In a recent speech to a conference on Consumer Affairs, the Chairman of the Federal Reserve, Ben Bernanke, considered one of the most critical issues facing regulators - how to encourage financial innovation while protecting consumers from its unintended consequences?
Dr. Bernanke began by pointing out "as we have seen only too clearly during the past two years, innovation that is inappropriately implemented can be positively harmful." He went on to argue that it would be "unwise to try to stop financial innovation, but we must be more alert to its risks and the need to manage those risks properly".
While somewhat a statement of the (blindingly) obvious it is nonetheless obvious and worth stating.
The chairman articulated a laudable goal for regulators: "to strike the right balance: to strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit."
Now that is a (really) tough challenge!
In reporting the efforts that the Fed has gone to in 'consumer testing' information disclosed about new financial products, the chairman concluded that "some aspects of increasingly complex products simply cannot be adequately understood or evaluated by most consumers, no matter how clear the disclosure." He did not point out, however, that some of these innovations were not adequately understood by regulators either, otherwise we wouldn't be in this mess.
Dr. Bernanke concluded that 'in those cases, direct regulation, including the prohibition of certain practices, may be the only way to provide appropriate protections." Wow, an admission that we may have to get the big stick out of the bullpen and retire the carrot!
So far, so good.
Then the Chairman's speech went down hill, rapidly.
In searching for an example of how regulation in the face of innovation may be applied, Dr. Bernanke spoke about the efforts of the Fed to attack the problems of 'over-charging' (or in Fed speak 'payment allocation') for cash advances on credit cards. It turns out that the nasty banks have been forcing customers to pay off outstanding 'low interest' balances (such as card purchases) before they allocate money against 'high interest' balances, such as cash advances. In this situation, of course, the term low and high are relative and must be likened to the difference between K2 and Everest; in fact 'low' means 'high' and 'high' means 'extortionate'.
[Maybe we could get Starbucks to design financial Product Disclosure Statements (PDS) and then we could charge Grande, or even Venti, interest rates?]
Having failed to come up with an adequate scheme for disclosing the complex rules for allocating payments, that ordinary folk could understand, the Fed admitted defeat and had put "rules in place that will limit the discretion of creditors to allocate consumers' payments made above the minimum amount required."
[Note, this is not as dramatic as - Stop! But more like: kindly take some time to consider should you slow down?]
The Chairman boasted that this, and other actions on mortgages, was "part of the most comprehensive change to credit card regulations ever adopted by the Board."
However, he forgot to point out that these rules are the first major changes to the famous/infamous 'Regulation Z' of the TLA (Truth in Lending Act) since 1981! Nor did he remind us that these changes have been in the pipeline for several years and that the legislation to enact the new rules is still wending its way through the US Congress.
The Fed appears to move at a pace that makes Tectonic plates seem like extras in 'Fast and Furious'.
Aside from the inability of the Fed to tackle the unpleasant side effects of financial innovation promptly, if at all, the more disturbing issue is the use of the credit card example.
Now while granted that the Chairman's speech was to a group of US consumer advocates, it is disconcerting that the only example of vigorous regulation that he could come up with was a relatively minor tweak to the rules for a product (credit card cash advances) that can hardly be termed state of the art.
What is the Fed going to do when it is faced with fiendishly complex products, such as CDO squared? It should be remembered that the market for complex CDOs only came into existence around 2004/2005 and flamed out in 2007/2008. And what is the Fed going to do about innovations that emanate from outside the US?
Unless regulators begin to think and, more importantly, move as fast as financial innovators, governments will be faced with more and more of the unpleasant side effects of innovation, such as trillion dollar deficits. Since banning innovation has never worked in the past, regulators must accept that innovation will happen and that it will have unintended consequences and they must focus on how best to protect consumers (and also the regulators' employers, the taxpayer).
Dr. Bernanke is like the little Dutch boy who put his digit in the dyke to prevent flooding, all the while, a few feet away, the levee has broken and (Katrina like) toxic waste is flooding into the financial system. Every little bit does help - but not a lot.
Finding a balance between financial innovation and consumer protection is extremely challenging for regulators, but when a senior regulator addresses the Global Financial Crisis using the example of revising relatively simple rules for allocating credit card payments, there is only one rational reaction - Panic!
