July 17, 2009
A century ago anyone with a bathtub and some chemicals could mix and sell drugs—and claim fantastic cures. These "innovators" raked in profits by skillfully marketing lousy products because customers were poorly equipped to tell the difference between effective and ineffective treatments. In the decades following, that changed with the advent of the Food & Drug Administration and some basic rules about safety and disclosure. Companies then had greater incentives to invest in research and develop safer, more effective drugs. Eliminating bad remedies made room for creating good ones.
Applying this basic economic principle to the marketing of financial products, President Obama recently proposed the creation of a Consumer Financial Protection Agency (CFPA), an agency that will promote financial product safety while supporting market competition and economic growth.
We've become familiar enough with the financial industry's bad products and harmful "innovations" in the past several years: Lenders offering sound fixed-rate mortgages and straightforward adjustable-rate loans were undercut by those promoting exotic products—most with fees and complex pricing "explained" in incomprehensible fine print. Millions of consumers who qualified for traditional market-rate mortgages were pushed toward these subprime loans because they weren't able to compare products and make real choices.
This information gap between lender and borrower exists throughout the consumer credit market. The average credit-card contract is dizzying—and 30 pages long, up from a page and a half in the early 1980s. Lenders advertise a single interest rate on the front of their direct-mail envelopes, burying costly details deep in the document. Faced with legalese and obfuscation, consumers can't really compare offers or make clear-eyed choices about borrowing at all.
Big banks gear up to fight
In short, the consumer credit market is broken. Real competition, the kind that permits informed choices and allows the best products to rise to the top, has disappeared. And as we know all too well, a broken credit market doesn't hurt just consumers. Reckless lending and borrowing has jeopardized the soundness of some of our biggest banks and caused a severe economic downturn.
The agency proposed by the President would promote clear disclosure of the risks and costs for everything from mortgages and credit cards to payday loans and bank overdraft fees. It would also regulate financial products by type—home loans, say—regardless of what kind of lender issued them. The change would stitch up the hole in the current system that permits credit-card issuers to pick their regulators and lets nonbank mortgage companies grant loans with no effective oversight.
The CFPA would also reduce the total regulatory burden by transforming fragmented, cumbersome, and complex regulations spanning seven federal agencies into a coherent set of smarter rules. It would further cut regulatory burdens by pre-approving templates for plain-vanilla contracts designed to be read in less than three minutes—a regulatory safe harbor that would eliminate the need to pay legions of lawyers to ensure compliance with the maze of laws. The lender would still set rates, credit limits, penalties, and due dates. But consumers would be able to lay out a half-dozen simple-to-read contracts on the table and choose the card that best fits their needs. Banks and other lenders could continue to offer complicated or risky products—as long as the risks are disclosed so that customers can understand them without relying on a lawyer.
Some big banks are gearing up to fight the proposed agency. The American Bankers Assn. claims the new agency would limit consumer choice and undermine innovation. But what kind of innovation exists when consumers can't differentiate good products from bad—or drive the market with their preferences?
No agency can, or should, replace personal responsibility. A credit-card holder who goes on an unaffordable shopping spree should bear the consequences, as should someone who buys an oversize house or a budget-busting new car. But most consumers—those willing to act responsibly—would thrive in a credit marketplace that makes costs clear up front. And for the vast majority of financial institutions that would rather win business by offering better service or prices than by hiding "revenue enhancers" in fine print, the CFPA would point the way to a stable, efficient, and more competitive financial system.
Harvard Law School Professor Elizabeth Warren is currently chair of the Congressional Oversight Panel created to oversee the banking bailouts.