July/August 2012 Too Important to Fail

Predatory lending still poses a systemic risk to the economy. Will Obama's new Consumer Financial Protection Bureau succeed in taming it, or will the agency be strangled in its crib?

By John Gravois

The CFPB is also designed so that, rather than receive its funding through a system of regulatory fees, it survives on a dedicated stream of money from the Federal Reserve. That means it relies on neither industry nor Congress for its supper. This is hugely important. Consider the case of the Commodity Futures Trading Commission, which was given huge new responsibilities under Dodd-Frank to set up so-called derivatives exchanges, a technically complex feat demanding substantial new manpower, technology, and money. The CFTC receives its funding through congressional appropriations, however. And Congress—perhaps in a spirit of austerity, or perhaps because Republicans have simply been looking for quiet ways to sink a knife into Dodd-Frank’s back all along—has more or less flat-lined the agency’s budget. As a result, the CFTC has missed scads of deadlines along the way to fulfilling its new obligations.

Unlike other financial regulators, the CFPB’s prime mission is to ensure the safety and soundness of financial products for consumers, not to ensure the safety and soundness of financial institutions. Under the old regime, regulating financial markets with an eye to consumer protection ranked low on several agencies’ lists of priorities. “Orphan mission” and “bastard stepchild” were terms I heard a few times in my reporting. At times, regulators even justified industry behavior that was widely considered to be predatory by saying such practices were necessary to keep these institutions solvent, which was the main regulatory concern. The bureau has no such built-in conflict of interest. (The CFPB’s decisions are subject to something called the Financial Stability Oversight Council, and may be overturned if they are seen to pose a risk to the financial system.)

Finally, the CFPB has a uniquely broad range of tools and powers at its disposal. It has the power to conduct onsite supervision of big banks and nonbanks, write and enforce rules, collect and track consumer complaints, and conduct original research on markets. And under its mandate to “facilitate access and innovation,” the CFPB’s remit includes running public financial education campaigns and could conceivably stretch, some experts say, to facilitating randomized trials of financial products to help create ones that aren’t predatory.

Indeed, the most innovative, interesting, and potentially powerful work of the bureau has to do with fixing the signals that move markets and drive consumer behavior. Until now, consumer financial protection in America has basically involved forcing lenders to disclose their onerous terms in what you and I know as the “fine print.” Under this regime, financial institutions were legally in the clear as long as the backdoor fee, the interest rate hike, or the obscure charge was noted somewhere in a product’s thirty-page contract. The idea was that somehow, because humans are rationally optimizing creatures, these important but buried signals were clear enough to guide the market to its best outcome for everyone.

Meanwhile, companies actually market their products based on a scientific understanding of how we humans actually behave. They highlight a few carefully chosen facts about a product, and hold them out as the most salient ones, knowing that these will be the signals that truly move the market. And these signals aren’t selected using mere guesswork; they are usually based on an empirically robust understanding of the way large populations of people have behaved in the past, and how they are likely to respond to certain stimuli in the future.

Credit cards, in particular, are like the fruit flies of finance: they generate reams of data about consumer behavior week in and week out. “You can run all kinds of tests all the time,” says Raj Date, referring back to his time at Capital One. Credit card issuers know, for instance, that lowering a customer’s minimum required monthly payment can make him into a more profitable user, because people then tend to carry a larger balance. Issuers also know that, simply by increasing a customer’s credit line—from, say, $2,000 to $20,000—there is a decent chance the customer will go from someone who reliably pays off his balance to one who will fall behind, and thus, again, become more profitable. “There are ways to model what are the attributes of somebody for whom that’s going to be true, versus not,” Date says, “and frankly, that’s more science than art. And it’s that kind of insight that has been almost exclusively the domain of issuers and not at all that of consumers.”

Probably one of the best ways to understand the consumer bureau is to think of its job as rectifying that imbalance. “I almost think about it as democratizing the value of data,” Date says. Ever since the bureau opened a year ago, it has been running experiments on new forms of disclosure—one- or two-page documents rather than novellas of fine print—under a program called “Know Before You Owe.” By posting model disclosure forms online, tweaking them over time, and eliciting feedback from tens of thousands of consumers, the bureau has begun gathering its own data on how people actually process different contract information. Similarly, it has also begun datamining the customer complaints about financial products that it collects.

But that’s just the beginning. The bureau’s research department—which will be made up not only of economists, but also psychologists and marketing experts—is only just getting off the ground, but could one day have the capacity to oversee large-scale randomized trials. At the same time, the bureau is also amassing huge amounts of industry data. Soon, it will have access to account-level information from nine of the largest credit card issuers—a far larger database, in other words, than what any individual issuer has on its own.

So what will the bureau do with all this information? In much the same way that companies use all their data to figure out exactly how best to profit from their customers, the bureau will use data to decide exactly how best to hold the market to the standards outlined in Dodd-Frank—how to keep it fair, transparent, and competitive; how to make sure that it is not abusive or deceptive; and how to make sure it supplies consumers with information that is timely and understandable.

It’s still too early to say exactly how the bureau will intervene, but much of the early rhetoric surrounding the agency points to the idea of requiring a radically simplified form of disclosure—one that essentially merges a product’s marketing pitch with its fine print. Across a given market of products, for example, the bureau could mandate a standard one- or two-page contract written in plain English, with required fields and consistent framing.

John Gravois is an editor of the Washington Monthly.


  • paul on July 09, 2012 1:30 PM:

    The other week I was reading some century-old novel from Gutenberg, in which the hero, a munitions manufacturer (!) decides that he's not going to gouge the government for a huge set of emergency war orders. Instead, he's going to take "only a banker's profit."

    That's what commodity businesses where customers know exactly what they're buying ultimately come down to: small, consistent profits. Exactly the opposite of the financial industry today.

  • kay sieverding on July 14, 2012 11:29 AM:

    I don't understand why no one is talking about modifying the 1948 McCarran Ferguson Act. It prohibits federal regulation of insurance.

    Even if the McCarran Ferguson is allowed to stand, the feds should step in when the states fail to regulate insurance.

    Look at this insurance company. It claims to be a Bermuda company and claims to sell insurance across the U.S. It's not listed on the website of the National Association of Insurance Commissioners


    Look at Colorado Intergovernmental Risksharing Agency. Here's a blog I wrote about CIRSA


    Now the State of Colorado links to the NAIC. Previously they listed TIG as active and selling health insurance. The phone number listed was a residential cell phone and the address listed was a private home.

    There are other examples. If you look at state insurance websites you will see that they list out of state insurers. But the states where they are listed as being based in won't have records of them. Often the names are changed slightly too indicating that legally they aren't the same company.

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