The Consumer Financial Protection Board, which was set up by Title X of the Dodd-Frank Act, is waiting for the President to appoint a director to organize the new agency and pursue its mandate to prevent unfair, deceptive and abusive practices. Insights into how the agency may go about its job, and think about the problem of consumer credit, can be gleaned from the forceful and influential article by Elizabeth Warren, along with Oren Bar-Gill, who has been the leading advocate for a new agency focused on consumer credit.
Their “Making Credit Safer” summarizes the concerns with credit generally but focuses much of its attention on credit cards. Whether you agree or disagree with what these authors say it is likely that their views will heavily influence how the new agency approaches regulation-even more so if Professor Warren becomes the new director. Without editorial comment, this piece summarizes their thoughts on the problems with credit.
Oren-Bar Gill and Warren’s Making Credit Safer: A Summary
“Consumer credit products … pose safety risks for consumers. Credit cards, subprime mortgages, and payday loans can lead to financial distress, bankruptcy, and foreclosure.” The government regulates ordinary products so that consumers for example don’t have to worry that they will be electrocuted by their toaster. While credit products have provided a lot of value to consumers, they also pose risks, and should be regulated too to make them safer.
The basic problem is that consumers are not well informed when it comes to credit. They are also overly optimistic about how quickly they will pay off the loan and there aren’t entirely rational. “The application of these principles in the credit card market, for example, illustrates the welfare costs. An imperfectly rational consumer might underestimate the likelihood of a penalty-triggering event. This consumer, even if she is aware of the high penalties, will underestimate the risk associated with high penalties. Consequently, this consumer might obtain a credit card that is not welfare maximizing for her. Moreover, she might use this credit card in a way that unduly exposes her to the risk that penalties will be imposed.” Moreover, three features of credit products make them particular dangerous: (1) their complexity; (2) the ability of the lender to easily change terms by simply printing and mailing; and the (3) the ability of lenders to change terms after the fact.
Competition between lenders and various help services like Consumer Reports aren’t sufficient to eliminate these problems. For example, “there is some evidence that creditors are not able to inform consumers about safer products. The example of Citibank is instructive. In the wake of complaints by consumer groups, investigations by Congress, and significant press coverage, Citi announced that it would stop two of the most dangerous consumer practices associated with credit cards: universal default and any-time interest rate changes. The company made a large public show of the decision, receiving substantial praise in Congress and elsewhere. Within two years, Citi announced that it was reinstituting universal default. John P. Carey, the chief administrative officer for Citigroup’s credit card unit explained, ‘[w]e hoped and expected that these two points of differentiation would lead customers to vote with their feet. . . . We have been disappointed with the results we have seen so far.’ When the largest credit card issuer in the country has given the most public launch of a safety feature and it is nonetheless unable to explain to consumers why they should choose this safer card, the limits of creditor education become clear.”
The evidence shows that “imperfect information and imperfect rationality are serious problems in many credit product markets.” There is a lot of evidence, mainly from behavioral economic studies, that consumers make a lot of mistakes when it comes to credit cards. For example, many consumers take advantage of cards with low introductory rates to shift their balances but a majority of these consumers do not follow the optimal strategy flipping to yet another card when the introductory rate expires. They lose about $250 a year from this mistake. Another mistake is that consumers borrow high but lend low: they have the liquidity to pay down high rate balances from their checking and savings accounts but don’t. They also incur many late fees that they could avoid simply. Credit card users exploit the imperfect information and imperfect rationality on the part of consumers. That includes everything from high APRs, to late fees and other penalties, to introductory teaser rates.
The evidence “suggests that many credit products are extremely costly to consumers. The data on credit card choice and user show that consumer mistakes cost hundreds of dollars per consumer. Failure to switch cards at the end of the introductory period costs $250 a year. Choosing lower introductory rates lasting for shorter introductory periods instead of higher introductory rates lasting for longer introductory periods costs $50 a year. Paying high interest rates on credit card balances while holding liquid assets that yield low returns costs $200 a year.” Moreover, these costs are most likely to be incurred by poorer people and members of racial minorities.
In summary: “Theory predicts and data confirm that markets for credit products are failing. Consumers, their families, their neighbors, and their communities are paying a high price for systematic cognitive errors. Creditors have aligned their products to exploit such errors, driving up costs for many consumers.” While competition has produced valuable products and features it has also “produced an “array of risky products and unsafe features.”
The Bar-Gill-Warren article appeared in the University of Pennsylvania Law Review which also published two comments on the article by law professors Robert Lawless and Ronald Mann. Both are worth reading.
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