Randall S Kroszner: Protecting consumers in the credit marketplace
Speech by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of Cleveland Community Development Policy
Summit, Cleveland, Ohio, 11 June 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
* * *
I am delighted to be here today to help open this important conference. I thank my hosts,
President Pianalto and her staff at the Federal Reserve Bank of Cleveland, for the invitation.
This year's conference explores a confluence of consumer-related finance issues in the
context of the current difficulties in the mortgage markets. In my remarks today, I would like
to discuss the key role of consumer credit in our economy and describe how information
disclosure and protecting consumers can work to facilitate and promote the efficient
functioning of markets for such credit.1
Good information is essential to achieving well-functioning markets. Consumers, equipped
with the right information at the right time, can make the choices most appropriate to their
individual circumstances and desires. For consumers to make the most meaningful use of
the relevant information, such information should be accessible and understandable. In turn,
businesses rely on consumers through their choices to signal their desires and preferences
in order to produce the products that consumers want. If consumers are not well informed, it
is difficult for them to be effective in conveying to businesses what they most want and in
rewarding those businesses that do produce such products. Good information in a
marketplace thus not only empowers consumers to make better choices but also helps
competition work more effectively to provide the products consumers most desire.
There are challenges in ensuring that the appropriate information is provided to help markets
function efficiently. Product suppliers may not always provide needed information or present
it in a format that enables meaningful comparison across competing products. Consumers
must also have the financial skills to evaluate the information effectively. However, even in
the presence of good information, practices can emerge that offer little benefit to consumers
and, in some cases, may cause harm. In such cases, improved disclosure alone may be
insufficient to address these issues.
Rules can establish standards that promote increased certainty and restrain abusive
practices. At the same time, such rules need to be implemented in a careful and informed
manner so that the potential benefits of such rules are not offset by unintended
consequences or the imposition of unnecessary costs. The challenge to policymakers is to
strike the right balance - that is, to find ways to empower and protect consumers without
diminishing access to credit and hindering future innovation. With these principles in mind, I
will briefly describe some of the key steps that the Federal Reserve is undertaking to strike
this balance in the area of consumer regulation to protect consumers and provide them with
the information they need, and when they need it, to make sound decisions.
Credit and the economy
Credit is the lifeblood of the American economy. Whether it is to finance an education,
purchase an automobile or home, or simply bridge short-term differences in the timing
between our income and expenses, virtually all of us rely on credit at various points in our
lives. Accordingly, choosing the right type of credit with the most appropriate terms and
conditions is important to each of us. The Federal Reserve has an important role to play in
this regard, as it has been given a mandate by the Congress to help ensure that the costs
and terms of credit use are both transparent and understandable and to protect consumers
from unfair and deceptive lending acts and practices. In our role as a supervisor of banking
institutions, the Federal Reserve also seeks to ensure that lending is undertaken in a safe
and sound manner.
Credit is not only important to each of us as individuals; it also plays a central role in the
working of our economy. Today's economy relies on consumer spending as an engine of
growth - it accounts for about 70 percent of the gross domestic product. Credit is an
important underpinning to such spending. Overall, evidence from the Federal Reserve's
Survey of Consumer Finances shows that about three-quarters of all households carry some
debt.2 About three-quarters of automobile purchases are currently either financed or leased,
and about 95 percent of home purchases involve a mortgage. The use of revolving credit is
similarly widespread; about 75 percent of consumers hold credit cards. The annual
transaction volume on general-purpose credit card accounts reached nearly $1.8 trillion in
2006, and our latest information suggests that consumers owed nearly $1 trillion on revolving
credit accounts of all types. Because consumer credit plays a central role in the economy,
the Federal Reserve has a macroeconomic interest in facilitating the efficient functioning of
consumer credit markets.
The role of credit
The prudent use of credit by households provides a number of important economic benefits.
First, for many families, credit allows for easier and timelier purchase of assets and goods,
such as homes, educations, and automobiles and other consumer durables that can
generate savings in cost and time and improve employment and income-generating
opportunities.3 By facilitating such investment-oriented spending, credit enables consumers
to save and consume at times that meet their needs. For example, the purchase of an
automobile, which many are only able to do using credit, can expand employment
opportunities, which, in turn, can lead to higher incomes. Access to consumer credit also
enables many entrepreneurs to finance the start-up or expansion of small businesses, a
large source of employment in the United States.
Second, a robust consumer credit market facilitates the growth of consumer durables
industries (e.g., computers, autos, and appliances) in which new technologies, mass
production, and economies of scale have historically created employment growth and new
wealth. It is simply hard to imagine the pace of development in the automobile and appliance
industries in the twentieth century without the availability of credit to purchase their output.
Indeed, the lack of well-developed credit markets has been found to be an impediment to
economic growth and prosperity.4 Even in a well-developed economy such as ours,
innovation in credit markets over the past two decades or so has expanded credit availability
to lower-income households and increased options for middle-income consumers as well.5
Third, from an economy-wide perspective, credit provides an important outlet for the savings
of consumers through the financial intermediation process. Ultimately, the source of funds for
consumers who borrow is other consumers who have savings they hold in deposit accounts,
life insurance and pension reserves, or portfolios of securities that include bonds, stocks, and
mutual fund shares. Efficient markets for household credit are part of a well-functioning
system of financial intermediation that allocates savings to the most productive uses.
The developments in credit markets have generally benefited consumers. However, some of
these developments have increased the complexity of our choices and made mistakes
potentially more costly.6 A key challenge is to find ways to improve consumers' ability to
identify products that are suitable to their needs without diminishing the benefits market
innovations can provide and without reducing future access to credit. One important way this
challenge can be met is by improving the information available to consumers.
The central role of information
Information is critical to the efficient functioning of markets.7 A central tenant of economics is
that markets are more competitive, and therefore more efficient, when accurate and
complete information is available to both consumers and product suppliers. Accurate and
complete information about credit terms and prices is essential for households to make
sound judgments about the use of credit. Information disclosure improves consumers' ability
to compare products and to choose those products that will help them meet their personal
goals.
To be effective, disclosures must give consumers information about credit pricing and
important terms at a time when it is relevant, and in language consumers can easily
understand. The information must also be presented in a format that allows consumers to
pick out and use the information that is most important to them. Effective disclosures give
consumers information they notice, understand, and can use. Better credit-term disclosures
permit better-informed credit decisions and lead to more-intense competition among
creditors. In a nutshell, effective disclosure empowers consumers to choose wisely and
enhances competition.
In some circumstances, the disclosure rules can facilitate efficient market outcomes by
establishing guidelines to improve information flows and establishing uniform standards for
how information is provided. For example, since enactment of the Truth in Lending Act of
1968, which requires uniform disclosure of the cost of credit and other key lending terms,
consumer awareness of and sensitivity to interest rates in credit decisions has increased.8
Evidence also suggests that these disclosures have improved competition and helped
consumers.9 The prohibition of the provision of misleading or erroneous information can also
help to improve competitive outcomes.
To evaluate the effectiveness of disclosures, we must know what consumers understand,
what information they use, and how they use the information in making decisions. In
designing rules, we need to take consumers' actual behavior and understanding into
consideration. As a result, the Federal Reserve has been using consumer testing to address
the considerable challenge of making disclosures effective. As mentioned, consumers
increasingly face more-diverse and more-complex financial products, including nontraditional
mortgages and credit cards with multiple and complex features. Given this complexity, we
are mindful of the challenges of information overload and seek to design disclosures that are
not only accurate, but also clear and concise, so that they are meaningful and useful to
consumers.
Numerous pages of fine print may provide the comprehensive descriptions that lawyers may
prefer, but they can also be confusing, or provide limited value, to consumers. We
increasingly rely on feedback from surveys and testing from actual consumers to determine
the information they need to make informed choices. In this regard, we recently completed
several rounds of consumer testing for credit card disclosures. That testing has been
essential to our effort to redesign and improve them. We have also begun using consumer
testing of mortgage disclosures to help develop more-effective disclosures around product
features and other terms that consumers need to know.
Limitations of disclosure protections
When consumers are fully aware of and understand product terms and features, they are
better positioned to make the right choices and achieve the outcomes most appropriate to
their given circumstances, as well as give the signals and rewards to businesses that
produce the products and services consumers most value. However, some product features
and contract terms may be so complex that they are not readily understood. In some
instances, even small misunderstandings, misjudgments, or the challenge of focusing on the
most essential features of a product can lead to serious problems down the road. This is one
reason why financial education and literacy efforts are essential to enabling consumers to
navigate our complex consumer financial marketplace.
Problems can arise if competition does not ensure that relevant information on some terms
or product features is provided in a timely and comprehensible way.10 Moreover, product
terms or features can sometimes emerge that offer little or no benefit to the vast majority of
consumers. Double-cycle billing, for example, is a practice in the credit card industry that is
so complex that few consumers can fully understand the implications of this practice, even in
the presence of full disclosure. Generally speaking, institutions using this practice assess
interest not only on the balance for the current billing cycle, but also on the balance for the
preceding billing cycle. The Board has conducted extensive consumer testing of various
ways to describe this balance computation method and found that disclosures are not
successful in helping consumers understand it. In such cases, improving information
disclosure alone may not adequately address the issue. Consequently, the goal of consumer
protection may be most effectively realized, weighing the potential costs and benefits, if
certain product features are modified by rule or prohibited outright rather than disclosed.
Current challenges and the Federal Reserve's regulatory proposals
In today's vast and complex consumer finance marketplace, we face the challenge of
ensuring that disclosures for consumer credit remain effective in light of the growing
complexity of consumer credit products and terms. We also face the challenge of identifying
when restrictions and prohibitions are appropriate to ensure meaningful consumer protection
and do not involve unintended consequences that could ultimately reduce consumer welfare.
With the increased complexity of mortgage loans and credit cards in recent years, for
example, there has been great concern about the need for more-effective disclosure and
increased consumer protection in these transactions. The Federal Reserve has undertaken
extensive efforts to gain insight into industry practices and consumer experiences to
understand how to improve disclosures when possible and to enhance consumer protections
where needed.
With respect to mortgage lending, we have been working to finalize the rules under the
Home Ownership and Equity Protection Act that we proposed in December. In developing
this proposal, we gained valuable insight through public hearings, discussions with industry
and consumer groups, input from our Consumer Advisory Council, and other sources. The
amendments we have proposed would better protect consumers from a range of unfair or
deceptive mortgage lending and advertising practices that have been the source of
considerable concern and criticism. Our proposal includes key protections for higher-priced
mortgage loans secured by a consumer's principal dwelling. Specifically, the proposal
addresses concerns about underwriting and lenders' consideration of the borrower's ability to
make the scheduled payments, including verifying the income and assets that lenders rely
upon in making the loan. The proposal also addresses concerns about prepayment penalties
and the impact on consumers when lenders fail to establish escrow accounts for taxes and
insurance. We are working toward issuing final regulations in July.
For credit cards, the Federal Reserve has employed a two-step strategy toward improving
consumer protection. Our first step was the Board's proposal to substantially revise and
improve credit card disclosures under the Truth in Lending Act. We have done extensive
consumer testing to determine the type of information and its format that consumers find
most useful in shopping for and choosing a credit card. We issued this proposal last year,
and we are still carefully considering the public comment letters received on that proposal,
many of which contain suggestions for how we might further improve the disclosures. We
believe that this proposal will result in credit card disclosures that are significantly more
effective for today's complex products. Testing disclosure forms and formats with credit card
users is crucial to ensuring that the disclosures are understandable and useful to consumers.
Effective disclosures can help to empower consumers and enhance the competition because
consumers find it easier to comparison shop. We are continuing to use consumer testing as
we work toward issuing final rules by year-end.
This extensive consumer testing - and the thousands of public comments generated by our
2007 credit card proposal - suggested that disclosures might not provide sufficient consumer
protection with regard to certain practices. Therefore, in May we took the next step in our
ongoing effort to enhance protections for consumers who use credit cards by proposing rules
under the Federal Trade Commission Act to prevent financial harm to consumers from
specific practices. We proposed rules that go beyond disclosure and could require financial
institutions to make changes to their business models and to alter some practices.
The Board has worked jointly with the Office of Thrift Supervision and the National Credit
Union Administration in drafting and issuing a proposal intended to prevent financial harm to
consumers from specific practices that the agencies find to be potentially abusive. Among
other things, the proposed rules would address the following:
•
Creditors would be required to provide consumers a reasonable amount of time to
make payments before they are considered late.
•
As a general rule, for accounts having multiple interest rates for different balances,
creditors would be prohibited from maximizing interest charges by applying
payments exceeding the minimum to the lowest rate balance first.
•
Creditors would no longer be permitted to increase the interest rate on existing
account balances at any time for any reason. Instead, card issuers could only apply
a higher rate to the existing balance under limited circumstances, such as when a
consumer has been delinquent for 30 days. Of course, creditors could still increase
the rate on new transactions and could offer variable-rate cards that have the rate
on existing balances adjust based on changes to an index.
•
Creditors could no longer accrue finance charges using the two-cycle balance
computation method.
The rules also prohibit a practice associated with the issuance of some subprime credit
cards, in which most of the credit limit is used for security deposits and high fees imposed at
account opening before the consumer actually receives the card.
In addition to rules for credit cards, our proposal also addresses potentially abusive practices
in connection with banks' payment of overdrafts to ensure that consumers have a choice of
obtaining overdraft protection and receive information related to its service and costs.
Conclusion
A robust, innovative, and competitive consumer finance market is crucial to a healthy
economy and, as I described earlier, can provide significant benefits to consumers. Such a
market works most effectively and brings the greatest benefits when consumers are
wellinformed and are not subject to abusive practices. The Federal Reserve is working diligently
to best use its authorities to provide both creditors and consumers with rules that strike the
right balance between ensuring that consumers receive useful information at an appropriate
time and restricting certain practices, while at the same time minimizing the risk of
unintended consequences and the imposition of unnecessary costs that could reduce the
benefits of a vital consumer finance marketplace.