CL&P Blog

Banks Fear Consumer Confusion as House Moves Up Effective Date for Credit CARD Act

by Jeff Sovern

Earlier this week, as the Times reported, the House passed a bill to move up the effective date of some of the Credit CARD Act provisions to December 1.  Here's an excerpt from the Times article:

Industry executives, however, said the move could backfire by prompting companies to restrict the availability of credit at a time when the economy is in a recession.

“This will create significant confusion for consumers and will further restrict access to credit for both consumers and small businesses, all to the detriment of the broader economy,” said Kenneth J. Clayton, a senior vice president at the American Bankers Association.

It's a relief to see that banks are concerned about consumer confusion.  I wish that concern extended to their consumer contracts.

Vincent DiLorenzo on Market Deregulation and Moral Hazard in the Mortgage Market

My colleague, Vincent DiLorenzo of St. John's, has written Mortgage Market Deregulation and Moral Hazard: Equity Stripping Under Sanction of Law.  Here's the abstract:

This article examines the failure of the current regulatory structure to adequately protect consumers against risks in a home mortgage lending market characterized by complexity and limited transparency. It explores the reliance of bank regulators, particularly the Federal Reserve Board, on market discipline to control risks and the failure of market discipline. It also explores the Federal Reserve’s view that market intervention is only justified based on net societal benefits. This is a viewpoint that prevented regulatory intervention until the financial sector was in crisis, and a viewpoint that is at odds with the view of the Congress. This article urges a rejection of the net societal benefits standard as the determinant of regulatory intervention in the mortgage market.

Fed Action on Bounce Loans?

In Senate testimony last Wednesday, Federal Reserve governor Daniel Tarullo promised a final regulation on bounce loans (overdraft fees) within the month.  Banks are charging an average fee of $34 for average overdrafts of $17.  One hot issue raised by the proposed rule is whether customers should have to opt in to overdraft loans and fees, or whether banks can enroll them automatically while allowing them to opt out.  Any behavioral economist will tell you that far more consumers will "choose" to avoid overdraft fees if an opt-in mechanism is required than if they are required to opt out.

 

USA Today recently reported that the Fed has decided to require banks to have consumers affirmatively opt in before paying overdrafts and charging hefty fees, based on Wednesday's testimony.  The Wall Street Journal also announced the Fed's decision.  I watched the video of the exchange between Senator Shumer and governor Tarullo, and did not hear the governor announce any decision on the opt-in/opt-out issue.  On the other hand, given the intense pressure to demonstrate some consumer protection moxie, or lose jurisdiction to the proposed CFPA, it would not be surprising to see the Fed opt consumers out of expensive bounce loans, and require banks to get them to opt back in.

Interesting Newsweek Take on CFPA Proposal

The story is titled You Call This Financial Reform?  Why there's been a lot of talk about protecting consumers but little action . . .

Joe Nocera Column Calling for Consumer Financial Protection Agency

by Jeff Sovern

Joe Nocera has a terrific column in today's Times, Have Banks No Shame?, supporting the Consumer Financial Protection Agency.  The column should be required reading for anyone interested in consumer protection.  Here's my favorite part:

The current bank regulators, [bankers] point out correctly, already have consumer protection as part of their portfolios. “All they need to do is enforce the regulations already on the books,” one top banker told me recently.

Exactly!  But they won't because the existing regulatory structure discourages regulators from enforcing consumer protection.  That's why we need the CFPA--because regulators focused on other matters (safety and soundness, for example) lose sight of consumer protection. And because the existing structure, with financial institutions able to choose which regulator they will be subject to, pits regulators against each other in a competition for financial institutions to regulate.  Regulators competing for financial institutions are not likely to impose strict rules on those institutions; instead, they have every incentive to race for the bottom.  And that is undoubtedly a big part of the reason financial institutions prefer the current system: they would rather control the regulators than be controlled by them.

Could a Consumer Financial Protection Agency Have Prevented the Economic Crisis?

That's the title of my op-ed at FinReg21.  Here are the first two paragraphs:

The economic crisis was caused in part by millions of borrowers taking out loans on which they later defaulted. Perhaps if the Obama administration’s proposed Consumer Financial Protection Agency (“CFPA”) had existed in time, things would have been different. The administration’s proposal would give the CFPA the power to ban unfair, deceptive, and abusive lending practices, as opposed to the laws in place at the time of the borrowing binge, which required lenders to disclose loan terms to borrowers and assumed—incorrectly, as it turned out—that that was all borrowers needed to make good decisions.

We are still studying why disclosures failed to warn borrowers off of the doomed loans. Until recently, mortgage originators were not obliged to show many borrowers their final loan terms until the closing. My research assistant, Sabihul Alam, and I recently conducted a survey of more than a hundred mortgage brokers in 26 states to discover how borrowers use those disclosures. The brokers, who collectively participated in over fifty thousand loan closings, were nearly unanimous in saying that borrowers never withdrew from a loan after reading the final disclosures at the closing, and never used those disclosures for their stated purpose of comparison shopping for loans. Our survey also indicates that many consumers spend a minute or less with the disclosures—even though a mortgage may be the largest, longest-term, and most complex obligation a consumer ever assumes. In other words, we cannot depend on these disclosures to keep consumers from entering into loans with toxic terms.

Adam Levitin Paper on the Consumer Financial Protection Agency

Still more on the proposed CFPA (a theme of the last few days): Adam Levitin of Georgetown, and one of the signatories of our letter, has written The Consumer Financial Protection Agency.  Here's the abstract:

The Obama administration has proposed restructuring financial services regulation by transferring all consumer protection functions from existing agencies to a new Consumer Financial Protection Agency (CFPA). The goal of the CFPA legislation is to address the flaws in the regulatory architecture that have inhibited effective responses to the substantive problems, rather than mandate specific new substantive consumer protection laws.

The current consumer financial protection is based on disclosure regime and is policed through supervisory feedback, enforcement actions, and occasionally prohibitions on terms, products, and practices that are deemed inherently unfair and deceptive. On the federal level, consumer protection in financial services is divided among a number of agencies: the OCC, OTS, NCUA, Federal Reserve Board, FDIC, FHFA, HUD, VA, FTC and DOJ. Some of these agencies have the ability to promulgate regulations, some also exercise supervisory authority over financial institutions, and some may only enforce existing regulations. Sometimes authority is over a class of institutions, and sometimes it is over a particular type of product.

There are four main structural criticisms of the current regulatory structure: that consumer protection is a so-called 'orphan' mission; that consumer protection conflicts with, and is subordinated to, safety-and-soundness concerns; that no agency has developed an expertise in consumer protection in financial services, and; that regulatory arbitrage of the current system fuels a regulatory race-to-the-bottom.

Consolidation of consumer financial services protection authority could: place all financial services companies, regardless of the form of their charter, under a single regulator, thus ending its orphan status; separate consumer protection from safety-and-soundness regulation, thus ending subordination; encourage the development of a deep bench of regulatory expertise and knowledge, and; end the opportunity for regulatory arbitrage and any potential race to the bottom.

There are several potential concerns about a CFPA: conflicts with prudential regulators; ambiguity with respect to Consumer Reinvestment Act authority, and; potential overregulation resulting in higher costs of financial products, less product availability, and discouragement of innovation. Still, there are compelling reasons to believe that the present regulatory architecture cannot produce the optimal consumer protection regime and will continue to fail in its task, resulting in unfair treatment of consumers and a potentially significant source of systemic risk. To this extent, consideration of a CFPA should strive to distinguish between the basic thrust of the legislation - a consolidation of the regulatory authority of - and the proposed new substantive powers granted to the agency.

Dozens of Law Professors Join Letter Supporting Creation of the Consumer Protection Financial Agency

by Jeff Sovern

74 law professors teaching in areas related to consumer and banking law have joined in a letter supporting creation of the Consumer Financial Protection Agency.  The professors, who teach at law schools in 28 states and the District of Columbia, are legal experts who do not have an economic stake in creation of the CFPA but support the agency because they believe it would be better for the country than the current regulatory system. 

The principal drafter of the letter was Professor Norman Silber; I contributed, Profesors Charles B. Shafer, Teresa M. Schwartz, and Alan M. White generously provided cite-checking assistance, and others made thoughtful suggestions. During the last two weeks, the letter was circulated privately among law professors, and many--too many to thank here--passed it on to colleagues.  Though the letter is now public and will be sent to its addressees--Congressional leaders--today, we welcome additional signatories.

As the accompanying press release explains:

The Statement concludes that on balance, the existing regulatory structure places “a higher value on protecting the interest of financial product vendors who promote complex debt instruments using aggressive sales practices, than on protecting the interests of consumers in transparent, safe, and fair financial products.”

The body of the Statement is 8 pages long, single-spaced. It refers specifically to dozens of scholarly articles and studies demonstrating that at “critical moments of consumer confusion and vulnerability,” the existing regulators “have been unwilling to expend resources to develop appropriate rules and guidelines and to police mortgage and credit instruments.” The Statement urges passage of H. 3126 because “consolidated authority and a dedicated consumer-oriented mission would be likely to improve public confidence in the safety and efficiency of the vast consumer financial products marketplace.” It further provides an analysis of desirable aspects of the legislation and points to extensive scholarship supporting the need for a new approach to handling consumer financial regulation.

Update: Coverage at the Banking Law Prof Blog,  Commercial Law Blog, Huffington Post, US PIRG Consumer Blog, and Wall Street Journal Real Time Economics Blog,

Ray Brescia on Improving Financial Sector Practices Through Voluntary Codes of Conduct

Ray Brescia of Albany has written Trust in the Shadows: Law, Behavior and Financial Re-Regulation, Buffalo Law Review.   Here's the abstract:

In the deep throes of the Great Depression, in an effort to restore faith in America’s economy, the Roosevelt Administration promoted the development of voluntary codes of conduct to govern employment and manufacturing practices across hundreds of industries. Compliance with these codes permitted a company to display a Blue Eagle, which was supposed to signify support for New Deal efforts, and that the company was trustworthy. In this way, the Blue Eagle served as a heuristic - a cognitive shortcut - that helped consumers identify those companies engaged in fair practices so that those consumers could show their support for the recovery effort by patronizing compliant companies. Could this Depression-era technique - the use of the Blue Eagle or some similar, useful symbol - serve important ends today? Could it help restore consumer trust in institutions and actors in the financial system so that they might earn consumer trust, and prove trustworthy?

At present, the United States faces a crisis of trust not unlike that which plagued recovery efforts during the Depression. This crisis is one of a lack of trust in our financial institutions. Efforts to restore trust to the financial system are foremost on the agenda of the Obama Administration and Congress. While restoring trust to the financial system will be no small feat, the financial crisis was, in many respects, a product of too much trust: in lenders, brokers and the Bernie Madoffs of the world. And this faith operated within a regulatory philosophy that believed that the market, left to its own devices, could operate at optimal efficiency. In the end, this web of trust fostered predation, overconfidence and unregulated risk; it brought about financial ruin for many and has caused incalculable hardship across the globe. For all the talk of restoring trust in the financial system, the proper focus of such efforts must be the restoration not just of trust, but of trustworthiness. To accomplish one without the other would simply invite the same set of pathologies that helped to bring about the current crisis.

An approach directed at restoring trustworthiness to the financial system will require an appreciation for what makes such a system - and the actors within that system - trustworthy. Informed by the principles of Behavior Economics, psychology and game theory, research shows that there are certain conditions likely to foster either trustworthy or untrustworthy behavior: with weak rules against cheating, and little oversight, it is more likely that people will cheat; that when in long-term relationships in which cooperative behavior can be developed, nurtured and rewarded, individuals are more likely to cooperate in the pursuit of mutually beneficial ends; that in situations with greater social distance between people, they are more likely to act in a less trustworthy fashion towards others; that where communication encourages cooperation, people tend to act in a more cooperative and trustworthy fashion.

After assessing the role these principles can play in informing efforts at re-regulation in several key areas within the financial sector, in concluding this piece I propose that regulatory agencies develop a set of voluntary codes of conduct for financial sector firms. To the extent such firms follow these codes, they will be able to market this information to consumers in an easily communicated manner: in the same way the Roosevelt Administration utilized the symbol of the Blue Eagle to reflect compliance with codes of conduct across a range of industries. These codes will reflect an appreciation for the fact that most lay people will be unable to assess for themselves the extent to which financial institutions are trustworthy or not. Instead, through the development of voluntary codes of conduct, built around the principles that are more likely to lead to trustworthy behavior, consumers will be well positioned to place their faith in those firms following these codes, which will, in the end, generate strong market share for such firms.

New Paper Debunks Industry Arguments that CFPA Should Preempt State Law

NCLC has just released a white paper Preemption and Regulatory Reform: Restore The States’ Traditional Role As ‘First Responder,’that has particular relevance to bank lobbyists' attempts to expand bank immunity from state law in the proposed Consumer Financial Protection Agency.  The paper rebuts claims that allowing states to protect consumers will lead to an untenable regulatory burden.  The paper describes the historic role state consumer protection laws have played in the banking world and why the federal banking agencies’ actions in the last several years to preempt state law were a major factor in the mortgage crisis and other credit abuses. 

 

“Banks like to blame the mortgage crisis on nonbank lenders, but in the peak year of 2006, 32% of subprime loans, 40% of alt-A loans, and 51% of the toxic payment-option and option ARM loans were made by national banks, federal thrifts, or their subsidiaries who were immune from state laws,” said Lauren Saunders, the paper’s author and the Managing Attorney of NCLC’s Washington, DC office.  “Overall, $700 billion of the riskiest loans in 2006 were made by banks who could ignore state law.  Federal law also prevented states from addressing the most dangerous terms of mortgages offered by nonbank lenders.  Credit card and overdraft fee abuses can also be traced to preemption.”

 

President Obama’s plan to establish a new Consumer Financial Protection agency calls for leveling the playing field so that all lenders will have to comply with the same rules.  The plan has run into heavy opposition from bank lobbyists working to expand the immunity of banks from state law.   

 “In 2005, it was estimated that the cost of complying with state predatory lending laws was only $1/mortgage,” Saunders said. “Banks offer numerous niche products for many segments of consumers and are certainly capable of accommodating variations in state laws.  The costs to consumers, the financial industry, and the economy would have been far less if states had not been hindered in protecting consumers.

The paper is available here.  For more information, contact Lauren Saunders, managing attorney of NCLC's DC office, lsaunders@nclcdc.org, 202-452-6252 x 105.