Vanilla Financial Products Could Help Remedy Clear Market Failures

Do we have no fight left in us at all? Mike Konczal and Kevin Drum are excellent as always, but must we really write eulogies? Is one of the best regulatory proposals so far dead just because a single well-bought congressman says so?

Extracting the vanilla from the CFPA is not, as Felix Salmon put it, "the beginning of the end of meaningful regulatory reform". It is the end of the end. Vanilla products were the only part of the CFPA proposal that was likely to stay effective for more than a brief period, that would be resistant to the games banks play. All the rest will be subject to off-news-cycle negotiation and evasion, the usual lion-and-mouse game where regulators are the rodents but it's the rest of us that get swallowed.

Wall Street's favorite comedian-politician, Barney Frank, was very savvy in framing the debate over the issue with his well-placed mischaracterization of vanilla products as "anti-market". That is bass-ackwards. The vanilla option is pro-market, because it is procompetitive. Of course, that is precisely why banks hate it: Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price.

Ezra Klein is suitably depressed, but he's wrong when he writes that "the 'plain vanilla' provision was never likely to do that much." Vanilla products would be very popular, which is why they are so threatening. Financial services are an area where markets not only fail due to informational problems, but where participants are very aware of that failure. Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing. Status quo financial services should be a classic "lemons" problem, a no-trade equilibrium. Unfortunately, those models of no-trade equilibria don't take into account that people sometimes really need the products they cannot intelligently buy, and so tolerate large rent extractions if they must in order to transact.

The price of assuring that one is not taken advantage of by financial service providers is not participating in the modern economy. You cannot have a job, because payments are by check or direct deposit. You cannot buy a home or a car, because for the vast majority, those purchases require financing. Try traveling with only cash for plane tickets, hotel rooms, and car rentals. People will "voluntarily" participate in markets rigged against them for the privilege of being normal. And we do, every day.

But define a reliable vanilla option, and the dynamic flips on its head. Instead of tolerating rent-extraction as a cost of participation, consumers put up with one-size-fits-all products in exchange for peace of mind. Most consumers benefit very little from exotic product features, and I suspect that many are made deeply nervous by the complex contracts they can neither negotiate nor understand, but nevertheless must sign. Vanilla financial products would be extensively vetted and and their characteristics would soon become widely known. Inevitable malfunctions would be loudly discussed in the halls of Congress, rather than hushed-up in rigged private arbitrations. Vanilla products would face discipline both from private markets (no one is suggesting we forbid other flavors) and from a very public political process. Politics and markets are both deeply flawed, but they are flawed in different ways, and we should take advantage of that. In Arnold Kling's lexicon, a market in which vanilla and exotic financial products coexist and compete offers the benefits both of exit and of voice.

Rather than being anti-market, vanilla financial products would help correct very clear market failures that arise from imperfect information and high search costs. It is the status quo that is anti-market.

I'm sympathetic to the principled libertarian objection to having the government require that private parties offer a product they otherwise might not. No one should be forced to offer vanilla financial products. Small-enough-to-fail boutiques should be free to offer only the products they wish. However, if an institution wishes to avail itself of government-provided deposit insurance or to access Fed borrowing facilities, it is perfectly legitimate for the government to set requirements. The government can choose not to offer its safety net to institutions that don't offer vanilla products, just as banks currently choose not to offer me a credit card unless I sign up to binding arbitration and unilateral contract changes. I fail to see why one is coercive and the other not. (The government has no monopoly on deposit insurance. Private insurers are free to provide similar insurance, and do so for many financial service companies already.)

An Economist anonobloggeer has some peculiar non-compliments about the vanilla products proposal:

The vanilla offering seems to be intended to substitute for sophistication or research on the part of the customer, but I'm just not sure that's a good way to approach the issue. As best I can tell, the vanilla plan wouldn't mandate the price of the simple option; just because a bank would have to offer a vanilla mortgage loan doesn't mean it would have to offer a competitive vanilla mortgage loan. If that's the case, banks could easily use high rates on the simple products to steer individuals toward the complex offerings. Or, the vanilla rule could actually serve to direct bank collusion toward high-priced, high-margin products.

Just because a commodity exchange standardizes the quality of corn that must be delivered into a futures contract doesn't mean that any seller has to offer corn at a good price. So true! But sellers that offer commodities at above market prices don't usually find buyers. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price. Banks are very, very good at forming tacit cartels, but colluding on complicated terms and conditions is easier and less likely to attract the antitrust authorities than fixing a headline price.

More from the econoanonoblogger:

To me it seems like the more effective solution would be to require that financial institutions explain, in detail, each and every fee they are assessing (or might potentially assess) to customers. That would inform consumers of what's going on in the monthly bill, and it would create an incentive to reduce the number and complexity of fees, as lengthy explanations would be a hassle for all involved and would reduce business.

One of the great errors in modern policy is to confuse disclosure with information. It is not the case, currently, that banks secretly take your money without itemizing the charge on some statement. (Sometimes when they take your money they call it "service fee" or something equally nondescriptive, and it'd be nice if that practice went away.) Rather, banks intentionally define contracts in such a way that the cost to many customers of understanding and competitively shopping all the dimensions of the product seems higher than the cost of terminating the search and signing the dotted line. More detailed disclosure doesn't eliminate, and can sometimes exacerbate, the real information costs customers face, which derive from the complexity of the required analysis and lack of information about alternatives, not from an absence of product data. Of that we all have pages, with more arriving every month. You might think there'd be a market for ostentatious simplicity, and there might be. But no bank's lawyers would sign off on a single page, 12 point text, no-extratextual-incorporation-or-unilateral-modification contract. When routine contracts get more complex than that, it's just gibberish competing with gibberish for people who have lives. Some financial products are necessarily complex. But one way of managing complexity is standardization. It may be worth it for consumers to carefully study the one contract they will probably sign in a way that it would not be worth poring through 100 freeform contracts, 99 of which they will never sign.

The most serious objection I know to vanilla financial products is that they would be harmful precisely because they would catastrophically succeed. The theory is that nothing is more dangerous than a commodified bank, and the evidence is May Day, 1975, when the SEC ended fixed stock trading fees in the brokerage industry. Some commentators (e.g. Barry Eichengreen) claim that by eliminating a stable, cushy profit center, the May Day deregulation forced gentle investment banks to become hungry innovators, that the financial system has grown progressively less stable because under cut-throat competition risk-takers dominate (until they self-destruct and take the rest of us down with 'em). I don't buy the May Day story, but for the sake of argument, let's suppose it's true. Let's suppose that, in the name of stability, the best policy would be to ensure banks easy profits so that they needn't dabble in dangerous things. Then two conclusions follow:

1. If we are going to strike a policy bargain whereunder banks get a nice sinecure in exchange for a promise of stodgy mellowness, it seems reasonable that they should commit to the stodgy mellowness. Dull, subsidized banks should be heavily regulated banks, or, to use the term of art, "narrow banks".

2. If we are going to impose a regime that ensures bank profitability, we ought to do so in a reasonably equitable way. Business models that hide profit generators in complex contracts, or that extract fees especially from the disorganized and naive, are not reasonable instruments of public policy for keeping banks healthy. If we do go with the coddled but heavily regulated model of banking (not my preference!), and we're not willing to have the Treasury end the capitalist charade and just cut checks to its payment-systems subcontractors, then a decent approach would be to have narrow banks offer only vanilla products and provide monopoly rents by putting floors under fees and ceilings above deposit interest rates (as existed in the US until the 1980s). Under either a competitive or "regulated utility" model, the fairness and informational case for defining standardized vanilla products remains compelling.

I think people like Barney Frank, when they try to sleep at night, have been sold on the "we need healthy banks, so let's protect their profit centers" story, although they'd never admit to it while scoring points comparing powerless people with furniture. I wonder if it even occurs to Mr. Frank that maybe something serious should be demanded of banks in return for state protection of market power at the expense of the weak and disorganized. But then Mr. Frank has already gotten very much in return.

Comments

[Steve Russell:]

The fundamental argument seems to be that a clamp down here exports risk which means we will export capital.

Say that's true in the short term, which I doubt.

It also exports the bust when risk is chased over a cliff. I am aware of no historical unlimited pursuit of risk that did not go over a cliff.

Also, I presume our paradigm won't be far off the rest of the world, such that the only place for capital to go will be the next Iceland.

Tax 'em and they'll leave. Regulate 'em and they'll leave. The young people in the streets around the G-20 are not the only anarchists, and I'd as soon be governed by one as by the other.

Sep 27 10:43 AM

[La Marque:]

This is the best explanation of why we need a consumer finance protection agency. Thank you, Mr. Waldman.

I consider myself moderately financially literate; but I know no one who actually understands their loan agreements in total. My present car loan is thru a credit union precisely because they have no prepayment penalty such as 'rule of 72.'

A further point as to why we need a CFPA is that you as a options buyer/seller are required to acknowledge the risks involved in trading the riskier stuff by stating that you have at least received/read a booklet on the subject. Nobody understands that booklet; we simply trust our broker at that point.

Sep 27 11:35 AM

[Curtis Forbes:]

How about a financial product that has three levels of guarantee for the investor, is a hedge against inflation and keeps homeowners in their homes building equity with access to healthcare coverage? This financial product exists in concept but the product does not.

www.azcentral.com/memb...

Sep 27 12:24 PM

[dragonpaw:]

Mr. Forbes; would like a free lunch thrown in with that financial product on a daily basis. If so, welcome to the new gov't "all is guaranteed, nothing is too big or too little to fail, everything is too good to be true Alice in financial Wonderland."
If on the other hand, we could return to "old world" banking, where in banks had real collateral, money was lent on fixed terms that were understandable, buyer's had to put up, say 20% down on a home loan where they actually lived, banks held these loans, investers in the banks were paid real interest (maybe only2-3% over low actually inflated dollars. Sounds boring but nonetheless this fairy-tale thinking would have averted the latest Fannie Mae, Freddie Mac, GM(obster), Chrysler-crash, gang-bankster, delusional-derivative, et al melt-down.
Oh sure the DOW would not have hit 14000, but then again the Ponzi schemes would never have started. We might be legitimately at 9500 today and no worse for the wear.
However we're right back on track with the same schilling, and with the markets gushing over themselves that "happy days are here again."
Are any but the insiders and sheeple buying this s--t???!!!

Sep 27 02:37 PM

[TinyTim:]

Put this product in an article on vanilla and transparency? I might have known it came from Phoenix, a hotbed of real estate scam artists.


On Sep 27 12:24 PM Curtis Forbes wrote:

> How about a financial product that has three levels of guarantee
> for the investor, is a hedge against inflation and keeps homeowners
> in their homes building equity with access to healthcare coverage?
> This financial product exists in concept but the product does not.
>
>
> www.azcentral.com/memb...

Sep 27 02:59 PM

[Bolton Peck:]

I hear Barney Frank on the radio complaining about how bad the 'vanilla' option would be and how unfair it would be to the banks-and I just wanted to scream!

The vanilla option would have kept me and 20 million of my closest friends out of trouble, bankruptcy, home foreclosure, etc. It would give people the option of getting what they need at a price that's fair-and expose these 'exotic' products for the scams they are.

No wonder the banks vigorously oppose this law.

Sep 27 03:02 PM

[Moon Kil Woong:]

I'm amazed we even got as far as discussing this. Usually, and certainly under the Bush Jr. this wouldn't even be debatable. Unfortunately progress doesn't always lead to action. The author is very right that most people when buying a home have no real understanding of the contract, little bargaining power, and lots of strange charges on the way. And he is certainly right in the fact that banks and financial institutions profit from it at the costy of the consumer.

This is called assymetric information. Market players want to keep it so they can keep using it against you and will do most anything to insure that it happens. And as other economist have pointed out including Freakanomics, the mortgage market is one of the most assymetric markets out there.

It is ludicrious that financial institutions won't fight tooth and nail to prevent you from getting a fair shake. Just as ludicrious as the fact that banks and financials won't stuff mortgage bonds with loans they know will default when thery sell them to Fannie Mae, Freddie Mac, the Fed, the Treasury, FHA, or anyone else dumb enough to buy them (the taxpayer is not only dumb they don't even get to decide).

Requiring to offer a base package creates a level playing field in which people can use as a base determinant for assessing value. Not only will it hurt plain vanilla profits for banks but then they will have to explain why you pay more for anything else marginalizing those gains too. Thus, even if they don't sell a single vanilla package which is highly doubtful, it will do its work crystalizing value in the minds of consumers.

While we are on this topic. Essentially, a public option in health care will do the same. Even if no one buys it, it will lead to lower costs. However, unlike public healthcare, the vanilla option costs nothing asides from bank's peace of mind.

Sep 28 06:51 AM

[Sacandaga:]

There is a model for the vanilla system: the cable TV carriers, who are required by the rules granting them franchise territories to offer a regulated, plain-vanilla service that includes local broadcast channels and any local, carrier-produced content, usually for around $15 per month.
The analog-to-digital conversion of broadcast TV has driven many Americans disinterested in cable programming (or at least in the way it is bundled and sold) into this "plain vanilla" cable product that is never advertised and roundly criticized by cable providers. It has also gained subscribers no longer able to afford enhanced programming packages.
While it's true that there is typically only one source of this plain vanilla product in each market, the fact that the "take rate" for regulated basic cable is so high vs. the converter box suggests that consumers are willing to pay for something that they previously got for nothing if they are presented with an option that is simple and understandable.

Sep 28 10:39 AM

[Leftfield:]

Large interests have had a field day complicating everything. The manager of my bank made mistakes when attempting to interpret my checking account statement. Hidden charges, "mistakes," reams of computer-generated gobbledygook are rampant. It's all a major profit center, and our incumbent politicians are even more eggregious with the use of insane complexity.
Blame the insurers, sure, but hospitals have unequaled levels of unintelligible proceduritis and they fight against simple local clinics that could take the load off their ER's. The same scam dynamic here works against solutions that would be understandable to average people if, they were honest.

Sep 28 02:01 PM

[Smrt1:]

If one looks at the history of the financial boom and bust cycles that the United States can't seem to get enough of, there is a pattern easily seen if you can understand the picture. That pattern is "excitement" in the banking and financial services industry. Each time there is a massive bust in our financial services market one can see a corresponding period of time where leading up to said bust there is a period of "financial innovation" where the banking world becomes cool, hip and exciting. Some risky scheme is justified by dubious (the home pricing models of sub-prime risk formulas couldn't even input the option of falling house prices) and oft inconsistent economic and mathematical formulas and subsequently repackaged as a new type of derivative or security. The fact of the matter is that none of these loans should have been made in the first place. Granted the lenders and bankers are not entirely to blame because they had an eager market in the government backed companies of Fannie and Freddie waiting to take these terrible mortgages off their books because we determined politically that everyone no matter the ability to pay should be able to own a house. However, they were extremely willing participants who could not wait to complete more and more of these ridiculous transactions because they were essentially zero risk guaranteed profit centers. The point is, Basic Banking is an essential service required for a capitalist merchant based society. The bankers are entitled to a fair return assuredly because they do provide said service, however Basic Banking=Vanilla Banking. Vanilla Banking Options should absolutely be on the table, in fact I would go so far as to propose that those Vanilla Options be required by any bank seeking FDIC guarantees. If a bank wants to offer more complex items, spin off an investment firm but banking, basic vanilla banking should be in a word: Boring.

Sep 28 02:31 PM