Bankruptcy

New Consumer Regulation: Education and Disclosure Is Not Enough

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?

Full post as published by Credit Slips on November 17, 2010 (boomark / email).