The Bankwatch

Tracking the consumer evolution of financial services

Financial Innovation and Consumer Protection | Bernanke has the wrong culprit

Chairman Ben S. Bernanke speaking at the Federal Reserve System’s Sixth Biennial Community Affairs Research Conference, Washington, D.C.  His topic is innovation and the risks to consumers from that innovation.

First the sources of innovation.

Financial Innovation and Consumer Protection | Bernanke

Sources of Financial Innovation

Where does financial innovation come from? In the United States in recent decades, three particularly important sources of innovation have been

  1. financial deregulation,
  2. public policies toward credit markets, and
  3. broader technological change.

I am interested in the third group in particular – technological change.

On the technological front, advances in information technology made possible the low-cost collection, processing, and dissemination of household and business financial data, functions  that were once highly localized and, by today’s standards, inefficiently managed.   As credit reporting advanced, models for credit scoring gradually emerged, allowing for ever-faster  evaluation of creditworthiness, identification of prospective borrowers, and management of existing accounts.

He speaks of the complexity associated with innovative products, and uses credit cards as an example.  Credit cards have many options and flavours, and he refers specifically to situations whereby      “innovation often brought consumers improved access to credit, it also brought increased complexity and an array of choices that consumers have often found difficult to evaluate properly.”

Growing complexity, however, has increased the probability that even the most diligent consumers will not understand or notice key terms that affect a plan’s cost in important
ways. When complexity reaches the point of reducing transparency, it impedes competition and leads consumers to make poor choices. And, in some cases, complexity simply serves to disguise practices that are unfair and deceptive.

He refers to mortgages, and how ” The practice of securitization, notwithstanding its benefits, appears to have been one source of the decline in underwriting standards during the recent episode” and goes on to note that “complexity may diminish consumers’ ability to identify products appropriate to their circumstances” with results that we are now all to familiar with.

The vulnerabilities created by misaligned incentives and product complexity in the mortgage market were largely disguised so long as home prices continued to appreciate, allowing troubled borrowers to refinance or sell their properties. Once housing prices began to flatten and then decline, however, the problems became apparent. Mortgage delinquencies and foreclosure starts for subprime mortgages increased dramatically beginning in 2006 and spread to near-prime (alt-A) loans soon thereafter. By the fourth quarter of 2008, the percentages of loans 60 days past due, 90 days or more past due, and in foreclosure were at record highs.

Finally in his examples, he refers to overdrafts and associated fees, and how even small purchases or ATM withdrawals could inadvertently result in fees that greatly exceed the value of the transaction.

He wraps up rather weakly with the Federal Reserves commitment to better rules on employee incentives for mortgage origination or better consumer education from the Fed, and notes:

I don’t think anyone wants to go back to the 1970s. Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.

Relevance to Bankwatch:

On reflection, Bernanke has it all wrong.  The problem is not complexity and consumer understanding in my view.  For exmaple interest rate resets on mortgages are not complex – in 6 months your interest rate will increase – very simple.  Or, overdraft fees – if you spend $5 and that takes your account into overdraft you will be charged a $45 overdraft fee – nothing complicated there either.  Bernankes thinking and the title of his piece will take us down the track of less innovation, whereas I would argue we need more, but not from banks.  Banks have introduced complexity without innovation I would argue by using middlemen.

The real culprits in the examples cited are caused by non-transparency of rules at time of product usage:

  1. banks hiding behind broker and arms length product originations that act as a sales ‘front’ for banks, with no apparent meaningful accountability to the Bank
  2. amalgamation of account and account access into complex agreements that have no visibility at time of usage

Broadly speaking our world is ruled by agreements and legal paperwork.  The one thing that the web despises and that is generally ignored online is legal paperwork.  Of course the lawyers will note that this absolves no-one from accountability, but the smart lawyers will also note that the race to plain language and simpler documents is an essential adjunct to the web, otherwise the claims of ‘I did not understand’ will be rampant.  In my own ebusiness experience both in the bank and outside, are that there is an increasing desire for force fit old style legal documentation onto the web and an even greater desire to resuly on that documentation, yet there is less and less co-relation between the online service expectations and those documents.

Back to what I believe to be the problems, ie the broker model, and the disproportionate complexity of agreements relative to the service provided.  What these two factors have in common is the lack of direct transaprency between the customer and the product provider.

The solution to overly complex products that favour the banks, is not going to be solved by rules.   There are gems of clues even in the examples of this speech.  Usually the culprit for what Bernanke refers to as complexity, is really one or more middlemen.  Those middlemen could be, brokers, ATM machines, or debit card terminals.  These ‘middlemen’ provide the bank protection behind a set of rules and agreements, and the ability to deny complicity in the complexity.

The accountability for customers must surely lie with the product provider, with no reason to ‘farm off’ any accountability to the middleman.  The rules of engagement should be 100% clear at time of transaction, whether executing a mortgage, or paying with a debit card.  This will generate cries of unfairness and forcing increased costs.  This is where new competition comes in, because if the rules allow competition, new competitors will find ways to accomodate the transparency required.

This might give us a future, for example, with more decoupled debit cards, or alternative mortgage providers using P2P Lenders.  In both case these examples they provide transparency between product and customer.  This is a new theme I will work on some more.  Thank you Ben.

Written by Colin Henderson

April 17, 2009 at 15:52

Posted in Uncategorized

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