Raj Date | Establishing minimum standards for the safety of financial products
Given the urgency and severity of the financial crisis, it is not surprising that most policymakers have to date been focused on here-and-now tactical initiatives to stabilize the financial system, rather than laying the foundation for a more sound and better regulated system in the future.
There are exceptions; Sen. Durbin’s proposal for a Financial Product Safety Commission is one of them. The proposed commission would establish minimum standards for the safety of financial products, and would focus especially on identifying deceptive and fraudulent practices. The institution’s mandate would be analogous to the Consumer Product Safety Commission. As the proposal’s sponsors argued to the Treasury Secretary in a recent letter, “there is no reason for us to have regulations that prevent toasters from exploding into flames, but no protections to prevent mortgages and credit cards from doing the same.”
Opponents, thus far, have mustered what seems a half-hearted and formulaic argument against the proposal: introducing a new bureaucracy as the ultimate arbiter of product safety would effectively iron out differences in product structures and pricing, and dampen innovation.
The opposite is true. We have minimum standards on practically every consumer product – from automobiles to the aforementioned toasters – but innovation appears to proceed apace. You would be surprised what toasters can do these days!
Minimum product standards, then, don’t necessarily crowd out innovation. Instead, the difficulty for principled innovators in consumer financial services has been engineering new, improved product structures that can economically match the value captured through questionable, customer-unfriendly practices engaged in by competitors. Take the prime credit card business, for example. It is difficult to compete with large incumbents willing and able to use zero percent teaser rates, coupled with hair-trigger universal default repricing. The economic value of that customer-unfriendly practice was a killer advantage which stifled the need or potential for innovation.
A more persuasive objection to the proposed commission is that it would add to the existing thicket of state and federal financial regulators, rather than replacing them. By doing so it would create further administrative hoop-jumping and destructive friction on innovation.
The proposed commission avoids the political complexity of reducing an incumbent institution’s authority; but the fact remains that some regulators are dreadful when it comes to consumer protection. It was not by accident that Countrywide decided to re-charter its depository away from the OCC when the Fed and OCC began raising consumer protection concerns about non-traditional mortgage structures.
In reality, the industry suffers from too many regulators not from too much regulation. The proposed commission should pre-empt them – or, at least, it should pre-empt other federal authorities on these issues. The result would be more clarity, less arbitrage, and fewer burdens.
The proposal could be improved with an expansion of its mission from merely setting minimum standards. It is certainly true that deceptive sales practices are a major problem in consumer financial services, but they aren’t the main problem.
The main problem is that consumers – who, as it turns out, are human beings – are, in general, incapable of adequately weighing abstract financial risks and rewards. Perhaps the most telling example is banks’ “free checking” offerings, which aren’t free at all, because they tend to generate significant fees through non-sufficient funds (“NSF”) penalties on overdrafts. Consumers are aware of NSF fees; they just systematically underestimate how often they will incur them.
This is where the proposed commission could help. Let me suggest an analogy. Restaurants in Los Angeles County are required to post a large placard in their front windows, showing an “A”, “B”, or “C”. Those letter grades correspond to an establishment’s scoring in routine health department inspections. The Los Angeles approach made more transparent the hygienic disparity between restaurants. That is, it helps consumers understand that while many restaurants meet minimum standards, they are not all equally safe.
Using this approach with financial products would allow the Commission to encourage and reward especially consumer-friendly product structures, while not ironing out innovative product wrinkles. This is the outcome that we should all desire.
Raj Date is the chairman and executive director of the Cambridge Winter Center for Financial Institutions Policy. He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.