Editors’ Note: In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act created a new U.S. federal agency, the Consumer Financial Protection Bureau, to improve the functioning of consumer financial services markets. The bureau is scheduled to open its doors in July 2011. Its first director will be responsible for setting the agency’s policy direction and for establishing its organizational structure and management climate. Four professors of economics, law, public policy, and business draw on their research in consumer finance to offer advice to the new director. Though the new CFPB is a U.S. agency, the advice applies to financial regulators the world over. Dear Director, Congratulations! You and your team have been entrusted with the task of shaping and enforcing regulations for the consumer finance sector. Your purview includes deposit and savings products, credit products, credit ratings, loans made by nonbank financial institutions, and financial education. The markets for these offerings represent nearly $20 trillion in household assets and liabilities. Consumers have benefited from these products, which help people save money and buy homes, but many have suffered greatly because of unfairness or unscrupulousness in the design and sale of some products and turmoil in financial markets. Building your new agency is a job that’s part start-up and part roll-up, as you will inherit jurisdiction and personnel from at least half a dozen existing agencies. It is an important, exciting, and daunting task. We respectfully offer a few pieces of advice, grounded in our work in economics, law, public policy, and business. Setting Priorities The first order of business is to set your priorities. We see a plethora of “P’s” that might influence you: principles, people, politics, and pet projects. We urge you to focus on the first two and beware the pull of the latter two. You have surely already felt the pressure of politics from industry lobbyists, consumer advocates, and elected officials seeking to influence your decisions. You could easily choose to appease the most powerful among them or the people you know best. But that approach can lead to regulatory capture—when an industry comes to control the agency that ostensibly regulates it. You may also be tempted to start by focusing on the pet projects that your staff members find intriguing. That approach would motivate your team but wouldn’t necessarily address society’s pressing needs. Principles make a far better starting point. We urge you to begin by thinking about the conditions that justify regulation. One is market failure. Consumer financial markets fail for a variety of reasons—for example, when one party in a transaction has more relevant information than the other. Consumers may have better information than the bank about the likelihood of their defaulting on a loan; financial professionals may not reveal their compensation structures—that is, their incentives—to customers. Well-designed regulatory interventions can correct such market-failure problems cost-effectively. Concerns about fairness offer a further rationale for regulatory intervention. Markets may benefit some people at the expense of others. The costs to banks of providing “free” checking are paid for by those consumers who incur overdraft charges. Additional regulatory needs arise because of the inherent complexity of consumer financial products and because so many people have only limited financial capabilities. Consumers can easily fall prey to unscrupulous vendors and deceptive marketing practices in this kind of market. (For a full discussion of the rationales for intervention, see the exhibit “When Intervention Makes Sense.”) When Intervention Makes Sense Externalities When the actions of one party impact another party who had no say in the outcome Foreclosures are costly for entire neighborhoods, not just the borrowers and lenders who are directly involved Information Failures When one party in a transaction has more relevant information than the other Consumers may have better information than the bank about the likelihood of their defaulting on a loan Market Power When firms are able to set prices much higher than their costs of production The cost of comparing the prices and features of different cell-phone plans reduces the likelihood that consumers will switch providers and allows firms to charge higher prices Public Goods When it is difficult for firms to prevent consumers from using a product even if they haven’t paid for it Unbiased information about products, firms, and markets tends to be underprovided because it is costly to supply and consumers can often access information without paying for it Cognitive Biases When the way our brains process information causes systematic errors in judgment Individuals tend to place more weight on the immediate consequences of a decision than on future ones, which may lead them to save too little or borrow too much Financial Capabilities When people’s lack of understanding about financial markets and products limits their ability to make good decisions Dementia, which often comes on later in life, is one reason that the elderly are often the primary targets of financial scams Unfair Outcomes When markets are making some people better off and others worse off The costs to banks of providing “free” checking are paid for by consumers who incur overdraft charges Source: John Y. Campbell, Howell E. Jackson, Brigitte C. Madrian, and Peter Tufano (2011). “Consumer Financial Protection,” Journal of Economic Perspectives, 25(1): 91-114. As you think through which priorities should top your list, we advise you to talk to people—consumers and suppliers of financial consumer products, among others—to understand their concerns. One member of our team has worked with a global market-research firm to poll a nationally representative sample of U.S. households to gauge their feelings about financial regulation. At the product level, the highest levels of dissatisfaction across the board were with credit cards (47%) and stored value cards (37%). Fraudulent lending practices and identity theft also generated high levels of dissatisfaction—42% and 35% respectively. But going beyond these common issues, the top pain points for rich and poor differed substantially. (See the sidebar “The Power of Market Research” for a summary of the survey’s results.) The Power of Market Research Although market research doesn’t set policy, it can inform policy decisions by identifying priorities and measuring progress. The CFPB needs to reach out to a broad sample of consumers to get both positive and negative feedback, just as marketers and political pollsters do. Here’s a look at how survey feedback can help regulators understand consumer needs and pain points. In October 2010 I worked with the market research firm TNS to poll a national sample of 2,276 Americans about their views on current financial laws and regulation. We asked participants the following question: To what degree do you think that your household’s financial interests are appropriately protected today by laws and regulations? Some 28% of respondents gave existing regulation a nonpassing grade. (They answered either “not protected very appropriately” or “not protected appropriately at all.”) A detailed analysis of the data revealed pain points by segment and by product—but it’s up to the CFPB to determine which issues top the priority list and craft the right policy responses. —P.T. Which Consumers Are Most Dissatisfied? The survey data suggest that consumer discontent is not associated with any one demographic variable—for instance, income, age, gender, or education. The two factors most likely to be associated with discontent seem to be financial vulnerability and product usage patterns. Disapproval ratings are substantially higher (more than 10 points) for consumers who can’t come up with $2,000 in 30 days, those who are unemployed, and those who define themselves as indebted. Discontent is somewhat higher (5 to 7 points) for those who have mortgages and who carry a credit card balance. Which Products Are the Worst Offenders? The survey also asked people to describe their satisfaction or dissatisfaction with specific products and financial practices. We found that consumers across the board felt that their interests were not being protected adequately by financial regulation in areas like credit cards and stored value cards (see data at right). But beyond these common issues, the pain points for the rich and poor differ substantially. Poorer people focused on problems with debt collectors and payday loan rates. Richer respondents were more concerned with fees on pension products, obtaining and interpreting credit scores, and preventing identity theft. Setting Metrics and Policy The CFPB can use market research not only to catalog consumer pain points but also to come up with appropriate metrics for measuring the bureau’s performance. The online survey results suggest a metric the CFPB might use: the degree to which consumers feel protected by regulation. Responses would also highlight a central policy question that the CFPB must address: What levels of dissatisfaction are acceptable—and among which groups? Pain Points Percentage of respondents who were dissatisfied with regulations regarding: Credit cards 47% Identity theft 35% Stored value cards 37% Fraudulent lending practices 42% Investment products 32% Of course, we can’t tell you exactly which issues you should tackle first, but we can suggest eight simple ways to identify the problems that deserve your early attention: Look for high stakes. Even with a budget of about $400 million a year, you will still face constraints. Prioritize problems that put large numbers of households at material financial risk. It may be hard to ignore isolated cases of dramatic financial hardship, but you should focus first on pervasive problems. Later you can tackle inefficiencies that affect many people but for which the stakes are small. Look for confusion. You should be concerned when consumers routinely misunderstand the terms of a consumer financial product, especially if that confusion can result in material financial harm. Many consumers, for example, don’t understand the interest rate adjustments and payment due dates on their credit cards (this problem has already been addressed by the Credit CARD Act of 2009). You should also be concerned if consumers don’t understand the compensation structure of the financial professionals they’re dealing with, such as mortgage brokers. Look for regret. A basic problem in consumer finance is that big decisions—about mortgage borrowing or retirement savings, for example—are made so infrequently that consumers do not become adept at navigating the options. Also, their consequences become clear only after much time has passed. When cohorts of people routinely regret the decisions they have made, there may be an educational role for the bureau in helping the next generation avoid similar mistakes. Look for folly. Certain consumer behaviors are so widespread and so contrary to best practice that they should attract your attention. One obvious example is that many households lack even a modest rainy day fund and must therefore seek expensive short-term credit when unexpected financial needs arise. Another is that some people, particularly those with less education, don’t refinance their fixed-rate mortgages when the opportunity arises to significantly lower their interest rate. Look for suckers. Some financial products generate a large chunk of their profits from a small fraction of customers. Bank customers who are attracted to initial low rates on checking accounts but fail to read the fine print on overdraft fees, or borrowers who jump at credit card offers but don’t understand how rising interest rates will affect their balances, tend to be very profitable. In a competitive market for financial services, these profits are typically passed on to other customers in the form of reduced bank charges and lower mortgage rates. Naive (often poor and uneducated) customers can end up subsidizing sophisticated customers. Your agency should be concerned about both the efficiency and the fairness of these subsidies. Look for rip-offs. Or, as economists would say, look for wide price dispersion in otherwise identical financial products. If an expensive product survives in a competitive market, it could mean that some consumers don’t understand what they’re buying. Of course, you shouldn’t expect complete price uniformity in a well-functioning market. Indeed, uniform prices can indicate collusion. Price dispersion should concern you only when gaps are substantial, affect many people, and are unconnected to differences in cost. In policing price dispersion, look across product lines that serve the same underlying purpose. For example, short-term credit is available through home-equity lines, credit cards, payday loans, bank overdraft protection, and so on. Consistent pricing within each product line should not comfort you: If one type of product is always more expensive than another type that has similar risks and serves the same purpose—payday loans are always substantially more expensive than home-equity loans, for instance—that’s a warning sign. Look beyond product names. Products that have different names, or are offered by very different types of organizations, can be functionally similar if not identical. Think in terms of product function, rather than name, when gauging the need for regulation. Look for opportunities. Be alert not just for problems in U.S. consumer financial markets but also for innovations introduced elsewhere in the world that could have a bright future here. Advances in payment technologies abound, from smart credit cards to mobile banking. The bureau could play a constructive role in promoting such innovations. There’s a risk that your bureau will become too defensive and wary of change. The problem stems in part from your name: the Consumer Financial Protection Bureau. “Protection” conjures all sorts of images—protecting people from crime (police), fires and disasters (firefighters), enemy invaders (the military). The shield on your website only reinforces such defensive images. Your aim should be not only to police bad behavior but also to stimulate the kind of innovation that benefits consumers. A more constructive approach would be to frame the agency as a Consumer Financial Promotion Bureau, aimed at promoting the interests of consumers. This conjures a different set of images—of helping consumers make better financial decisions and assisting companies in bringing more attractive consumer financial products to the marketplace. The aim should be not only to police bad behavior but also to promote good behavior and stimulate the kind of innovation that benefits consumers. Selecting Appropriate Policy Responses You have a wide range of tools at your disposal to help you meet your mandate. They include educating and providing advice to consumers, requiring information disclosure by firms, setting standard terms that will be appropriate for most consumers, and prohibiting unfair, deceptive, or abusive practices. How should you determine which levers to pull? At the risk of oversimplification, it may help to evaluate consumers along two dimensions—how homogeneous they are and how financially sophisticated. First, consider to what extent consumer preferences vary. For some products, the answer is not at all. No one wants a toaster that explodes into flames or an insurance policy from a company that’s likely to be out of business by the time you file a claim. But there are just as many instances where consumer preferences differ significantly. We don’t all want to eat the same breakfast cereal or drive the same car. A 30-year fixed mortgage is not the best option for all home buyers, and not all individuals want to save the same amount for their children’s education or for their retirement. Indeed, most consumer financial products are not like toasters, and the agency must craft regulation that accounts for legitimate variation in consumer preferences and needs. Second, examine consumers’ level of financial sophistication. Some people have better knowledge about financial products and decisions than others. For example, many individuals don’t understand the time-value of money and are prone to confusion when dealing with products that involve compound interest or payments spread across a long period of time. (See the exhibit “Don’t Know Much About Finance.”) Your policies should take into account the degree to which consumers are capable of making good decisions when given appropriate information. Don’t Know Much About Finance A survey of Americans showed that many consumers lack even a basic understanding of financial markets and products. For example, significant numbers of people were unable to correctly answer the questions below. (Correct answers are in italics.) Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow? a. more than $102 b. exactly $102 c. less than $102 21% answered incorrectly or did not know Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account? a. more than today b. exactly the same c. less than today 33% answered incorrectly or did not know If interest rates rise, what will typically happen to bond prices? a. they will rise b. they will fall c. they will stay the same d. there is no relationship between bond prices and the interest rate 70% answered incorrectly or did not know A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less. True or false? 24% answered incorrectly or did not know We’ve mapped potential areas of regulatory concern along these two dimensions (see the exhibit “Evaluating Policy Options”). Take stored value cards, such as prepaid phone cards or public transit cards. Consumers of these products tend to be financially unsophisticated: They’re typically low-income individuals with limited access to the banking system and poor credit scores. Consumers of these products also have similar preferences about the terms of these cards: They don’t want cards that expire quickly or impose high monthly fees on inactive accounts. Because of the group’s lack of financial savvy and the homogeneity of preferences, relatively strict requirements—of the sort that the Federal Reserve Board has imposed on gift cards—may be appropriate. In contrast, consider hedge funds, an illustrative case even though they don’t fall under your agency’s direct oversight. Consumers of hedge funds tend to be financially sophisticated investors with quite heterogeneous preferences. From a consumer protection perspective, the appropriate regulatory response is likely to be lighter, focusing on disclosure requirements and fraud prevention and otherwise leaving consumers to fend for themselves. Evaluating Policy Options Evaluating consumers along two dimensions—how homogeneous and how financially sophisticated they are—is useful in identifying potential policy approaches the CFPB could take to various financial products. Products located in the bottom left of this grid—those used by a large number of unsophisticated customers who have similar preferences—are probably best treated through the application of strict regulations. In contrast, products and services in the upper right—whose users are savvy and have varying preferences—require lighter regulations that focus on disclosure requirements and fraud prevention. Click here for a larger image of the graphic. A greater challenge lies in regulating products such as credit cards and residential mortgages. Both credit cards and mortgages are marketed to a wide range of consumers who might legitimately have different preferences: Some consumers want a credit card with no annual fee and a higher interest rate whereas others want a lower rate with an annual fee; in the case of mortgages, optimal pricing arrangements and maturity terms might differ a good deal among consumers. In such cases, softer-touch interventions like disclosure requirements may be inadequate, but highly prescriptive rules may be inappropriate. The bureau’s response must be careful and creative in these areas, helping consumers make intelligent choices without dictating specific terms. For instance, regulators could develop streamlined procedures for obtaining a 30-year fixed-rate loan as a sensible way to encourage all mortgage consumers to consider that option—likely to be a good choice for many—while leaving latitude for others, particularly the more financially sophisticated, to opt for other products. Another regulatory approach might be to harness the expertise of independent parties to help consumers make informed choices. Take credit card fees. The bureau might require credit card issuers to release data about the actual fees charged to different kinds of consumers in recent years. Private vendors could then analyze the data and publish ratings of credit cards for different kinds of consumers. Consumers could use the ratings to choose among cards, rather than try to make complicated comparisons on their own. In many contexts, the mandated release of aggregate data would be more helpful than boilerplate disclosures that the Truth in Lending Act currently requires. Promoting targeted financial education may also help consumers with at least some degree of sophistication choose wisely among heterogeneous products. Of course, no regulatory interventions are free from cost—even disclosure requirements expend real resources. For each regulatory goal, the bureau should identify the least-costly approach and intervene only when the benefits clearly exceed the costs. And as you decide which levers to pull, remember that you can’t legislate away economic principles. The rules of business and economics don’t stop inside the Beltway in Washington: Supply and demand ultimately determine both prices and availability. Companies can’t operate if their revenues don’t cover their costs, and firms will abandon lines of business if regulatory requirements are too severe. Finally, we urge you to stimulate innovation. The Dodd-Frank act permits the bureau to run internal pilot programs and experimental evaluations, especially those likely to benefit low-income consumers in underserved communities. We encourage you to tap outside experiments as well: Recent academic research projects have tested the effectiveness of simplifying the college financial aid application, improving disclosure forms, and selling savings bonds at tax time. Such experiments can provide useful information about consumer behavior. The bureau should take an early stanceon innovations as they come to market. The bureau should take an early stance on innovations as they come to market. The Securities and Exchange Commission has established the practice of issuing “no action” letters to clarify the application of laws in new contexts where existing requirements are unclear, and the bureau should consider adopting similar procedures. For example, the bureau could work with the Treasury Department to find practical ways for firms to comply with Know Your Customer rules in order to facilitate new no-frills financial products for unbanked consumers. Another policy tool to spur innovation might be awards. The Malcolm Baldrige National Quality Awards have been instrumental in encouraging firms to increase the quality of their products; awards for innovative financial products that benefit consumers could have a similar effect. Managing Your New Organization Your new job does not come with an instruction manual; new federal agencies of your scale are not created regularly. But large businesses are built, or created through merger, quite often. We believe that the corporate world offers some lessons that may be particularly useful in your new job. Focus on data and independent analysis. The best businesses are data- and evidence-driven in their decision making, and we firmly believe that the bureau should take this approach as well, especially given the political pressure it will face from elected officials and lobbyists. We are heartened by Dodd-Frank’s insistence on setting up a research group and by the early signs that research will be broadly defined. Make sure that researchers have both independence and a strong voice in the bureau, and be proactive in disseminating data so that outside researchers can be your allies as you crowdsource the analysis of consumer financial markets. The best businesses are evidence-driven in their decision making, and we believe that the bureau should be, too. Fail forward. As a new organization, you are bound to get some things wrong. Although the politics of Washington may make you hesitant to acknowledge failure, as a start-up, you need to do so to make progress. Research by our academic colleagues convincingly demonstrates that smart businesses recognize and learn from failure. Organizational effectiveness is impaired when failure is not acknowledged or when work-arounds prevent it from being systematically addressed. Although Washington politics may make you hesitant to acknowledge failure, you must do so to make progress. Pick your metrics with care. In business, metrics matter. So they do for you. But whereas corporate executives have obvious markers of progress—profits, market share, customer satisfaction, and share price—you will have to make choices carefully. Don’t choose metrics that have superficial policy appeal only. A cautionary tale: The metric widely used to assess the effectiveness of housing policy until quite recently was the home-ownership rate. Home ownership may be a way to build strong communities and foster wealth accumulation, but it also involves taking a highly leveraged bet against an expensive and volatile asset. Driving that number up during the housing bubble had calamitous consequences. Some experts have suggested the personal bankruptcy rate as a measure of effective consumer financial protection. While bankruptcy is undoubtedly a traumatic experience for households, it does facilitate debt relief, and a personal bankruptcy rate that is too low could be as detrimental to consumer well-being as one that is too high. It may be a poor metric of the bureau’s success. A better approach would be to measure your success with the same methods you use to identify problems. For example, survey households to measure their understanding of financial services products. Track the levels of precautionary savings by American consumers, and monitor their overall satisfaction with the state of their financial affairs. Look for reductions in the portion of profits generated by small subsets of customers and for decreases in overall price dispersion in consumer financial products. And don’t forget to measure successful innovation as well as new regulations. We wish you the best of luck in your new task, and we urge you to use your authority to promote a more vibrant consumer finance sector, whose businesses voluntarily supply products that offer better value to consumers and whose consumers make more informed and intelligent financial decisions. If you succeed, we’ll all be better off. As scholars of consumer finance, we stand ready to assist you in your task. Respectfully, John Y. Campbell Howell E. Jackson Brigitte C. Madrian Peter Tufano
