Consumer Financial Protection.

The recent financial crisis has led many to question how well businesses deliver services and how well regulatory institutions address problems in consumer financial markets. This paper discusses consumer financial regulation, emphasizing the full range of arguments for regulation that derive from market failure and from limited consumer rationality in financial decision making. We present three case studies—of mortgage markets, payday lending, and financing retirement consumption—to illustrate the need for, and limits of, regulation. We argue that if regulation is to be beneficial, it must be tailored to specific problems and must be accompanied by research to measure the effectiveness of regulatory interventions. Over the past 65 years, financial innovation has presented U.S. households with an everwidening set of financial options from an expanding set of firms and accompanied by a sometimes dizzying amount of information. At the same time, consumer finance has increasingly become a “do-it-yourself” activity (Ryan, Trumbull and Tufano, 2010). Households are expected to make decisions about pension plan contributions and payouts, to choose from a wide array of credit instruments to fund everything from home purchase to short-term cash needs, and more generally to assume a greater level of responsibility for their financial well-being. All the traditional, market-failure-based justifications for regulation apply to consumer financial markets. In addition, consumer autonomy with respect to more, and more important, financial decisions poses special public policy concerns in light of the mounting evidence that consumers do not always behave as time-consistent, rational utility maximizers. For example, many consumers appear to have present-biased preferences, which lead them to favor present consumption even though they would display greater patience if they could commit to a plan of savings and future consumption. Some consumers may lack the cognitive capacity to optimize their financial situation, even if presented with all the information that in principle is required to do so. Such biases and cognitive limitations may be particularly important in the financial context because learning from experience in major financial decisions is difficult. Many financial decisions like choosing a mortgage or investing a retirement account are undertaken only infrequently. Moreover, the outcomes of these decisions are delayed, perhaps for decades, and are subject to large random shocks, so that personal experience is slow to accumulate and is contaminated by noise. It can also be difficult to learn about financial decisions from the experiences of others. Financial shocks are often correlated across individuals, so that averaging the experience of neighbors or acquaintances may not eliminate noise. The rapid pace of financial innovation reduces the relevance of older cohorts’ experiences. Social taboos on discussing personal finances further reduce the effectiveness of social learning (Zelizer, 1994). In the next section, we argue that these considerations provide a rationale for consumer financial protection that goes beyond the standard market failures, both because unregulated financial markets may be inefficient and because they may generate undesirable distributional outcomes. We then use three case studies—of mortgage choice, payday lending, and retirement saving—to explore these issues. Finally, skepticism about consumers’ ability to understand and use financial products is an important motivation for the Consumer Financial Protection Bureau authorized in legislation passed in the summer of 2010. We conclude by proposing an agenda for the new Bureau, taking into account some potential limits to its regulatory effectiveness.