Discerning financial documents as important as disclosure
Despite all reports to the contrary, I have not suspended my campaign for national personal financial benevolent dictator.
In fact, today I add a new plank to my platform: regulation through comprehension, rather than disclosure. I’ll unpack what I mean by that below.
I’m in the process of renewing the home equity line of credit, or HELOC, on my house.
As you can imagine, my mailbox and email box are filled to the brim with dozens upon dozens of disclosure documents for my signature. These are virtually unreadable, and they will go unread by me. Nevertheless, I will sign them.
Lauren Willis, a law professor whose criticism of financial literacy programs I recently described admiringly, has a replacement for these disclosure documents, and I’ve stolen her idea for my platform.
She argues in a 2017 paper, “The Consumer Financial Protection Bureau and the Quest for Consumer Comprehension,” that financial products regulation should focus less on disclosure and more on creating a system of consumer comprehension.
Here’s what she means. Financial service providers — of credit cards, insurance, investments and mortgages — would need to regularly show to regulators that a large majority of their customers could pass a simple comprehension test about their product.
Placing the burden on financial firms to stay consumer-compliant is analogous to requiring car companies to prove they can meet emissions standards or toy manufacturers to adhere to child safety standards.
Willis’ point: Disclosing terms in tiny print over 30 pages never helps. It puts the burden on the consumer. Instead, the burden should be on the firm to show — with a consumer comprehension audit — that customers know what they are buying. After all, wasn’t that the point of these ineffective disclosures in the first place?
Our default system is free market. And I’m a free markets guy. I like classical economics’ trust that prices and quantities will reach equilibrium as long as we minimize frictions such as taxes and government interference. Few people will purchase a $10 tomato when a $1 one is available, says classical economics. Firms able to offer $1 tomatoes will sell many more units than a purveyor of Gucci tomatoes.
But the past 40 years of behavioral finance has taught us that classical equilibrium theory doesn’t work as well in areas such as personal finance because of predictable inherent biases and errors of thought. As a result, people are unknowingly purchasing $10 tomatoes when they should, logically, be buying $1 tomatoes.
And, yes, regulation like this would be expensive to firms. But the alternative is not free market efficiency. The alternative is people paying for $10 tomatoes out of predictable ignorance.
One objection: Some people just can’t be taught because math is hard. And financial concepts are especially hard. OK, true. But Willis’ proposal focuses on setting a target for average comprehension. Like maybe just 70 percent of customers have to pass the “comprehension audit.” Not everyone, just a good majority. That seems reasonable and flexible to me.
Another objection: Comprehension seems costly for firms, as they would be required to create educational programs around their products. Maybe. But wouldn’t it also seem that firms facing the potentially high cost of consumer education would be greatly incentivized to simplify these same financial products? Wouldn’t firms pivot toward selling things that any fifth grader could understand?
I am certain, for example, that variable annuities would rightly disappear from the face of the earth if insurance companies were forced to educate consumers about how they actually work. Because, quite simply, they cannot be explained in simple terms.
You know what else is costly? About 25 percent of subprime mortgage borrowers defaulting in the same year, sending the world financial system into a tailspin and requiring a huge bailout of Wall Street.
Another objection: True financial complexity cannot be captured in short consumereducation segments. Willis addresses this by analogy with energy-efficiency regulation. Simple labeling with stars currently informs consumers of energy-efficient dishwashers and refrigerators. I don’t have to be an electrical engineer to understand the energy-efficiency star system. I just need to know enough about what the Energy Star label on my dishwasher means.
A simple and consistent labeling system for credit cards, mortgage and investment products could go a long way toward building consumer comprehension.
This is a results-oriented approach to regulation.It’s about proving — with reasonable room for variation — that people using the products actually know what they’re getting and at what price.