mitigating the "scalability of bad practices" in consumer finance
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Mitigating the “Scalability of Bad Practices” in Consumer Finance
Raj DateExecutive Director, Cambridge Winter Center
Conference on Regulating Consumer Financial ProductsFederal Reserve Bank of New YorkJanuary 6, 2010
CAMBRIDGE WINTER CENTERfor Financial Institutions Policy
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CONSUMER PRODUCT REGULATION IS AT THE CORE OF EFFECTIVE FINANCIAL REGULATORY REFORM
Management Consumers
At the core:Atomized, arm’s length
private sector transactions
Positive risk bias
Positive risk bias
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CONSUMER PRODUCT REGULATION IS AT THE CORE OF EFFECTIVE FINANCIAL REGULATORY REFORM
Management Consumers
At the core:Atomized, arm’s length
private sector transactions Equity Markets discipline management risk-taking(Boards of Directors)Positive
risk biasPositive risk bias
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CONSUMER PRODUCT REGULATION IS AT THE CORE OF EFFECTIVE FINANCIAL REGULATORY REFORM
Management Consumers
At the core:Atomized, arm’s length
private sector transactions Equity Markets discipline management risk-taking(Boards of Directors)
Debt Markets discipline Boards’risk-taking(Rating Agencies)
Positive risk bias
Positive risk bias
![Page 5: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/5.jpg)
CONSUMER PRODUCT REGULATION IS AT THE CORE OF EFFECTIVE FINANCIAL REGULATORY REFORM
Management Consumers
At the core:Atomized, arm’s length
private sector transactions Equity Markets discipline management risk-taking(Boards of Directors)
Debt Markets discipline Boards’risk-taking(Rating Agencies)
Regulators discipline all other actors (Prudential & Systemic Regulators)
Positive risk bias
Positive risk bias
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REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
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REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
![Page 8: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/8.jpg)
REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
- Bad for consumers• The “grandmother” test• Transparency, fairness, suitability
![Page 9: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/9.jpg)
REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
- Bad for consumers• The “grandmother” test• Transparency, fairness, suitability
- Bad for investors
![Page 10: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/10.jpg)
REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
- Bad for consumers• The “grandmother” test• Transparency, fairness, suitability
- Bad for investors
•What enables this scalability of bad practices?
![Page 11: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/11.jpg)
REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
- Bad for consumers• The “grandmother” test• Transparency, fairness, suitability
- Bad for investors
•What enables this scalability of bad practices?
- Broken ethics
![Page 12: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/12.jpg)
REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
- Bad for consumers• The “grandmother” test• Transparency, fairness, suitability
- Bad for investors
•What enables this scalability of bad practices?
- Broken ethics
- Broken value transparency
![Page 13: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/13.jpg)
REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
- Bad for consumers• The “grandmother” test• Transparency, fairness, suitability
- Bad for investors
•What enables this scalability of bad practices?
- Broken ethics
- Broken value transparency
- Broken funding market feedback
![Page 14: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/14.jpg)
REGULATING CONSUMER FINANCE IS HARD BECAUSE OF “THE SCALABILITY OF BAD PRACTICES”
• “Bad” products quickly crowd out “good” ones
- Bad for consumers• The “grandmother” test• Transparency, fairness, suitability
- Bad for investors
•What enables this scalability of bad practices?
- Broken ethics
- Broken value transparency
- Broken funding market feedback
Information Asymmetry
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INFORMATION ASYMMETRY HELPS BAD PRODUCTS TO CROWD OUT GOOD ONES
SALES UNDERWRITING SERVICING FUNDINGCUSTOMER
Example(“traditional”
bank loan)
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INFORMATION ASYMMETRY HELPS BAD PRODUCTS TO CROWD OUT GOOD ONES
SALES UNDERWRITING SERVICING FUNDINGCUSTOMER
•Small business
•Community bankExample
(“traditional” bank loan)
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INFORMATION ASYMMETRY HELPS BAD PRODUCTS TO CROWD OUT GOOD ONES
SALES UNDERWRITING SERVICING FUNDINGCUSTOMER
•Home buyer
•Mortgage broker
•Bank •ABS markets
•CDO markets
Example(ABS-funded
option-ARMs)
•Third-party servicer
•Small business
•Community bankExample
(“traditional” bank loan)
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INFORMATION ASYMMETRY HELPS BAD PRODUCTS TO CROWD OUT GOOD ONES
SALES UNDERWRITING SERVICING FUNDINGCUSTOMER
Asymmetry #1Broker’s Information Advantage vs Consumer
•Home buyer
•Mortgage broker
•Bank •ABS markets
•CDO markets
Example(ABS-funded
option-ARMs)
•Third-party servicer
•Small business
•Community bankExample
(“traditional” bank loan)
![Page 19: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/19.jpg)
INFORMATION ASYMMETRY HELPS BAD PRODUCTS TO CROWD OUT GOOD ONES
SALES UNDERWRITING SERVICING FUNDINGCUSTOMER
Asymmetry #1Broker’s Information Advantage vs Consumer
•Home buyer
•Mortgage broker
•Bank •ABS markets
•CDO markets
• Result: Consumers . . .- Overestimate own credit-worthiness- Underestimate all-in cost and risk- Borrow and pay more than they
otherwise would- Systematically favor teaser rates, gimmicks‣Bad product drives out good
• New approach: “LA Restaurant Grades”
Example(ABS-funded
option-ARMs)
•Third-party servicer
•Small business
•Community bankExample
(“traditional” bank loan)
![Page 20: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/20.jpg)
INFORMATION ASYMMETRY HELPS BAD PRODUCTS TO CROWD OUT GOOD ONES
SALES UNDERWRITING SERVICING FUNDINGCUSTOMER
Asymmetry #1Broker’s Information Advantage vs Consumer
•Home buyer
•Mortgage broker
•Bank •ABS markets
•CDO markets
• Result: Consumers . . .- Overestimate own credit-worthiness- Underestimate all-in cost and risk- Borrow and pay more than they
otherwise would- Systematically favor teaser rates, gimmicks‣Bad product drives out good
• New approach: “LA Restaurant Grades”
Asymmetry #2Risk Seller’s Information Advantage vs Buyer
Example(ABS-funded
option-ARMs)
•Third-party servicer
•Small business
•Community bankExample
(“traditional” bank loan)
![Page 21: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/21.jpg)
INFORMATION ASYMMETRY HELPS BAD PRODUCTS TO CROWD OUT GOOD ONES
SALES UNDERWRITING SERVICING FUNDINGCUSTOMER
Asymmetry #1Broker’s Information Advantage vs Consumer
•Home buyer
•Mortgage broker
•Bank •ABS markets
•CDO markets
• Result: Consumers . . .- Overestimate own credit-worthiness- Underestimate all-in cost and risk- Borrow and pay more than they
otherwise would- Systematically favor teaser rates, gimmicks‣Bad product drives out good
• New approach: “LA Restaurant Grades”
• Result: - Dubious loans get funded- Breakdown in feedback loop from credit
performance to origination standards- Originate-to-sell-garbage less capital intensive
than originate-to-hold-quality‣Bad product drives out good
• New approach: Risk Retention Requirements
Asymmetry #2Risk Seller’s Information Advantage vs Buyer
Example(ABS-funded
option-ARMs)
•Third-party servicer
•Small business
•Community bankExample
(“traditional” bank loan)
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NEW RISK RETENTION REQUIREMENTS SHOULD BE IMPLEMENTED ON TWO DIMENSIONS
Potential Risk Retention Framework and Examples
• Twin objectives: - Prevent breakdown of
performance-to-origination feedback loop . . . but- Preserve liquidity throughout
capital structure
• Not all products & channels are created equal
• Not all market-driven structures were broken (e.g. credit card residuals)
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NEW RISK RETENTION REQUIREMENTS SHOULD BE IMPLEMENTED ON TWO DIMENSIONS
Seller’s influence on the value of
the loan
High
Low
Potential Risk Retention Framework and Examples
• Twin objectives: - Prevent breakdown of
performance-to-origination feedback loop . . . but- Preserve liquidity throughout
capital structure
• Not all products & channels are created equal
• Not all market-driven structures were broken (e.g. credit card residuals)
![Page 24: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/24.jpg)
NEW RISK RETENTION REQUIREMENTS SHOULD BE IMPLEMENTED ON TWO DIMENSIONS
Seller’s influence on the value of
the loan
Difficulty for markets to diligence
Easy Hard
High
Low
Potential Risk Retention Framework and Examples
• Twin objectives: - Prevent breakdown of
performance-to-origination feedback loop . . . but- Preserve liquidity throughout
capital structure
• Not all products & channels are created equal
• Not all market-driven structures were broken (e.g. credit card residuals)
![Page 25: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/25.jpg)
NEW RISK RETENTION REQUIREMENTS SHOULD BE IMPLEMENTED ON TWO DIMENSIONS
Seller’s influence on the value of
the loan
Difficulty for markets to diligence
Easy Hard
High
Low
High• Credit card
receivables
Potential Risk Retention Framework and Examples
• Twin objectives: - Prevent breakdown of
performance-to-origination feedback loop . . . but- Preserve liquidity throughout
capital structure
• Not all products & channels are created equal
• Not all market-driven structures were broken (e.g. credit card residuals)
![Page 26: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/26.jpg)
NEW RISK RETENTION REQUIREMENTS SHOULD BE IMPLEMENTED ON TWO DIMENSIONS
Seller’s influence on the value of
the loan
Difficulty for markets to diligence
Easy Hard
High
Low
High• Credit card
receivables
Medium• Dealer-
originated auto loans
Potential Risk Retention Framework and Examples
• Twin objectives: - Prevent breakdown of
performance-to-origination feedback loop . . . but- Preserve liquidity throughout
capital structure
• Not all products & channels are created equal
• Not all market-driven structures were broken (e.g. credit card residuals)
![Page 27: Mitigating the "Scalability of Bad Practices" in Consumer Finance](https://reader033.vdocuments.us/reader033/viewer/2022061121/546f3097b4af9ff00b8b4616/html5/thumbnails/27.jpg)
NEW RISK RETENTION REQUIREMENTS SHOULD BE IMPLEMENTED ON TWO DIMENSIONS
Seller’s influence on the value of
the loan
Difficulty for markets to diligence
Easy Hard
High
Low
High• Credit card
receivables
Medium• Dealer-
originated auto loans
Low• Whole-loan
sales of bank-originated CRE
Potential Risk Retention Framework and Examples
• Twin objectives: - Prevent breakdown of
performance-to-origination feedback loop . . . but- Preserve liquidity throughout
capital structure
• Not all products & channels are created equal
• Not all market-driven structures were broken (e.g. credit card residuals)