople are under heavy pressure to
cross-sell, leading to unneeded new accounts or up-sold services, sometimes
attached to an array of embedded and sometimes undisclosed fees. Certain products,
such as some kinds of variable annuities, can be almost impossible for
consumers and even salespeople to value and identify the associated risks.
And it’s not too late to remember
the mortgage “affordability” resets, embedded options and prepayment penalties
offered to eager households back in the glory days of the mortgage boom a
decade ago. The
financial crisis soon placed many of these issues in sharp relief in the US
housing market’s mortgage-origination “fee machine,” and through financial
contagion its contribution to global systemic risk.
As in any market, there are buyers and sellers, and it’s in the interest
of both to come to market fully informed about the price and the exact terms of
what is being bought and sold. There are always mistakes being made, but the
playing field should be as level as possible for the market to do it’s work –
wealth creation, rather than wealth redistribution.
The argument for regulatory intervention is that consumers frequently suffer from market attributes that are
stacked against them, so that caveat
emptor is an inappropriate model for conduct in the marketplace. The basic
sources of consumer disadvantage are found in lack of education and financial
skills, lack of transparency in financial products and services, lack of
fiduciary responsibility on the part of financial services vendors, and
exploitation of vendor conflicts of interest.
Few would argue that consumers
should escape the need for proper due diligence, or escape the consequences of
their own errors. Moral hazard alone makes an excessively robust consumer safety
net untenable. There should be plenty of holes in the safety net. But a
systematically biased playing field that aggressively steers consumer choice, provides
incomplete and biased information, and creates conditions of financial
exploitation is no less toxic. It drains trust
from the system. Without trust, neither financial efficiency nor stability can
be assured – and ultimately encourages excessive regulation when the political
costs get too high. So there is a legitimate argument that both remedial and
preemptive improvements in some key dimensions of consumer finance are a good
idea.
First, consumers need to be
financially literate in order to make well-informed
choices in complex financial decisions.
There have been some severe gaps. Consumers often
do not understand fundamental financial
concepts such as compound
interest, risk diversification, real versus nominal values, and even the
difference between stocks and bonds. Indeed, the evidence suggests that
consumers with
higher levels of financial literacy plan better for retirement, while those with
lower levels of literacy borrow more, save less, and have more trouble repaying their debt, making
ends meet, planning ahead, and making important financial
choices.
But seriously, who’s going to cut
down on time devoted to their jobs and recreational priorities to take Adult
School classes in basic finance? And sometimes too much information is provided and leads to information overload,
which can cause consumers to focus on only a few pieces of easily understood
information, not necessarily the key aspects for complex financial decisions –
relying instead on a few simplified explanations.
There are of course counter-examples. One is lapsed life insurance that
can be surrendered with total loss of capital, sold back to the insurance
carrier at a substantial discount, or sold to third parties for securitization
and marketed to investors - sometimes called “death bonds” or “mortality bonds”.
Another example is long-term care
insurance, which can be an expensive but rational choice for consumers, or a
combination of life insurance and long term care insurance to lower the cost. Consumers sometime seem to display remarkable
clarity in thinking about the options, even though pricing and disclosure
specifics may remain obscure.
Still, consumers can be overly
optimistic in interpreting information in a way that that helps lead them to a desired if irrational conclusion. And there’s concern
that some financial firms purposely design and proactively advertise products to mislead consumers
about benefits, leaving
“financial health warnings” to the fine print. Some classes of consumers - such
as older people preoccupied with life’s
other challenges, minorities and women
- may be particularly vulnerable to aggressive
marketing practices for financial products and leave consumers disproportionately
on the receiving end of exploitation. And it’s been argued
that complex financial products survive in the marketplace because they enable
cross subsidizing sophisticated consumers at the expense of the unsuspecting.
Regulatory intervention in that context will tend to redistribute income away
from sophisticated customers, who prefer less consumer protection.
The underlying argument is that
fairness embodies more than moral or ethical content in the financial
architecture. Failure to provide equitable treatment undermines confidence in
the system and impact liquidity, efficiency and growth. It distorts financial
flows on the part of ultimate sources and uses of funds, and undermines the
political legitimacy of financial intermediaries and those who regulate them. So
sensible government intervention is needed as a matter of the public interest.
Dodd-Frank and the
Consumer Financial Protection Bureau
This is the logic behind the 2010 Dodd-Frank Wall
Street Reform and Consumer Protection Act, which created the Consumer Financial
Protection Bureau (CFPB) as an independent unit within the Federal Reserve System. Dodd-Frank was mainly about
financial stability and systemic risk. But “consumer protection” in the title
signaled the its political centrality in setting out the future rules of
engagement.
Dodd-Frank’s consumer protection legislation covers depository
institutions with assets exceeding $10 billion, mortgage lenders, mortgage
servicers, payday lenders and private education lenders. It does not cover
automobile financing.
The legislation created the Consumer Finance
Protection Board (CFPB) with a mandate to aid consumers in understanding and using relevant information and shielding
them from abuse, deception, and fraud by ensuring that disclosures for financial products are easy to
understand. It is also mandated to conduct consumer finance research and provide financial literacy
education. It has the authority to set rules under existing
consumer financial law and take appropriate enforcement action to address
violations. It is charged with collecting, investigating, and responding
to consumer complaints. And it has a mandate
to ensure that suitable financial products and services are made available
to consumer segments and communities that have traditionally been underserved.
The CFPB itself is an entity of the Federal Reserve
System, and its budget is self-determined and funded out of Fed resources, not
by Congressional appropriation – thereby offering some protection against
inevitable lobbying pressure. It is managed by a Director (currently Richard Corday) who is appointed by the President with
the advice and consent of the Senate, serving a five-year term and who
(like that Chair of the Federal Reserve Board) can be dismissed only “for
cause.”
The Financial Choice Act
The consumer protection provisions of
Dodd-Frank and the CFPB were controversial from the start, with criticism
spanning a range of issues from the constitutionality of its mandate and the
heavy hand of overregulation to the “blank check” funding through the Fed and
the early cases demonstrating its allegedly excessive use of enforcement
powers. Much of the criticism was concentrated in the draft Financial Choice
Act (FCA) tabled by Republicans on the House Committee on Financial Services in
June 2016..There are two major themes in this proposed CFPB revision:
The first
is governance and accountability. As a unit of the Federal Reserve System, CFPB
governance was considered both indirect and lacking a clear public mandate and
political accountability. Moreover, its budget (close to $1 billion in fiscal 2016)
is thought to escape the kinds of checks and balances that apply to other
Federal agencies. The Financial Choice Act would broadly extend to the CFPB the
kinds of governance, accountability and budgetary appropriations that apply to
other federal agencies.
The
second key issue is the matter of consumer choice and cost. The CFPB is thought
to preempt free consumer choice, transferring to CFPB bureaucrats key decisions
about which financial products will be available and to whom, what product
information needs to be disclosed, and how they are marketed and priced. The
argument is that the CFPB has reflected a retrograde turn away from the market
economy towards increased paternalism of the state. It highlights presumptive
cuts in access to financial services to the un-banked and under-banked,
increases in the cost of financial services, violates consumer privacy, and
harms small businesses that rely on consumer financial products.
That said, convincing
evidence suggests that tough consumer protection measures can in fact work.
Take for example the 2009 Credit Card Accountability and Responsibility and
Disclosure (CARD) Act, which capped credit card penalty fees that card issuers
were using to make up for lost revenues during the recession.
A
careful study of the CARD Act’s impact found that the reduction in fee revenue
from cancelled "over-limit" and late fees did not in fact lead to
banks increasing credit card interest rates or significantly raising other fees
in the period through 2015, nor did it reduce access to credit for US
households. In combination, the Act reduced cut the cost of financial services
to consumers by about $11.6bn annually.
The Financial Choice Act proposes a range of specific
reforms that would fundamentally change the operations, governance, accountability
and funding of the CFPB, although it does not propose to scrap it.
Where
Should the Trump Administration Be Heading?
Where the Trump
Administration will come down on consumer financial protection and the fate of
the CFPB and the Financial Choice Act is uncertain. But at least the FCA offers
a considered road-map for change, one which deserves to be debated. It seeks to
pare away some of the Dodd-Frank provisions considered superfluous or
counterproductive, and increase the accountability and budgeting process of the
CFPB to align it to governance of other important federal agencies, while
increasing accountability to elected officials.
It is hard
to argue against political accountability and financial discipline. Still, in a
system driven by heavy lobbying and financial contributions by those who stand
to gain or lose from consumer protection measures, the survival and impact of
Financial Choice Act proposals, if enacted, are difficult to gauge. It is a
major, highly complex exercise in cost-benefit analysis – one in which both
costs and benefits are often obscure and second-best solutions are often
welcome. Inserted into the coming overheated, lobbyist-driven political debate,
it is not hard to imagine that consumer interests will once again come at the
end of the line.
Of course there is always the
threat of over-regulation, but there is also value in helping consumers gain
financial literacy, in improving our understanding of how consumer financial
markets work, in helping people access and use relevant information, and in protecting them from
abuse, deception and fraud.
Fintech is the wild card in the
game. Several dozen players ranging from start-ups and proof-of-concept players
to established veterans seeking “unicorn” status by disrupting a retail
financial services considered overdue for disruption. They range from
marketplace lending to robo-advising, from financial aggregation to retail
remittances, from e-brokerage to retirement planning. As these “direct-connect
linkages take root, some of the key household disadvantages in finance could
melt away – especially as new generations of consumers come on the market – and
the case for consumer finance regulation may weaken.
On the other hand, the legacy
players weren’t born yesterday, and a wide range of fintech initiatives have
already been internalized by the established financial intermediaries – even
the independent “disruptors” themselves have found it opportune to link-up with
fintech upstarts in joint ventures and as attractive acquisition targets. The
fintech dynamic has its own ways of tilting the playing field and generating
new forms of conflicts of interest. Good new or bad news? Some of both, no
doubt, and time will tell. What is certain is that consumer financial
protection will be a moving target.
What’s also
certain is that there will continue to be many “sticky fingers” in finance, amply
reflected in the waves of wholesale and retail banking scandals since the
financial crisis. If nobody’s watching the store, bad things happen. The recent
Wells Fargo case involving consumer cross selling - a core strategy deeply
ingrained in Wells Fargo’s history, culture and incentive systems - shows how
easily a good institution and good people can overstep even the most basic
trust and fiduciary constraints in dealing with “soft target” consumers.
Indeed, in a
highly competitive financial services market, profit often lurks in the shadows.
Retail finance is particularly vulnerable to questionable financial practices given
its gaps in information and understanding. So it is surely in the public
interest to focus on remedies for market imperfections and professional
malfeasance as they appear, and if possible preempt them. It may not be the
“best” and most efficient approach, but “second best” can also leave the world
better off – as always, the devil is in the details.
Whether the
Trump administration and the Congress ultimately chooses the “high road” to
consumer financial protection remains to be seen.
