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.

Compliance Summit

Photo Caption: Moderating New Orleans ABA mortgage panel of (LtoR) Leonard Chanin, Morrison & Forster; Cheryl Snyder, Park National Corporation; and Bruce Schultz, Spirit Bank.

The people who keep banks in compliance with consumer protection laws have one key annual gathering - the American Bankers Association's Regulatory Compliance Conference.  Last week's conclave in New Orleans showcased how profoundly their world has changed.

For a meeting about regulation, it felt like a rock concert (okay, only slightly, but still....).  A record crowd of over 1,700 jammed into a huge ballroom watching speakers on the faraway stage and jumbotron screens.  And attendees didn't hear many dry regulatory updates.  Instead they grappled with the breathtaking challenges raised by the financial crisis and the Dodd-Frank law, including creation of the Consumer Financial Protection Bureau.

I had the pleasure of moderating the first morning's general session on the sweeping new CFPB mortgage rules, which aim to prevent recurrence of the subprime bubble.  My panelists - two veteran bankers and a top Washington lawyer - incisively analyzed the progress to date including whether the regulations will overcorrect, leaving credit too tight.  I'll sum up the panel’s view as so-far-so-good-but-too-early-to-tell, and costly.

There was a showstopper, though, in a panel of three bank CEO's discussing compliance in ways never seen before.  Ally Bank chief compliance officer Dan Soto queried his boss Michael Carpenter, plus Hancock Bank's John Hairston and  John Ikard of FirstBank, on how consumer protection challenges have changed.  The thoughtfulness and candor of these three leaders reflected, and may even accelerate, a turning point in how banks think about these issues.  One or another of them - sometimes all - made these points:
 

• Bank business line leaders used to view regulatory hurdles as something to be "gotten around."  No more.  Now it's a top priority, permeating everything they do.

• Today's regulatory environment is so new and fast-changing that both banks and regulators need – but don’t have -- time to "practice" to get things right

• This "regulatory unpredictability" keeps CEO's awake at night, deterring them from serving marginal consumers who need access but who raise extra regulatory risk if the bank does something wrong - under standards not yet clear.

• One of these banks spent hundreds of millions of dollars to make itself acceptable to bank regulators

• One CEO said he "lost 2-3 times more money with the flick of a pen in Washington" changing regulatory requirements, than in all their loan and business losses.  "Think about that," he said.

• One said the regulators' aborted foreclosure review project had found almost no foreclosures of people who could have kept paying, but damaged the system that will provide mortgage credit going forward

• One said he is a little afraid of his compliance officer (seated in the front row), and told stories of learning very hard lessons from her.

• One said if the compliance officers in the room don't have a great relationship with their CEO, "look in the mirror."  CCO's must perform as top bank executives, at the table with the executive team and with the "stature to be there."  This is very new thinking for many compliance professionals.

They were asking regulators to be clear.  They were asking compliance officers to be leaders and change-agents, not subject matter experts.  And they were telling us that CEO's, for the first time ever, have brought compliance into the heart of the competitive race in banking.     

I’m writing my book because the aftermath of the financial crisis, combined with new technology, is creating an unprecedented chance to improve consumer financial services and how they are regulated.  One critical new factor is that for the first time ever, bank CEO’s are genuinely interested.  They used to delegate “compliance” to their technical experts.  Today’s skyrocketing regulatory risks and costs have changed that.  As this panel vividly illustrated, CEO’s are thinking deeply about these issues.  Their engagement totally changes what can be done.

If you have thoughts for the book on the new engagement of banking leaders in these topics, please write to me.

Blogging at the crossroads: Off to a great start!

We launched this blog about two weeks ago and, with the site still under construction, have not done anything to draw readers beyond tweeting and linking to the posts.  Therefore, it has been terrific to see that the blog has already received over 550 views.  I’ve also been hearing from people in multiple channels, including LinkedIn and email.  The comments are wonderfully thoughtful and thought-provoking, coming from a wide range of participants in the financial ecosystem. 

The early input confirms my sense that a lot of smart people are thinking deeply and creatively about how we could do better.  I’ve heard from former regulators who have spent decades grappling with these challenges, and from bankers whose whole careers have been about trying to keep regulators satisfied, while doubting it does much good for consumers.  And I’ve heard from people outside the financial arena too, concerned about the things that have gone wrong.

Their comments also confirm my sense that people interested in these issues don’t have many good, safe forums where they can talk openly.  Regulators and regulatees have an inherently adversarial relationship and are rarely candid with each other (I know this from experience, having been on both sides of that divide).  Consumers often feel no one listens.  I’m hoping this blog can be a place where people bring ideas and stories that can cross these boundaries.  I’ll encourage you to post them on the site publicly, but do also feel free to reach me in other ways if you want your comments private.  I’ll keep them that way, but will learn from them and bring them into the flow of thinking in the blog and in my book.

I think one of the biggest barriers to doing better is that no one deeply understands all the valid perspectives – everyone functions mainly inside silos.  This can be a place to break some walls down.

My book will include the voices of people from every corner of the financial services world – consumers, advocates, business leaders, front-line staff in financial companies, compliance professionals, attorneys, technology innovators and investors, media, educators, academics, regulators, legislators -- everyone.  Please keep communicating with me in whatever venue works best for you.

Photo courtesy of Wonderlane

Compliance through Quality

“Regulatory excellence” may sound like an oxymoron but is actually – counterintuitively – the key to cutting compliance costs (and risks). 

My former colleague Lyn Farrell has shared the secret formula for curing most bank regulatory challenges in her new American Banker article. 

Banks are grappling with skyrocketing regulatory risks, and most, not surprisingly, are therefore hiring more people and spending more money on compliance – many thousands of new hires throughout the financial industry.  My own recent ABA Banking Journal article chronicled this phenomenon, which is destabilizing and remaking the compliance profession itself.  These investments are necessary up to a point, but they miss the more important change banks must make to contain the escalation in both risks and costs:  namely, to shift the lead compliance responsibility from the “compliance” function into the business line, and make it a core component of quality. 

As Lyn notes, other industries do this, using zero-defect and LEAN methodologies to be sure their products contain no errors.  Banks, of course, spend tremendous sums on technology and systems to avoid compliance mistakes, but virtually every bank still makes them in their business functions, and then catches and corrects them through their compliance function.  The mistakes are inherently hard to avoid because both the products and regulations are complicated and constantly changing, and also because many banks still use old technology that is not geared to preventing rather than detecting errors.

Most banks will say that their business lines “own” compliance, but few have actually created sufficiently robust systems and cultures in their business units to produce zero compliance defects.  It was not uncommon, a few years back, to hear bankers say they would not want their compliance performance to deserve an A+ rating, because that might mean they were spending too much.  A solid B might suffice.  Accompanying that logic was the assumption that the business line leaders should focus on financial performance metrics and rely on the compliance and legal staffs to manage the regulatory challenges.

That thinking is backwards, because in reality, it’s much more expensive to find and fix errors after-the-fact than to prevent their happening at all.  This is always true about quality – doing things right the first time is by far the cheapest approach.   The banks that truly begin to reverse this old old pattern -- those whose business lines fully internalize compliance accountability, whose business leaders spend time personally thinking deeply about it, and whose technology strategies transform around preventing problems (including meeting the regulators’ evolving standards on “fairness”) – those banks will gain huge competitive advantage.  They will both contain costs and become positioned for growth with minimal regulatory headwinds.

The regulators have a key role too.  They have traditionally set expectations for the “three lines of defense,” with the business unit as the first line, the compliance/risk group as second, and audit as third – by emphasizing the need for independent (and thus) redundant reviewing by all three to assure correct regulatory outcomes.  They want to see very robust second and third lines because, as Lyn rightly notes, they don’t much trust the first lines.  They worry that the business units want to skimp on compliance.

What if banks’ business units could actually win the regulators’ trust?  It would take a lot to overcome skepticism, but embracing “regulatory excellence” is the pathway to lean, clean, low-cost, low-risk regulatory performance.

Lyn’s article maps out how to get there.  As with all of today’s critical compliance challenges, the keys are culture and technology.

As I work on my book, I’m looking for input from both business and compliance people at financial companies on the difficulties of compliance.  I’m especially interested in hearing about costs, and areas where costs are high and benefit to consumers is low – or where consumers are actually harmed by regulatory efforts to help them.  I’ll be interviewing people as well.  I’ll welcome hearing perspectives and stories.

Protecting people from themselves?

I’m thinking about this topic in drafting my book’s chapter on the current regulatory environment.  For those who have commented on my first post, thanks so much for the input.  I’ll welcome more ideas.

A core dilemma in consumer financial protection is how much the government should protect people from themselves, given that over-protection can do as much damage as under-protection by raising costs and drying up markets that consumers want and need.  This issue arises most dramatically regarding expensive products aimed at vulnerable consumers, where regulators worry that people can easily be preyed upon or are simply at high risk of making “bad choices” that will hurt them.   An example is payday and other short-term lending, with which the CFPB regulation-writers are currently grappling.  Should the government bar some options outright because too many people who choose them suffer harm, or should people be free to make such choices, or is the answer somewhere in the middle?

Even among mainstream consumers, there is a thorny question on how to assign “fault” when consumers have difficulties.  People get hurt in their financial dealings for a range of reasons involving varying kinds of fault by them and by others.  Sometimes they just make poor choices – spending, borrowing, or paying too much, saving too little, signing up for a financial product without studying it or comparing options  – even though the financial products they’re using are completely fair.  At the other end of the spectrum, sometimes people are intentionally preyed upon by unscrupulous providers that target and trick and exploit consumers who are vulnerable due to lack of education or sophistication, or are financially desperate.  In between, there is a wide spectrum of scenarios in which people get into bad situations where the fault, if there is some, could be thought of as shared.  Yes, the consumer could have done a better job of reading and understanding the product terms, but likewise the provider, knowing most people will not understand a complex product, could have made the terms more clear.  Most of these situations have, at their core, the problem that the consumer does not thoroughly understand the product.  Classic market forces often fail in consumer financial transactions because the “willing buyer and willing seller” do not have equal knowledge.  The seller almost always has an advantage.

Most financial transactions live in this murky middle ground.  Providers correctly meet legal requirements but offer complicated products they know most consumers don’t understand.  Consumers largely ignore the disclosures and sign up without comprehending the product, based on their trust in the provider and generally being too busy to delve into detail.  Buried in the product’s complexity are, often, features that work to the provider’s advantage.  The consumer could theoretically have found these features and sought to negotiate them or to find another provider, but didn’t.  Then something happens to bring this feature to the surface, and the consumer feels harmed.  Whose fault is that?

Before the financial crisis, the prevailing view was these kinds of problems were consumers’ fault – that if the provider had met the technical legal requirements,caveat emptor should rule.  Post-crisis, the regulators, and especially the CFPB, are emphasizing that products also must not be “unfair.”  Despite some legal case history on UDAAP  (the ban on unfair, deceptive, and abusive practices), it is not clear how these emerging standards should apply.

The issue can be framed as a question:  which party should have to be the active player, and which can be passive, in assuring that consumers have good outcomes?  Must the provider actively try to assure that consumers understand all adverse product terms, and maybe even try to assure that people make “good” choices, or even make the choices that are “best” for them?  Or should the provider be free simply to offer products that meet legal requirements, and put the onus on the consumer to be the active player who must understand and choose well? 

Again, the latter system has largely prevailed in the past and hasn’t worked terribly well, as evidenced in the subprime mortgage crisis, for one.  However, forcing the provider to be responsible for customers making “suitable” choices (a concept that shapes securities law), raises profound questions as well in terms of consumer freedom, risks of adverse customer stereotyping, the huge difficulties of enforcing subjective standards, and the potential to drive providers out of important markets due to fear of regulatory risks they can’t assess.

And what if the regulators decide, instead, to divide up responsibility between the customer and provider differently based on types of products, providers, and consumers?  How should they decide – using what criteria – on where to draw those lines? 

Again, please share your thoughts and stories with me, whatever your perspective and experience may be.

photo credit: Matt Van Buskirk

The Conundrum - How do we create a better system for consumer financial services?

THE CONUNDRUM

I’m working today on my book’s opening chapter, tentatively called, “The Conundrum.” 

How do we create a better system for consumer financial services?  We want it to have certain traits:

• High protectiveness -- against unfair, deceptive, and abusive practices and discrimination
• High availability – with many competing choices, and easy to access
• High affordability – with competitive prices, and with basic services for lower income people

And a corollary is that the system needs innovativeness, to keep all three of these traits improving over time.

Here’s the conundrum:  these characteristics don’t go together.  If we push for more of one, we generally get less of another.  High protectiveness, in the form of government regulation, tends to reduce availability and affordability, because providers respond by offering less of the highly-regulated product and/or by building regulatory costs into what consumers must pay.  Those effects are mostly invisible, but are very real. Conversely, low regulation can incent high availability, but can leave consumers at risk, especially since financial services are so complex that most people don’t understand them well.

Our system currently pretends these tradeoffs don’t exist.  Broadly speaking, politicians, regulators and advocates seek ever-higher protectiveness, as if this has no drawbacks for consumers.  Meanwhile the financial industry and its champions do the opposite, arguing for low regulation as if free markets never cause consumer harm.  Both sides usually mean well, but both views are wrong, or at best incomplete.

My book is going to grapple with this and argue for fresh thinking.  As I start this journey in chapter 1, the questions are clearer than the answers, but I’ve mapped out much of what lies ahead. 

First, the most critical thing – the reason for high hope – is that we can now leverage innovative technology as it changes everything – how financial services are designed, delivered, priced, selected, used, and regulated.

Second, we should accept that the old system’s reliance on mandatory consumer disclosures was a logical approach that has mostly failed.  Instead of burying consumers in paper and boring them with mouse-print, we need to provide  interesting information, especially in their smart phone.   This will improve protectiveness, availability, and affordability, all at once.

Third, let’s face the fact that disruptive innovative technology is about to blow the circuits of the regulatory machine.   Regulatory change takes years.  Market change – big change – is coming daily.  Old industries, and the old regulatory agencies built long ago to oversee them, are being undermined and superseded by whole new financial products and channels and whole new consumer behaviors.  We are going to have bad outcomes – under-regulation, over-regulation, inconsistent regulation, and outright wrong regulation – if we don’t begin to think differently.  One key, here, is that a new agency is on the scene, the Consumer Financial Protection Bureau, with a new design and new kinds of powers, that could make things much better, or potentially much worse.

Financial services can’t solve all the world’s economic and cultural problems, but they matter.  Optimizing the conundrum’s three traits can help people of every age, race, income level, and lifestyle build flourishing lives, whether they are students, retirees, workers, new immigrants, growing families, or entrepreneurs, whether financially on track or at risk, whether financially sophisticated or vulnerable.

I’m collecting stories as I write, from consumers, providers, advocates, regulators, educators, from in the U.S. and beyond, everyone.  Good stories and bad stories.  Please email me, and I’ll blog about what I learn from you as the book takes shape.