It’s Time To Reset Consumer Financial Protection

Consumers definitely need consumer financial protection. They are preyed upon by providers looking to make money on folks who are gullible, innumerate or just not paying attention. Fraud and deception are all too common.

There’s something else consumers usually need at various times in their lives: a loan. People would be pretty miserable if they couldn’t borrow money when they need it, for buying a house, a car or covering an emergency.

Financial service providers should vilified for doing wrong. And they are. A public beating on Capitol Hill is a common part of running the gauntlet. They should, however, be commended for lending money. Too often, though, they are vilified for that, too. They certainly don’t get much credit for credit, within the Beltway or in the media.

It is time for a reset. Time to recognize the importance of lending for consumers and small businesses and for making the economy go ‘round and ‘round. To recognize the valuable role financial service providers play in making loans for all sorts of reasons, for all kinds of people. And time to put the consumer back into consumer financial protection.

This reset requires a change in mindset in Washington, D.C. Policymakers have to value the critical role that borrowing plays in the lives of normal people and the virtues of having financial service providers that are willing to lend money even when they face significant risks of not getting it back. The CFPB must show greater concern for losing the benefits consumers get from borrowing in its efforts to stamp out wrongdoing. That’s going to require an institutional revolution. Meanwhile, financial services providers must do a better job of explaining how lending helps consumers and, of course, policing themselves.

The Short End Of The Economic Stick

“A lot of the people who voted for Trump are people who got the short end of the economic stick,” according to Ira Rheingold, executive director of the National Association of Consumer Advocates. “And the fact is, the CFPB is an important protector of those people.”

That’s not so clear based on the economic circumstances of people in households that made less than $40,000 a year in 2015 — about 42 percent of people 18 or older that year — found by the Federal Reserve Board’s report on the economic wellbeing of households. These lower-income households need more credit.

The Fed asked people what their biggest concerns were. For the under $40K group, the biggest concern (30 percent pointed to this) was meeting their short-term needs — like putting food on the table and paying their rent. The next biggest ones were employment (17 percent) and medical (17 percent). Credit and debit cards came in fourth (11 percent) — we’ll see below that their concern isn’t the fees but just being able to get credit.

Adults in the bottom 42 percent of the household income distribution are just hanging on. Of them, 17.7 percent reported that it was difficult to get by, and another 31.6 percent said they were just getting by. Almost 60 percent of adults in households making less than $40K a year were therefore not getting by or just getting by.

To get a sense of how close to the edge people are, the Federal Reserve Board asked people whether they were be able to cover a $400 emergency payment with cash or with a credit card. Of people in households that make less than $40,000, 56 percent say they could not.

Now, that is a number to dwell on.

Many emergencies — traveling to take care of a sick parent, deductibles for medical care and putting food on the table for a few months if income dries up — can cost a lot more than $400. So, the inability of more than half of adults in these families to cover just $400 for current funds or on an existing credit card is deeply concerning.

Many of these households have volatile incomes. The Fed doesn’t report a figure for the adults in the under $40K households separately, but overall, 42 percent of households have volatile incomes. And that figure is likely to be much higher at the lower end. More than half (54 percent) of those with volatile incomes in the less than $40K group struggled to pay their bills.

Borrowing on a credit card is one way to deal with financial emergencies and hardships. But, of the adults in households making less than $40,000 a year, 41.1 percent didn’t have a credit card. Less than a third (32.4 percent) of them were confident they could get a credit card approved (versus 61.5 percent for adults in households with income between $40K and $100K).

Around half of adults, across all income categories, wanted more credit in the year before the survey was taken. Yet, 56 percent of adults in households that made less than $40,000 a year, who wanted more credit, had trouble getting it. They were denied credit or offered less than they sought (21 percent), didn’t apply because they expected to be denied (19 percent) or both (15 percent). By comparison, only 34 percent of adults with household incomes of $40K–$100K had trouble getting more credit.

Not surprisingly, adults in households that make less than $40,000 tend to use alternative financial service (AFS) providers — 37 percent do compared to 21 percent of to those in the $40,000–$100,000 range. That includes 10.1 percent that are unbanked but use AFS providers, and 26.9 percent that have bank accounts but also use AFS providers. Of the 15.1 percent of adults in households that make less than $40,000, and are unbanked, almost two-thirds (63 percent) use an AFS provider.

Adults who experience a hardship are much more likely to borrow money from an AFS provider. That includes tax refund anticipation loans, pawnshop loans, payday loans, auto-title loans and paycheck advances. For adults in households making less than $40K a year, 20.5 percent of those who reported a hardship took an AFS-based loan compared to 8.1 percent who did not experience a hardship. (That compares to 11 percent versus 3.7 percent for households in the $40,000–$100,000 category.) AFS providers are lenders of last resort to families who face emergencies.

The economic travails of lower-income households in America, most of which have hardworking people looking to do better, is a serious problem. To state the obvious, these adults need more jobs, better jobs and better pay. They are living too close to the edge.

They also, however, need better access to credit — for paying for medical emergencies, funerals and, sometimes, even putting food on the table. The Fed survey didn’t ask people about problems from borrowing too much on their credit cards or relying too much on payday loans. Some people who did borrow in these ways probably did encounter problems. But overall, the data shows that their main problem, when it comes to financial services, is they can’t get credit when they need it most.

That’s a serious problem.

Taking Care Of Consumers

When it comes to borrowing money, the CFPB is not the “important protector” of those with the short end of the economic stick. The agency errs on the side of making sure that people who get credit don’t get hurt. It doesn’t place much weight on helping people get credit they merely want or desperately need.

The proposed rules on payday, auto title and similar loans are a good example of how the CFPB strikes the balance between boosting lending and stopping bad behavior. The agency proposes to impose many significant obligations on lenders. No doubt, these rules would result in fewer people taking out loans they would come to regret because they would face mounting interest costs or lose the title to their cars.

Those rules would almost certainly, however, make it more difficult, and expensive, for AFS providers to lend this way. Last week, payday lenders asked a federal judge for emergency relief, claiming there was a concerted effort by federal regulators, including the CFPB, to effectively shut them down.

Shutting them down, or cutting their supply of loans much, would be unfortunate, since the evidence doesn’t support preventing consumers from borrowing this way or AFS providers from lending this way. In “Reframing the Debate about Payday Lending,” Young, Mann, Morgan and Strain show that (a) payday loans are priced competitively to account for risk; (b) states that have capped interest rates at 36 percent have shut down lending in those states; (c) there’s no evidence of spiraling fees; and (d) there’s no definitive evidence that payday loans hurt consumers. They do find that chronic rollovers might be a problem, but there’s not enough evidence to say.

In devising the proposed rules, the CFPB hasn’t carefully considered the benefits that consumers get from taking out various short-term and high-interest loan products. In many cases, consumers are taking out these loans because they don’t have enough cash or credit available to deal with a hardship. They may realize enormous benefits from being able to borrow money for a short term, even at high interest costs and even with some risk.

The CFPB also hasn’t carefully considered the unintended consequences of reducing the supply of this type of lending. Desperate people just look for more desperate solutions, which could range from dealing with unsavory loan sharks to theft and risk of jail.

An economically sound consumer financial protection regulator would design rules that, on net, make consumers better off. It would weigh the benefits of rules to consumers against the cost. That’s not what the CFPB does. Or was set up to do — a point we return to below.

Credit Is Good

Yes, bankers behave badly sometimes and deserve to be slapped down and verbally whacked around. Policymakers, media and other commentators, however, need to recognize how important consumer and small business lending have been to making people better off. In the run-up to the creation of the CFPB, Professor Joshua Wright and I conducted a study (our research was funded by the American Bankers Association) of the role of consumer and small business lending in the economy and the risks that the proposed regulations posed to this.

Lending benefits consumers directly by enabling them to time-shift income and expenses over their lifecycles. That makes it possible to buy houses, cars, home appliances and other durables, to smooth fluctuations in income and deal with some of hardships discussed above and splurge when they get the urge. Mortgages and credit cards have been important sources of loans.

Entrepreneurs often use personal credit cards to finance the very early days of their startups. That includes people who open pet stores, restaurants and small retail stores dotting Main Streets across America. It also includes entrepreneurs who have started global enterprises.

Well before they have an angel investor or a venture capital giving them money, entrepreneurs use their credit cards. Here’s one’s anecdote from Entrepreneur magazine:

“Reluctant to leave their studies, the duo ran the operation out of their dorm rooms … [F]inally convinced [of the promise of their invention], they maxed out $15,000 worth of credit cards to purchase a terabyte of disk space and drafted a business plan.”

That duo consisted of Sergey Brin and Larry Page in mid-1998. They were excited because they were getting 10,000 searches a day and needed a bigger hard drive.

Lending also benefits consumers indirectly by stimulating economic growth and, therefore, employment. Part of that is promoting startups. But much of it is simply stoking demand by people who have lifetime wealth that they want to spend now. More spending, more demand, more production and more jobs.

During the 20th century, credit became more widely and cheaply available to American consumers as a result of Big Data methods for scoring credit risks. (Remember, for all the talk of Big Data today, the use of computers to analyze large quantities of data has been going on for decades in financial services.) Credit cards drastically reduced the friction of taking out small loans. Before the widespread use of credit cards, people had to go apply for a loan at their local bank.

Everyone should be watching for evidence of speculative bubbles built on easy credit, as well crazy incentives to sellers’ reps for handing out loans that people can’t pay back. Right now, though, people would like more credit, not less. The Fed survey discussed above found that, overall, 46 percent of adults wanted additional credit in the year before the survey (2014). It also found that 40 percent of those who wanted more credit faced a real or perceived difficulty in accessing credit.

Putting The Consumer Back Into Consumer Financial Protection

Consumers, unfortunately, do need protection from financial service providers who trick and trap them. It is one thing when the local payday lender rips off some desperate guy who can’t speak English or really understand what he’s agreeing to. It is another when thousands of employees at a well-regarded financial institution open up millions of phony accounts to pump up their bonuses. We need strong consumer financial protection laws, and enforcement of those laws, to make everyone involved in financial services — from lowly employees pushing products, to local managers at AFS providers, to CEOs at big financial institutions — to think long and hard about scamming consumers.

The overarching purpose of consumer financial protection, however, isn’t to punish financial service providers. It is to help consumers. Punishing wrongdoers is simply a means to that end. Unfortunately, the leading consumer financial protection regulator, the CFPB, is not designed institutionally to maximize the net consumer benefits from consumer financial services. It is designed to minimize consumer problems by, if necessary, effectively prohibiting products that harm some consumers some of the time.

Professor Joshua Wright pointed out one source of the problem in a Yale Law Journal article. The CFPB has its intellectual foundation in behavioral law and economics, which takes the view that at least some consumers don’t make decisions in their own self-interest. It is easy to go from that predicate to the conclusion that a D.C.-based regulator knows better than a mom that it is a bad idea to take an auto-title loan to put food on the table for the next two weeks. Many articles in the behavioral law and economics literature identify all sorts of ways in which consumers could make bad decisions in purchasing consumer financial products. The CFPB’s rulemaking and investigations have followed this line — at least implicitly.

That institutional bias against financial service products is accentuated by a perverse reward system. The CFPB gets plaudits whenever it imposes fines. Seeing bankers taken out to the woodshed is still quite popular among voters. The CFPB has also become the focal point for consumers to file their grievances to financial service providers.

People don’t, however, think about complaining to the CFPB — or to their local congressman — when they need more credit and can’t get it. The CFPB doesn’t get blamed when consumers lose access to financial service products or get credit when it becomes easier to borrow money. Any rational person heading this institution would, therefore, focus on beating up financial service providers. That’s where all the upside is.

Finally, there is no external force that would require the CFPB to consider the costs that consumers incur from regulations of financial services products, as well as the benefits. (Until, perhaps, now. Read on.) There has been bipartisan support for requiring regulators to weigh the benefits and costs of regulations to maximize economic welfare. Executive orders dating back to 1993 have required agencies to follow this approach. President Obama signed Executive Order 12866 in Jan. 2011 that mandates this sort of smart regulation. As it turns out, the CFPB has not been subject to these orders because of the peculiar structure that the Dodd-Frank Act put in place for the CFPB and has not conducted serious cost-benefit analyses in regulating consumer financial services products.

The current structure of the CFPB exacerbates these problems.

The D.C. Circuit Court of Appeals recently found that the current structure of the CFPB is unconstitutional. As the court observed, a single executive director, who has more unilateral power than anyone in D.C. with the exception of the president, runs the CFPB. Unlike most executive agencies, such as the U.S. Department of Justice, the director doesn’t serve at the will of the president. The president can only fire the director for cause. There are independent agencies, like the Federal Trade Commission, that the president doesn’t have direct oversight over. But those agencies have several commissioners, drawn from both parties, who provide checks and balances on each other.

Under this structure, the director apparently doesn’t have to follow executive orders, like the ones on cost-benefit analysis, or at least doesn’t believe he does. (See Congressman Hensarling’s letter to Richard Cordray.) Congress also doesn’t have any ability to control the CFPB through appropriations since its budget is hardwired as a proportion of the Federal Reserve Board budget. There are no, as Wright observed, external pressures on the CFPB to maximize consumer welfare.

Following the D.C. Circuit decision and the change in political control in D.C., there is renewed attention to what to do with the CFPB. One possibility, if the D.C. Circuit decision stands, is to make the director of the CFPB subject to removal by the president just like any other executive agency head. In that case, in theory at least, the CFPB would have to start using cost-benefit analysis. Another possibility, which has been promoted for a while, is to replace the single director with a bipartisan commission, like the Federal Trade Commission. The commission approach is appealing because it enables a diverse group of professionals to provide checks and balances on each other. Most importantly, it promotes stability and certainty in the regulatory approach.

The fundamental problem with the CFPB, though, isn’t who’s on top. It is that the CFPB does not have an institutional desire, or incentives, to make sure that the financial services industry supplies consumers with products that consumers need, including loans. Congress and the new administration need to change that situation.

Basic steps include:

appointing commissioners, assuming that’s the direction pursued, that recognize the value of consumer financial services products for people in diverse economic circumstances;

mandating that the regulations maximize economic welfare after accounting for benefits and costs; and

making the agency accountable for its overall impact on consumers of financial services products.

That would be a start in putting the consumer back in consumer protection.

David S. Evans, an economist, is the Chairman of the Global Economics Group. He has testified before the House Oversight Committee and the House Financial Services Committee on the CFPB and written several scholarly articles on the agency.