Ben S Bernanke: Financial innovation and consumer protection
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve System's Sixth Biennial Community Affairs
Research Conference, Washington DC, 17 April 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
The concept of financial innovation, it seems, has fallen on hard times. Subprime mortgage
loans, credit default swaps, structured investment vehicles, and other more-recently
developed financial products have become emblematic of our present financial crisis. Indeed,
innovation, once held up as the solution, is now more often than not perceived as the
problem. I think that perception goes too far, and innovation, at its best, has been and will
continue to be a tool for making our financial system more efficient and more inclusive. But,
as we have seen only too clearly during the past two years, innovation that is inappropriately
implemented can be positively harmful. In short, it would be unwise to try to stop financial
innovation, but we must be more alert to its risks and the need to manage those risks
properly.
My remarks today will focus on the consumer protection issues raised by financial innovation.
First, though, I want to say how pleased I am to join you for the sixth biennial Federal
Reserve System Community Affairs Research Conference. We all want to see our
communities grow and thrive, especially those that have been traditionally underserved. But
the people in this room know as well as anyone that, when it comes to consumer protection
and community development, good intentions are not enough. Hard-won knowledge, as
exemplified by the empirical work presented here during the past two days, is required. I
applaud your diligent and tough-minded research in analyzing what works and what doesn't.
Only with such knowledge can efforts to spread prosperity more widely become increasingly
effective.
Sources of financial innovation
Where does financial innovation come from? In the United States in recent decades, three
particularly important sources of innovation have been financial deregulation, public policies
toward credit markets, and broader technological change. I'll talk briefly about each of these
sources.
The process of financial deregulation began in earnest in the 1970s, a period when stringent
regulations limited competition and the range of product offerings in the markets for
consumer credit. For example, Regulation Q, which capped interest rates on deposits,
hampered the ability of depository institutions to attract funding and thus to extend credit.
Restrictions on branching were a particularly significant constraint, as they limited the size of
the market that individual depository institutions could service and thus their scope to reduce
costs through economies of scale.1 The lifting of these regulations, especially branching
restrictions, allowed the development of national banking networks. With national networks,
the fixed costs of product innovation could be spread over larger markets, making the
development and marketing of new products more profitable.
Many public policy decisions have affected the evolution of financial products and lending
practices. One particularly important example was the Community Reinvestment Act of 1977
(CRA), which induced lenders to find ways to extend credit and provide services in low- and
moderate-income neighborhoods. Another important set of policies was the government's
support for the development of secondary mortgage markets, particularly through the
government-sponsored enterprises, Fannie Mae and Freddie Mac. Secondary mortgage
markets were rudimentary and thin in the 1970s; indeed, the Federal Reserve's Flow of
Funds accounts do not even record private securitization activity until the early 1980s. As
secondary mortgage markets - an important innovation in themselves - grew, they gave
lenders both greater access to funding and better ability to diversify, providing further
impetus to expansion into new markets and new products.
On the technological front, advances in information technology made possible the low-cost
collection, processing, and dissemination of household and business financial data, functions
that were once highly localized and, by today's standards, inefficiently managed.2 As credit
reporting advanced, models for credit scoring gradually emerged, allowing for ever-faster
evaluation of creditworthiness, identification of prospective borrowers, and management of
existing accounts.
All these developments had their positive aspects, including for people in low- and
moderateincome communities. Prior to the introduction of the CRA, as you know, many of these
communities had limited access to mortgages and other forms of consumer credit.
Subsequent innovations in financial products and services, processes, and technology
helped at least some underserved consumers more fully enter the financial mainstream, save
money, invest, and build wealth, and homeownership rates rose significantly.
Yet with hindsight, we can see that something went wrong in recent years, as evidenced by
the currently high rates of mortgage delinquency and foreclosure, especially in minority and
lower-income neighborhoods. Indeed, we have come almost full circle, with credit availability
increasingly restricted for low- and moderate-income borrowers. And the damage from this
turn in the credit cycle - in terms of lost wealth, lost homes, and blemished credit histories -
is likely to be long-lasting. One would be forgiven for concluding that the assumed benefits of
financial innovation are not all they were cracked up to be.
A number of factors explain the recent credit boom and bust, including problems stemming
from financial innovation. From a consumer protection point of view, a particular concern has
been the sharp increase in the complexity of the financial products offered to consumers,
complexity which has been a side effect of innovation but which also has in many cases
been associated with reduced transparency and clarity in the products being offered. I will
illustrate the issue in the context of some familiar forms of consumer credit: credit cards,
mortgages, and overdraft protection.
Credit cards, mortgages, and overdrafts: some instructive examples
The credit card is an example of financial innovation driven by technological advance,
including improvements in communications, data management, and credit scoring. When the
first general-purpose credit card was issued in 1952, it represented a way to make small
loans more quickly and at a lower cost than the closed-end installment loans offered by
retailers and finance companies at the time. Moreover, this form of credit doubled as a
means of payment. Card issuers benefited by spreading fixed costs over multiple advances
of credit, over larger customer bases, across geographic areas, and among many
merchants.3 From the consumer's perspective, credit cards provided convenience, facilitated
recordkeeping, and offered security from loss (by theft, for example).4 Their use gradually
expanded among American families, rising to 43 percent in 1983 and to 70 percent by 2007.
Among lower-income families, usage increased from 11 percent in 1983 to 37 percent in
2007.5
Mortgage markets saw similar product innovations. For example, in the early 1990s,
automated underwriting systems helped open new opportunities for underserved consumers
to obtain traditional forms of mortgage credit. This innovation was followed by an expansion
of lending to borrowers perceived to have high credit risk, which became known as the
subprime market. Lenders developed new techniques for using credit information to
determine underwriting standards, set interest rates, and manage their risks. As I have
already mentioned, the ongoing growth and development of the secondary mortgage market
reinforced the effect of these innovations, giving mortgage lenders greater access to the
capital markets, lowering transaction costs, and spreading risk more broadly. Subprime
lending rose dramatically from 5 percent of total mortgage originations in 1994 to about 20
percent in 2005 and 2006.6
Innovation thus laid the groundwork for the expansion of credit card and mortgage lending
that has taken place over the past 15 years or so, as well as some other forms of credit like
auto loans. However, while innovation often brought consumers improved access to credit, it
also brought increased complexity and an array of choices that consumers have often found
difficult to evaluate properly.
Take the case of credit cards. In the early days, a card may have allowed the user to make
purchases or obtain cash advances, with a single, unchanging annual percentage rate, or
APR, applied to each feature. Card fees were typically limited to an annual fee, a charge for
cash advances, and perhaps fees for making a late payment or exceeding the credit limit. In
contrast, today's more-complex products offer balance transfers and treat different classes of
purchases and cash advances as different features, each with its own APR. In addition,
interest rates adjust much more frequently than they once did, and the array of fees charged
for various features, requirements, or services has grown.
More-complex plans may benefit some consumers; for example, pricing that varies according
to consumers' credit risk and preferences for certain services may improve access to credit
and allow for more-customized products. Growing complexity, however, has increased the
probability that even the most diligent consumers will not understand or notice key terms that
affect a plan's cost in important ways. When complexity reaches the point of reducing
transparency, it impedes competition and leads consumers to make poor choices. And, in
some cases, complexity simply serves to disguise practices that are unfair and deceptive.
3
Dagobert L. Brito and Peter R. Hartley (1995), "Consumer Rationality and Credit Cards," Journal of Political
Economy, vol. 103 (April), pp. 400-33.
4
Board of Governors of the Federal Reserve (2006), Report to the Congress on Practices of the Consumer
Credit Industry in Soliciting and Extending Credit and their Effects on Consumer Debt and Insolvency
(Washington: Board of Governors, June).
5
See note 4, Report to the Congress on Practices of the Consumer Credit Industry, table 6; and Board of
Governors of the Federal Reserve System (2007), 2007 Survey of Consumer Finances, Board of Governors.
6
See Chris Mayer and Karen Pence (2008), "Subprime Mortgages: What, Where, and to Whom?" Finance and
Economics Discussion Series 2008-29 (Washington: Board of Governors of the Federal Reserve System,
June); and Inside Mortgage Finance (2007), The 2007 Mortgage Market Statistical Annual vol. 1; The Primary
Market (Bethesda, Md.: Inside Mortgage Finance Publications).
BIS Review 47/2009
Mortgage products have likewise become much more complex. Moreover, in recent years,
the increased complexity has sometimes interacted with weakened incentives for good
underwriting, to the detriment of the borrower. The practice of securitization, notwithstanding
its benefits, appears to have been one source of the decline in underwriting standards during
the recent episode. Depending on the terms of the sale, originators who sold mortgage loans
passed much of the risk - including the risks of poor underwriting - on to investors.
Compensation structures for originators also caused problems in some cases. For example,
some incentive schemes linked originator revenue to particular loan features and to volume
rather than to the quality of the loan. Complexity made the problem worse, as the wide array
of specialized products made consumer choices more difficult. For example, some
originators offered what were once niche products - such as interest-only mortgages or
nodocumentation loans - to a wider group of consumers. And, we have learned, loan features
matter. Some studies of mortgage lending outcomes, after controlling for borrower
characteristics, have found elevated levels of default associated with certain loan features,
including adjustable rates and prepayment penalties, as well as with certain origination
channels, including broker originations.7 Although these results are not conclusive, they
suggest that complexity may diminish consumers' ability to identify products appropriate to
their circumstances.
The vulnerabilities created by misaligned incentives and product complexity in the mortgage
market were largely disguised so long as home prices continued to appreciate, allowing
troubled borrowers to refinance or sell their properties. Once housing prices began to flatten
and then decline, however, the problems became apparent. Mortgage delinquencies and
foreclosure starts for subprime mortgages increased dramatically beginning in 2006 and
spread to near-prime (alt-A) loans soon thereafter. By the fourth quarter of 2008, the
percentages of loans 60 days past due, 90 days or more past due, and in foreclosure were at
record highs.8
Credit cards and mortgages are not the only product classes for which innovation has been
associated with increased complexity and reduced transparency. I will cite one more
example: overdraft protection.
Historically, financial institutions used their discretion to determine whether to pay checks
that would overdraw a consumer's account. In recent years, institutions automated that
process with predetermined thresholds.
Although institutions usually charged the same amount when they paid an overdraft as when
they returned the check unpaid, many consumers appreciated this service because it saved
them from additional merchant fees and the embarrassment of a bounced check. However,
technological innovations allowed institutions to extend the service, often without consumers'
understanding or approval, to non-check transactions such as ATM withdrawals and debit
card transactions. As a result, consumers who used their debit cards at point-of-sale
terminals to make retail purchases, for instance, could inadvertently incur hundreds of dollars
in overdraft fees for small purchases. In response to this problem, the Board last December
proposed regulatory changes that would give consumers a meaningful choice regarding the
payment of these kinds of overdraft fees, and we expect to issue a final rule later this year.
Protecting consumers in an era of innovation and complexity
In light of this experience, how should policymakers ensure that consumers are protected
without stifling innovation that improves product choice and expands access to sustainable
credit? The first line of defense undoubtedly is a well-informed consumer. The Federal
Reserve System has a long-standing commitment to promoting financial literacy, and we
devote considerable resources to helping consumers educate themselves about their
financial options.9 Consumers who know what questions to ask are considerably better able
to find the financial products and services that are right for them.
The capacity of any consumer, including the best informed, to make good choices among
financial products is enhanced by clear and well-organized disclosures. The Board has a
number of responsibilities and authorities with respect to consumer disclosures,
responsibilities we take very seriously. In the past year or so, the Board has developed
extensive new disclosures for a variety of financial products, most notably credit cards, and
we are currently in the midst of a major overhaul of mortgage disclosures.
In designing new disclosures, we have increased our use of consumer testing. The process
of exploring how consumers process information and come to understand - or sometimes
misunderstand - important features of financial products has proven eye-opening. We have
used what we learned from consumer testing to make our required disclosures better. For
example, our recently released rules on credit card disclosures require certain key terms to
be included in a conspicuous table provided at account opening; we took this route because
our field testing indicated that consumers were often already familiar with and able to
interpret such tables on applications and solicitations, but that they were unlikely to read
densely written account agreements.
We have also learned from consumer testing, however, that not even the best disclosures
are always adequate. According to our testing, some aspects of increasingly complex
products simply cannot be adequately understood or evaluated by most consumers, no
matter how clear the disclosure. In those cases, direct regulation, including the prohibition of
certain practices, may be the only way to provide appropriate protections. An example that
came up in our recent rulemaking was the allocation of payments by credit card issuers. As
creditors began offering different interest rates for purchases, cash advances, and balance
transfers, they were also able to increase their revenues through their policies for allocating
consumer payments. For example, a consumer might be charged 12 percent on purchases
but 20 percent for cash advances. Under the old rules, if the consumer made a payment
greater than the minimum required payment, most creditors would apply the payment to the
purchase balance, the portion with the lower rate, thus extending the period that the
consumer would be paying the higher rate. Under these circumstances, the consumer is
effectively prevented from paying off the cash advance balance unless the purchase balance
is first paid in full.
In an attempt to help consumers understand this practice and its implications, the Federal
Reserve Board twice designed model disclosures that were intended to inform consumers
about payment allocation. But extensive testing indicated that, when asked to review and
interpret our best attempts at clear disclosures, many consumers did not demonstrate an
understanding of payment allocation practices sufficient to make informed decisions. In light
of the apparent inadequacy of disclosures alone in this case, and because the methods of
payment allocation used by creditors were clearly structured to produce the maximum cost to
the consumer, last year we put rules in place that will limit the discretion of creditors to
allocate consumers' payments made above the minimum amount required. We banned
socalled double-cycle billing - in which a bank calculates interest based not only on the current
balance, but also on the prior month's balance - on similar grounds; we found from testing
that the complexity of this billing method served only to reduce transparency to the consumer
without producing any reasonable benefit. These actions were part of the most
comprehensive change to credit card regulations ever adopted by the Board.
Similar issues have arisen in the mortgage arena. Many of the poor underwriting practices in
the subprime market were also potentially unfair and deceptive to consumers. For example,
the failure to include an escrow account for homeowners' insurance and property taxes in
many cases led borrowers to underestimate the costs of homeownership. In this case,
allowing greater optionality - which we usually think of as a benefit - had the adverse effects
of increasing complexity and reducing transparency. Restricting this practice was one of the
new protections in the residential mortgage market that the Board established in a
comprehensive set of rules released in July. Banning or limiting certain underwriting
practices, which the new rules do for the entire mortgage market, also helps to address the
incentive problems I discussed earlier. For institutions that we supervise, these incentive
issues can also be addressed by requiring that lenders set up compensation plans for
originators that induce behavior consistent with safety and soundness.
Where does all this leave us? It seems clear that the difficulty of managing financial
innovation in the period leading up to the crisis was underestimated, and not just in the case
of consumer lending. For example, complexity and lack of transparency have been a
problem for certain innovative products aimed at investors, such as some structured credit
products.
Conclusion
I don't think anyone wants to go back to the 1970s. Financial innovation has improved
access to credit, reduced costs, and increased choice. We should not attempt to impose
restrictions on credit providers so onerous that they prevent the development of new
products and services in the future.
That said, the recent experience has shown some ways in which financial innovation can
misfire. Regulation should not prevent innovation, rather it should ensure that innovations are
sufficiently transparent and understandable to allow consumer choice to drive good market
outcomes. We should be wary of complexity whose principal effect is to make the product or
service more difficult to understand by its intended audience. Other questions about
proposed innovations should be raised: For instance, how will the innovative product or
practice perform under stressed financial conditions? What effects will the innovation have
on the ability and willingness of the lender to make loans that are well underwritten and serve
the needs of the borrower? These questions about innovation are relevant for
safety-andsoundness supervision as well as for consumer protection.
In sum, the challenge faced by regulators is to strike the right balance: to strive for the
highest standards of consumer protection without eliminating the beneficial effects of
responsible innovation on consumer choice and access to credit. Our goal should be a
financial system in which innovation leads to higher levels of economic welfare for people
and communities at all income levels.