INTRODUCTION TO CONSUMER FINANCIAL SERVICES REGULATION. Richard P. Hackett, Esq. National Institute on. Consumer Financial Services Basics

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1 INTRODUCTION TO CONSUMER FINANCIAL SERVICES REGULATION Richard P. Hackett, Esq. National Institute on Consumer Financial Services Basics September 20, 2010 Introduction This paper is intended to provide an overview of why and how consumer credit regulation works. Consumer credit regulation is incredibly detailed, multi-layered and (at times) self contradictory. There are, however, consistent overarching themes in the purposes and methods of credit regulation. Equally important, regulation has become so all-encompassing and burdensome that one cannot discuss how consumer credit products function without discussing how they are regulated. In this institute we will discuss what the products are, how they are regulated, why they are regulated, and the changing of the regulatory guard (the who of regulation). I. Why is Regulation Ubiquitous? Retail financial services is a business in which market competition (and other general principles around which the U.S. economy is organized) have failed to deliver pricing, availability, and other terms that our society deems fair and reasonable. For this reason and others, every state and the federal government have systems of consumer credit regulation. The reasons go beyond mere economics. Regulation is deemed necessary for at least three reasons:

2 Morality: In parts of the Judeo-Christian tradition (as well as under Sharia Law and other ethical and religious systems), lending money on interest is immoral, and the idea of borrowing itself is viewed as a sign of moral failing. Inequality of bargaining power of lender and borrower is ubiquitous and (I will argue) necessary. The complexity of financial products and general lack of consumer financial literacy often leads to outbreaks of abusive practices. Such practices have injured both consumers and our entire financial system in recent years. The business paradigm for retail financial services is to deliver identical products to millions of customers, thereby achieving economies of scale. As with any mass market product (like a toaster), uniformity is critical to driving down prices. Only uniform, fungible products can be delivered at low cost, planned and analyzed for credit risk effectively, and pooled into a secondary market economically. But financial products are not toasters; they are contracts. As with toasters, the only economically viable, consumer-driven product variation is the color of the box. This means that, just as the toaster manufacturer dictates the size and settings of the toaster, offering no meaningful consumer choices, financial institutions dictate the functionality and contract terms of the mass-market consumer credit product Richard P. Hackett 2

3 The necessary result is that we deal in contracts of adhesion. There is no negotiation of legal terms. It is take it or leave it. Because legal terms of complex products are hard to compare, there is no effective competition in terms and conditions. Theoretically, price competition should function, where there are many providers and there is a uniform mechanism for comparing price, such as the Annual Percentage Rate under Regulation Z. At the extremes, price competition works. Few consumers will willingly accept a 50% APR credit card, if they can qualify for 25% APR. No one will willingly take a 15% home mortgage, if a 5% APR is available 1. Most consumers are not capable, however, of reading non-price terms and conditions. In addition, for complex reasons of consumer inattention, information overload, obfuscation by creditors, lack of comparability and others, the industry tends to evidence a race to the bottom with respect to both pricing and non-financial terms, leaving consumers with the potential to accept bad deals they cannot escape, absent government oversight. For example, credit card issuers have long played copycat, with the entire industry adopting new fees as soon as one lender implements a new charge or fee. That is a race to design the worst product (from the consumer s perspective); it is the reverse of normal price competition (which should drive fewer and lower fees). Congress recently acted in the Credit CARD Act to stop this race to the bottom. Over the past three years, the sub prime mortgage market collapse has highlighted another factor that requires regulation. Aggressive and often misleading sales techniques have been combined 1 Note, however, that the bastion of comparison credit shopping, the APR, is under attack. Even the FRB has concluded it is confusing to borrowers, and has downplayed it in new subprime student loan disclosure rules Richard P. Hackett 3

4 with rapid development of capital markets in a way that dissociates credit risk from credit marketing and lending. The result is moral hazard, i.e., the temptation to take the money and run because there is no risk associated with such action. Market actors succumb to the temptation to take the broker fee or lender premium on ever-more-aggressive deals, secure that they can off-load the credit risk in the capital markets and that there is no regulatory risk. We will talk about this phenomenon in our sessions that cover the mortgage meltdown. Layered on top of the foregoing economic and legal realities are values that extend beyond consumer economics that Congress has imposed on the consumer credit system. I call these community values. These include protection of privacy and protection from identity theft, protection from commercial harassment, promotion of equal rights for protected classes, and pursuit of apparently unrelated values such as the control of terrorism and drug trafficking and the collection of income tax. Finally, we come back to morality. Since borrowing is bad for the soul and profiting from sin is equally bad, state constitutions and laws limit the return on loans (usury limits) for the purely normative reason that returns should be limited. To summarize, consumer financial services are regulated because Society does not trust financial institutions to charge fair prices as an ethical matter and does not trust the free market to regulate pricing or other terms charged by banks 2010 Richard P. Hackett 4

5 There is no room in the system for consumer bargaining with respect to important non-financial terms and consumers do not shop intelligently on prices, so regulation must modulate bank power and bank adhesion contracts Financial services are so little understood by consumers that they lend themselves to abuses that harm both consumers and the marketplace II. The Regulatory Palette The How of Regulation In keeping with the issues identified above, our study of consumer credit is the study of: Price regulation Regulation of non-price terms and conditions Conduct regulation in marketing, servicing and collection Multiple layers of required disclosure (promotion of consumer education and transparency) Consumer and governmental remedies for creditor misbehavior Conduct regulation to promote community values This institute will not focus on another critical consumer protection in the delivery of consumer credit: state licensing and examination of marketers, brokers, lenders, servicers and collectors. Licensing focuses on the financial solvency, character and training of non depository lenders. We focus in this institute on depository financial institutions, who are generally exempt from 2010 Richard P. Hackett 5

6 state licensing because federal and state banking regulators deal with the issues managed in the licensing of non-bank actors. III. The Relevant Products The What of Consumer Credit You can define the relevant products by asking yourself what types of credit consumers need to live the American Dream : Finance a house Keep up that house and improve it over time Finance durable goods (cars, boats, snowmobiles) Finance major expenses (college, insurance, medical care) Have a supply of revolving credit for no particular reason at all Have a non-cash payment system to facilitate consumer transactions Provide emergency cash (payday lending, pawnbrokers) When these products are not available, we experience a deep recession, such as we faced in When these products are available in excess, we experience a bubble of demand, as in the housing bubble that burst in 2007 and continues to deflate. Our study of consumer credit regulation will look at systems that regulate single products, like RESPA and mortgage lending, and systems that regulate all products, like Truth-in-Lending Richard P. Hackett 6

7 IV. Drilling Down on the Regulatory Approaches Expanding the list of How we regulate, we will touch on most of the following: A. Price Regulation 1. State Usury Laws, constitutional, civil and criminal. 2. State Credit Codes and Retail Installment Sales Acts. 3. Penalty disclosures for higher pricing Home Owners Equity Protection Act. The primary source of price regulation, including both rate limits and limitations on fees and charges beyond interest rates, is State law. But price regulation at the State level does not work, because Federal law allows all Federally-chartered institutions and all State-chartered institutions with Federal insurance (virtually all institutions) to select the laws of a particular state where they are primarily located and export those laws to all other states. The result is a race to the bottom (or to Delaware and South Dakota). This is the subject of the session on federal preemption. B. Conduct Regulation 1. Marketing Telemarketing regulation, (CAN)SPAM regulation, Affiliate Information Sharing limits 2010 Richard P. Hackett 7

8 Truth-in-Lending advertising and marketing rules RESPA Section 8 limits on marketing payments Unfair and deceptive practices regulation Consumer Financial Protection Act ( CFPA ) Truth in Savings 2. Servicing and Collection Fair Debt Collection Practices Act RESPA servicer rules Fair Credit Billing Act CFPA Truth in Savings Electronic Funds Transfer Act 3. Other Prohibited Conduct Predatory Lending loan underwriting requirements under TILA (HOEPA), state laws, and Dodd-Frank Home Equity Loan Consumer Protection Act UDAP-based credit card and mortgage lending rules CARD Act CFPA C. Disclosure 1. Truth-in-Lending Act 2010 Richard P. Hackett 8

9 2. RESPA 3. Fair Credit Reporting Act 4. Equal Credit Opportunity Act 5. State Laws overlapping all the foregoing and adding more. 6. CFPA 7. Truth in Savings Act 8. EFTA 9. Expedited Funds Availability D. Consumer Remedies and Regulatory Sanctions 1. FFIEC enforcement policy guidelines (TILA) 2. The Roles of the OCC, FDIC, FRB, OTS, FTC and Bureau of Consumer Financial Protection 3. The Roles of State Attorneys General 4. The Roles of the private attorney general under TILA, RESPA, FCRA, ECOA, FDCPA, TISA, EFTA and State statutes E. Promoting Community Values 1. Equal Credit Opportunity Act. Fair access to credit for a wide range of protected classes. 2. Fair Credit Reporting Act Privacy of sensitive data, protecting the accuracy of each consumer s critical connection to the credit system. 3. General rights to privacy including Gramm-Leach-Bliley Act and Regulation P 4. Data Security and Integrity (FFIEC Safeguarding Rules; FCRA Identity Theft Deterrence) 2010 Richard P. Hackett 9

10 5. Keeping the Government out of your bank: Right To Financial Privacy Act 6. Banks as public utilities: the Community Reinvestment Act (another course) 7. Finding out what your bank is up to: the Home Mortgage Disclosure Act 8. Catching terrorists and money launderers: (another course) 9. Collecting taxes and child support (another course) Citations for all the foregoing are found in Appendix I: Consumer Financial Alphabet Soup. V. Who Does the Regulating. A. Federal Reserve Board Until enactment of the CFPA on July 21, 2010, Congress looked to the Federal Reserve Board as the primary source of rulemaking and interpretation of TILA, TISA, EFTA and ECOA. The FRB has been entitled to Chevron deference in judicial review of its interpretations of those laws FRB interpretations are valid unless demonstrably irrational. Ford Motor Credit Co. vs. Milhollin, 444 U.S. 555 (1980). CFPA changes all of that, transferring rulemaking for all enumerated consumer laws plus primary enforcement for larger banks to the Consumer Financial Protection Bureau ( CFPB ) on the designated transfer date. That date is scheduled to occur between January 2011 and January The CFPB is part of the Federal Reserve System, but independent in its budget and its management. B. Federal Trade Commission The FTC is responsible for enforcing TILA and ECOA against non banks. The FTC also has significant enforcement and rulemaking authority for much of FCRA, sharing that authority with the federal banking agencies (FRB, OCC, OTS, FDIC, NCUA). In a new approach, Congress required the federal banking agencies and the FTC to work in concert in issuing rules under major amendments to FCRA known as FACTA (which focuses on identity theft protection) Richard P. Hackett 10

11 The FTC also enforces its version of the Gramm-Leach-Bliley privacy rules (Reg P) against nonbanks. C. Federal Banking Agencies Every depository institution has a primary federal regulator. That regulator will examine the consumer compliance of its institutions, at least until the CFPB takes over that chore for banks with over $10 billion in assets. The agencies include: FDIC examines state chartered banks and thrifts who are not Fed members FRB examines Fed members with state charters OCC national banks OTS federal thrifts (for now) NCUA all credit unions D. HUD The Department of Housing and Urban Development has had enforcement and rulemaking authority for RESPA, at least until the CFPB takes over. HUD and the FRB did not play well in the residential mortgage sandbox, and Congress has charged CFPB with unifying residential mortgage disclosures under TILA and RESPA within one year Richard P. Hackett 11

12 Appendix I Consumer Finance Alphabet Soup Types of Lending Products RISC Retail Installment Sale Contract Residential Mortgage (Home-secured loan) Chattel Finance (Car and Boat Loans) HEL Home Equity Loan HELOC Home Equity Line of Credit Lenders XYZ, NA National Bank XYZ, FSB Federal Savings Bank XYZ Bank or Bank and Trust Company, or Savings Bank State Bank or Thrift XYZ, ILC FDIC insured Industrial Loan Company/Corporation Licensed Lenders State Licensed (generally non-bank) Sales Finance Company State Licensed 3 rd Party Finance Company Federal Statutes and Regulations AMPTA Alternative Mortgage Transactions Parity Act 12 U.S. C et seq. CLA Consumer Leasing Act 15 USC 1667, et seq. DIDMCA Depository Institutions Deregulation and Monetary Control Act 12 U.S.C. 1831d ECOA Equal Credit Opportunity Act 15 USC 1691, et seq. EFTA Electronic Funds Transfer Act 15 U.S.C et seq. FACTA Fair and Accurate Credit Transactions Act part of FCRA FCRA Fair Credit Reporting Act 15 USC 1681, et seq. GLB Gramm-Leach-Bliley Act, Section 501, et seq., 15 USC 6801 et. seq. HMDA Home Mortgage Disclosure Act 12 USC 2801 HOEPA Home Owners Equity Protection Act part of TILA HOLA Home Owners Loan Act 12 U.S.C et seq. Reg B Regulation adopted under ECOA 12 CFR Part 202 Reg DD Regulations adopted under TISA 12 CFR Part 230 Reg E Regulation adopted under EFTA 12 CFR Part 205 Reg M Regulation adopted under CLA 12 CFR Part 213 Reg P Privacy, 12 CFR Part 370 (FDIC version) Reg X (RESPA) 24 CFR Part 3500 Reg Z Regulation adopted under TILA 12 CFR Part 226 RESPA Real Estate Settlement Procedures Act 12 U.S.C et seq. TILA Truth in Lending Act 15 USC 1601, et seq. TISA Truth in Savings Act 12 USC 4301, et seq. State Statutes and Regulations UCC Uniform Commercial Code UCCC Uniform Consumer Credit Code 2010 Richard P. Hackett 12

13 RISA Retail Installment Sales Act Federal Financial Regulatory Agencies FTC Federal Trade Commission ( FRB Federal Reserve Board ( OCC Office of the Comptroller of the Currency ( OTS Office of Thrift Supervision ( FDIC Federal Deposit Insurance Corporation ( FFIEC Federal Financial Institutions Examination Council (FRB + OCC + FDIC + NCUA) NCUA National Credit Union Administration Resources CCH Consumer Credit Guide NCLC National Consumer Law Center ( SafeBorrowing.com ( ABA Business Law Section Consumer Financial Services Committee ( FRB: -- excellent source of proposed, recently added and compiled rules Regs B, DD, C, CC, E, Z, M FTC: -- excellent source of plain language explanation of identity theft rules FDIC: for FILs Other Acronyms NSF Non-sufficient funds (bad check charges) ACH Automated Clearing House NACHA National Automated Clearing House Association EFT Electronic funds transfer FNMA Fannie Mae FDMC Freddie Mac Sources beyond statutes and regulations: FRB Official Staff Commentary has force of regulation. Appears as a Supplement to FRB regulations in CFR. FTC Commentary to FDCPA unofficial FFIEC Examination Guidelines and Guidances tantamount to a regulation for a depository institution. Search through FDIC FILs (Financial Institution Letters). High profile topics: Authentication in Internet Banking Vendor Management OCC Interpretive Letters. See website and CCH. FDIC Financial Institution Letters. See website and CCH Richard P. Hackett 13