The long gestation of the Consumer Financial Protection Bureau, which was mandated by the Dodd-Frank Act, is over.
Now that the bureau’s chairman, Richard Cordray, is in place and it is rolling out programs, it is a good time to think about how government intervention can improve outcomes in the financial products consumers buy. Regardless of whether one prefers caveat emptor, a paternalistic federal government or something in between, the CFPB is a reality. Improving financial decisions by consumers is a worthy goal, but it will not be easy to design effective government actions to help them do so.
When consumers make poor financial decisions, they often do so because they lack information and understanding of product features. Financial literacy and sophistication is shockingly low: About one-third of the U.S. population understands the concepts of compound interest or how credit-card debt works. Such financial illiteracy is correlated with high levels of debt and high fees for financial services, and is greater among people with low incomes and low education, as well as minorities and the elderly.
Almost as distressing is the body of research that demonstrates poor judgment in financial decision-making. Experiments with people making real decisions show that changes in the way choices are presented can have large effects on outcomes, such as portfolio composition in retirement accounts. Consumers often focus on subsets of terms for mortgages, insurance policies, bank accounts and credit cards, rather than the financial impact of all the relevant terms. Default rules, which require consumers to actively opt in to employer-sponsored retirement programs, have dramatic effects on the levels of savings in 401(k) plans.
In many areas of life, people make mistakes, bad outcomes result and a lesson is learned. But financial decisions are important and infrequent. Feedback often occurs only when it is too late -- for example, when variable-rate increases make a mortgage unaffordable, or when suffering a financial setback leads to huge fees from banks, or when retirees discover that they have insufficient savings.
Seller sophistication can exacerbate these problems. Financial-services firms collect and analyze consumer information, including detailed transactions data. They then design highly tailored offerings that may exploit behavioral and decision-making weaknesses. For example, those identified as procrastinators end up with products loaded with high late fees. This expanded menu of offerings and customization makes it more difficult for consumers to rely on the market choices of others: Just because my sophisticated neighbor chooses to use Bank X doesn’t mean that the services and prices I get from that institution will be good for me.
Regulations that restrict product offerings are rarely effective. They can prevent many beneficial products from being sold and stifle innovation. In addition, the costs of required regulatory reviews are enormous, and poor decisions among the available choices would persist. Fortunately, this doesn’t seem to be the CFPB’s approach.
Instead, it prefers a regime of transparent disclosure of prices and other terms. The CFPB’s website states that “this means ensuring that consumers get the information they need to make the financial decisions they believe are best for themselves and their families -- that prices are clear up front, that risks are visible, and that nothing is buried in fine print.”
But there are problems with relying on disclosure. For one thing, it doesn’t ensure transparency. Given complexity, the way in which terms are disclosed is critical and must be regulated. The experience of APR -- a single summary interest rate in loan disclosures -- shows how such information mandates can be manipulated by providers, and allow insufficient data to be passed on to consumers. To create transparency, all fees would need to be presented in clear language upfront; perhaps fees should be presented in their order of importance to a provider’s revenue, much as food labeling requires the most heavily used ingredients to be listed first.
It is even more difficult to make fee increases transparent, and these might be even more important as consumers are not always attentive to such rises and perceived or real switching costs may be substantial.
Even if regulations could achieve transparency, they won’t ensure comprehension. Improved information without improved consumer understanding and judgment may accomplish little. Disclosure will only be effective if it improves consumer decision-making. The usual regulatory approach is to educate consumers to avoid manipulation and make better choices. The flaw with this approach is one of scale. Financial illiteracy is rampant, and Congress is unlikely to provide sufficient resources to make even a dent, even with well-designed programs.
Simply put, the problem of poor consumer financial decision-making is large, and current regulatory solutions won’t solve it. The only alternatives are market-based solutions. Consumers need advice. If the value of better financial decisions is great and the cost of education is large, consumers should simply pay for financial counseling. Yet the market for consumer financial advice seems small and ineffective.
One of the reasons is that biased advice -- provided by advisers who are pushing a product for which they get a commission -- can drive out fair and neutral counsel. Biased advice often appears to be cheaper, and consumers may be ignorant of the bias or discount it. Disclosure of conflicts may not be mandated and, even if it is mandated, there is evidence to suggest that such disclosure may be ineffective.
The only regulatory regime that has a chance of making substantial progress is one that helps the market-based solution for advice work better. Structuring disclosure regulation to make advice markets more efficient rather than to make disclosure more understandable to consumers should be a goal. For example, my Chicago Booth colleague Richard Thaler has recommended requiring standard machine-readable disclosure of all financial terms to reduce the costs of comparisons across offerings. In a world of individualized offerings, the savings could be huge.
A second policy is for the government to develop an effective certification program for consumer financial advisers. In addition to knowledge requirements, the government would require that advisers have no financial incentives to prefer some products to others. Rather than teaching financial literacy, outreach programs could focus on educating consumers on the need for a competent, unbiased, certified financial adviser.
(Robert H. Gertner, a professor of strategy and finance at the University of Chicago Booth School of Business, is a contributor to Business Class. The opinions expressed are his own.)
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