Regulating to Avoid the Next Financial Crisis

What ever caused the sub-prime mortgage crisis to become a full-blown credit
freeze, it’s clear that at its core were bad mortgage loans made to borrowers
who didn’t understand the long-term implications of the loan by lenders acting
in their own self-interest. Meanwhile, credit card balances and delinquencies,
caused in part by confusing terms and ineffective disclosures, are
skyrocketing. And, without easy and automatic ways to save, the personal
savings rate is mired at or below 1%.

A new approach to the way we write the rules for buying homes, getting
credit cards and managing our finances is needed, one based on real-world human
behavior, not just economic theory. Regulations governing these transactions
can play an extremely constructive role if they are better attuned to both
consumers’ and producers’ behavior, incentives and self-interest.

On October 17, the Asset Building Program of the New
America Foundation held a lively discussion on these topics
and released a seminal
paper on this timely topic by Professors Michael Barr of the University of
Michigan Law School, Sendhil Mullainathan of Harvard University, and Eldar
Shafir of Princeton University entitled Behaviorally Informed Financial
Services Regulation. Using the tools of behavioral economics, Professors
Barr, Mullainathan and Shafir-three of the nation’s leaders in this field —
propose that regulators should pay attention to both the “rules of the
game” — what a provider must do or say, and the “scoring” —
the reward or penalty arising from obeying or ignoring the rules. Based on this
novel framework, the authors propose ten innovative ideas for regulating
mortgages, credit cards and bank accounts for saving.

Professor Shafir began the event by giving an overview of behavioral
economics, and stressed the importance of “framing” when options are presented
to borrowers and consumers. He argued that people are often “context dependent”
and will often make decisions that adversely affect their health or financial
well-being if options are presented in an overly complicated or convoluted way,
even in circumstances when they may know the beneficial behavior. The solution,
Shafir argued, is to frame choices such that consumers are nudged into the
right decisions.

Professor Barr continued the discussion by offering a number of innovative
ideas that are informed by behavioral economics. In particular, Professor Barr
promoted ideas ranging from an opt-out payment plan for credit cards (where a
credit card holder with a balance would be automatically enrolled into a
certain payment level, and they could opt-out at anytime) to a “sticky” opt-out
mortgage plan, where potential homebuyers would be automatically enrolled into
a certain mortgage (say, 30-year fixed-rate) unless they otherwise noted. The
“sticky” part of the mortgage would involve increased liability exposure for
deviations from the original choice, as they may harm consumers.

Alex Pollock of the American Enterprise Institute followed with an
enlightening critique of the new paper. He argued that applying patterns in
human decision-making to financial services is both an obvious idea and an idea
that has been around for many years, and that simplicity in choice is entirely
consistent with the behaviorally-informed policy laid out by Professors Barr
and Shafir. Mr. Pollack also advocated for a single-page mortgage form that
would give potential homeowners a simple document with which they could make an
informed decision on a mortgage.

Finally, Travis Plunkett of the Consumer Federation of America discussed
these topics in the context of the credit market, and concurred with the idea
of an “opt-out” payment plan for credit cards. Mr. Plunkett stated that the
current business model has very little cost on the front end for the credit-card
holder, and lower minimum payments have been instituted, people have run up
unsustainable amounts of debt.

A dynamic Q&A session followed, moderated by David Wessel of The Wall
Street Journal that touched on issues of paternalism, applying these behavioral
principles to current regulators, and the current financial crisis.

 —Event summary by Mark Huelsman, Program Associate, Asset Building Program

Participants

Featured Speakers

• Michael Barr (PowerPoint Presentation – PDF, 15 pps.)
  Professor, University of Michigan Law School
• Eldar Shafir (PowerPoint Presentation – PDF, 14 pps.)
  Professor, Princeton University
• Alex Pollock
  Fellow, American Enterprise Institute
• Travis Plunkett
  Legislative Director, Consumer Federation of America

Moderator

• 
  David Wessel
  DC Bureau Chief, The Wall Street Journal

Introductions

• Ellen Seidman
  Financial Services Policy Director, Asset Building Program, New America Foundation