Financial Consumer Protection Agency Necessary

A watchdog to aid borrowers in weighing up the riks would avoid repetition of the current crises writes Bill Hobbs

What sense if any can be made from the lessons of the banking crisis and the fundamental change in use of debt by ordinary people? Is there a need for a new form of consumer protection that protects consumers from themselves and from banks and other financial service firms’ excessive market power and risky innovation?

Discussion on the banking crisis has largely focussed on the role bankers played in making far too much credit available to too many people who ought not to have borrowed the amounts they did. But what made so many people borrow so much and take on such high risks? For sure bankers were at fault in abusively marketing credit. But human behaviour and those that encouraged a change in how people used debt were equally at fault.

We live in a society that promotes the notion of consumer sovereignty which holds that ordinary people who have reasonable access to relevant information are the best judges of what will promote their own welfare. It is a form of anti-paternalism which sits at the heart of our economic model and policy maker’s attempts to engineer consumer behaviour in desired directions. Take for example the emphasis on ordinary people taking responsibility for their own careers and financial futures in providing for their own health care and retirement. Gone are the days when the social welfare state promised the job for life and provided a financial safety net for its citizens. The modern social contract requires people to live two conflicting lives – the current self and future self.

Rarely discussed this conflict between the current and future self is important to understand, as it is central to appreciating how people use money more especially its most dangerous form – bank credit. Satisfying the current self through borrowing today effectively locks in future income and exposes many people to excessive financial vulnerability. Yet few ordinary people realise they are being manipulated by powerful forces that engineer the availability of bank credit and promote its use. Fewer still appreciate how their own and collective patterns of human behaviour draw them into debt traps which in hindsight should have been obvious.

Some of these human behaviours include; using heuristics or rules of thumb such as “property investment is a safe bet”; suffering myopia or short sightedness; herding, where people collectively move in the one direction. As individuals, people are highly prone to over optimism believing they are not as exposed to a negative outcome as the average person is. People also tend to underestimate risks to themselves. These are but some of the behaviours present in how individuals and groups use money and debt. Faced with complex sophisticated financial products, people use mental shortcuts leading to predictable mistakes. Those who at the height of the boom, borrowed to invest in overpriced property at unsustainable rent levels demonstrated two of the most enduring of human behaviours – over optimism and underestimation of risks.

Central to Government policy and bank regulatory thinking is the idea that the rational informed educated consumer will take time to assess all available options and select the optimal one for their circumstances. It’s believed this process will result in a form of meta-regulation where consumers acting en-masse will pressurise banks to behave themselves and provide quality products at reasonable prices.

But providing people with more information and educational support has proven to be largely ineffective. People have been shown to have an insufficient ability to accurately process information they have in so far as it bears on their own risks – having information doesn’t imply optimal behaviours, judgements or decisions in using debt.

Rather a new approach is evolving that recognises three things : regulation is imperfect, consumers are not financially literate and financial service firms will either lean towards their customers or away from them – in other words suit themselves when it comes to making products available.

If it is accepted that a new approach is required to protect consumers from themselves and from banks which would exploit consumer behaviour, then a different model of consumer protection emerges – one where products themselves are regulated and licensed as being safe and sound for consumer use.

At the forefront of this thinking is Professor Elizabeth Warren who has long advocated for product licensing and is now heading up the new US Financial Consumer Protection Agency. Professor Warren says we don’t expect our TV’s to explode in our living rooms – consumer safety standards ensure they are safe. She asks why we should accept unsafe financial products? Here in Ireland many people who were aggressively marketed credit and investment products have justifiable cause to question the safety of the products they were being enticed to buy.

Banks and others who argue that product licensing will stifle innovation miss the point. Innovation is good when it benefits consumers but bad when it exposes them and banks to undue risks. Banks innovate not to provide greater value to people but to extract more value from people’s wallets.

If as believed, banking will become a utility – then why the need to market sophisticated, complex products few people understand and are sold by advisors who don’t actually understand the products themselves?

Consumerism needs one important ingredient to make it work – bank credit. And without bank credit, modern economies misfire and fail to work as is happening here. Fixing the banking system requires a reformed central bank and regulatory authority to monitor individual bank risk and overall system risk. As banking consolidates, fewer larger banks will restrict consumer choice for some time to come. Balancing the market dominance and power of banking requires an agency charged with acting in the best interests of consumers. What is needed is a properly constituted financial consumer protection agency with powers to set and police safety standards for consumer products.