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.