Randall S Kroszner: Creating more effective consumer credit disclosures
Remarks by Mr Randall S Kroszner, Member of the Board of Governors of the US Federal Reserve
System, at the George Washington University School of Business, Financial Services Research
Program Policy Forum, Washington DC, 23 May 2007.
* * *
Information is critical to the effective functioning of markets. A core principle of economics is that
markets are more competitive, and therefore more efficient, when accurate information is available to
both consumers and suppliers. When information on alternatives is readily available, product offerings
will have to meet customers' demands and offering prices will have to reflect those of market
competitors.1 In addition, information helps individual consumers by improving their ability to compare
products and to choose those that will help them meet their personal goals.
These arguments are not just theoretical. There is systematic evidence that in practice, changes in
disclosure affect both consumer and supplier behavior in a number of consumer product markets.2 In
1968, Congress passed the Truth in Lending Act (TILA), which significantly changed a number of
consumer credit disclosure practices. For example, it required that creditors disclose an "annual
percentage rate." These disclosures are generally believed to have improved competition and helped
individual consumers.3
Today, we face the challenge of ensuring that disclosures for consumer credit remain effective. To be
effective, disclosures must give consumers information about credit pricing at a time when it is
relevant, and in language consumers can easily understand. The information must also be 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 disclosure
permits better-informed credit decisions and, hence, more effective competition among credit card
issuers. In a nutshell, effective disclosure empowers consumers and enhances competition.
The Federal Reserve Board has recently undertaken an innovative approach to improve the
effectiveness of disclosure - namely, surveying and responding to consumers through consumer
testing. Having taught at a business school for many years, I am well aware of the types of consumer
testing that firms have long employed: surveys, focus groups, and so-called "mall intercepts" in which
shoppers are interviewed at random. Systematically using such techniques to improve the
effectiveness of disclosure requirements set out in the regulations of the Federal Reserve and other
financial regulators, is, however, relatively novel.
Consumer testing can help the Federal Reserve address the considerable challenge of making
disclosures more effective. Consumers increasingly face more-diverse and more-complex financial
products, including nontraditional mortgages and credit cards with multiple features. Given this
complexity, we have to be mindful of the dangers of information overload. We must seek to carry out
the responsibilities Congress has given us to design disclosures that are not only accurate, but also
clear and simple enough that they are meaningful and useful to consumers.
In other words, pages and pages of fine print may provide comprehensive descriptions that lawyers
might love but that consumers find confusing, or, worse, useless. We need to translate legalese into
something consumers can use. This requires the Board to make judgments about which credit terms
are most important to highlight and which could be eliminated. However, we plan to make these
judgments with the benefit of feedback from actual consumers gathered through surveys and testing.
We recently completed several rounds of consumer testing for credit card disclosures, and that testing
was critical to our effort to redesign and, I believe, dramatically improve those disclosures.
Just this morning, the Board took a major step toward making credit disclosure more effective, by
voting to seek public comment on proposed revisions to the Board's Regulation Z, which implements
the Truth In Lending Act - revisions that will improve credit card disclosures. I will share with you some
of the results of our consumer testing, how they influenced our newly issued proposal concerning
credit card disclosures, and how consumer testing will influence future proposals for improvements of
mortgage loan disclosures.
The Board's recent actions related to mortgage loan disclosures
First, however, I want to note that the Board has already taken some steps to improve disclosures
concerning mortgages, including subprime mortgages, which is the topic of this forum. Last summer,
the Board held a series of four public hearings on home-equity lending, where we gathered views on
the impact of federal and state predatory lending laws and on the adequacy of mortgage disclosures,
particularly those concerning nontraditional mortgage products. Following those hearings, the Board
revised the consumer handbook that creditors are required to provide with applications for
adjustablerate mortgages, or ARMs. As you well know, a substantial majority of recent subprime mortgage
originations have been ARMs. The revised handbook gives consumers a better explanation of the
features and risks of nontraditional ARMs, especially "payment shock" and the risk of increasing loan
balances, also known as "negative amortization."
The Board will be holding a fifth hearing on June 14, here in Washington, D.C., and I will chair that
meeting. We will focus on how the Board might use its rulemaking authority under the Home
Ownership and Equity Protection Act, or HOEPA, to address concerns about abusive mortgage
lending practices.
The purpose of the hearing is to gather information to evaluate how the Federal Reserve can prevent
predatory lending in a way that also preserves incentives for responsible lenders. A robust and
responsible subprime mortgage market benefits consumers by allowing borrowers with non-prime or
limited credit histories to become homeowners, access the equity in their homes, or have the flexibility
to refinance their loans as needed. Following the hearing, we will consider whether there are lending
practices that should be prohibited under HOEPA. The Federal Reserve will do all that it can to
prevent fraud and abusive mortgage lending practices. However, any new rules should be drawn
clearly to avoid creating legal or regulatory uncertainty that could have the unintended consequence of
restricting consumers' access to responsible subprime credit.
As I mentioned earlier, effective disclosure can make markets more competitive and weed out abuse.
Therefore, we will also consider how mortgage disclosures can be improved to ensure a robust
subprime market and responsible subprime lending. In fact, the Board is conducting a comprehensive
review of all Truth in Lending Act disclosures. As the Board reviews mortgage disclosures, it will
consider a variety of recent suggestions. For example, given the large volume of documents presented
to consumers at mortgage loan closings, the Board will consider whether creditors should be required
to provide disclosures for home-refinance loans and home-equity loans within three days of application
instead of at consummation, as currently required for home-purchase loans. The Board will also
review the requirements concerning advertisements, to ensure that when lenders promote low initial
rates and low monthly payments they also adequately disclose the limits of those low rates and
payments and the potential payment shock. Our review of mortgage disclosures is now under way.
I would now like to turn to the initial phase of the Board's review of credit disclosures, which has
focused on credit cards and other revolving credit accounts. The substantial investment we have made
in developing and testing revised credit card disclosures has given us insights that will surely
contribute to our ability to make mortgage disclosures more effective.
The challenges of disclosing credit card costs
In our effort to create more effective credit card disclosures, we face several challenges. First,
disclosing the cost of revolving credit to facilitate consumer shopping is inherently challenging because
key variables are not known in advance, such as the amount of credit that the consumer will use and
the timing and amount of the consumer's payments. Creditors' solicitations disclose only a nominal
APR based on the periodic interest rate, and they list any fees separately. Related variables, such as
the grace period and balance calculation method, also have to be explained. On periodic billing
statements, an "effective APR" can be disclosed after the credit is extended, but even then
assumptions must be made about the consumer's payments. For example, the effective APR assumes
that transaction fees are amortized over one billing cycle, regardless of how long the credit is actually
outstanding.
The increasing complexity and diversity of credit card features and pricing present a second challenge.
Because creditors use risk-based pricing, their solicitations might disclose a range of possible rates for
which the consumer could qualify. Creditors discount their initial interest rates, sometimes deeply.
While competing on the initial rate, creditors compensate with "back-end" pricing.4 Temporary
introductory rates are followed by a higher rate, and penalty rates and fees have increased and are
now easier to trigger. Consumers might not focus on costs that are contingent on future events, and it
can be challenging to explain clearly how these contingencies can increase consumers' costs.
A third major challenge is crafting disclosure rules that are, on the one hand, clear and specific enough
to facilitate compliance and promote consistency among creditors but, on the other hand, flexible
enough to accommodate market developments as products and pricing continue to change. We have
a responsibility to avoid undue burdens that would hinder innovation and raise costs without producing
sufficient offsetting benefits in the credit card market.
Faced with these developments, the Board's challenge is to determine what information should be
highlighted for consumers. How much information is enough, and how much is too much? How can we
encourage plainer language, recognizing that there may be a trade-off between simplicity and
accuracy? What formats work best in presenting the information? When is the best time to present
information so it will be most relevant and useful to consumers? How can we craft disclosure
requirements that are flexible enough to accommodate innovation and change and to enhance
competition?
Using consumer testing to improve credit card disclosures: highlights of the proposal and
lessons learned
Although the Board has used consumer focus groups in the past, this is the first time that we have
conducted extensive, in-depth interviews with individual consumers to study the effectiveness of
disclosures. The first step was using both focus groups and one-on-one interviews to evaluate how
well consumers understand and use the current credit card disclosures. With a consultant's help, we
then redesigned the disclosures and conducted more one-on-one interviews using the revised formats.
We went through this process several times, each time adjusting our designs to incorporate the
lessons learned. We plan to follow the same testing process with mortgage disclosures. In addition,
there were other sources of information, such as public comment letters and informal input from
industry and consumer groups, discussions by the Board's Consumer Advisory Council, a study by the
Government Accountability Office, and data from consumer surveys.
As I noted earlier, our task is to take a complex credit product and design disclosures that can explain
the terms not only accurately but also clearly enough to be meaningful and useful to consumers - all
while enhancing, not stifling, competition and innovation. I will briefly describe the highlights of the
proposal issued by the Board this morning and use them to illustrate some general lessons we have
learned about making disclosure more effective for consumers.
First, we learned firsthand what information consumers find useful when making credit decisions and
what information they ignore. Second, we learned what information consumers comprehend and what
information they do not. Third, we saw the impact that different formats and presentation can have on
consumers' ability to notice and use the information.
The first significant lesson from our consumer testing was that there are some disclosures that
consumers just do not find useful. Most participants acknowledged that they do not read the
cardholder agreements that contain their account-opening disclosures because they are often written
in small print and dense prose. At the same time, they wanted some sort of disclosure they could use,
before opening an account, to confirm that the terms are what they expect. Participants also said that
often they do not carefully read their change-in-terms notices because they are frustrated by the
format and technical language.
With this information in hand, we explored how we could improve the disclosures to change consumer
behavior. Under the proposed rules, when an account is opened, the consumer would receive a
summary of the credit agreement in the form of a table, which they can compare with the original
solicitation.
Creditors would also have to provide a disclosure table with their change-in-terms notices, to
summarize the changes. In our tests, such a table was very effective in making the change-in-terms
notice more usable, and consumers were more likely to correctly identify the changes to the terms of
their accounts. The Board's proposal also would require creditors to give consumers more advance
notice before increasing the interest rate or making changes to other key terms. Creditors would have
to send a notice to consumers 45 days in advance of a rate increase, compared with the current 15
days. The intent is to give consumers more time to make other credit arrangements, if necessary,
before the higher rate becomes effective. The Board is expressly seeking comment on whether 45
days is the appropriate amount of time.
The second lesson learned from our consumer testing was which disclosures consumers comprehend
and which they do not. Before deciding that the core information was not useful, we explored other
ways to explain complex information and to improve consumers' understanding. We explored whether
consumers would benefit from using different terminology or whether particular terms need to be
accompanied by an explanation. This is a particular challenge in the case of the term "effective APR."
We experimented with terminology and explanatory language as well as formats. The proposed
changes for disclosing the effective APR have shown promise, but this is an area where we will be
conducting additional consumer testing.
The test participants also often did not correctly understand what creditors meant by the term "fixed
rate." They equated this with the fixed rate on their mortgage. Thus, under the proposed rules we
would allow creditors to describe their rates as "fixed" only if there is a specified period during which
the rate cannot be increased for any reason. If no period is specified, the term "fixed" could be used
only if the rate cannot increase while the credit plan is open.
Consumers in our tests also did not understand the term "default APR." We would therefore require
creditors to refer to the "penalty APR" rather than the "default APR," which improved consumer
understanding in our tests. Consumers also did not consistently understand the term "grace period,"
which is significant considering the cost implications of not paying on time. Based on language we
tested with consumers, we are proposing to add an explanation of the term.
The third lesson of our consumer testing was the impact that different formats and presentation can
have on consumers' ability to notice and use the information. Our testing confirmed that one of the
most effective ways to present credit card disclosures is in the table provided with solicitations,
commonly known as the "Schumer box." Although this table is effective, we were nevertheless able to
use the one-on-one interviews to improve both the content and format. For example, when a creditor
uses risk-based pricing, solicitations may show a range of rates, and many test participants had
trouble understanding how a card issuer would select an initial APR. We are therefore proposing to
add a simple explanation that consumers' initial rate is based on their creditworthiness. We also
reformatted the Schumer box into two major sections, to separate information about rates from the
information about fees. This seemed to enhance consumers' understanding and improve the usability
of the disclosures.
In addition, disclosures inside the Schumer box were more readily noticed than when the same
information was placed just beneath it. We propose to move information that was more important to
consumers - such as the circumstances that trigger a penalty APR - inside the Schumer box. The
creditor's balance-calculation method, however, was removed and located beneath the Schumer box,
because our testing showed that consumers do not use the information to shop.
A related finding concerning format is that regrouping information in the Schumer box improved
consumers' ability to use the disclosures. Specifically, we found that grouping certain information
together on periodic statements made it easier to understand. For example, consumers more easily
determined the number and amount of fees when they were itemized, grouped together, and totaled.
So the revised rules would require creditors to locate the fees and interest charges in one place on the
statement. Fees would have to be grouped together with a total dollar amount instead of listed
chronologically with purchase transactions, as they are today. Interest charges would also be grouped
together, with a total dollar amount.
Finally, most consumers said that they throw away any inserts included with their periodic statement,
including any inserts that describe changes to their account terms. To alert consumers to the
significance of the insert, creditors that insert a change-in-terms notice with the periodic statement
would have to summarize the changes on the front of the periodic statement rather than on the insert.
Similar challenges in improving mortgage disclosures
As I mentioned earlier, the Board also plans to conduct consumer testing as part of its review of
mortgage disclosures. Like credit cards, mortgage products have become more diverse and more
complex. In some cases, creditors are using pricing strategies similar to those used for credit cards,
for example, offering customers discounted introductory rates that will be replaced in a short time by a
much higher rate, often a variable rate. Of course there is an inherent difficulty in adjustable-rate
mortgage disclosures because future interest rate changes are not known. Consumer testing is
needed to determine whether consumers would find disclosure of the maximum rate and a worst-case
payment example useful, given that these might not occur for several years or more and that the
consumer's own financial circumstances may change.
The wider marketing of payment-option mortgages presents another challenge. Consumers have the
choice of making low minimum monthly payments that increase the overall cost of the credit and may
ultimately lead to longer amortization periods. Just as with credit cards, however, disclosing a
consumer's repayment obligation and the cost of the credit is more complex when there are unknowns
- such as the rate, the amount of the consumer's monthly payment, and the possibility of negative
amortization. When the Board reviews mortgage disclosures, it will consider these developments and
conduct consumer testing to determine how the features and risks of today's mortgage products can
be communicated effectively.
The Board's upcoming hearing on mortgage lending practices
As I mentioned earlier, in June the Board will be conducting another public hearing on mortgage
lending, which will focus on how the Board might use its rulemaking authority to prevent abusive
lending. Some of these concerns may call for more-effective disclosures.
Last year, the federal agencies that supervise depository institutions issued guidance on nontraditional
mortgage products, and they recently proposed similar guidance for subprime mortgages. Both
guidance statements discuss underwriting practices as well as the need for lenders to give consumers
more complete and balanced information while they are still shopping for a mortgage, before they
apply for the loan.
Prepayment penalties as well the use of "stated-income" or "low-doc" loans will also be discussed at
the upcoming hearing. We will hear arguments about such practices and consider whether disclosures
can be made more effective to adequately inform consumers about how penalty clauses operate and
the implications of not documenting their income.
Conclusion
In fulfilling its responsibility to protect consumers, the Federal Reserve will do all that it can to prevent
fraudulent and abusive mortgage lending practices. Because information is critical to more
competitive, and thus more efficient, markets, effective disclosure also has the capacity to weed out
abuses. Consumers who do not have accurate information and an understanding of what that
information means will have difficulty choosing among competing products and making decisions that
are in their best interest. This is true in both credit card and mortgage markets. Accordingly, we will
consider how mortgage disclosures can be more effective and empower consumers to make
betterinformed decisions and achieve their financial goals. Better-informed consumers will strengthen
market competition. The Federal Reserve also will consider how we might use our rulemaking
authority to address predatory practices without restricting consumers' access to responsible subprime
credit.
By using consumer testing systematically, the Federal Reserve is taking an innovative approach to
revising its regulations and improving the effectiveness of disclosures. We are finding that it is
tremendously beneficial to listen to consumers so that we can learn more about how they use
information and how we can simplify disclosures and enhance consumers' understanding. Surely, the
lessons we have already learned from consumer testing for credit cards will also help us improve
mortgage disclosures and contribute to a more robust, competitive, and responsible subprime market.