by Vicki Morwitz and Robert Whitelaw
This spring Senator Dodd unveiled a Senate bill claiming to place the protection of consumers at the top of the list. Consumers--homebuyers, taxpayers, the everyman investor--were the big losers in the greatest financial crisis in recent history. Now, with a bill moving swiftly, perhaps, through the Senate, victory may be at hand. Or is it?
We suppose the good news is consumers, politicians, and businesses at least all seem to agree that some of the most important decisions we make in life involve financial products: a mortgage to purchase a home, retirement investments, and insurance to keep our families secure. In the past, the government and employers often made financial decisions for households; now households are frequently on their own. While financial products have become increasingly complex, studies show that many consumers lack the basic financial knowledge they need to make informed decisions. Add to this the growing evidence that some financial firms purposely design and proactively advertise products to mislead consumers and it seems clear that consumers need protection.
But is the proposed legislation enough? Are we really setting up the needed checks and balances to protect consumers? According to the comptroller of the currency, letting consumer protection trump safety and soundness is simply "backwards." Clearly, we're not all playing on the same team.
If consumer protection is really the goal, the newly proposed Consumer Finance Protection Bureau (CFPB) would, in fact, have a real mandate to protect consumers. What would this regulatory body look like if this was indeed the case? To start, the new regulatory body would be independent, not subsumed within the Fed or Treasury or any other governing body that has a separate purpose and focus. With independence would come full rulemaking and enforcement authority over all financial firms and products to prevent regulatory arbitrage, and a sufficient budget to carry out the mandate. And this agency would set the federal floor, and not the ceiling, for consumer protection.
Under the Senate proposal, the CFPB would have to consult with other regulators before writing a new rule, and these other regulators would have veto power over any new rules written. The CFPB would have enforcement power over banks and credit unions with more than $10 billion of assets, but smaller banks and financial firms would continue to be overseen by their current regulators. And federal regulations could well be the ceiling rather than the floor for consumer protection for national banks and thrifts, since under the Senate proposal, the national bank regulator could rule that tougher state standards would not apply. The politicians involved seem more concerned with protecting firms, their party, and perhaps their own political legacy than in really protecting consumers. More smoke and mirrors, all at the expense of the very group they're claiming to project.
But even independence is just the tip of the iceberg.
More is sorely needed. While everyone agrees the new CFPB should have a financial consumer education mandate, financial consumer education is a worthy goal, but, as research demonstrates, it is not sufficient to protect consumers from poor choices. Past consumer financial regulation focused largely on requiring disclosures, supposedly to help consumers to better understand the benefits and risks of financial products. However disclosures clearly were not sufficient. Even when disclosures are provided, consumers often use simple rules to make decisions about financial products because they are overloaded with complex information. They therefore focus on a few pieces of easily understood and salient information and often ignore the most relevant, but often more complex pieces of information. This explains many of the disastrous mistakes many consumers made when they selected mortgages and even credit cards in the run up to the crisis. The CFPB should therefore also: (1) have the option to require financial service providers to offer "plain vanilla" products; (2) ensure that default options are prudently chosen; and (3) consider marking certain products with a "seal of approval."
The CFPB should also assist consumers with litigation in cases of abuse, deception, and fraud. For better or worse, the threat of litigation helps to provide good incentives to the suppliers of financial products and services, just as litigation by the FTC does for the suppliers of consumer products. Finally as a last resort, the CFPB should have the right to prohibit the sale of financial products and practices, after market-based evidence of misuse and consumer harm. In this case it must have the authority to protect consumers from themselves. It is nice to imagine that a combination of education, regulation, and disclosure will solve all consumer protection problems, but, if history is any guide, it won't.
So where do we go from here? We have one chance to get this right. Unfortunately, bets are off that consumers will be the ones that come out on top.
The authors are respectively professors of marketing and finance at NYU Stern School of Business and contributors to the forthcoming book, "Regulating Wall Street: The New Architecture for Global Finance," John Wiley & Sons, 2010.