America’s current financial system is essentially broken for the many working Americans who live on the edge financially. Mismatched incentives are at the heart of the problem. One has only to look at the sad history of payday and car title loans, subprime mortgages, or bank overdraft “protection” schemes for examples of financial products and practices that are profitable for providers but damaging for vulnerable populations.
Unfortunately, regulation hasn’t done much to create win-win solutions. Deference to efficient market theory and “consumer choice” has created a regulatory system that largely places responsibility — absent the most egregious abuse — on the individual consumer. In a new report, we argue that what is needed is a different regulatory approach that ties financial-services providers’ profit to customers’ financial health. In short, banks should only do well financially when their customers do well financially.
Such a regime would be similar to experiments currently happening in health care that pay providers for improving patients health, rather than paying them simply for treating patients regardless of the outcome of the medical intervention. Of course, the markets for health care delivery and consumer finance differ considerably — in competitiveness, concentration, public and professional ethical, and regulatory regimes and incentive structures. But while the U.S. health care system is not perfect, there is a general consensus that quality of care and patient outcomes among the insured population have benefited significantly from investment in, and deployment of, patient data and associated analytics to measure and improve patient outcomes.
We desperately need similar innovations in the financial services industry. The good news is that many of the pieces are in place for reform. Recent decades have witnessed an enormous expansion in both the quantity and quality of consumer financial data and data science techniques that can be used to improve credit analysis, customer authentication, risk management, and marketing. At the same time, more sophisticated measures of consumer “financial health” have been developed. The best known of these have been created by Consumer Financial Protection Bureau and The Financial Health Network, and measure things like whether individuals spend less than they earn, pay their bills on time, plan ahead for expenses, and have sufficient liquid and long-term savings, a sustainable debt load, access to affordable credit, and appropriate insurance. Applying metrics like these to the trove of financial data held by providers using data science techniques makes it possible to watch an individual’s overall financial well-being evolve over time, as well as discern how their financial health may be affected by their use of specific financial products and providers.
Our regulatory proposal has three stages and would be implemented over time. The first stage would require large consumer financial services providers to periodically make available to regulators internal data that regulators can use to analyze and measure changes in customer financial health. At the same time, regulators and the industry will collaborate on the testing, refinement, and standardization of a set of consumer financial health measurements which can be used at both the product and provider level. These outcomes measures can be normalized to avoid favoring providers who serve affluent customers, to track differences in outcomes by income, age, sex, education, race, geography, etc., and to control for the impact of recessions and other macroeconomic factors. Once the initial set of consumer financial health metrics are ready for use, the regulatory data sciences team will use the compiled provider data to analyze and measure correlations between financial product usage, product characteristics, individual providers and provider practices, on the one hand, and outcomes, on the other hand.
To give a sense of how this type of analysis would work, we looked at bank overdraft practices, which have a clear connection to one indicator of financial health — consumers’ ability to pay their bills on time with their regular earnings. Consumers who regularly fall short each month and overdraw their accounts as a result are, by definition, struggling financially. Our analysis found dramatic differences among larger banks in both the frequency with which individual bank customers overdraw their accounts (a four-to-one spread in overdraft intensity) and the relative contribution that overdraft revenue makes to the bank’s bottom line. Not surprisingly — and reflecting the perverse incentives at play — there is a correlation between banks’ dependence on overdraft revenues and the likelihood that their mass-market customers will be chronic overdrafters.
This enormous differences in overdraft intensity between banks likely have little to do with consumer choice. They could stem from differences in provider practices, such as how the banks process checking transactions or in how aggressively they encourage their customers to opt-in to debit card overdraft coverage, or possibly from differences in the programs and tools the banks provide to encourage customers to accumulate emergency savings, track balances, and avoid overspending. Today, we can only guess what really causes these large outcome disparities. But that will change under our proposal. When information like this is cross correlated with other data by regulators, we believe that both the causes of the disparity and the impact on customer financial health will become apparent.
In the second stage, regulators would publicly release their analysis of financial health outcomes on an institution-by-institution and product-by-product basis and make the underlying data available to researchers, consumer advocates, legislators and governmental agencies. Such transparency — when coupled with appropriate privacy protections — will stimulate further analysis and insight and bring feedback into the regulatory process. Consumer advocates will use comparative data to press for changes in the practices of poorly performing institutions and adoption of practices employed by high-performing institutions. Shopping comparison sites will incorporate the data in their reviews of companies and their products leading some consumers to change their providers. Some providers will likely modify their products or practices in response to adverse financial health performance disclosed by the data and work to improve their performance relative to competitors.
We believe public disclosure alone will be insufficient to realign the provider business models, however. Our third stage would provide a regulatory counterweight (similar in some ways to the role insurers play in health care) to the mismatched incentives prevalent in consumer finance. It would make improving consumer financial health a statutory goal of federal regulation and require regulators to issue a periodic public “Financial Health Rating” (FHR) for each provider in a manner similar to the Community Reinvestment Act (CRA) rating system. Under the CRA, which requires banks to meet the credit needs of low- and moderate-income neighborhoods where they do business, a poor rating can derail a bank’s long-term growth strategy by preventing new branch openings and merger or acquisition transactions. A negative CRA rating also can also severely damage relations with regulators, customers, employees, and community constituents. For those reasons, banks focus intently on achieving the best CRA rating possible. A similarly-structured FHR system would impose a meaningful regulatory “price” on low-performing providers which should cause them to adjust their business practices to emphasize delivery of products and services that can be shown to improve the financial health of their customers. This approach has the added advantage of working largely through market mechanisms implemented by providers in their own interest.
While the three stages will not be an immediate substitute for existing U.S. consumer financial protection law, the framework will generate rich empirical insights into the harms and benefits to consumers that result from particular provider practices or product features and inform traditional regulatory approaches. When the new framework is fully operational, many aspects of the U.S.’s current imperfect and contentious rules and disclosure-based regulatory regime can be gradually discarded. In its place will be a “learning” system that is principles-based, data-driven, transparent and leverages market mechanisms to deliver improved financial health for consumers.