Does regulation undermine financial innovation?
Richard Thaler and Cass Sunstein recently wrote this piece calling on regulators to emphasize disclosure and transparency by requiring electronic disclosures. The authors suggest that machine-readable disclosures containing general information about credit terms and individualized consumer information would make consumers better shoppers. The authors' basic point that regulators should think beyond paper disclosures is a good one. The prior paper disclosure forms were ineffective and the proposed paper forms will not guarantee that consumers only enter into feasible loans.
The authors' more ambitious claim is that "government should not decide which pricing practices are permitted; it should simply require suppliers to make their pricing observable." In support of disclosure over regulation in the mortgage context, Thaler and Sunstein argue that low-income borrowers are the principal beneficiaries of "financial innovation."
The authors are not simply arguing that taking options off the table undermines lower-income borrower interests by narrowing the pool of available products. This argument would not jive with the authors' point that the pool of product available to lower-income consumers (all consumers for that matter) depends on how much lenders can make off of particular products: "If some method of making money is eliminated, lenders will find a new way in the near future." If regulators ban a profitable "affordability" product, lenders will make alternative profitable products available in the near future. There is a will, so there will be a way.
The suggestion is that banning certain financial products (perhaps just the ones that frequently result in foreclosure) stifles financial innovation in a way that limits access to lower-income borrowers. Why is this the case? Are credit innovators harmed in some way that will stop them from profitable innovation when regulators take some product off the table? If the parties responsible for innovation were punished for their innovation in addition to a ban (e.g. through sanctions or reputational harms), innovators might stop innovating. But the chill on innovation would be associated with the punishment and not the ban. If the costs associated with a ban (e.g. placing people into new products) outweighed the benefits, innovators might stop innovating. Here, the chill on innovation would depend on how the regulator carried out the ban -- if the regulator takes steps to minimize the costs (e.g. by banning the product on a going-forward basis), she can minimize the possible chill on innovation. Perhaps there is more innovation when companies can build on their experiences with existing products so that banning a product leads to less innovation. It is not clear that this is the authors' concern. Still, companies have lots of data about products before regulators take them off the table that they can use to develop new products.
If financial innovation is like other types of innovation, innovators will innovate when it makes sense. Regulators can take products off of the table in ways that do not raise the costs in an innovation calculus.
Pay no attention to well-paid, tenured libertarians.
Financial "innovation" is newspeak for fraud. How many sub-prime mortgages did Sunstein take out?
What we have seen over the past several decades is just another variation on the Ponzi scheme, where the later investor's money is used to pay back high returns to the earlier ones. The only "innovation" this time was finding a way for so many hands to reach into the till at the same time. Ponzi kept all the funds to himself, which meant that the collapse came quicker and was easier to understand when it failed.
August 22, 2008 1:58 PM | Reply | Permalink
While I wouldn't call financial innovation fraud, it is certainly unnecessary in plain vanilla consumer banking. Making legal mumbo-jumbo available in more places, does not make something more transparent. Simplicity and ease of understanding does.
As the saying goes, if you don't understand the product, don't buy it.
August 22, 2008 3:15 PM | Reply | Permalink
I just lost a bunch of respect for Cass Sunstein. Of course regulation inhibits innovation, both by barring certain paths and by diverting resources to compliance. But unless you have evidence that some particular kind of regulation will hinder a particular innovation path that we're agreed we want, it's just a shibboleth to utter to show you're a "serious", "moderate" type.
As for the underlying idea that transparency should allow all options to be made available, sure. As soon as all conversations between mortgage brokers and clients are recorded, and the brokers and their employers are jointly and severally liable for any misrepresentations made during the course of those conversations. Transparency is as transparency does, and no amount of disclosure documentation is ultimately going to trump someone whose paycheck depends on getting you to sign the papers that earn them the biggest paycheck.
So yes, regulation should take some options off the table, same as we don't let people buy cars without seatbelts or houses made of nitrocellulose, no matter how much cheaper or more innovative they might be, and no matter how fully the risks are disclosed.
The idea of electronic disclosures is pretty cool. Imagine, for example, that every loan package had to show a bunch of sensitivity analyses with graphics depicting the odds of keeping your house for the next 1-10 years depending on income, local costs, market fluctuations and so forth.
August 22, 2008 3:20 PM | Reply | Permalink
Lest someone forget to mention SOCIALISM- OH MY GOD, WE’RE ALL GOING TO DIE – Define Socialism. Remember that once upon a time in America the following industries (and others) were regulated (overseen) by the government. Google. Google. Google.
Deregulation (what our corporations – a.k.a. Republican sponsored charities – like to refer to as “anti-socialism “ – which means “no oversight/no accountability” – and seem to have sold you on with a frightening amount of success) has brought you the current state of economic and political affairs we are so enjoying at this moment, including but not limited to:
Home Mortgage Crisis:
“Home Mortgage Crisis” translates to Mortgage Fraud, including appraisal fraud, a circumstance beyond your control but which nevertheless will cost you dearly should real estate agents and appraisers be in cahoots. This practice, as far as I know, is illegal as well as unethical, but is embraced more often than we’d like to admit. Or maybe the law has changed, which it has a funny way of doing when you’re not looking.
How would I know? Well, “Hi, I’m Karen. I’m a recovering home equity loan processor.” My choices were either to quit or have a heart attack, but since I had no health insurance, having a heart attack wasn’t an option.
Lacking any limitations, and apparently no particular reason to regulate themselves, mortgage companies invented a series of financial “products” which included the Adjusted Rate Mortgage (ARM), Interest-only Mortgage, Home Equity Line of Credit, Balloon Rate Mortgage, and Combined Mortgage (super-sized mortgages, meaning first and second rolled into one which negated the 20% down rule). And who knows what else.
Now, it’s not so much that unprecedented numbers of “greedy” consumers suddenly decided to make a run on banks in pursuit of the home mortgage Holy Grail. In fact, it was the other way around. Mortgage brokers were tripping over each other in order to offer consumers the deal of a lifetime: low (or lower) interest rates and low (or lower) monthly payments.
If you owned a home between the years 2000 and 2008 you probably received unsolicited phone calls, and/or direct mail offers, and/or email from a few mortgage brokers. Chances are you were inundated with mortgage loan solicitations until you cried uncle. For the most part, the idea was to get people who already owned a home to refinance their existing mortgages at lower interest rates or to otherwise take out an adjustable rate loan on the equity in the home.
And that would have been fine if the parties concerned had been at all concerned about the prospect of going to hell.
It should come as no surprise that once a prospective borrower sat down to crunch numbers, a predatory mortgage broker may “inadvertently” have failed to apprise said borrower of the sort of loan structure that would produce the incredibly low interest rates and the magnificently low monthly payments. No need to bother about it really, seeing as the broker was in a position to electronically submit a loan application on behalf of the borrower even if the borrower decided against it. This last bit had to do with commissions.
In order to ensure that a borrower remained unapprised, one strategy that worked well for us (the lender) was to ensure that closing documents (containing, naturally, the loan agreement) did not make it to the closing agent until the day of closing.
Now, anyone who has ever been held captive at a closing table can attest to the fact that reading your closing documents at the table is a no-no. Get the picture? Even if a borrower had the opportunity and did take the time to read the sixty pages contained in the closing packet (yes, at last count we were at sixty pages), the legalese contained therein would on principle presuppose a lack of comprehension. But then again, it rarely occurred to these borrowers to adopt any sort of CYA (cover you’re a**) policy because there has never really been a precedent for the widely-distributed, wholesale fleecing that took place. Those who did catch on were, shall we say, a little huffy.
Somehow, these mortgage companies, along with mortgage brokers, and even appraisers, got the idea that there would be no consequences for this veritable free-for-all. Where’d they get that idea, I wonder? No oversight/no accountability and a change in the laws that had previously kept mortgage lenders and investment banks from fondling each other.
So, before the ink even had a chance to dry, the mortgage lenders turned right around and sold those “subprime” mortgages to other banks. Then the rotten apples got bundled into packages alongside the good apples and the whole kit-and-caboodle went up for sale again. And so on and so forth. Finally the bad apples made their way into the investment market where stock brokers proceeded to sell them to investors. Some of those investors were companies managing retirement accounts – the retirement accounts of your granny and mine.
When the interest rates on these mortgages got cleared for take-off, as everyone (except maybe the borrower) knew was inevitable, and monthly mortgage payments began to mushroom beyond the borrower’s capacity to pay, then all hell broke loose. Thus, record numbers of people began to lose their homes.
There you go – in a nutshell.
I would say that the industry hasn't proven itself capable of functioning ethically without a federal babysitter. It should be regulated.
August 22, 2008 4:02 PM | Reply | Permalink
I hear what you're all saying, but the one point made in the article was that regulations are like whack-a-moll. They are reactive. The government's agencies cannot keep up with the sophistication and speed-to-market of financial products. Problems are identified after the fact, followed by regulation.
The trade off for transparency is that it stays current with products. The problem here is the aforementioned sophistication of the prooduct--not something Joe American will understand.
August 22, 2008 5:45 PM | Reply | Permalink
Regulations are like whack-a-mole only if the regulators are underfunded and lack political support. Thank you, right-wing revolutionaries.
August 22, 2008 9:58 PM | Reply | Permalink
Regulations as whack-a-moles is only valid if it makes everything legal that isn't specifically prohibited. This method makes 'innovation' much more likely to quickly find a way around any new rule, and the end result will probably be an unnecessary increase in overall complexity. If, instead be only allow products that are specifically allowed, then each new product will have to justified (why do we need this new innovation anyway?) and better incorporated into the existing regulatory framework.
August 24, 2008 7:47 AM | Reply | Permalink
Regulation of financial innovation wasn't the problem. Banks and investment houses are interested in self-preservation. However, we had a system whereby the private sector enjoyed all the gains while the taxpayers bore all the risks. Everyone allowed the pretense to develop that all these risky home loans were backed by the full faith and credit of the U.S. taxpayer. And, in a certain sense, they were since the banks knew that, if the debt load got big enough, the taxpayers would have to bail them out to avert an economic meltdown (of course). In for a penny, in for a pound. It doesn't take a regulatory genius to see the essential flaw in this arrangement. But, it took the full complicity of Congress to let it go on for so long and to such depths. Full discloser won't effectively expose a lie that was making billions of dollars for some of the most powerful interests in the nation. So, what if the few protesting financial analysts had had more concrete data to wave around?
August 25, 2008 5:44 PM | Reply | Permalink
Financial institutions invite regulation from government when they start to hurt families and communities. Payday lenders in Ohio invited government intervention when they trap hundreds of thousands of consumers in a cycle of debt each year. The Ohio legislature acted by capping interest rates at 28% APR. The payday lenders are now lying to Ohio voters in attempt to overturn one of the nation's best consumer protection laws in November.
Watch here: http://www.youtube.com/watch?v=zDoeXujagE4.
The payday lobby is spending millions on TV to deceive voters and convince Ohioans that 391% amounts to financial freedom! 391% is not freedom, it's a trap! Payday lenders need to acknowledge that their business is predicated on their ability to trap people in debt!
Payday lending is a scourge on our families, our communities and our economy! VOTE YES ON OHIO ISSUE 5!
http://www.yesonissue5.org
August 28, 2008 3:50 PM | Reply | Permalink
The problem with financial innovation is that it is being done to find ways to increase profits. There is nothing wrong with making money, and innovating to increase growth in sales and profits is one of the things that makes America great. However, there are certain industries where the profit motive works contrary to the interest of society. Banking is one of those industries. It adds nothing to the production of any products or services that create value in our economy. Rather, banking sucks value out of the economy with interest and fees for holding other people's money for them, and lending money out for a margin on interest. It is purely an administrative function, and is terribly overpaid. Banks are in the nicest buidlings, bank executives are some of the highly paid positions. Banks have taken on too much overhead as an industry. So the solution, to me, is not to load them down with more regulation to justify more overhead to deal with the regulation, but rather to remove the profit motive. The banking industry should be non-profit. It would revolutionalize banking strategy, and put the focus back on serving the public, instead of stockholders. It would also do wonders for our economy, because loan officers would no longer be in retail sales, paid on commission. People in banking would be there to do what bankers originally sought to do, provide financial services in a way that benefits the public and the economy.
http://www.thetruthaboutcredit.com
Jim Anderson
September 3, 2008 11:38 AM | Reply | Permalink