The problem with consumer financial protection regulation is that it doesn’t work.
Yes, many regulatory measures help consumers. And yes, our financial system overall serves millions of people very well.
The core problem, though, is intractable. Few consumers are educated on financial issues, leaving most susceptible to making poor choices and many vulnerable to outright victimization.
How government tries to level things
Governments address this challenge using four main tools.
1. Fostering education. The new Consumer Financial Protection Bureau (CFPB) has an unprecedented focus on this.
2. Banning, or mandating, certain specific product terms and practices.
3. Requiring detailed, standardized consumer disclosures. Disclosure has been the primary measure employed by U.S. law and regulation, aimed at promoting healthy market forces with minimal government interference by equipping consumers to make good decisions.
These last two approaches—concrete mandates or bans, plus disclosures—together make up the effort called “rules-based” regulation.
4. Supplementing all the above with a “principles-based” method, in which they use discretion to seek adherence to general, subjective standards of fair treatment.
Societies have been working on this issue for a very long time. Ancient Athens banned debt bondage in 400 B.C. Cultures throughout the world and over the centuries have outlawed “usury.” In America, Congress and our regulatory agencies have been creating consumer protection laws and rules almost non-stop since the dawn of the consumer movement nearly 40 years ago.
For U.S. banks and their customers, the outcome is an enormous, very high-cost regulatory apparatus that provides some protections. However, it also markedly raises the price of consumer financial products and sometimes perversely distorts markets.
In addition, our current system has ended up delivering disclosure overload, which can actually deter consumer understanding by discouraging efforts even to read so much voluminous and, often, low-value material.
The limitations of these efforts came to a head dramatically in the recent financial crisis, which found millions of Americans terribly harmed by subprime mortgages and other financial products that had, in most cases, met all the extensive, expensive technical requirements mandated by law.
The pendulum swings. Now what?
Congress responded by creating and massively empowering CFPB, while all the prudential bank regulators similarly refocused sharply on consumer protection. The resulting shifts in regulatory approach have knocked the bank compliance world off its axis, with the biggest destabilizer being the sudden tilting of regulatory emphasis toward principles-based, rather than rules-based, regulation.
Today, financial services must be not only “compliant,” but also “fair.” This new approach, embodied in fresh thinking about fair-lending and especially in the heightened federal focus on UDAAP (unfair, deceptive, and abusive acts and practices), is now the top compliance challenge facing the industry.*
My earlier bankingexchange.com article, “Compliance Tsunami Survival,” explored what this shift means for banks. In response, some of this website’s readers asked a related question—what does it mean for the regulators?
Specifically, could the new emphasis on principles-based consumer protection potentially replace some of the burdensome old rules, rather than being simply layered on top of them?
This article is the first in a two-part series discussing whether and how this might be done and more broadly, how the regulators might optimize their mix of tools to achieve an ideal blend of rules-based and principles-based protections. I draw on my three-plus decades as a consultant; regulator (full confession—I have written and enforced consumer rules myself); Senate staffer; trade association official; and volunteer with consumer nonprofit and education groups, as well as insights gleaned from discussions with thoughtful bankers, lawyers, and former regulators. Those conversations have included outreach to the United Kingdom, which has traveled this “fairness principles” path considerably longer and farther than we have.
No universal, easy answers
The short answer is that there is no ideal solution.
In fact, the people I consulted differed markedly in their ideas on best approach.
Clearly, regulation must use both concrete rules and supervisory judgment, recognizing that each type of tool carries pros and cons.
In general, rules-based regulation has the advantage of certainty, usually producing a clear yes/no answer on whether the bank has complied. However, concrete rules also tend to be complex, which makes them likely to impose high regulatory costs and burdens as well as, sometimes, technicality-driven penalties that are disproportionate to actual harm done.
In contrast, a principles-based approach can theoretically minimize those problems but has its own drawbacks, especially in almost always increasing uncertainty. Uncertainty in turn opens the door to regulator inconsistency (usually well-meaning but occasionally capricious), which leaves both banks and their customers facing uneven levels of protections and costs.
Also, ironically, uncertainty can actually generate more rather than less expense, as banks feel required to aim excessively high in order to be sure of clearing a regulatory bar that is invisible to them.
The UK’s “Treating Customers Fairly” law (TCF) and evolving emphasis on bank “conduct” have produced what some observers call a ratchet effect, forcing the industry toward a “highest common denominator” of controls and therefore costs due to fear of penalties (which have exceeded 10 billion pounds and are still climbing, almost exclusively for just one product type).
To some extent, the regulators like to see banks aiming very high, and they sometimes intentionally use uncertainty to encourage that behavior. Beyond some point, however, excessively high uncertainty creates problems not only for providers, but also for their customers.
The same is true for excessively complex and cumbersome rules.
Doubling down doesn’t improve things
The current situation—which combines both very high levels of technical requirements and very high levels of subjectivity—is arguably the worst of both worlds. While public sympathy for banks is scarce these days, it is nonetheless true that these problems ultimately harm the consumers whom regulators are striving to protect, in several ways.
First, a suboptimal regulatory mix raises the price of financial services directly through high compliance costs.
Compliance expense is notoriously difficult to measure, mainly because it is embedded in nearly every function a provider performs. All technology, operations, processing, marketing, loan and deposit servicing, HR systems—everything costs extra because every activity must be made and kept compliant with the consumer protection rules.
Studies suggest these costs might account for 20–30% of bank operating budgets. One regional bank I know tells me that 30% of its employees are now in risk management jobs. Community banks, in particular, are sounding an alarm, wondering how and even whether they can survive today’s heightened regulatory challenges, or should even try to do so.
Second, these high costs and risks reduce market competitiveness and consumer access.
Here again, community banks are considering withdrawal from whole product areas for regulatory reasons, while larger banks are contracting activities in products or markets where expected regulatory cost and risk exposure outweigh profit potential.
Such reduced competition will raise prices for everyone.
It will also shrink access to financial services for consumers at the financial margin, who need more, rather than fewer, good choices.
Aiming higher for everyone
Given these risks, the logical question is, could we do better?
CFPB has both the mandate and power to try, and other federal and state regulators also have critical roles to play. How might they best achieve the following widely-shared goals?
• High “protection”
• High consumer access
• High competition (to keep consumer prices low and choices abundant)
• High, healthy innovation (to expand access and constrain prices), and
• Low regulatory costs
Unfortunately, these objectives trade off against each other in complex ways that will always prevent full optimization. For principles-based regulation, the evolution of really good standards will take years.
One of my UK correspondents estimates their financial authorities needed eight years to reach reasonable clarity, and are still working on it.
In the U.S., no matter how smart the regulators are, they cannot quickly, clearly, consistently, and soundly apply broad fairness principles to every product and practice, achieving good outcomes and avoiding unintended consequences, anytime soon. Eventually, their efforts will solidify around some meaningful guidelines, common metrics, and a widely shared ability to make good judgments by both bankers and regulators .
First, however, the whole thing will get much harder before it gets easier.
Similarly, CFPB will need years to rethink and wisely revise the current huge body of consumer laws and regulations. It may or may not ultimately succeed, or even seriously try. Consumer advocates and other industry critics generally agree that the current disclosure apparatus is not sufficiently helpful, but they are always suspicious of changes aimed at streamlining or reducing burdens on banks.
Meanwhile the industry, despite wishing for less complexity and cost, is rightly leery of any regulatory change that requires overhauling systems and processes, which is very expensive to do. Banks know that every regulatory revision will definitely raise costs, at least during transition, and may produce only marginally better rules—and possibly worse ones.
Other daunting factors are at play. CFPB has a mandate to level the consumer protection playing field between banks and non-banks—a very difficult undertaking from every standpoint, including both practical and political obstacles. Add in the wild card of new technology, the reality that Congress and the regulators will have to struggle with novel challenges arising from the tech revolution that is sweeping financial services, producing both pro- and anti-consumer impacts.
Forecast: turbulence ahead
All this means that the next few years will bring a revolutionary transition in financial consumer protection regulation in which all the relevant agencies, and especially CFPB, will be driving change in three realms:
1. Developing increasingly clear and consistent fairness standards through a mix of enforcement, formal and informal guidance, examiner procedures and training, and possibly rule-making;
2. Reviewing the existing body of regulations to determine whether and how technical requirements could be trimmed to reduce complexity and cost, either because they already have low value for consumers or because they eventually become unnecessary as broad-based fairness programs actually succeed in preventing the “unfair, deceptive, or abusive” practices that rules aim to prevent.
3. Leveraging new opportunities created by technology, which will be transforming all three of the relevant functions at once: consumer information and products, industry compliance processes, and regulatory examination and oversight tools.
One thing we know for sure—there will never be a utopia in which all financial consumers make great choices and never experience harm. That sounds like Lake Woebegone, and no one lives there.
Still, we can do better in the future than we have in the past. The next article in this two-part series will suggest principles that might guide the mixing and balancing of principles-based and rules-based regulation for consumer financial protection.
* The federal ban on UDAP with one “A,” i.e. Unfair and Deceptive Acts and Practices, is not new. However, Dodd-Frank added a second “A” for “Abusive” and, more importantly, catalyzed an upsurge in the emphasis placed on these subjective fairness principles by all of the banking regulators. Similarly, the fair lending laws and regulations are old, but are being enforced today with increased focus on unintentional “disparate impact” discrimination—an interpretation that ABA and others have attacked in “friend of the court” briefs and other mechanisms—leading to rising uncertainty on how to satisfy broad regulatory principles.
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