DIARY OF A MAD FINANCIAL SYSTEM

December’s release of early findings from the U.S. Financial Diaries Project should change our thinking on how to expand financial access.

The financial lives of lower-income families are mostly a closed book, poorly understood by both financial companies and policy-makers seeking to meet their needs.  Since generalized consumer data mask vast complexity in how underserved households operate, the Diaries project was launched to dig deeper.  Led by the Center for Financial Services Innovation (disclosure -- I serve on CFSI’s board of directors) and NYU Wagner’s Financial Access Initiative, the work is supported by the Citi Foundation, Ford Foundation, and Omidyar Network.  NYU’s Jonathan Morduch and CFSI’s Rachel Schneider organized a unique research team that intimately observed and chronicled the real financial lives of 200 families for a year. 

The results explode much of the conventional thinking about financial health and access. 

Volatility is the key

Amidst many rich findings, one key insight stands out:  For many struggling families, the problem is not insufficient income.  It’s insufficient stability – volatility and unpredictability, in both income and expenses.

Even in households whose annual income exceeds their annual bills, unmanageable dynamism in both inflows and outflows leaves many people in periodic deficit.  Since they lack a savings cushion and good options in today’s financial services market, these shortfalls create huge and lasting damage.

This means that addressing instability, itself, is critical.  Unfortunately, that focus is largely absent from traditional thinking.  For decades, public policy has assumed that these consumers mainly need more availability or affordability of standard bank products.  Even our terminology reflects this – we call people “underserved,” or “under-banked” and define the solution as easier “access” to banks.  Efforts ranging from the Community Reinvestment Act to regulatory jawboning urge banks to offer more products like basic checking accounts and especially credit – mortgage credit in particular.  While these measures have yielded benefits and remain important, they have settled into a fairly stale policy debate over a narrow set of options.  The Diaries research should catalyze new thinking. 

The researchers found widely varied consumer situations, most of which elude conventional stereotypes. Many participants work full-time, and more.  Some own their homes.  Some have college educations.  Some clearly are upwardly mobile, budgeting, building credit scores, and even saving.  They range from two-parent families to single mothers and mature single men, and include new immigrants and urban and rural households from coast to coast. Some participants rely on seasonal income (one in the tax advice industry) and on sporadic sources like caring for foster children or renting out rooms.  Some have bank accounts, mortgages, and credit cards. All, though, live at the financial edge, vulnerable to – and often in unsustainable debt because of – unexpected shortfalls. 

The Diaries participants use an array of financial strategies that weave together the formal and informal economy. Many rely on family for emergency loans and/or in-kind help, often in reciprocal arrangements that can work well for all. Some have both bank accounts and payday loans.  A high percentage have at least one serious health problem and manage that cost by adjusting medications (medicalexpense is a key source of volatility). Nearly half don’t have credit cards; of those who do, about a third are maxed out. Many are very savvy about their financial lives, managing income and outflows with precision timing to cover their bills (see my 6/30 blog post “Underserved and Underestimated").  Many use the Earned Income Tax Credit essentially as a forced saving mechanism. One person “saves through Mom” as the spending gate-keeper. Many save “in a sprint” when needed, or “save for soon” to meet upcoming needs but not long goals like education, retirement, or accumulating a financial shock absorber.

New ideas

The Diaries’ December kickoff featured Vox.com’s Danielle Kurtzleben and a panel of Professor Morduch; the Urban Institute’s Ellen Seidman; former CFPB official Raj Date; and Bill Bynum of Hope Credit Union in Mississippi, who also chairs the CFPB’s Consumer Advisory Board. The panel and invitation-only audience voiced optimism that the financial system can actually solve much of this problem.  Raj Date noted that people either borrow at 0% from friends and family or at 300% in payday loans, arguing for something in between (his company, FenwaySummer, offers a subprime credit card). Ellen Seidman cited the need for more community-focused institutions like the Hope Credit Union run by Bill Bynum, who pointed out that over 90% of post-recession branch closings have been in low- and moderate-income census tracts.

The session left me pondering the mismatch between the current system and financially-marginal families.  American Express estimates 70 million Americans live at the edge of the formal financial system, spending a lifetime average of $40,000 in unnecessary fees -- $89 billion in fees and interest in 2012.  This is a huge market with clear financial capacity.  These consumers can’t readily access mainstream products partly due to the volatility problem, which clearly limits creditworthiness by traditional standards.  Still, they can and do pay for financial services, at high prices, mainly at non-banks and in the informal economy.  Could new insights like the Diaries findings, combined with new technology and fresh thinking, bring them better options?

Here are some thoughts:

• Payday Lending and Bank Overdrafts: 

CFPB is considering how best to regulate these two financial products that aim to cover emergency cash shortfalls.  The Bureau should study the Diaries’ sharp distinction between consumers whose problems are inadequate income versus volatility.  Aaron Klein of the Bipartisan Policy Center has framed this as differentiating insolvency from illiquidity (see link here). Insolvent consumers are inevitably harmed by getting credit.  Illiquid consumers, in contrast, can benefit from emergency credit if it doesn’t trap them. This argues for practical regulatory standards on ability-to-pay and more broadly, rules that enable banks and non-banks to offer fair, profitable, and innovative products.

• Savings: 

As Bill Bynum noted at the Diaries event, most people experience financial volatility, but affluent people weather it through savings (and access to well-priced credit).  Maybe it’s time for both policy-makers and industry to emphasize savings options and incentives, and deemphasize credit. Ideas include more focus on automatic and opt-out savings arrangements and innovative savings rewards programs, including ones styled on sweepstakes and lottery models that foster wide engagement.

• Insurance: 

The classic financial tool for covering unpredictable events is insurance.  Advocates have long critiqued traditional credit insurance as a high-cost add-on that sometimes overstates coverage and/or is sold too aggressively -- not to mention that it only pays off the related loan.  Innovators have begun talking about broader, affordable insurance for people who live within their means but face timing shortfalls. Solutions should, again, distinguish between illiquidity and insolvency, and regulators should prevent abusive designs and sales practices.  Meanwhile, the continuing policy debate on health insurance reform should include focus on the outsized impact of unexpected medical expenses on financial system access, upward mobility, and government dependency, regardless of what the ultimate outcomes may be.

• Alternative structures: 

Another promising approach lies in linking successful nontraditional and informal financial arrangements into the mainstream system.  One example is Jose Qunonez’ Mission Asset Fund in San Francisco, which tracks repayment records of people borrowing within Latin American-style lending circles and creates data usable by mainstream credit bureaus, helping borrowers build formal credit scores.  There’s also growing exploration of how to use big data to develop nontraditional but predictive metrics on creditworthiness.

• Mobile PFM: 

Lower-income people are disproportionately high users of smart phones, including for financial tasks (see my 10/12/14 blog post The Benefits of Bitcoin).  This is a game-changer, potentially opening whole new ways for people to improve their financial lives.  Over time, PFM – personal financial management – in smart phones will permit effortless savings, budgeting, warnings against dangerous product terms, and much more. Think about BBVA’s Simple.com account, which takes the “simple” but powerful step of displaying the customer’s “safe to spend” number more prominently than the account balance.  Such services won’t help all consumers but as PFM tools evolve and converge, they could revolutionize consumers’ options and behaviors.

• Regulatory clarity: 

As I argued in Forbes last fall, a major barrier to widened financial access is the industry’s fear of enforcement and reputation risk in areas where regulatory standards are subjective and evolving, such as in defining discriminatory lending and “unfair and deceptive” practices.  The more regulators can reduce this uncertainty, the more financial companies, especially banks, will do in underserved markets.

• Community Reinvestment Act: 

It’s time to revisit CRA, which dates from 1977 when banks were local, banking was branched-based, and policy concerns focused overwhelmingly on access to credit, especially mortgages. The bank supervisory agencies are gradually updating CRA policy through new question-and-answer guidance. Their thinking should incorporate the Diaries insights and consider giving banks CRA credit for innovations of the kinds outlined above.

• Innovators:  

Speaking of innovation, both startups and the innovation labs at big financial companies are busily leveraging technology to reach traditionally underserved consumers affordably and in ways that offer better choices, better information, and more control.  Regulators should encourage these efforts, and carefully not stifle them, while also watching for signs of emerging abuse.

• More research:  

We need more research like the unique but costly Diaries project, deepening the insights, identifying high-impact solutions, and also looking at the longer-term patterns of these consumers.

If fewer people struggled with financial volatility, vulnerability, and damage, the larger economy and society would benefit.  So would financial companies serving them profitably as an “emerging” market, much like today’s expanding markets the developing world.

Follow the Diaries work here.  And if you haven’t seen American Express’ film Spent, download it for free and share it with your organization. 

Please also think about fresh ideas, for industry, regulators, innovators, advocates, or academics.  Send me your thoughts, and please share the blog with colleagues and others who might be interested!

The Benefits of Bitcoin

I had a birthday this month and two of my children – both in their 20’s -- gave me a joint gift. This left my daughter in London owing money to my son in Boston. She paid him in Bitcoin.

Granted we’re not typical since (full disclosure) my son works for Circle, a startup aiming to bring digital currency to the mass market.  While digital money is nowhere near being practical and safe for mainstream consumers, it has huge potential to get there and to bring us all enormous benefits.  It’s a mistake to dismiss it as either unserious or as intrinsically more risky than worthwhile.

Non-mystique

For most people, the first hurdle in understanding digital currency is to get past the weirdness factor, which is huge.  We hear about how Bitcoin was created anonymously, was arguably not legal, and sprang from conspiracy theories on the illegitimacy of the Fed.  We hear the odd words – the “block-chain,” “crypto-currency,” the “keys” stored in secure cold vaults, the “mining” that creates Bitcoin as big computers solve complex mathematical problems.  We are asked to trust that the supply will be permanently limited by some shadowy non-governmental entity.  We read of exotic-sounding scandals – Silk Road, Mt. Gox, mentions of murder for hire.  I’ve been in numerous sessions with very sophisticated financial people who just cannot wrap their heads around any of it. 

However, using Circle, and presumably its competitors, is simple as pie.  You sign up online, link your bank account or credit card, and voila, you have a Bitcoin account to spend as you want.  I just bought a shirt on Overstock.com and sent $50 to my London-based daughter.  It was in her account a minute later.

Digital currency is confusing because it doesn’t fit into any pre-existing categories. Government agencies are variously trying to regulate it as a currency, a payment system, and an investment asset.  It has attributes of all these, but it isn’t fully any of them.  That said, its main disruptive power, and potential consumer benefit, is as a new and better payments system. 

Benefits

Why better?  Because this innovation can make moving money essentially instant and free.  It can do this because the money moves on the internet. Remember how people originally found it hard to believe the internet is free, or later that Skype’s internet phone calls are free?  Digital currency is like that.  It simply bypasses the old infrastructure.  And its disruptive potential is huge because that old payments infrastructure is the opposite of instant and free – it is expensive and slow, domestically and more so in international payments. 

Here are a few recent examples from my own life.  I got a $15 late fee on a monthly payment I make automatically from my online bank account, which inexplicably took ten days to reach a huge national company.  Sending funds “online” to my Boston son always takes over a week, because my bank generates a paper check and puts it in the mail.  For my daughter, things are worse.  Before she and her husband moved from Washington, DC to London they visited their local branch of a huge bank to arrange to wire money into a new account at a UK bank.  When they got to London, they learned the branch’s instructions were wrong and spent hours trying to get their money, including 40 minutes of hold time during a call with their U.S. bank. We ultimately solved it through my personal banker, who also waived the wire fee and helped in other ways because I have more money than my kids do. I appreciated it of course, but financial systems should work for everyone.  I recently met a man who spent over $300 wiring a fairly small sum to his mother in eastern Europe.  It’s a situation ripe for disruption.

Think of all the consumer problems caused by slowness.  If payments were instant, a huge share of overdrafts -- and overdraft fees – would disappear as people stopped misjudging when deposits and debits would hit their accounts. Instant payments could also enable underserved consumers to drop costly check-cashing services, because they could pay pressing bills electronically as soon as they received the money to cover them. Real-time accurate balances might even foster better habits as people regain financial clarity and control, especially if they adopt phone-based mobile tools like ApplePay (See my prior blog post on Disruption).  Imagine also transferring money internationally with no currency exchange rate risk, or without even touching sovereign currencies at all.

Those benefits all flow from speed.  Now consider costs.  If money can move nearly for free, banks’ costs for low-balance checking accounts would plummet, widening access to mainstream banking.  International remittance charges would plunge too. Furthermore, near-zero costs enable tiny payments.  Whole industries’ online business models could shift as high-priced bundled content, like newspaper subscriptions, could profitably be divided and sold in small units, such as single articles for a few cents. In the developing world, people could access a new formal, regulated, transparent, cost-effective system far more fair than old markets, and far safer than cash.  My son at Circle likes to say someone in Kenya will be able to send 17 cents to someone in India, at no cost.

Risks

These potential benefits clearly bring enormous consumer risks.  For one, digital currency vehicles like my Circle account fluctuate in value with Bitcoin.  A mainstream system will have to protect people’s money or be limited to those who can afford to lose it. Business models will emerge with hidden pricing that will raise concerns. Global activities will strain our regulatory structures. We now have “ransomware,” in which computers are encrypted and held hostage until the attackers are paid off in Bitcoin. Threatened legacy industries will adopt both business and political tactics that could cause harm. Massive challenges lie ahead in consumer education, disclosure, privacy, data security, taxation, anti-money laundering, and fraud, although some of these cut both ways.  Digital currency is much more traceable than cash, partly because the whole system’s activities are open and visible on the internet.  On the negative side, instant money movement can obviously abet laundering and fraud, which is one reason the current system contains delays. 

Smart observers also warn, rightly, that nothing that’s highly regulated -- as this ultimately will be -- can stay “free” forever. 

Unlike many other payments innovators of recent years, Bitcoin is an open platform upon anyone with a good idea can build. Like the internet itself, it will undergo cycles of rapid innovation – it’s currently in the equivalent of the pre-Netscape era. Since it’s an evolving protocol rather than a static technology, no one knows what it will bring (including whether Bitcoin itself will be the dominant digital medium).  Still, some version of digital currency will likely become a major force, because its intrinsic advantage is so great.  Already central banks and payment system leaders are exploring how these innovations could strip time and costs out of today’s antiquated payments flow, and also how both traditional and new systems might harmoniously coexist in a new framework allowing digital-age progress while preventing most harm. People interested in consumer access and protection should join in this dialogue.

Let me know what you think.  And for one further note, see below.

My daughter’s anecdote

In case you’re interested, here is my daughter’s account of the London transfer fiasco.  Gotta love that last sentence….

To make a long story short - Nick went in to a (bank’s name) branch, told them we were moving to the UK, and asked how we could transfer our money to a UK bank once we opened an account.  They told him it would be no problem - that we'd just need to call once we had the new account and pay a $40 transfer fee- and gave him a sheet with our account information before sending him on his way.

Once we had moved and opened our account in the UK we called (bank name) to try to initiate the transfer.  We were on the phone, mostly on hold, for nearly an hour before we hung up on them out of frustration.  We were transferred between four different people who all gave us different information.  The second person tried repeatedly to sell us a product for bill paying exclusively in the USA. It was completely irrelevant to our current situation (which he, the bank employee, admitted) but still tried to make us answer the question "do you think you might ever use this product in the future" repeatedly. 

The next two transfers went up the management chain but ultimately we were told that we had been given the wrong information in the branch, and that we had to do the wire transfer in person, which we were at that point clearly unable to do as we had already moved.  Effectively (bank name) told us we could not have our own money.

Other solutions suggested by the highest-level person we spoke to were to increase the amount of money we could withdraw from the ATM (which would have incurred a fee each time we made a withdrawal). Useless.  We were also told to deposit a check with the British bank but were informed that it would take a while to clear and no one could estimate how long that could take. 

The best and worst of times for underserved consumers: revolution, mobile, and CRA

September was a big month for the financially underserved.  First Apple Pay spotlighted how mobile payments are likely to disrupt banking, and especially branches.  Then Wal-Mart and Green Dot launched the GoBank checking account.  These shifts raise huge questions.  What will now happen to lower-income and vulnerable customers -- and for them?  And how should public policy try to shape these trends?

The answer is that things will soon get much better, or much worse, for the underserved, depending on what both government and industry do next, including on the Community Reinvestment Act.

The worst of times?

For decades, federal policy has pushed for widened access to financial services, especially through CRA’s mandate that banks affirmatively help meet credit needs of low- and moderate-income areas in their markets.  I was present at birth for CRA, staffing the bill on the Senate floor and then becoming the first Deputy Comptroller of the Currency to implement it.  In those ancient times -- over 35 years ago – nearly all banking was locally-rooted and branch-based.  Today it’s mostly virtual, increasingly national and global, and often not even done by banks. 

Nevertheless, CRA’s focus remains local, and it still emphasizes branches.  Advocates love branches for giving neighborhoods economic ballast, both bringing and demonstrating stability.  They also like branches’ face-to-face service, which is preferred by many lower-income consumers caught in the “digital divide.” 

So what will happen now to these consumers -- and to banks’ unique CRA mandate -- if we really see widespread shrinkage and repurposing of branch networks?  I think we will.  Pew research shows most people now bank online, and also that mobile banking rose from 18% of cell phone users to 35% in only about two years. Like post offices, banks simply have too many costly buildings housing activities that have moved to the internet.

If banks are going to close or reorient branches in affluent areas, they will certainly do so in less profitable lower-income markets.  CRA pressures will slow this process, but I cannot imagine CRA preventing it.  If somehow it did, we should worry that depository institutions – the only providers covered by CRA -- would become competitive losers to leaner, more profitable companies, a trend that would ultimately constrict access.  Beyond some point, government can’t force the most expensive delivery channel into the least profitable markets, no matter how much affected consumers might prefer it.  New approaches will have to come.

Or the best of times?

But here’s the good news.  Lower-income customers do not lag behind the general population in using mobile phones.  In fact, they lead.  They also lead in using phones for financial tasks like bill-paying. Ironically, the very digital divide that has constrained their online banking – the cost of PC’s and internet access – makes them disproportionately ready now to leap straight to mobile.  While these generalizations mask great complexity, it is still true that a huge, growing group of underserved consumers already have a mobile financial tool in their hands and know how to use it.  This creates a historic chance to widen access to good and affordable financial services. 

Or, wait, maybe it’s still the worst….

Or does it?  If millions of lower-income people do adopt mobile, they’ll soon face a whole new set of problems.  As with subprime mortgages and high-cost short-term lending, some providers will target them to exploit unsophistication or desperation. Underserved consumers will also be confused (won’t we all?) by novel services coming from a proliferating set of providers.  And consumer advocates suspect the new channels, despite their low cost, will actually bring high prices and hidden fees, not affordability.

Or, ok, so it’s all the above

In short, the mobile payment revolution is like the French revolution Charles Dickens famously called the “best and worst of times.”  Like all innovation, it will bring both good and bad.  And optimizing that balance will be hard with today’s regulations, including CRA.  The agencies have been updating CRA through helpful new questions and answers (Additional materials here), but fear that opening a deep review could become politically controversial.  Meanwhile, again, the creaky old CRA law applies only to depository institutions – i.e. a shrinking share of financial services -- and is still anchored in geography, not technology.  It is also enforced solely by the prudential bank regulators, not the CFPB, structurally impeding holistic new regulatory thinking.

Some questions:  Will people in lower-income neighborhoods be cut off from branches?  Should banks actively help them switch to mobile?  Should doing so win CRA credit? How about CRA credit for signing families up as a team, so young members can teach older ones?  How will elderly consumers be impacted by mobile overall?  (Elizabeth Costle of AARP notes that aging may reduce people’s fingerprint definition, potentially impairing fingerprint-based authentication).  Will/should banks and nonbanks open new low-cost facilities in needy areas?  Storefront?  In stores?  Kiosks?  Will GoBank be a good model?  Would Skype-based video service work for people wanting personalized help?  Where do community banks and credit unions fit in?  Should the agencies collaborate on research?  Pilot tests?

A banker I know visited his company’s branch in a major Asian city, in a mall at night.  The small space was packed with customers huddled around staff using tablets to meet people’s needs, as in an Apple store.  The next morning he stopped by the bank’s marble-clad flagship branch. A long row of teller windows were staffed, ready, and idle.  Only two customers had come all day.  This may be the future.

Let’s go back to Dickens:  the regulators will do a “far, far better thing” if they can meet this revolution with fresh ideas.

What ideas do you have for them, and for bank and nonbank providers?  Please share your thoughts in the comments.

Disruption!

My new opinion piece in Forbes crystallizes my belief that everything is about to change for financial consumers, the industry that serves them, and the government officials trying to protect them.

I think consumer financial services face the same kind of disruption that has transformed whole business sectors in recent years, ranging from how Amazon and online shopping changed  retail stores, to the breaking and rebuilding of business models in music, publishing, video, travel, taxis, and many more.  For financial services, the drivers are innovative technology, shifts in regulation, and changing demographics and lifestyles.

The risks and potential benefits for consumers are unlike anything we have seen in our lifetimes.  The industry will change radically, leaving a very different and dynamic competitive map.  As my Forbes piece argues, our regulatory system will need to be completely rethought.  It is simply not designed to meet the challenges ahead.

The My Forbes op-ed coincided with release of the I-Phone 6.  Apple Pay is going to supercharge financial change.  Think about this:  the I-Phone arrived in 2007, the same year the financial crisis hit.  Ever since, the industry and regulators have been busy with crisis-related work, while an even bigger challenge has been building up, in plain sight but not clearly seen.

Please read the Forbes piece linked above, tell me what you think, and come often to my blog as we explore this uncharted frontier.

I'll soon be offering podcasts and video briefings on these critical challenges, for boards, executive teams, business leaders, risk and compliance people, regulators, policymakers, advocates, and consumers.  I promise they will be unlike anything you'll find elsewhere.

Meanwhile, please follow me on Twitter and connect with me on LinkedIn.

Let's prepare for creative destruction!

My New Motto: Don't Be Boring

As someone who’s spent decades fascinated by consumer financial protection, I feel entitled to state the following truth.  One of the core problems is that the whole topic bores everyone to death.  Okay, not everyone – there are many lawyers and regulators and (I say this affectionately) compliance geeks who love it, but are there any consumers who do?  Anywhere?

The question is on my mind after a recent lunch with my former colleague Lyn Farrell of Treliant Risk Advisors.  As a top-tier consultant, Lyn travels every week and long ago attained super-elite Global Services status on United Airlines.  When our conversation turned to our favorite topic of how consumer financial information can be made more useful, Lyn caught me by surprise by asking if I’ve seen United’s new onboard safety video.  She proceeded, on the basis of having seen this little film exactly one time a  week ago, to describe it to me in detail with nearly full recall, scene by scene.

It’s hard to imagine disclosure information more boring to a seasoned traveler than the standard safety briefing.  The script usually still tells us how to fasten a seatbelt -- by inserting the flat metal fitting into the buckle and pulling the strap until the belt sits low and tight across our laps, and then to release by pulling up on the metal tab.  Those words were written during an ancient era before cars had seatbelts, which according to Wikipedia ended 46 years ago.  Is there anyone older than a toddler who travels in an airplane and does not know how to buckle a seatbelt? 

The fact that the script starts with this instruction and its accompanying how-to explanation sends an immediate signal to everyone on board:  stop listening, because we are not saying anything useful.  If the rest of the briefing is better, few people ever find out because they haven’t heard it.  And how about that language?  How many of us could even define the noun, “fitting”?  It’s a good thing we already know how to put on a seatbelt.

Various airlines – famously Southwest – have tried to recapture our attention to the safety briefing through humor, and now United has decided to change it up in their video.  Here is the link

Notice some things.

It makes you chuckle.  It’s not hilarious, but it makes you smile and even laugh, and more than once.

It surprises you repeatedly, both with its setup and at specific moments, such as when you first realize the woman has turned her sheet of paper into an origami airplane.

It’s culturally and visually rich.

It depicts sensory variety -- people stowing underseat luggage by sliding it through sand on a beach, people hanging in the air in a gondola, no one at all in an airplane.

It takes you on a journey not only with your eyes, but also with your ears as the iconic United theme, Rhapsody in Blue, plays in different musical styles for different kinds of places (more sensory engagement).

It includes cute animals.

I suppose it may get boring to see the video over and over, but it caught Lyn’s attention, and mine.  I’d love to know what “innovator” had the bright idea to break the old boring information out of the old boring mold, and whether they’ll change it again when people lose interest.

Meanwhile, there are lessons for consumer financial disclosure.  Granted, it’s a stretch for regulators to inject cute animals into their mandates.  Still, they – and financial companies too – should think about how to convey information in ways that are fresh, engaging, visually appealing, and actually interesting.  They should also think about ways to avoid shutting down the consumer’s interest at the very first glance, with the equivalent of a seatbelt-fastening tutorial.  They should make information highly useful. 

The CFPB has consciously moved in this direction, and more would be welcome, at least to actual consumers.

So, here is my new motto for consumer financial protection – DON’T BE BORING!

Tell me what you think.

Harming Instead of Helping

One of the toughest challenges for regulators is foreseeing and managing unintended consequences.  Sometimes these are side-effects that hit ancillary activities, and sometimes they are an actual backfire – government action worsens the very problem it is trying to solve.  This backfire is occurring today in mortgage and consumer lending, where well-intended regulation and enforcement are undermining the goal of fair access to credit by driving providers out of the market.

Industry laments about regulatory burden are obviously old news.  What’s new and alarming, now, is that lenders are not just complaining. They are giving up.  They are beginning to curtail mortgage and other consumer credit due to sheer fear that they can’t figure out how to comply with the laws. I’ve been hearing this for at least a year (see my post of June 18th - Compliance Summit), but never more pointedly than at recent roundtable of thoughtful people involved in housing – lenders, advocates, government officials, attorneys, real estate brokers, academics, innovators, and providers of mortgage-related services.  The emotional intensity in the room spiked as industry participants described a whole new kind of frustration and pessimism.  The saddest part is that the borrowers who will be hardest hit by lender retrenchment are the vulnerable families the government wants most to help.

Invisible rules

The core challenge is that regulatory punishment has preceded regulatory clarity.  To some extent this is unavoidable -- the financial crisis clearly called for both heightened enforcement and a deep rethinking of the regulatory risk standards that failed so dramatically.  Given the complexity and novelty of the issues, regulators need time to figure out and codify new norms on many topics. While they do so, they are necessarily employing a high degree of subjective judgment that, in turn, is inevitably bringing ambiguity, unpredictability, and inconsistency.  The “rules” today are simply not clear enough for the industry to follow -- and yet failure to follow them carries very high penalties.  Whether the regulators could have done this better is an interesting question but is ultimately irrelevant to the impact on the market.

Examples of unclear, subjective standards cross wide swaths of regulatory activity, especially in lending.  One area is the escalating use of “disparate impact” legal theory for enforcing the non-discrimination laws in cases where there is clearly no discriminatory intent.  Regulators analyze statistics showing that a lender’s loan approval rates or pricing come out differently for different groups of customers (which occurs almost universally since applicants’ creditworthiness varies), and then require the lender to prove a business justification without explaining what factors are considered valid.  Another driver is UDAAP – the ban on Unfair, Deceptive, and Abusive Acts and Practices.  Intensified enforcement by both the CFPB and prudential banking supervisors has succeeded in capturing everyone’s attention, but have not been followed by practical guidance on how to meet these intrinsically subjective requirements.

Compounding the challenge is the aggressive enforcement and litigation climate, particularly in mortgages.  The government is invoking powers in new ways under the False Claims Act and the Financial Institutions Reform, Recovery and Enforcement Act (FIREEA) to allege fraud and threaten tremendous penalties.  Potential damages are so high that lenders feel forced to settle even before seeing legal charges that are developed fully enough to rebut.  They also face shifting standards on recourse over mortgage representations and warranties and interpretations that are effectively lengthening statutes of limitations.  Challenges are coming from all directions – borrowers, shareholders of all kinds, counterparties, FHA, GSE’s.  Banks also have to address new capital standards for mortgage servicing.  Even the central premise of mortgage pricing – that a house is reliable collateral that sharply limits risk – is now in doubt not only because home values collapsed, but also because foreclosure law and policy are in upheaval.

 Temporary or forever?

The industry has assumed this post-crisis enforcement era will run its course and eventually evolve into a new normal that should work for all.  Some observers see glimmers of this hope in last week’s $16.65 billion settlement of the Bank of America mortgage case – perhaps this signifies, for mortgages, that the end may be near.  Maybe so, but I increasingly hear a new concern.  What if all this huge unpredictable risk is permanent?  It’s one thing to redress past actions.  It’s another to face enormous risks for new loans being originated and serviced today under best efforts to meet today’s standards.  If the risks of a business cannot be understood, managed, and priced for, some providers will invest their capital elsewhere. 

Backfire

It’s an understatement to say the national mood is unsympathetic to financial industry complaints about over-regulation, and again, many of these matters do involve lender fault.  Still, if regulatory activity locks creditworthy borrowers out of access to loans, the public will not ultimately benefit.  Lenders are already quietly retrenching, especially, unfortunately, for the lower-income and vulnerable customer groups whose needs attract the brightest regulatory spotlight.  As time goes on, more providers will fully exit consumer lines of business. This is especially true for banks, many of which already find their consumer services less profitable than other business lines.  For all the criticism of banks, public policy has always sought to encourage their involvement in lending for housing and especially to lower-income communities, because depository institutions are widely seen as preferable to these consumers’ other options.  The Community Reinvestment Act – for which I was present at birth -- was created precisely for this reason.  It would be a painful irony for public policy to inadvertently push banks out of these markets.

Regulators and advocates often assume the financial industry is a static thing that can be molded and shaped to serve public goals.  They are often right.  Soon, though, they will find themselves with a dwindling set of providers to mold.  One senior Clinton-era official recently said the mortgage industry is being “parboiled,” and will probably emerge as something unrecognizable to us today.

Clarity is hard

Again, the problem is not that the government is being tough.  The problem is that it isn’t being clear. 

Regulators sometimes rightly prefer to avoid bright-line rules because industry tends to go right up to them -- a risk-filled buffer zone helps deter practices that just barely meet the letter of the law while flouting its spirit.  Conversely, industry often thinks it wants clear rules until it gets them.  Those bright lines sometimes get drawn in places that businesses dislike, and clear rules also almost always become detailed and burdensome, especially as they expand over time.  All this is true, but still, today’s balance between clarity and ambiguity has tilted too far.  If it doesn’t get re-centered, it’s not the industry that will be hurt.  It’s the consumer. 

Is it on the regulators’ strategic agenda to strive toward gradually giving financial companies guidance they can reliably follow, beyond deciphering lessons embedded in legal settlements?  The CFPB is writing rules on some major issues, and all the regulators periodically issue clarifying material.  They also try to make their rules workable in the market.  Nevertheless, they don’t often express concern about hitting a tipping point where “regulatory unpredictability” – the phrase I’m suddenly hearing everywhere – decreases consumer access to good, affordable financial services.  It’s worthy of some focus.

Let me know what you think. 

Lessons from London

I spent last week in London researching my book on the financial crisis and consumer protection.  UK regulators began emphasizing principles-based financial "fairness" years before their American counterparts, and I knew they are grappling with the toughest issues.  Still, my interviews with regulators, former regulators, bankers, attorneys, and consumer advocates were even more thought-provoking than I expected.

Quick background:  The UK’s Financial Services Authority (FSA), launched a Treating Customers Fairly initiative, or TCF, in 2000.  Regulators laid out broad principles that financial companies must follow.  They also undertook an aggressive enforcement regime, especially on payment protection insurance.  PPI is similar to the debt cancellation add-on products that became the target of CFPB’s first set of bank enforcement actions, but the UK’s mandated penalties and consumer refunds have been much larger -- topping 15 billion pounds and still climbing.  While this massive cost has captured the full attention of the industry, the original TCF approach was deemed insufficient.  In 2013, the UK reorganized financial regulation to separate prudential oversight from “conduct” standards, and created a new Financial Conduct Authority, or FCA.  This logic mirrors the thinking behind creation of the CFPB in the U.S., although the FCA covers more than consumer issues.

There are many parallels between the consumer protection approaches in the U.S. and UK, but I was struck by the differences.  With the disclaimer that the following reflects still-limited research and greatly oversimplifies these complex topics, here are some observations on themes that go to the heart of how best to provide and regulate consumer financial services:

Principles- versus rules-driven regulation:  Virtually all regulators use both principles- and rules-based tools.  In the U.S., however, apart from non-discrimination mandates and a recent focus on UDAAP (unfair, deceptive, and abusive practices), the government has mostly relied on complex, prescriptive rules (especially disclosures), for consumer financial protection.  While the U.K., too, has many prescriptive rules, it puts much more emphasis on principles. A sampling:

• Principle 6:  A firm must pay due regard to the interests of its customers and treat them fairly. 
• Principle 7:  A firm must pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading.
• Principle 8:  A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client. 
• Principle 9:  A firm must take reasonable care to ensure the suitability of its advice and discretionary decisions for any customer who is entitled to rely upon its judgment.

These principles, while subjective, are mandatory.  Every regulated company must take and sustain comprehensive actions to make them drive its business.

The centrality of culture:  In the U.S., the CFPB emphasizes and evaluates financial companies’ compliance cultures, but the FCA has made this element much more central.  British banks have embarked on a deep redesign of business decision-making, driven by boards and senior executives who are accountable for results.  One banker told me their outside directors now demand that every board meeting devote hours to conduct issues, whereas old-style “compliance” received minimal attention.  In 2006, the FSA’s Clive Briault said, “Treating Customers Fairly needs to be embedded into the culture of a firm at all levels, so that over time it becomes business as usual.  This is very much a responsibility of senior management, not just a compliance issue.”

Depth of change:  The explicit emphasis on culture and change-management has moved British regulators and banks into a massive effort to alter the core nature of the industry.  One bank described a process of identifying several hundred factors that impact customer fairness, ranging from product terms, pricing, and disclosures to sales and servicing practices.  The bank has evaluated each element, changed them where necessary, and now requires every business line head to certify personally that the going-forward factor is fully fair.  Almost all my interviewees emphasized that these are now core business decisions, with accountability in the business line, rather than “compliance” functions in the traditional sense.  People spoke of shifting accountability from the second line of defense (the compliance function) to the first line – the business itself.  This contrasts with trends in the U.S., where regulators do expect the first line of defense to be robust, but have increasingly emphasized the need for major investment in second line and also the third (audit).

Deemphasizing “controls:”  The CFPB and the other US regulators are highly focused on requiring robust compliance management systems, called CMS.  These systems set and test a vast body of “controls” that assure that every regulatory requirement will be met.  Controls range from policy, procedure, and training to IT systems and redundant testing that detects and fixes errors.  The testing regime is structured to be conducted by various players who are independent of each other -- in large banks, there is testing by the business line, the compliance group, audit, and numerous other functions like operations and credit risk management.  Banks often lament the cost and inefficiency of this redundancy, complaining about needing “checkers checking the checkers.”   The regulators, however, view CMS as the only way the bank, itself, can assure strong compliance.  A highly reliable CMS system, in theory, enables the regulators to trust that the bank is managing compliance well, which in turn can lead to streamlined examinations – an objective the industry shares as well.

Emphasis on the CMS, however, raises problems.  One is that these control systems have become more and more expensive, while bringing diminishing returns.  A deeper issue is that they are overwhelmingly designed to assure compliance with technical consumer regulations that, while perhaps necessary, have not produced true consumer “fairness.” Companies spend tremendous amounts of money producing and quality-checking mandated disclosures that their customers do not read.

The UK seems to be moving beyond the CMS emphasis and staking its regulatory strategy on cultural change.  Technical rules and disclosure requirements still exist and banks must still have controls around them, but numerous people told me they are now subordinated to the conduct and fairness principles.  One bank says they now have separate groups testing controls versus assuring fairness, with the testing now being a limited effort.  If they can get conduct right, the “policing” of compliance would become less necessary.

Focus on full product lifecycle and consumer ”outcomes:”  Deemphasizing compliance controls and emphasizing principles leads to thorny definitional and measurement issues regarding what constitutes fairness.  The UK is struggling toward a new approach that will measure “consumer outcomes.”  The FCA has identified six required outcomes, including that consumers be “confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture;” that services are “designed to meet the needs of identified customers groups and are targeted accordingly;” that customers receive “clear information and are kept informed before, during and after the point of sale;” that any advice given is “suitable” and takes account of the customer’s “circumstances;” that products “perform as firms have led (the customer) to expect;” and that customers “do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint.”

The outcomes focus requires looking holistically at the customer’s entire experience with the product, to determine whether the person received what was promised and was treated well at every step of the change.  This product life-cycle approach (which mirrors the CFPB’s broad emphasis on “risk to the consumer” and its “consumer-centric” perspective) necessitates a major shift from most banks’ highly siloed business models.  Retail business lines often don’t even know what happens to customers after the origination stage of a product – whether problems arise or penalties are imposed or consumers are denied claims for insurance or rewards features.  A holistic approach also creates huge data and metrics challenges, since business lines normally measure success by sales volume and revenue, not customer outcomes.  Banks typically have not even collected some of the relevant information, much less tracked and analyzed it.

Positive, not negative mandates:  UDAAP is a framed as a negative prohibition – it bars acts and practices that are unfair, deceptive, or abusive.  In contrast, the UK’s TCF and conduct principles are framed as positive mandates, affirmatively requiring fairness and “integrity.”  The two deal with largely the same topics, but this difference in emphasis produces different approaches.  In practice, there can be a big gap – gray space -- between practices that are clearly fair versus clearly unfair.  Historically, U.S. regulators applied UDAAP mainly to unusual practices at the margins of the industry, rarely hitting mainstream products.  Since creation of the CFPB, all the US regulators have largely reversed this – they are interpreting UDAAP much more broadly.  Still, they focus on practices, and see issues like culture and controls as means to the end of eliminating problematic acts.  The UK, in contrast, focuses directly on conduct, explicitly seeing culture as the core issue, not something in the background. 

One can worry that the UK’s affirmative approach casts too wide a net.  After all, principles of fairness and transparency are not defined with precision, and almost any financial practice may seem unfair or confusing to someone.  Still, I see value in the positive and principles-based approach, if it can be implemented well.  In the U.S., the very term “UDAAP” undermines the lofty goal of fairness.  It’s a bad-sounding acronym that must be translated for anyone from outside the financial regulatory world.  Inside that world, it joins the numerous other alphabet soup regulations that have long fostered a view of “compliance” as an arcane endeavor for subject matter specialists, disconnected from common sense business strategy or customer value.  “Treating Customers Fairly” and good “conduct” are better grounded in compelling, comprehensible values.

Structural solutions:  Several interviewees expressed doubt that separating prudential regulation from conduct supervision will accomplish much.  One noted that both models existed globally before the financial crisis, without producing noticeably better outcomes correlated with either design.  Another lamented the tendency of legislatures to respond to problems by doing the easy thing – reorganizing government – rather than the harder work of figuring out the underlying issues.  On the other hand, many interviewees believe that consumer protection never has and never will win equal attention from regulators who are charged with keeping the financial system sound.  That has certainly been the history in the U.S., despite extensive efforts by the bank regulators (I myself led the original consumer protection unit at the Comptroller of the Currency).

Global focus:  London is one of the world’s most international cities, and nearly all my interviewees spoke from a global perspective.   Most of the bankers are actively involved with UK, European, and U.S. bank regulators and had interesting thoughts on similarities and differences.  One person talked about the diversity of both cultures and laws around the world, pointing out practices that are banned in some countries, restricted in others, and actually required in certain places (adjusting interest rates on outstanding balances is an example).  This Individual also observed that privacy is a top regulatory concern in the U.S. and Europe, but is less valued in parts of Asia with stronger communal, rather than individual, social and cultural roots.  It was a reminder that “fairness” will be forever elusive.

Costs, competition, and market dynamics:  Most of my interviewees, especially the bankers, described the costs of the fairness efforts as enormous, even shockingly so, although the expense is hard to quantify.  There is also great concern about what will happen if regulators cannot apply the conduct principles with sufficient clarity and consistency.  While consumers might reward increased “fairness” and transparency with more business, there is fear that the opposite will happen – that firms making the most effort will be punished by the market, losing ground to less scrupulous competitors that exploit consumers’ lack of knowlege.  U.S. companies, too, speak of this problem.  Some tell stories of making their product terms more understandable, and immediately losing market share to others that drew in customer by being opaque or misleading. That pattern, left unchecked, will fuel growth of “unfair” companies and shrinkage of “fair” ones.

Building trust / Can this work?  The only possible solution (apart from consumer education, which hasn’t worked yet) is superlative wisdom and consistency from the regulators.  My UK interviewees described a grand experiment involving a huge, collective, simultaneous leap of faith by industry and regulators.  The government is asking the financial industry to shift its business models to try to remove any profit that derives from the consumer not understanding the product.  The industry, at all levels and with varying degrees of concern or enthusiasm, is trying to do this, undertaking efforts much more fundamental than most of what is underway in the U.S.  The process requires trust, in every direction.  The industry is trusting that the regulators will not punish them for finding and fixing their own problems (one banker said if that happens, the bank’s executives will instantly give up on the conduct changes).  Even more importantly, the industry is trying to trust that the regulators will be judicious and consistent in holding all competitors to the same standards, thereby blocking market advantage for those that do not change practices.  If the regulators fail in this, financial incentives will cause businesses to minimizes the changes they make, rather than to reach high as many are doing now.  Businesses that try to maintain higher standards against competitors that are permitted to use low ones, will lose market share (unless consumers actually understand and value the new fair practices, which is unlikely given the complex and arcane nature of many of them).

Just as the industry hopes it can trust the regulators, it also hopes for trust from them.  The goal is that these good faith efforts will win the government’s confidence, leading eventually to a regulatory regime that would be less punitive, intrusive, and burdensome.  As in the United States, bankers look forward to the day when regulators stop penalizing industry actions that occurred many years ago when regulatory standards were different (although most people acknowledge that the high penalties have been a key catalyst in sparking change).  Some hope compliance management systems can be streamlined, with resources redirected to higher-value efforts.

Consumers will always have problems with financial services; no regulatory approach can perfect the system.  The UK’s effort has been running for 14 years, and neither the regulators nor the industry have figured out the formula for assuring “fairness.”  Both banks and regulators described the current effort as a “journey,” with everyone struggling to figure out how best to proceed.  And of course, the themes I’ve distilled here are obviously not universally shared.  Still, I think U.S. banks and regulators might take some thought-provoking lessons from London.

Send me your comments on them – I would love to hear from you.

Underserved and Underestimated

I've spent most of June at events that have explored how best to help underserved financial consumers. Beyond the American Bankers Association regulatory gathering in New Orleans (see prior blog post), I was at the exciting Emerge conference of the Center for Financial Services Innovation in Los Angeles, and then at a meeting of CFSI's board, on which I serve. Last week I was in Reno with the CFPB's Consumer Advisory Board -- I serve on that as well.

I sense a turning point in how both industry and government think about the stubborn, seemingly unsolvable problem of the underserved, the "underbanked." It's complex, but a starting point is to replace old stereotypes with some new insights:

• First, lower-income people are typically more, not less, savvy than average consumers in handling their money, simply because they have to be. They generally know what money they have coming in, and when, and what they need to pay for, when, because they have tight timetables with little cushion. Most are playing close attention.

• The data are striking: lower-income people have very high rates of smart phone usage, not for banking, but for many financial functions like payments and shopping for discounts. This is a powerful foundation on which to build new, inclusive, affordable financial services.

• This means many actions that look "irrational" to financially comfortable bankers and policymakers may actually be smart choices. For instance, conventional wisdom assumes everyone benefits from using a bank. But what if you must pay a bill immediately upon receiving the funds to cover it? You may not want to put that transaction through a bank, waiting for a deposit to clear or worrying whether it will clear in time. Instead, you might just cash your check and pay the bill in person, even if it's time-consuming and the fees are high.

• At the same time, many Emerge speakers noted that lower-income consumers often prefer face-to-face service. This means they like the most expensive business model, despite being generally a low-profit customer group (at least for providers who won't exploit them). This mismatch is a key obstacle to widening access. At Emerge, Jose Quinonez of San Francisco's Mission Asset Fund suggested that the old "high-touch versus high-tech" thinking can be replaced with "high-tech touch," using technology to cut operating costs while keeping the customer interface personal. That makes sense, but future progress will also require drawing these consumers into technology channels that really work for them. This will happen naturally as the population ages, but the issue deserves hard thought.

• A highlight of Emerge was Princeton’s Dr. Eldar Shafir, co-author of “Scarcity: Why Having Too Little Means So Much.” The book uses behavioral economics to refine classic economic theory by recognizing emotional and cultural factors that compete with pure rationality in how people make decisions. Behaviors change under stress caused by shortage of a key resource like money, time, or food. People focus so tightly on the scarce thing that tunnel vision develops, blocking out both peripheral and long-term thinking and causing decisions that don’t make sense to others. This insight – that self-sabotaging behaviors are often driven by circumstances rather than ingrained life habits – could spark some fresh policy solutions. Note that Dr. Shafir’s coauthor is Sendhil Mullainathan, who led the startup of the CFPB’s research function.

• Dan Schulman, who leads Enterprise Growth at American Express, gave a remarkable speech at Emerge. Amex is repositioning its vaunted elite brand as an inclusive one, through its initiatives on Serve and the Bluebird/Wal-Mart card. Schulman spoke passionately of “reimagining” financial services to work better for more people, and on the enormous potential market this offers. Amex says surveys of its top-level cardholders show brand approval rising, not falling, based on the new, less exclusive approach.

• Schulman also urged viewing the new film “Spent: Looking for Change” , which Amex funded. I saw it this month with a group that sat in silence through the closing credits, still absorbing the powerful stories presented. One in four Americans – 70 million people – are struggling in a marginal financial world exacerbated by the financial/housing crisis and weak recovery. Millions spend as much on high-cost financial services as on groceries, and consume huge time and energy managing their financial lives. “Spent” attacks the stereotype that only impoverished or uneducated people use alternative financial services – these consumers also the “middle class.” The film is produced by Davis Guggenheim, who made “Waiting for Superman” and “An Inconvenient Truth.” It’s 35 minutes extremely “well spent.”

• CFSI’s CEO Jennifer Tescher spoke eloquently on the need to define the challenge as financial health. That approach -- being consumer-centric rather than product- or regulation-centric – is critical. Speakers suggested we develop health-like benchmarks of financial well-being, as we do for blood pressure or cholesterol.

I’ve worked for decades with the challenges of the Community Reinvestment Act, which channels bank lending to low- and moderate income people through a legal mandate. The results can be debated, but one thing is clear -- 35 years of CRA have not solved the problem. Time for some innovative thinking.

Please write to me with your ideas.