october 2008
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Behaviorally 

Informed Financial 

Services Regulation 

michael s. barr, sendhil mullainathan, 

and eldar shafir 

prepared for the 

asset building program 

New America Foundation
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© 2008 New America Foundation 

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Abstract
 

Financial services decisions can have enormous conse 

quences for household well being. Households need a 

range of financial services—to conduct basic transactions, 

such as receiving their income, storing it, and paying bills; 

to save for emergency needs and long term goals; to access 

credit; and to insure against life’s key risks. But the financial 

services system is exceedingly complicated and often not 

well-designed to optimize household behavior. In response 

to the complexity of our financial system, there has been a 

long running debate about the appropriate role and form 

of regulation. Regulation is largely stuck in two competing 

models disclosure, and usury or product restrictions. 

This paper explores a different approach, based on 

insights from behavioral economics on the one hand, 

and an understanding of industrial organization on the 

other. At the core of the analysis is the interaction between 

individual psychology and market competition. This is in 

contrast to the classic model, which relies on the interac 

tion between rational choice and market competition. The 

introduction of richer psychology complicates the impact 

of competition. It helps us understand that firms compete 

based on how individuals will respond to products in the 

marketplace, and competitive outcomes may not always 

and in all contexts closely align with improved decisional 

choice and increased consumer welfare. 

The paper adopts a behavioral economic framework that 

considers firm incentives to respond to regulation. Under 

this framework, outcomes are an equilibrium interaction 

between individuals with specific psychologies and firms 

that respond to those psychologies within specific market 

contexts. Regulation must then address failures in this 

equilibrium. The model suggests, for example, that in 

some contexts market participants seek to overcome com 

mon human failings (as for example, with under-saving) 

while in other contexts market participants seek to exploit 

these failings (as for example, with over-borrowing). 

Behaviorally informed regulation needs to take account of 

these different contexts. 

The paper discusses the specific application of these 

forces to the case of mortgage, credit card, and banking 

markets. The purpose of this paper is not to champion pol 

icies, but to illustrate how a behaviorally informed regula 

tory analysis would lead to a deeper understanding of the 

costs and benefits of specific policies. To further that under 

standing, in particular, the paper discusses ten ideas: 

• Full information disclosure to debias home mortgage 

borrowers. 

• A new standard for truth in lending. 

• A “sticky” opt-out home mortgage system. 

• Restructuring the relationship between brokers and 

borrowers. 

• Using framing and salience to improve credit card 

disclosures. 

• An opt-out payment plan for credit cards. 

• An opt-out credit card. 

• Regulating of credit card late fees. 

• A tax credit for banks offering safe and affordable 

accounts. 

• An opt-out bank account for tax refunds. 

Michael S. Barr is Professor of Law, University of Michigan Law School; senior fellow Center for American Progress; nonresident 

senior fellow, Brookings Institution. Sendhil Mullainathan is Professor of Economics, Harvard University. Eldar Shafir is Professor of 

Psychology and Public Affairs, Princeton University. The authors conduct research and development on public policy through Ideas42, 

with support from the Hewlett Foundation and the Russell Sage Foundation. The authors wish to thank Ellen Seidman and the New 

America Foundation for suggesting we undertake this project and for their ongoing support and encouragement. 

 

 

 

Financial services decisions can have enormous consequences for household wellbeing. Households need a range of financial services—to conduct basic transactions, such as receiving their income, storing it, and paying bills; to save for emergency needs and long-term goals; to access credit; and to insure against life’s key 

risks. But the financial services system is exceedingly complicated and often not 

well-designed to optimize household behavior. For example, choosing a mortgage 

is one of the biggest financial decisions an American consumer will make, but it 

can be a complicated one, especially in today’s environment where the terms and 

features of mortgages vary in multiple dimensions. Similarly, credit card contracts 

now often involve complicated terms and features that may encourage sub-optimal borrowing behavior. And it has long been remarked that households fail to 

optimize in their savings decisions. 

In response to the complexity of our financial system, 

there has been a long-running debate about the appropriate role and form of regulation. Regulation is largely 

stuck in two competing models—disclosure, and usury 

or product restrictions. Disclosure regulation, embodied 

in the Truth in Lending Act (TILA), presumes one market 

failure: the market will fail to produce a clear and comparable disclosure of essential product information needed 

by consumers. TILA responds, potentially, to two types of 

problems. First, firms will not reveal all information, for 

example, regarding the desirability of various features, that 

borrowers should understand and be able to analyze in 

determining whether to take out a loan. Second, firms will 

not reveal information in a way that facilitates comparability across products. The first concern speaks to consumer 

knowledge, “solving” the problem through the provision 

of information; the second concern addresses consumers’ 

ability to process the information, “solving” the problem 

through coordination of terms and definitions. 

Homo economicus is very much the intellectual basis for 

disclosure regulation. The model relies on fully rational 

agents who make intelligent choices. But these neoclassical assumptions are misplaced and in many contexts consequential. In particular, behavioral research has shown 

that the availability of data does not always lead to communication and knowledge; understanding and intention do 

not necessarily lead to action; and contextual nuances can 

lead to poor choices. Individuals consistently make choices 

that, they themselves agree, diminish their own well-being 

in significant ways. 

Regulation is largely stuck in two competing 

models—disclosure, and usury or product 

restrictions. 

By contrast to disclosure regulation, usury laws and product restrictions start from the idea that certain prices 

or products are inherently unreasonable, and that consumers need to be protected from making bad choices. 

But product regulation may in some contexts diminish 

access to credit or reduce innovation of financial products. Moreover, for certain types of individuals, some 

limitations may themselves increase consumer confusion regarding what rules apply to which products, and 

what products may prove beneficial or harmful. In addition, firms will likely develop ways around such product 

restrictions, undermining their core intention, increasing 

costs and further confusing consumers. 

behaviorally informed financial services regulation 1 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

We explore a different approach, based on insights from 

behavioral economics on the one hand, and an understanding of industrial organization on the other. At the core of our 

analysis is the interaction between individual psychology and 

market competition. This is in contrast to the classic model, 

which relies on the interaction between rational choice and 

market competition. In the classic model, absent market 

failures, because rational agents choose well, firms compete 

to provide products that improve welfare. Because rational 

agents process information well, firms compete to provide 

information that improves decision quality. By contrast, in 

our model, individuals depart from neo-classical assumptions in important ways. The introduction of richer psychology complicates the impact of competition. Now, firms compete based on how actual individuals will respond to products 

in the marketplace, and actual competitive outcomes may 

not always and in all contexts closely align with improved 

decisional choice and increased consumer welfare. 

We explore a different approach, based on 

insights from behavioral economics on the 

one hand, and an understanding of industrial organization on the other. 

In the home mortgage market, for example, the standard 

model assumes that people evaluate options well, and that 

the more options people have, the better. Firms will thus 

provide more options, people will pick the best ones, and 

healthy competition will drive out bad options. In reality, 

people are easily overwhelmed by too many options and 

make mistakes, often in predictable ways. Borrowers, for 

example, might pick the most salient dimension (lowest 

monthly cost) rather than focusing on their cost of credit 

over the expected life of their loan—or the fact that taxes 

and insurance will not be escrowed and are not included in 

the monthly cost. Consequently, firms can and will introduce options that cater to these behaviors, and people will 

pick options that carry a greater likelihood of failure than 

anticipated, and which they themselves would find suboptimal upon further reflection and analysis. These behavioral considerations suggest that disclosure of information 

alone will often be insufficient to provide consumers with 

what is needed to optimize their understanding and decision-making, and the resulting outcomes. 

Our work is clearly related to the emerging literature on 

behaviorally informed policy-making. This literature produces novel considerations in the design and implementation of regulation, including features such as the framing 

of information, the setting of defaults or “opt-out” rules, 

the provision of warnings, and other strategies to alter individual behavior.2 In this paper, we embed this thinking 

more deeply in the logic of markets. Specifically, we adopt a 

framework that considers in more depth firm incentives to 

respond to behaviorally motivated regulation. We envision 

outcomes as an equilibrium interaction between individuals 

with specific psychologies and firms that respond to those 

psychologies within specific market contexts. Regulation 

must then address failures in this equilibrium. 

This perspective produces two dimensions to consider. 

First, the psychological biases of individuals can either help 

or hurt the firms they interact with; hence firms’ and public-minded regulators’ interests are sometimes mis-aligned 

and sometimes not. Let us take the example of a consumer 

who does not understand the profound effects of the compounding of interest. Such a bias would lead the individual 

both to under-save, and to over-borrow. Society would prefer 

that the individual did not have such a bias in both contexts. 

Firms, however, would prefer that the individual not have 

the bias to under-save so that funds available for investment 

and fee generation would not diminish but, at least over the 

short term (and excluding consideration of collection costs), 

would be perfectly content to see the same individual overborrow. Because people are fallible and easily misled, transparency does not always pay off and firms sometimes have 

strong incentives to exacerbate psychological biases by hiding borrowing costs. Regulation in this case faces a much 

more difficult challenge than in the savings situation. 

The psychological biases of individuals can 

either help or hurt the firms they interact 

with; hence firms’ and public-minded regulators’ interests are sometimes mis-aligned 

and sometimes not. 

The market response to individual failure can profoundly 

affect regulation. In attempting to boost participation 

in 401(k) retirement plans, the regulator faces at worst 

2 new america foundation 
 

 

 

 

 

 

 

 

 

 

 

 

indifferent and at best positively inclined employers seeking to boost employee retention and to comply with federal 

pension rules.3 In forcing disclosure of hidden prices of 

credit, by contrast, the regulator often faces non-cooperative firms, whose interests are to find ways to work around 

or undo interventions. 

A second implication of our equilibrium model of firms in 

particular markets interacting with individuals with specific 

psychologies is that the mode of regulation chosen should 

take account of this interaction. One might think of the regulator as holding two different levers, which we describe as 

changing the rules and changing the scoring.4 When forcing 

disclosure of the APR, for example, the regulator effectively 

changes the “rules” of the game: what a firm must say. A 

stronger form of rule change is product regulation: changing what a firm must do. Behavioral rule changes, such as 

creating a favored starting position or default, fall between 

these two types. When changing liability or providing tax 

incentives, by contrast, the regulator changes the way the 

game is “scored”. Typically, changing the rules of the game 

without changing the scoring maintains the firms’ original 

incentives to help or hurt consumer bias, channeling the 

incentive into different behaviors by firms or individuals. 

In contrast, changing the scoring of the game (as through 

liability changes) can alter those incentives. 

This perspective highlights the care that must be taken 

when transferring the insights of the most prominent 

Table 1. The Firm and the Individual 

example of behavioral regulation—defaults in 401(k) participation—to other domains. According to the present 

analysis, changing the rules on retirement saving (by introducing defaults) works well because employers’ incentives 

align (or do not mis-align) with regulatory efforts to guide 

individual choice. In other words, under current conditions, employers are either unaffected or may even be hurt 

by individuals’ propensity to under-save in 401(k) plans.5 

They thus will not lean against an attempt to fix that problem. In contrast, in circumstances where firms’ incentives 

misalign with regulatory intent, changing the rules alone 

may not work well since firms may have the ability to work 

creatively around those rule changes. Under those conditions, psychological rules such as defaults or framing may 

be too weak, and changes in liability rules or other measures may be necessary, as we explain below. 

This distinction in market responses to individual psychology is central to our framework and is illustrated in Table 

1. In some cases, the market is either neutral or wants to 

overcome consumer fallibility. In other cases, the market 

would like to exploit or exaggerate consumer fallibility. 

The different provider incentives generated by consumer 

lack of understanding about the compounding of interest 

in the saving and borrowing contexts is discussed above. 

Similarly, when consumers procrastinate in signing up 

for the EITC (and hence in filing for taxes) private tax 

preparation firms have incentives to help remove this procrastination so as to increase their customer base. When 

Behavioral Fallibility Market neutral and/or wants to 

overcome consumer fallibility Market exploits consumer fallibility 

Consumers misunderstand 

compounding 

Consumers misunderstand 

compounding in savings 

› Banks would like to reduce this to 

increase savings base 

Consumers misunderstand 

compounding in borrowing 

› Banks would like to exploit this to 

increase borrowing 

Consumers procrastinate 

Consumers procrastinate in signing 

up for EITC 

› Tax filing companies would like to 

reduce this so as to increase number 

of customers 

Consumers procrastinate in returning 

rebates 

› Retailers would like to exploit this to 

increase revenues 

behaviorally informed financial services regulation 3 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

consumers procrastinate in returning rebates (but make 

retail purchases as if they are going to get a rebate), retailers benefit. Note the parallelism in these examples: firm 

incentives to alleviate or exploit a bias are not an intrinsic 

feature of the bias itself. Instead, they are a function of how 

the bias plays itself out in the particular market structure. 

In the consumer credit market, one worries that many 

firm-individual interactions are of the kind where firms 

seek to exploit rather than alleviate bias. If true, this 

raises the concern of over-extrapolating from the 401(k) 

defaults example to credit products. To the extent that 

401(k) defaults work because optimal behavior is largely 

aligned with market incentives, other areas, such as credit 

markets, might be more difficult to regulate with mere 

defaults. Furthermore, if the credit market is dominated 

by “low-road” firms offering opaque products that “prey” 

on human weakness, it is more likely that regulators of such 

a market will be captured because “high road” interests are 

too weak to push back against “low road” players; that market forces will defeat positive defaults sets; and that “lowroad” players will continue to dominate. Many observers, for 

example, believe that the credit card markets are, in fact, currently dominated by such “low road” firms (see, e.g., Mann 

2007; Bar-Gill 2004) and that formerly “high road” players 

have come to adopt the sharp practices of their low-road 

competitors. If government policy makers want to attempt 

to use defaults in such contexts, they might need to deploy 

“stickier” defaults or more aggressive policy options. 

Table 2 illustrates a conceptual approach to the issue of 

regulatory choice. In this stylized model, the regulator can 

either change the rules of the game or change the scoring 

of the game. Setting a default is an example of changing the 

rules of the game, as is disclosure regulation. Specifically, 

the rules of the game are changed when there’s an attempt 

to change the nature of firm-individual interactions, as 

when the regulation attempts to affect what can be said, 

offered or done. Changing the scoring of the game, by contrast, changes the payoffs a firm will receive for particular 

outcomes. This may be done without a particular rule about 

how the outcome is to be achieved. For example, pension 

regulation that penalizes firms whose 401(k) plan enrollment is top-heavy with high-paid executives is an example 

of how scoring gives firms incentives to enroll low-income 

individuals without setting particular rules on how this is 

done. Changing rules and changing scoring often accompany each other, but they are conceptually distinct. 

Table 2. Changing the Game 

Set the defaults in 401(k) savings Rules Organ donation 

401(k) top heavy requirements for tax Scoring Grants to states that enroll organ donors 

Table 3 weaves these two dimensions together, illustrating how regulatory choice ought to be analyzed according to the market’s stance towards human fallibility. In 

what follows, we discuss the specific application of these 

forces to the case of mortgage, credit card, and banking 

markets, with specific proposals that fall into each bin. 

Among other things, the discussion illustrates how policies in the top-right-hand corner of Table 3 face a particular challenge. Changing the rules of the game alone 

will be difficult when firms are highly motivated to find 

work-arounds. As such, when we suggest opt-out policies 

in mortgages below, the challenge will be to find ways to 

make these starting positions “sticky” so that firms do not 

simply undo their default nature. In our judgment, both 

achieving a good default and figuring out how to make it 

work requires separating low-road from high road firms 

and making it profitable for high road firms to offer 

the default product (for a related concept, see Kennedy, 

2005). For that to work, the default must be sufficiently 

attractive to consumers, sufficiently profitable for “high 

road” firms to succeed in offering it, and penalties associated with deviations from the default must be sufficiently 

costly so as to make the default “stick” even in the face of 

market pressures from “low road” firms. It may be that 

in some credit markets, low road firms have become so 

dominant that “sticky” defaults will be ineffectual. 

The default must be sufficiently attractive to 

consumers, sufficiently profitable for “high 

road” firms to succeed in offering it, and 

penalties associated with deviations from the 

default must be sufficiently costly so as to 

make the default “stick” even in the face of 

market pressures from “low road” firms. 

4 new america foundation 
 

Moreover, achieving such a default is likely more costly 

than making defaults work when market incentives align, 

not least because the costs associated with the stickiness 

of the default involve greater dead-weight losses given that 

there will be higher costs to opt-out for those for whom 

deviating from the default is optimal. These losses would 

need to be weighed against the losses from the current system, as well as against losses from alternative approaches, 

such as disclosure or product regulation. Nonetheless, 

given the considerations above, it seems worth exploring 

whether such “sticky” defaults can help to transform consumer financial markets. 

Table 3. Behaviorally Informed Regulation 

Market neutral 

and/or wants to 

overcome consumer fallibility 

Market exploits consumer fallibility 

Rules 

Public education 

on saving 

Direct deposit/ 

auto-save 

Licensing 

Opt-out mortgage or 

credit card 

Information debiasing 

on debt (full information disclosure, payoff 

time for credit cards) 

Scoring 

Tax incentives 

for savings 

vehicles 

IRS Direct 

Deposit 

Accounts 

Penalties to make optout system sticky 

Ex post liability 

standard for truth in 

lending 

Broker fiduciary duty 

and/or changing 

compensation (Yield 

Spread Premiums) 

The default example is just one of a set of examples we 

discuss as potential regulatory interventions based on 

our conceptual framework. As noted above, given market 

responses to relevant psychological factors in different 

contexts, regulation may need to take a variety of forms, 

including some that while informed by psychology are not 

designed to affect behavioral change but rather to alter 

the structure of the market in which relevant choices are 

made. Given the complexities involved, the purpose of this 

white paper is not to champion the specific policies below. 

Instead, we illustrate how a behaviorally informed regulatory analysis would lead to a deeper understanding of the 

costs and benefits of specific policies. We explore ten ideas 

to illustrate our conceptual approach in three main areas of 

borrowing and saving: home mortgage regulation, credit 

card regulation, and the provision of bank accounts. 

Behaviorally Informed Home 

Mortgage Regulation 

Full Information Disclosure to Debias Borrowers 

With the advent of nationwide credit reporting systems and 

refinement of credit scoring and modeling, the creditor and 

broker know information about the borrower that the borrower does not necessarily know about himself, including 

not just his credit score, but his likely performance regarding a particular set of loan products. Creditors will know 

whether the borrower could qualify for a better, cheaper 

loan, as well as the likelihood that the borrower will meet his 

obligations under the existing mortgage, or become delinquent, refinance, default or go into foreclosure. Yet lenders 

are not required to reveal this information to borrowers. 

At the same time, the lack of disclosure of such information is likely exacerbated by consumer beliefs. Consumers 

likely have false background assumptions regarding what 

brokers and creditors reveal to them about their borrowing 

status. What if consumers believe the following: 

“Creditors reveal all information about me 

and the loan products I am qualified to receive. 

Brokers work for me in finding me the best loan 

for my purposes, and lenders offer me the best 

loans for which I qualify. I must be qualified for 

the loan I have been offered, or the lender would 

not have validated the choice by offering me the 

loan. Because I am qualified for the loan that must 

mean that the lender thinks that I can repay the 

loan. Why else would they lend me the money? 

Moreover, the government tightly regulates home 

mortgages; they make the lender give me all these 

legal forms. Surely the government must regulate 

all aspects of this transaction.” 

In reality, the government does not regulate as the borrower 

believes, and the lender does not necessarily behave as the 

borrower hopes. Instead, information is hidden from the 

borrower, information that would improve market compebehaviorally informed financial services regulation 5 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

tition and outcomes. Given the consumer’s probably false 

background assumptions and the reality of asymmetric 

information favoring the lender and broker, we suggest 

that creditors be required to reveal useful information to 

the borrower at the time of the mortgage loan offer, including disclosure of the borrower’s credit score, and the borrower’s qualifications for the all of the lender’s mortgage 

products. Brokers could even be required to reveal the 

wholesale rate sheet pricing—the rates at which lenders 

would be willing to lend to this type of borrower. Such an 

approach corresponds to the use of debiasing information, 

in the top right of Table 3. 

Given the consumer’s probably false background assumptions and the reality of asymmetric information favoring the lender and 

broker, we suggest that creditors be required 

to reveal useful information to the borrower 

at the time of the mortgage loan offer, including disclosure of the borrower’s credit score, 

and the borrower’s qualifications for the all 

of the lender’s mortgage products. 

The goal of these disclosures would be to put pressure on 

creditors and brokers to be honest in their dealings with 

applicants. The additional information might improve comparison shopping and perhaps outcomes. Of course, revealing such information would also reduce broker and creditor 

profit margins. But if the classic market competition story 

relies on full information, and assumes rational behavior 

based on understanding, one can view this proposal as 

simply attempting to remove market frictions from information failures, and move the market competition model 

more towards its ideal. By reducing information asymmetry, full information disclosure would help to debias consumers and lead to better competitive outcomes. 

Ex Post Standards-based Truth in Lending 

Optimal disclosure will not simply occur in all markets 

through competition alone. Competition under a range of 

plausible scenarios will not necessarily generate psychologically informative and actionable disclosure, as the current crisis in the subprime mortgage sector suggests may 

have occurred. If competition does not produce informative disclosure, disclosure regulation might be necessary. 

But simply because disclosure regulation is needed does 

not mean it will work. Regulating disclosure appropriately 

is difficult and requires substantial sophistication by regulators, including psychological insight. 

A behavioral perspective could focus on improving disclosuresthemselves.Thegoalofdisclosureshouldbetoimprove 

the quality of information about contract terms in meaningful ways. That would suggest, for example, that simply 

adding information is unlikely to work. Disclosure policies 

are effective to the extent that they present a frame—a way 

of perceiving the disclosure—that is both well understood 

and conveys salient information that helps the decisionmaker act optimally. It is possible, for example, that information about the failure frequency of of particular products 

might help (“2 out of 10 borrowers who take this kind of 

loan default”), but proper framing can be difficult to achieve 

and to maintain consistently, given that it may vary across 

situations. Moreover, the attempt to improve decision quality through an improvement in consumer understanding, 

which is presumed to change the consumer’s intentions to 

act, and finally her actual actions, is fraught with difficulty. 

There is often a gap between understanding and intention, 

and particularly between intention and action. 

Disclosure policies are effective to the extent 

that they present a frame—a way of perceiving the disclosure—that is both well understood and conveys salient information that 

helps the decision-maker act optimally. 

Furthermore, even if meaningful disclosure rules can be 

created, sellers can undermine whatever before-the-fact 

or ex ante disclosure rule is established, in some contexts 

simply by “complying” with it: “Here’s the disclosure 

form I’m supposed to give you, just sign here.” For example, with rules-based ex ante disclosure requirements 

for credit, such as TILA, the rule is set up first, and the 

firm (the discloser) moves last. While an ex ante rule provides certainty to creditors, whatever gave the discloser 

incentives to confuse consumers remains in the face of 

6 new america foundation 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

the regulation. While officially complying with the rule, 

there is market pressure to find other means to avoid the 

salutary effects on consumer decisions that the disclosure 

was intended to achieve. 

In light of the difficulties of addressing such issues ex ante, 

we propose that policy makers consider shifting away from 

sole reliance on a rules-based, ex ante regulatory structure 

for disclosure embodied in TILA and toward integration 

of an ex-post, standards-based disclosure requirement as 

well. Rather than a rule, we would deploy a standard, and 

rather than an ex ante decision about content, we would 

permit the standard to be enforced after loans are made. 

In essence, courts or expert agencies would determine 

whether the disclosure would have, under common understanding, effectively communicated the key terms of the 

mortgage to the typical borrower. This approach could be 

similar to ex post determinations of reasonableness of disclaimers of warranties in sales contracts under UCC 2-316 

(See White & Summers, 1995). This type of policy intervention would correspond to a change in “scoring,” in the 

lower right of Table 3. 

We propose that policy makers consider 

shifting away from sole reliance on a rulesbased, ex ante regulatory structure for disclosure embodied in TILA and toward integration of an ex-post, standards-based disclosure 

requirement as well. 

In our judgment, an ex post version of truth in lending 

based on a reasonable person standard to complement 

the fixed disclosure rule under TILA might permit innovation—both in products themselves and in strategies of 

disclosure—while minimizing rule evasion. An ex-post 

standard with sufficient teeth could change the incentives 

of firms to confuse and would be more difficult to evade. 

Under the current approach, creditors can easily “evade” 

TILA, by simultaneously complying with its actual terms 

while making the required disclosures regarding the terms 

effectively useless in the context of the borrowing decisions 

of consumers with limited attention and understanding. 

TILA, for example, does not block a creditor from introducing a more salient term (“lower monthly cost!”) to compete 

with the APR for borrowers’ attention. Under an ex post 

standards approach, by contrast, lenders could not plead 

compliance with TILA as a defense. Rather, the question 

would be one of objective reasonableness: whether the 

lender meaningfully conveyed the information required for 

a typical consumer to make a reasonable judgment about 

the loan. Standards would also lower the cost of specification ex ante. Clarity of contract is hard to specify ex ante but 

easier to verify ex post. Over time, through agency action, 

guidance, model disclosures, “no action” letters, and court 

decisions, the parameters of the reasonableness standard 

would become known and predictable. 

While TILA has significant short-comings, we do not propose abandoning it. Rather, TILA would remain (with whatever useful modifications to it might be gleaned from our 

increased understanding of consumers’ emotions, thought 

processes and behaviors). Quite recently, for example, the 

Federal Reserve Board unveiled major and useful changes 

to its disclosure rules, based in part on consumer research.6 

TILA would still be important in permitting comparisonshopping among mortgage products, one of its two central 

goals. However, some of the burden of TILA’s second goal, 

to induce firms to reveal information that would promote 

better consumer understanding, would be shifted to the ex 

post standard. 

Of course, there would be significant costs to such an 

approach, especially at first. Litigation or regulatory enforcement would impose direct costs and the uncertainty surrounding enforcement of the standard ex post might deter 

innovation in the development of mortgage products. The 

additional costs of compliance with a disclosure standard 

might reduce lenders’ willingness to develop new mortgage products designed to reach lower-income or minority borrowers who might not be served by the firms’ plain 

vanilla products. The lack of clear rules might also increase 

consumer confusion regarding how to compare innovative 

mortgage products to each other, even while it increases consumer understanding of the particular mortgage products 

being offered. Even if one couples the advantages of TILA 

for mortgage comparisons with the advantages of an ex post 

standard for disclosure in promoting clarity, the net result 

may simply be greater confusion with respect to cross-loan 

comparisons. That is, if consumer confusion results mostly 

from firm obfuscation, then our proposal will likely help a 

good deal. By contrast, if consumer confusion in this context 

behaviorally informed financial services regulation 7 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

results mostly from market complexity in product innovation, 

then the proposal is unlikely to make a major difference, and 

other approaches focused on loan comparisons might be 

warranted (see, e.g., Thaler & Sunstein (2008)). 

Despite the shortcomings of an ex post standard for truth 

in lending, we believe that such an approach is worth pursuing. To limit the costs associated with our approach, the 

ex post determination of reasonableness could be significantly confined. For example, if courts are to be involved 

in enforcement, the ex post standard for reasonableness 

of disclosure might be limited to providing a (partial) 

defense to payment in foreclosure or bankruptcy, rather 

than being open to broader enforcement through affirmative suit. Alternatively, rather than court enforcement, the 

ex post standard might be enforced by the bank regulators 

or another expert consumer agency,7 through supervision 

and enforcement actions. The ex post exposure might be 

significantly reduced through ex ante steps. For example, 

regulators might develop safe harbors for reasonable disclosures, issue model disclosures, use “no action” letters to 

provide certainty to lenders, and the like. Moreover, firms 

might be tasked with conducting regular surveys of borrowers or conducting experimental design research to validate 

their disclosures, with positive results from the research 

providing rebuttable presumptions of reasonableness, or 

even safe harbors from challenge. The key is to give the 

standard sufficient teeth without deterring innovation. The 

precise contours of enforcement and liability are not essential to the concept, and weighing the costs and benefits of 

such penalties is beyond the scope of what we hope to do 

in introducing the idea here. Further work will be required 

to detail the design for implementation. 

“Sticky” Opt-Out Mortgage Regulation 

While the causes of the mortgage crisis are myriad, a central problem was that many borrowers took out loans that 

they did not understand and could not afford. Brokers and 

lenders offered loans that looked much less expensive than 

they really were, because of low initial monthly payments 

and hidden, costly features. Families commonly make 

mistakes in taking out home mortgages because they are 

misled by broker sales tactics, misunderstand the complicated terms and financial tradeoffs in mortgages, wrongly 

forecast their own behavior and misperceive their risks 

of borrowing. How many homeowners really understand 

how the teaser rate, introductory rate and reset rate relate 

to the London interbank offered rate plus some specified 

margin, or can judge whether the prepayment penalty will 

offset the gains from the teaser rate? 

Improved disclosures might help. Altering the rules of the 

game of disclosure, and altering the “scoring” for seeking 

to evade proper disclosure, may be sufficient to reduce the 

worst outcomes. However, if market pressures and consumer confusion are sufficiently strong, such disclosure 

may not be enough. If market complexity is sufficiently disruptive to consumer choice, product regulation might prove 

most appropriate. For example, by barring prepayment penalties, one could reduce lock-in to bad mortgages; by barring 

short-term ARMs and balloon payments, one could reduce 

refinance pressure; in both cases, more of the cost of the loan 

would be pushed into interest rates and competition could 

focus on a consistently stated price in the form of the APR. 

Price competition would benefit consumers, who would be 

more likely to understand the terms on which lenders were 

competing. Product regulation would also reduce cognitive 

and emotional pressures related to potentially bad decisionmaking by reducing the number of choices and eliminating 

loan features that put pressure on borrowers to refinance on 

bad terms. However, product regulation may stifle beneficial innovation and there is always the possibility that government may simply get it wrong. 

For that reason, we propose a new form of regulation. We 

propose that a default be established with increased liability exposure for deviations that harm consumers. For lack 

of a better term, we call this a “sticky” opt-out mortgage 

system.12 As with “opt out” regulation generally, a “sticky” 

opt out system would fall, in terms of stringency, somewhere between product regulation and disclosure; however, for reasons we explain below, market forces would 

likely swamp a pure “opt out” regime—that’s where the 

need for stickiness comes in. This approach corresponds 

to a combination of changing the rules of the game, in the 

top right of Table 3, and changing liability rules, at the bottom right of that table. 

We propose that a default be established with 

increased liability exposure for deviations that 

harm consumers. For lack of a better term, we 

call this a “sticky” opt-out mortgage system. 

8 new america foundation 
 

 

 

 

 

 

 

 

 

The proposal is grounded in our equilibrium model of firm 

incentives and individual psychology. Borrowers may be 

unable to distinguish among complex loan products and 

act optimally based on such an understanding (see, e.g., 

Ausubel 1991). We thus deploy an opt-out strategy to make 

it easier for borrowers to choose a standard product, and 

harder for borrowers to choose a product that they are less 

likely to understand. At the same time, lenders may seek 

to extract surplus from borrowers because of asymmetric 

information about future income or default probabilities 

(see Musto 2007), and, in the short term, lenders and brokers may benefit from selling borrowers loans they cannot afford. Thus, a pure default would be undermined by 

firms, and regulation needs to take account of this market 

pressure by pushing back. 

In our model, lenders would be required to offer eligible 

borrowers a standard mortgage (or set of mortgages), such 

as a fixed rate, self-amortizing 30 year mortgage loan, 

according to reasonable underwriting standards. The precise contours of the standard set of mortgages would be 

set by regulation. Lenders would be free to charge whatever interest rate they wanted on the loan, and, subject to 

the constraints outlined below, could offer whatever other 

loan products they wanted outside of the standard package. Borrowers, however, would get the standard mortgage 

offered, unless they chose to opt out in favor of a non-standard option offered by the lender, after honest and comprehensible disclosures from brokers or lenders about the 

terms and risks of the alternative mortgages. An opt-out 

mortgage system would mean borrowers would be more 

likely to get straightforward loans they could understand. 

But for the reasons cited above, a plain-vanilla opt-out policy 

is likely to be inadequate. Unlike the savings context, where 

market incentives align well with policies to overcome behavioral biases, in the context of credit markets, firms often have 

an incentive to hide the true costs of borrowing. Given the 

strong market pressures to deviate from the default offer, 

we would need to require more than a simple “opt out” to 

make the default “sticky” enough to make a difference in 

outcomes. Deviation from the offer would require heightened disclosures and additional legal exposure for lenders 

in order to make the default “sticky.” Under our plan, lenders would have stronger incentives to provide meaningful 

disclosures to those whom they convince to opt out, because 

they would face increased regulatory scrutiny, or increased 

costs if the loans did not work out. 

Deviation from the offer would require 

heightened disclosures and additional legal 

exposure for lenders in order to make the 

default “sticky.” 

Future work will need to explore in greater detail the 

enforcement mechanism. For example, under one potential approach to making the opt-out “sticky,” if default 

occurs when a borrower opts out, the borrower could raise 

the lack of reasonable disclosure as a defense to bankruptcy 

or foreclosure. Using an objective reasonableness standard 

akin to that used for warranty analysis under the Uniform 

Commercial Code, if the court determined that the disclosure would not effectively communicate the key terms 

and risks of the mortgage to the typical borrower, the court 

could modify or rescind the loan contract.8 Another alternative would be to have the banking agencies (or another 

expert consumer agency) enforce the requirement on a 

supervisory basis, rather than relying on the courts. The 

agency would be responsible for supervising the nature 

of disclosures according to a reasonableness standard, 

and would impose a fine on the lender and order corrective actions if the disclosures were found to be unreasonable. The precise nature of the “stickiness” required and 

the tradeoffs involved in imposing these costs on lenders 

would need to be explored in greater detail, but in principle, a “sticky” opt-out policy could effectively leverage the 

behavioral insight that defaults matter with the industrial 

organizational insight that certain market incentives work 

against a pure opt-out policy. 

A “sticky” opt-out policy could effectively 

leverage the behavioral insight that defaults 

matter with the industrial organizational 

insight that certain market incentives work 

against a pure opt-out policy. 

An opt-out mortgage system with “stickiness” might provide several benefits over current market outcomes. Under 

the plan, a plain vanilla set of default mortgages would be 

behaviorally informed financial services regulation 9 
 

 

 

 

 

 

 

 

 

 

 

 

easier to compare across mortgage offers. Information 

would be more efficiently transmitted across the market. 

Consumers would be likely to understand the key terms 

and features of such standard products better than they 

would alternative mortgage products. Price competition 

would more likely be salient once features are standardized. Behaviorally, when alternative products are introduced, the consumer would be made aware that such 

alternatives represent deviations from the default, helping 

to anchor consumers in the terms of the default product 

and providing some basic expectations for what ought to 

enter into consumer choice. Framing the mortgage choice 

as one between accepting a standard mortgage offer and 

needing affirmatively to choose a non-standard product 

should improve consumer decision-making. Creditors will 

be required to make heightened disclosures about the risks 

of the alternative loan products for the borrower, subject 

to legal sanction in the event of failure reasonably to disclose such risks; the legal sanctions should deter creditors 

from making highly unreasonable alternative offers, with 

hidden and complicated terms. Consumers may be less 

likely to make significant mistakes. In contrast to a pure 

product regulation approach, the sticky default approach 

would allow lenders to continue to develop new kinds of 

mortgages, but only when they can adequately explain key 

terms and risks to borrowers. 

Requiring a default to be offered, accompanied by required heightened disclosures 

and increased legal exposure for deviations, 

may help to make “high road” lending more 

profitable in relation to “low road” lending— 

at least if deviations resulting in harm are 

appropriately penalized. 

Moreover, requiring a default to be offered, accompanied by 

required heightened disclosures and increased legal exposure for deviations, may help to make “high road” lending 

more profitable in relation to “low road” lending—at least 

if deviations resulting in harm are appropriately penalized. 

If offering an opt-out mortgage product helps to split the 

market between high and low-road firms, and rewards the 

former, the market may shift (back) towards firms that 

offer home mortgage products that better serve borrowers. 

For this to work effectively, the default—and the efforts to 

make the default sticky—would need to enable the consumer easily to distinguish the typical “good” loan, benefiting both lender and borrower, which would be offered 

as the default, from a wide range of “bad” loans, including those that benefit the lender with higher rates and fees 

but harm the borrower; those that benefit the borrower but 

harm the lender; and those that harm the borrower and 

lender but benefit third parties, such as brokers. 

There will be costs associated with requiring an opt-out 

home mortgage. For example, the sticky defaults may not 

be sticky enough to alter outcomes, given market pressures. The default could be undermined, as well, through 

the firm’s incentive structures for loan officers and brokers, which could provide greater rewards for non-standard loans. Implementation of the measure may be costly 

and the disclosure requirement and uncertainty regarding 

enforcement of the standard might reduce overall access to 

home mortgage lending. There may be too many cases in 

which alternative products are optimal, so that the default 

product is in essence “incorrect,” and comes to be seen as 

such. The default would then matter less over time, and 

forcing firms and consumers to go through the process of 

deviating from it would become increasingly just another 

burden (like existing disclosure paperwork) along the road 

to getting a home mortgage loan. Low-income, minority 

or first-time homeowners who have benefited from more 

flexible underwriting and more innovative mortgage 

developments might see their access reduced if the standard set of mortgages does not include products suitable 

to their needs. 

One could improve these outcomes in a variety of ways. 

For example, the opt-out regulation could require that the 

standard set of mortgages include a 30-year fixed mortgage, a five- or seven-year adjustable rate mortgage, and 

straightforward mortgages designed to meet the particular needs of first-time, minority or low-income homeowners. One might develop “smart defaults,” based on key 

borrower characteristics, such as income and age. With a 

handful of key facts, an optimal default might be offered 

to an individual borrower. The optimal default would consist of a mortgage or set of mortgages that most closely 

align with the set of mortgages that the typical borrower 

with that income, age, and education would prefer. For 

example, a borrower with rising income prospects might 

10 new america foundation 
 

appropriately be offered a five-year adjustable rate mortgage. Smart defaults might reduce error costs associated 

with the proposal and increase the range of mortgages that 

can be developed to meet the needs of a broad range of borrowers, including lower-income or first-time homeowners; 

however, smart defaults may add to consumer confusion. 

Even if the consumer (with the particular characteristics 

encompassed by the smart default) only faces one default 

product, spillover from too many options across the market may make decision-making more difficult. Moreover, 

it may be difficult to design smart defaults consistent with 

fair lending rules. 

The opt-out regulation could require that the 

standard set of mortgages include a 30-year 

fixed mortgage, a five- or seven-year adjustable rate mortgage, and straightforward 

mortgages designed to meet the particular 

needs of first-time, minority or low-income 

homeowners. 

Another approach to improve the standard mortgage choice 

set and to reduce enforcement costs over time, would be 

to build in banking agency supervision as well as periodic 

required reviews of the defaults, with consumer experimental design or survey research to test both the products and the disclosures, so that the disclosures and the 

default products stay current with updated knowledge of 

outcomes in the home mortgage market. Indeed, lenders 

might be required to conduct such research and to disclose 

the results to regulators and the public upon developing a 

new product and its related disclosures. In addition, regulators might use the results of the research to provide safe 

harbors for disclosures that are shown to be reasonable ex 

ante through these methods. Regulators could also issue 

“no action” letters regarding disclosures that are deemed 

to be reasonable through such research. The appropriate 

federal and state supervisory agencies could be required 

to conduct ongoing supervision and testing of compliance 

with the opt-out regulations and disclosure requirements. 

The federal and state banking agencies could easily adapt 

to this additional role with respect to depositories, while 

the FTC, a new expert consumer finance agency, or state 

agencies would need to be provided with the authority 

and resources to conduct ongoing supervisory and testing 

functions for non-depositories, instead of relying solely on 

enforcement actions. Through these no action letters, safe 

harbors, supervision, and other regulatory guidance, the 

regulators can develop a body of law that would increase 

compliance across the diverse financial sectors involved in 

mortgage lending, while reducing the uncertainty facing 

lenders from the new opt-out requirement, and providing 

greater freedom for financial innovation. 

Restructure the Relationship Between 

Brokers and Borrowers 

An alternative approach to addressing the problem of market incentives to exploit behavioral biases would be to focus 

directly on restructuring brokers’ duties to borrowers and 

reforming compensation schemes that provide incentives 

to brokers to mislead borrowers. Mortgage brokers have 

dominated the subprime market. Brokers generally have 

been compensated with “yield spread premiums” (YSP) 

for getting borrowers to pay higher rates than those for 

which the borrower would qualify. Such YSPs have been 

used widely.9 In loans with yield spread premiums, unlike 

other loans, there is wide dispersion in prices paid to mortgage brokers. As Howell Jackson has shown, within the 

group of borrowers paying yield spread premiums, African 

Americans paid $474 more for their loans, and Hispanics 

$590 more, than white borrowers; thus, even if minority 

and white borrowers could qualify for the same rate, in 

practice minority borrowers are likely to pay much more.10 

An alternative approach to addressing the 

problem of market incentives to exploit 

behavioral biases would be to focus directly 

on restructuring brokers’ duties to borrowers 

and reforming compensation schemes that 

provide incentives to brokers to mislead borrowers. Mortgage brokers have dominated 

the subprime market. 

Brokers cannot be monitored sufficiently by borrowers 

(See Jackson & Burlingame), and it is dubious that additional disclosures would help borrowers be better monitors 

behaviorally informed financial services regulation 11 
(see, e.g., FTC 2007), in part because brokers’ disclosures 

of potential conflicts of interest may paradoxically increase 

consumer trust (Cain et al. 2005).11 Thus, if the broker is 

required to tell the borrower that the broker works for himself, not in the interest of the borrower, the borrower’s trust 

in the broker may increase: after all, the broker is being 

honest! Moreover, evidence from the subprime mortgage 

crisis suggests that while in theory creditors and investors 

have some incentives to monitor brokers, they do not do 

so effectively. 

It is possible to undertake an array of structural changes 

regarding the broker-borrower relationship. For example, 

one could alter the incentives of creditors and investors to 

monitor mortgage brokers by changing liability rules to 

make it clear that broker misconduct can be attributed to 

lenders and creditors in suits by borrowers (see Engel & 

McCoy 2007). One could directly regulate mortgage brokers through licensing and registration requirements (as 

is done elsewhere, e.g., in the UK); recent U.S. legislation 

now mandates licensing and reporting requirements for 

brokers. In addition, the ex post disclosure standard we 

suggest might have a salutary effect by making it more 

costly for lenders when brokers evade disclosure duties; 

this may lead to better monitoring of brokers. 

We also believe it is worth considering fundamentally altering the duties of brokers by 

treating mortgage brokers as fiduciaries to 

borrowers. 

We also believe it is worth considering fundamentally 

altering the duties of brokers by treating mortgage brokers 

as fiduciaries to borrowers, similar to the requirements for 

investment advisors under the Investment Advisors Act. 

This would, of course, require vast changes to the brokerage 

market, including to the ways in which mortgage brokers 

are compensated, and by whom. We would need to shift 

from a lender-compensation system to a borrower-compensation system, and we would need a regulatory system 

and resources to police the fiduciary duty. An interim step 

with much lower costs, and potentially significant benefits, 

would be to ban yield spread premiums. Banning YSPs 

could reduce some broker abuses by eliminating a strong 

incentive for brokers to seek out higher-cost loans for customers. In fact, quite recently a number of lenders have 

moved away from YSPs to fixed fees with some funds held 

back until the loan has performed well for a period of time, 

precisely because of broker conflicts of interest in seeking 

higher YSPs rather than sound loans. Banning YSPs now 

would reinforce these “high road’ practices, and protect 

against a renewed and profitable “low road” push for using 

YSPs to increase market share once stability is restored to 

mortgage markets. Banning YSPs would constitute a form 

of scoring change, corresponding to regulation in the bottom right of Table 3 because it affects the payoff brokers 

receive for pursuing different mortgage outcomes. 

Behaviorally Informed 

Credit Card Regulation 

Using framing and salience in disclosures 

to encourage good credit card behavior 

Credit card companies have fine-tuned product offerings 

and disclosures in a manner that appears to be systematically designed to prey on common psychological biases— 

biases that limit consumer ability to make rational choices 

regarding credit card borrowing.13 Behavioral economics 

suggests that consumers underestimate how much they 

will borrow and overestimate their ability to pay their bills 

in a timely manner.14 Credit card companies can then price 

their credit cards and compete on the basis of these fundamental human failings.15 Nearly 60% of credit card holders do not pay their bills in full every month.16 Moreover, 

excessive credit card debt can lead to personal financial 

ruin. Credit card debt is a good predictor of bankruptcy.17 

Ronald Mann has argued that credit card companies seek 

to keep consumers in a “sweat box” of distressed credit 

card debt, paying high fees for as long as possible before 

finally succumbing to bankruptcy.18 

The 2005 bankruptcy legislation19 focused on the need 

for improved borrower responsibility but paid insufficient 

attention to creditor responsibility for borrowing patterns. 

Credit card companies provide complex disclosures regarding teaser rates, introductory terms, variable rate cards, 

penalties, and a host of other matters. Both the terms 

themselves and the disclosures are confusing to consumers.20 Credit card companies are not competing, it appears, 

to offer the most transparent pricing. 

12 new america foundation 
Going forward, regulatory and legislative steps could help 

prod the credit card industry into better practices. The 

Office of the Comptroller of the Currency intervened to 

require national banks to engage in better credit card practices and to provide greater transparency on minimum 

payments,21 and the Federal Reserve recently released 

proposed changes to its regulations under the Truth in 

Lending Act (TILA), in part in the wake of TILA amendments contained in the bankruptcy legislation.22 Under the 

proposals, for example, creditors would need to disclose 

that paying only the minimum balance would lengthen the 

payoff time and interest paid on the credit card; describe 

a hypothetical example of a payoff period paying only the 

minimum balance; and provide a toll-free number for the 

consumer to obtain an estimate of actual payoff time.23 

Although the very length and complexity of the Board’s 

proposal hints at the difficulty of the task of using complex 

disclosure to alter consumer understanding and behavior, 

such improved disclosures might nevertheless help. 

Congress could require that minimum payment terms be accompanied by clear statements regarding how long it would take, and 

how much interest would be paid, if the customer’s actual balance were paid off only in 

minimum payments, and card companies 

could be required to state the monthly payment amount that would be required to pay 

the customer’s actual balance in full over 

some reasonable period of time 

But we could do much better. Congress could require that 

minimum payment terms be accompanied by clear statements regarding how long it would take, and how much 

interest would be paid, if the customer’s actual balance were 

paid off only in minimum payments, and card companies 

could be required to state the monthly payment amount 

that would be required to pay the customer’s actual balance 

in full over some reasonable period of time, as determined 

by regulation. These tailored disclosures use framing 

and salience to help consumers, whose intuitions regarding compounding and timing are weak, to make better 

informed payment choices based on their specific circumstances. Such an approach would correspond to changing 

the rules in order to debias consumers with behaviorally 

informed information disclosure, in the top right of table 3. 

Although credit card companies have opposed such ideas 

in the past, disclosures based on the customer’s actual balances are not overly burdensome. 

Disclosures regarding the expected time to pay off actual 

credit card balances are designed to provide a salient frame 

intended to facilitate more optimal behavior. But such 

disclosures may not be strong enough to matter. The disclosures are geared towards influencing the intention of 

the borrower to change his behavior; however, even if the 

disclosure succeeds in changing the borrower’s intentions, 

we know that there is often a large gap between intention 

and action.24 In fact, the borrower would need to change 

his behavior in the face of strong inertia and marketing by 

the credit card companies propelling him to make minimum payments. Furthermore, those market players who 

are strongly opposed to such disclosures would promptly 

attempt to undermine them once enacted with countervailing marketing and other policies. 

An Opt Out Payment Plan for Credit Cards 

A more promising approach, based on default rules establishing the starting point for behavior, rather than framing 

of disclosures to change intentions, would be to develop 

an “opt-out payment plan” for credit cards, under which 

consumers would be required automatically to make the 

payment necessary to pay off their existing balance over 

a relatively short period of time unless the customer affirmatively opted-out of such a payment plan and chose an 

alterative payment plan with a longer (or shorter) payment 

term.25 Such an approach corresponds to changing the 

rules through opt-out policies, in the top right of Table 3. 

Given what we know about default rules and framing, such 

a payment plan may be followed by many consumers. The 

payment plan would create expectations about consumer 

conduct and in any event inertia would cause many households simply to follow the plan. Increasing such behavior 

would mean lower rates of interest and fees paid, and lower 

incidence of financial failure. In any event, confronting an 

optimal payment plan may force card holders to confront 

the reality of their borrowing, and this may help to alter 

their borrowing behavior, or their payoff plans. Moreover, 

credit card industry players would find it difficult to argue 

publicly against reasonable opt-out payment plans and, in 

behaviorally informed financial services regulation 13 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

the face of such plans, to continue using a pricing model 

based on borrowers going into financial distress. 

A more promising approach would be to 

develop an “opt-out payment plan” for credit 

cards, under which consumers would be 

required automatically to make the payment 

necessary to pay off their existing balance 

over a relatively short period of time unless 

the customer affirmatively opted-out of such a 

payment plan and chose an alterative payment 

plan with a longer (or shorter) payment term. 

Of course, an opt-out payment plan will impose costs. 

Some consumers who, in the absence of the opt-out payment plan, would have paid off their credit cards much 

faster than the plan provides, might now follow the 

slower payment plan offered as the default, thus incurring higher costs from interest and fees, possibly even 

facing a higher chance of financial failure. Alternatively, 

some consumers may follow the opt-out payment plan 

when it is unaffordable for them, consequently reducing necessary current consumption such as medical 

care or sufficient food, or incurring other costly forms of 

debt. While there are undoubtedly problems with such 

an approach, public debate over the proposal would at 

least have the virtue of engaging all relevant players in 

an important conversation about fundamental changes 

in market practice. 

Regulate Late Fees 

A narrower intervention based on behavioral insights about 

credit card customers would seek to change the behavior 

of credit card firms, rather than consumers. One problem 

with the pricing of credit cards is that credit card firms 

can charge late and over-limit fees with relative impunity 

because consumers typically do not believe ex ante that 

they will pay such fees. In principle, firms need to charge 

late and over-limit fees to the extent that they wish to provide incentives to customers not to pay late or go over their 

credit card limits. In practice, given the fees they charge, 

credit card firms are perfectly content to let consumers pay 

late and go over their card limits, in order to obtain fee 

revenue from such occurrences. 

We would change the scoring of the game (corresponding 

to a regulatory choice in the bottom right of table 3). Under 

our proposal, firms could deter consumers from paying 

late or going over their credit card limits with whatever fees 

they deemed appropriate, but the bulk of such fees would 

be placed in a public trust to be used for financial education and assistance to troubled borrowers. Firms would 

retain a fixed percentage of the fees to pay for their actual 

costs incurred from late payments or over-limit charges, or 

for any increased risks of default that such behavior presages. The benefit of such an approach is that it permits 

firms to deter “bad conduct” by consumers, but prevents 

firms from taking advantage of the psychological insight 

that consumers predictably mis-forecast their own behavior with respect to paying late and borrowing over their 

limit. Firm incentives to over-charge for late payments 

and over-limit borrowing would be removed, while firms 

would retain incentives appropriately to deter these consumer failures. 

As with our other proposals, there would be costs as well: 

in particular, the reduced revenue stream to lenders from 

these fees would mean that other rates and fees would 

be adjusted to compensate, and there is little reason to 

believe that the adjustments would be in consumers’ favor. 

Moreover, taxing late and over-limit fees in this manner 

might be seen as a significant interference with contractual 

relationships beyond the form and content of disclosures 

required under TILA for credit card agreements. 

Opt Out Credit Card 

As a last option to consider in the credit card market, we 

might think about regulation requiring firms to offer a standard “opt-out” credit card. Elizabeth Warren has argued 

that private sector firms should offer “clean” credit cards 

with straightforward terms and honest pricing.26 We agree 

with her that this would be a significant achievement and 

would set an important example for others. Looking at the 

structure of the market, one wonders whether such a highroad firm offering a clean credit card could win market 

share and remain profitable. Given predictable consumer 

biases, such firms will have a hard time competing with 

low-road players offering less transparent and seemingly 

“better” offers. We thus wonder whether regulation might 

be designed to reward high-road credit card firms offering 

14 new america foundation 
 

 

 

 

such cards and penalize low-road firms offering products 

designed to take advantage of consumer failings. 

Consumers would be offered credit cards that 

meet the definition of “safe.” They could opt 

for another kind of credit card, but only after 

meaningful disclosure. And credit card firms 

would face increased liability risk if the disclosure is found to have been unreasonable. 

Warren’s innovative suggestion in this regard is for the 

creation of a consumer financial safety commission that 

could review credit card offers.27 Perhaps an entity such 

as this could specify terms and conditions that are “safe” 

and qualify for being offered as a standard credit card. As 

with the home mortgage idea discussed earlier, consumers would be offered credit cards that meet the definition 

of “safe.” They could opt for another kind of credit card, 

but only after meaningful disclosure. And credit card firms 

would face increased liability risk if the disclosure is found 

to have been unreasonable. As with our earlier concept, the 

precise details of liability determination and consequences 

would need to be carefully calibrated. In essence, the proposal would permit firms to continue to innovate in credit 

card practices, but with strong anchoring around straightforward practices and with the risk of increased consequences to firms when consumers opt out and wind up in 

trouble. This type of “sticky” opt-out provision, as with our 

proposal for an opt-out home mortgage, would correspond 

to changing both the rules and the scoring of the game on 

the right side of Table 3. 

Increasing Saving Among 

LMI Households 

We have focused in this paper thus far on improving outcomes in the credit markets using insights from behavioral 

economics and industrial organization. Our focus derives 

from the relative lack of attention to this area in the behavioral literature thus far. Savings is also an area ripe for further attention, however, because so much of saving policy 

has focused on using defaults to improve retirement saving. For many low- and moderate-income households there 

is a much greater need to focus on basic banking services 

and short-term savings options, services which, for this 

population, may require a different mix of governmental 

responses than typically suggested in the context of retirement savings for middle- and upper-income households. 

Many low- and moderate-income (LMI) individuals lack 

access to the sort of financial services that middle-income 

families take for granted, such as checking accounts or 

easily-utilized savings opportunities. High cost financial 

services, barriers to savings, lack of insurance, and credit 

constraints increase the economic challenges faced by LMI 

families. In the short run, it is often hard for these families 

to deal with fluctuations in income that occur because of 

job changes, instability in hours worked, medical illnesses 

or emergencies, changes in family composition, or a myriad of other factors that can cause abrupt changes in economic inflows and outflows. At low income levels, small 

income fluctuations may create serious problems in paying rent, utilities, or other bills. Moreover, the high costs 

and low utility of the financial transaction services used by 

many low-income households extract a daily toll on takehome pay. Limited access to mainstream financial services 

reduces ready opportunities to save and thus limit families’ 

ability to build assets and to save for the future. 

Market forces weaken or break down entirely 

with respect to encouraging saving for lowincome households. This is simply because 

the administrative costs of collecting smallvalue deposits are high in relation to banks’ 

potential earnings on the relatively small 

amounts saved, unless the bank can charge 

high fees; with sufficiently high fees, however, 

it is not clear that utilizing a bank account 

makes economic sense for LMI households. 

In theory, opt-out policies ought to work well here, as 

in the retirement world, in encouraging saving by such 

households. However, while in general the market pulls 

in the same direction as policy for saving, market forces 

behaviorally informed financial services regulation 15 
 

 

 

 

 

 

 

 

 

 

weaken or break down entirely with respect to encouraging saving for low-income households. This is simply 

because the administrative costs of collecting small-value 

deposits are high in relation to banks’ potential earnings 

on the relatively small amounts saved, unless the bank can 

charge high fees; with sufficiently high fees, however, it 

is not clear that utilizing a bank account makes economic 

sense for LMI households. Indeed, the current structure 

of bank accounts is one of the primary reasons why LMI 

households do not have them. 

With respect to transaction accounts, high minimum balance requirements, high fees for overdraft protection or 

bounced checks, and delays in check clearance dissuade 

LMI households from opening or retaining bank accounts. 

Moreover, banks use the private ChexSystems to screen 

out households who have had difficulty with accounts in 

the past. Behaviorally insightful tweaks are unlikely to suffice in this context; rather, we need to devise methods to 

change the nature of the products being offered and, with 

them, the behavior of the consumers who open and maintain the accounts. 

In this area, we need to figure out how to increase scale and 

offset costs for the private sector, in addition to increasing 

saving by low- and moderate-income families. As explained 

more fully below, we propose two options: a new tax credit 

to financial institutions for offering safe and affordable bank 

accounts, and a proposal under which the IRS would direct 

deposit tax refunds into “opt-out” bank accounts automatically set up through private sector financial institutions at 

tax time. Both proposals are designed to induce the private 

sector to change their account offerings by offering tax subsidies or government bundling to reach scale, as well as to alter 

consumer behavior through the structure of the accounts 

offered. The proposals pertain to changing the rules and the 

scoring on the left hand side of Table 3, where markets may 

prove neutral to, or even positively inclined towards, the 

potential overcoming of consumer fallibility. In particular, 

the tax credit and government backing change the scoring 

to firms for offering such products, while the opt-out nature 

of the proposal changes the starting rules. 

Tax Credit to Financial Institutions for Offering 

Safe and Affordable Bank Accounts 

To overcome the problem of the high fixed costs of offering 

sensible transaction accounts to low-income individuals 

with low savings levels, Congress could enact a tax credit 

for financial institutions for offering safe and affordable 

bank accounts to LMI households (see Barr 2004, 2007). 

The tax credit would be pay-for-performance, with financial 

institutions able to claim tax credits for a fixed amount per 

account opened by LMI households. The bank accounts 

eligible for the tax credit could be structured and priced by 

the private sector, but according to essential terms required 

by regulation. For example, costly and inefficient checking accounts with high risk of overdraft or hidden, costly 

features would be eschewed in favor of low-cost, low-risk 

accounts with only debit card access. In particular, bank 

accounts would be debit-card based, with no check-writing 

capability, no overdrafts permitted, and no ChexSystems 

rejections for past account failures, in the absence of fraud 

or other meaningful abuse. 

Congress could enact a tax credit for financial 

institutions for offering safe and affordable 

bank accounts to LMI households (see Barr 

2004, 2007). The tax credit would be pay-forperformance, with financial institutions able 

to claim tax credits for a fixed amount per 

account opened by LMI households. 

The power of the tax credit initiative could be significantly 

increased if it were coupled with a series of behaviorally 

informed efforts to improve take up of the accounts and 

savings outcomes for account holders. For example, banks 

could reach out to employers to encourage direct deposit 

and automatic savings plans to set up default rules that 

would increase savings outcomes. With an automatic savings plan, accounts could be structured so that holders 

could designate a portion of their paycheck to be deposited into a savings “pocket”; the savings feature would rely 

on the pre-commitment device of automatic savings, and 

funds would be somewhat more difficult to access than 

those in the regular bank account, in order to make the 

commitment more likely to stick. To provide necessary 

access to emergency funds in a more cost effective manner 

than usually available to LMI households, the bank account 

could also include a six-month consumer loan with direct 

deposit and direct debit, using relationship banking and 

automated payment systems to provide an alternative to 

16 new america foundation 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

costly payday loans. With direct deposit of income and 

direct debit of interest and principal due, the loan should 

be relatively costless to service and relatively low-risk for the 

bank. With a longer payment period than usual for payday 

lending, the loan should be more manageable for consumers living paycheck to paycheck, and would likely to lead 

to less repeated borrowing undertaken to stay current on 

past payday loans. Moreover, the loan repayment features 

could also include a provision that consumers “pay themselves first,” by including a savings deposit to their account 

with every payment. Such a pre-commitment device could 

overcome consumer biases to procrastinate in savings, and 

reduce the likelihood of the need for future emergency borrowing. All of these efforts would likely increase take up of 

the banking product and improve savings outcomes from 

becoming banked. 

To provide necessary access to emergency 

funds in a more cost effective manner than 

usually available to LMI households, the 

bank account could also include a six-month 

consumer loan with direct deposit and direct 

debit, using relationship banking and automated payment systems to provide an alternative to costly payday loans. 

An Opt Out Bank Account for Tax Refunds 

Congress could also enact a new, opt-out “tax refund 

account” plan to encourage savings and expanded access to 

banking services, while reducing reliance on costly refund 

loans (see Barr 2007). Under the plan, unbanked lowincome households who file their tax returns would have 

their tax refunds directly deposited into a new account. 

Banks agreeing to offer safe and affordable bank accounts 

would register with the IRS to offer the accounts, and a 

fiscal agent for the IRS would draw from a roster of banks 

offering these services in the taxpayer’s geographic area 

in assigning the new accounts. On receiving the account 

number from its fiscal agent, the IRS would directly 

deposit EITC (and other tax refunds) into those accounts. 

Taxpayers could choose to opt-out of the system if they did 

not want to directly deposit their refund but the expectation is that the accounts would be widely accepted since 

they would significantly reduce the costs of receiving one’s 

tax refund. Once the tax refund account is set up through 

the IRS-mechanism at tax time, households would receive 

their tax refund in the account, weeks earlier than if they 

had to wait for a paper check. Moreover, once it is established, the account could continue to be used long past tax 

time. Households could also use the account just like any 

other bank account—to receive their income, to save, to 

pay bills, and the like. 

By using an opt-out strategy and reaching households at 

tax time, this approach could help to overcome consumer 

biases to procrastinate in setting up accounts. By reducing the time it takes to receive a refund, setting up such 

accounts could help to reduce the incentives to take out 

costly refund loans, incentives that are magnified by temporal myopia and misunderstanding regarding the costs 

of credit. It could dramatically, efficiently, and quickly 

reach millions of LMI households and bring them into the 

banking system. A complementary approach (Koide 2007) 

would reach scale by using prepaid debit cards and pooled 

accounts offered by a more limited number of vendors 

chosen by the IRS, rather than individually-owned bank 

accounts offered by a large number of financial institutions. 

In that manner, the private sector vendor would be assured 

large scale of operations. In either event, opt-out strategies 

and government incentives would be coupled to reach lowincome households with essential banking services. 

Conclusion 

We have explored how existing regulation fails to take 

account of advances in behavioral research about how people think and act. By contrast, behaviorally informed regulation would take account of the importance of framing 

and defaults, of the gap between information and understanding, and between intention and action, as well as of 

other psychological factors affecting how people behave. 

At the same time, we argue, behaviorally informed regulation should take into account not only behavioral insights 

about individuals, but also economic insights about markets. Markets can be shown to systematically favor overcoming behavioral biases in some contexts, and to systematically favor exploiting those biases in other contexts. 

A central illustration of this distinction is the contrast 

between the market for saving and the market for borrowing—in which the same human failing in understanding 

behaviorally informed financial services regulation 17 
 

 

 

 

 

 

 

and acting upon the concept of compound interest leads 

to opposite market reactions. 

Behaviorally informed regulation would take 

account of the importance of framing and 

defaults, of the gap between information and 

understanding, and between intention and 

action, as well as of other psychological factors affecting how people behave. 

Rather than relying on the classic model of rational agents 

and maximizing firms, we have developed a model in 

which we understand outcomes as an equilibrium interaction between individuals with specific psychologies and 

firms that respond to those psychologies within specific 

markets. As we have seen rather dramatically in the case of 

subprime mortgages, for example, market outcomes may 

not be socially optimal. To the extent that the interaction 

produces real harms, regulation could potentially be usefully addressed to the social welfare failures, if any, in this 

equilibrium. Taking both individuals and industrial organization seriously suggests the need for policy makers to 

consider a range of market-context specific policy options, 

including both changing the “rules” of the game, as well as 

changing its “scoring.” 

We have sketched here ten policy suggestions derived 

from our conceptual model. In particular, in the home 

mortgage market, we have focused on a standards-based 

truth in lending law, a requirement of full disclosure 

of information favorable to the borrower, changing the 

incentives in the relationship between brokers and borrowers, and a new, opt-out home mortgage system. With 

respect to credit cards, we have explored more salient disclosures, an opt-out payment plan, an opt-out credit card, 

and regulation of late fees. We have also suggested ways 

in which behaviorally informed policy might promote 

basic banking and savings beyond the retirement world, 

for example, through an opt-out direct deposit account set 

up at tax time, or through tax incentives to firms to offer 

low-cost accounts. 

It is noteworthy that our current framework largely retains 

the classical perspective of consumers interacting in competitive markets. The difference is that consumers are now 

shown to be fallible in systematic and important ways, 

and firms are now understood to have incentives either 

to overcome such fallibility, or to exacerbate it, in different specific market contexts. Recognition of the serious 

social failures that can result from the interaction between 

individual psychology and industrial organization ought to 

lead to a range of behaviorally informed regulation of the 

types that we have described here, in order to restore fair 

and healthy competition. 

18 new america foundation 
 

Notes 

1 Michael S. Barr is Professor of Law, University of 

Michigan Law School; senior fellow Center for American 

Progress; nonresident senior fellow, Brookings Institution. 

Sendhil Mullainathan is Professor of Economics, Harvard 

University. Eldar Shafir is Professor of Psychology and 

Public Affairs, Princeton University. The authors conduct research and development on public policy through 

Ideas42, with support from the Hewlett Foundation and 

the Russell Sage Foundation. The authors wish to thank 

Ellen Seidman and the New America Foundation for suggesting we undertake this project and for their ongoing 

support and encouragement. 

2 These strategies have been called variously “Asymmetric 

Paternalism,” “Libertarian Paternalism,” and “Debiasing 

Through Law,” see, e.g., Camerer et al. (2003), Thaler & 

Sunstein (2008), Jolls & Sunstein (2005). 

3 We recognize that there are significant compliance 

issues regarding pensions and retirement plans, disclosure 

failures, fee churning and complicated and costly fee structures, conflicts of interest in plan management, as well as 

problems with encouraging employers to sign up low-wage 

workers for retirement plans. We do not mean to suggest 

that these failings are trivial; far from it. We only mean to 

suggest that, as a comparative matter, market incentives to 

overcome psychological biases in order to encourage saving are more aligned with optimal social policy than market incentives to exacerbate psychological biases to encourage borrowing. 

4 We use this bi-modal framework of regulatory choice 

to simplify the exploration of how our model of individual psychology and firm incentives affects regulation. We 

acknowledge that the regulatory choice matrix is more 

complex (see Barr 2005b). 

5 This is largely because of the existing regulatory 

framework: pension regulation gives employers incentives 

to enroll lower income individuals in 401(k) programs. 

Absent this, it is likely that firms would be happy to discourage enrollment since they often must pay the match 

for these individuals. This point is interesting because it 

suggests that even defaults in savings only work because 

some other regulation “changed the scoring” of the game. 

6 See Federal Reserve Board, Final Rule Amending 

Regulation Z, 12 CFR Part 226 (July 14, 2008); Summary 

of Findings: Consumer Testing of Mortgage Broker 

Disclosures, submitted to the Board of Governors of the 

Federal Reserve System, July 10, 2008; Federal Reserve 

Board, Proposed Rule Amending Regulation Z, 12 CFR 

Part 226 (June 14, 2007), Federal Register 72, No. 114: 

32948; Design and Testing of Effective Truth in Lending 

Disclosures, Submitted to the Board of Governors of the 

Federal Reserve System, May 16, 2007. 

7 Elizabeth Warren, for example, has proposed a new 

Financial Product Safety Commission, see Unsafe At Any 

Rate, Democracy #8, Summer 2007. 

8 A more aggressive approach would be to permit class 

action litigation on an affirmative basis. In this paper, we 

are not yet able to balance the costs of class action litigation 

against the benefits of stronger enforcement. 

9 See Jackson & Burlingame, supra, at 127. While in principle yield spread premiums could permit lenders legitimately to pass on the cost of a mortgage broker fee to a cash 

strapped borrower in the form of a higher interest rate rather 

than in the form of a cash payment, the evidence suggests 

that yield spread premiums are in fact used to compensate 

brokers for getting borrowers to accept higher interest rates, 

prepayment penalties, and other loan terms. 

10 Id. at 125; see also Jack Guttentag, Another View of 

Predatory Lending 8 (Wharton Fin. Inst. Ctr., Working 

Paper No. 01-23-B, 2000), available at http://fic.wharton. 

upenn.edu/fic/papers/01/0123.pdf. 

11 Cain, D.M., Lowenstein, G., & Moore, D.A. 2005, 

The Dirt on Coming Clean: Perverse Effects of Disclosing 

Conflicts of Interest, Journal of Legal Studies, 34: 1-25. 

12 We discuss this idea in further detail in Barr, 

Mullainathan and Shafir (2008). 

13 See generally Oren Bar-Gill, Seduction by Plastic, 98 

Nw. U. L. Rev. 1373 (2004). 

14 Id. at 1395 – 96. 

behaviorally informed financial services regulation 19 
 

 

 

 

15 Id. at 1394 – 95. 

16 Brian K. Bucks et al., Recent Changes in U.S. Family 

Finances: Evidence from the 2001 and 2004 Survey of 

Consumer Finances, Fed. Res. Bull., Mar. 22, 2006, at 

A1, available at http://www.federalreserve.gov/pubs/bulletin/2006/financesurvey.pdf. 

17 Ronald Mann, Charging Ahead: The Growth and 

Regulation of Payment Card Markets Around the World 

60 – 69 (2006). 

18 Ronald J. Mann, Bankruptcy Reform and the “Sweat 

Box” of Credit Card Debt, Ill. Law. Rev. 1:375 (2007). 

19 See Bankruptcy Abuse Prevention and Consumer 

Protection Act of 2005, Pub L. No. 109-8, 119 Stat. 23 (codified at 11 U.S.C. § 101 et seq (2005)). 

20 See, e.g., U.S. Gen. Accounting Office, Report 06-929, 

Credit Cards: Increased Complexity in Rates and Fees 

Heightens the Need for More Effective Disclosures to 

Consumers (2006). 

21 See, e.g., Office of the Comptroller of the Currency, 

OCC Bull. 2003-1, Credit Card Lending: Account 

Management and Loss Allowance Guidance (2003); Office 

of the Comptroller of the Currency, OCC Advisory Letter 

2004-4, Secured Credit Cards (2004), available at http:// 

www.occ.treas.gov/ftp/advisory/2004-4.doc; Office of the 

Comptroller of the Currency, OCC Advisory Letter 2004-

10, Credit Card Practices (2004), available at http://www. 

occ.treas.gov/ftp/advisory/2004-10.doc.. 

22 See Press Release, The Federal Reserve Board, Proposed 

Amendments to Regulation Z, available at http://www.federalreserve.gov/BoardDocs/Press/bcreg/2007/20070523/ 

default.htm (May 23, 2007). 

23 Id., Proposed Rule, 12 C.F.R. 226, proposed §.7(b)(12), 

implementing 15 U.S.C. §1637(b)(11). 

24 Buehler, R., Griffin, D., & Ross, M. (2002). Inside 

the planning fallacy: The causes and consequences of 

optimistic time predictions,” in T. Gilovich, D. Griffin, 

& D. Kahneman (Eds.), Heuristics and biases: The psychology of intuitive judgment. Cambridge: Cambridge 

University Press. Koehler, D.J., & Poon, C.S.K. (2005). 

Self-predictions overweight strength of current intentions. 

Journal of Experimental Social Psychology. 

25 Barr (2007). For a related proposal, see Robert Gordon 

and Derek Douglas, “Taking Charge”, The Washington 

Monthly (December 2005) (arguing for an opt-out direct 

debit arrangement for credit cards). 

26 Unsafe At Any Rate, Democracy #8, Summer 2007. 

27 Id. 

20 new america foundation 
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22 new america foundation 
 

 

 

 

About the Asset Building Program 

TheAssetBuildingProgramoftheNewAmericaFoundation 

was established in 2002 to significantly broaden savings 

and assets ownership in America, thereby providing all 

Americans both with the means to get ahead and with a 

direct stake in the overall success of the economy. 

For further information please contact the Asset Building 

Program at 202-986-2700. 
main office california office 

1630 Connecticut Avenue, NW 921 11th Street 

7th Floor Suite 901 

Washington, DC 20009 Sacramento, CA 95814 

Fax 202 986 3696 Fax 916 448 3724
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Phone 202 986 2700 Phone 916 448 5189 

www.newamerica.net