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Friday, April 18, 2008

Truth in Lending, Disclosure, and Regulation

This post from yesterday asks whether full disclosure alone is sufficient to protect consumers in mortgage markets, or whether regulations to restrict the terms that can be offered on mortgages are also necessary to protect consumers from assuming too much risk. For credit cards, which, like mortgages, are becoming increasingly complex, the Fed has decided that "Careful measures that would restrict credit card terms or practices may in some instances be more effective than disclosure to prevent particular consumer injuries":

Credit cards, Sandra F. Braunstein, Director, Division of Consumer and Community Affairs, Federal Reserve,  Testimony Before the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, U.S. House of Representatives: ...In June 2007, the [Federal Reserve] Board proposed substantial revisions to the credit card disclosures required under the Truth in Lending Act (TILA) regulations. Those revisions are focused on ensuring that consumers have the information they need about credit card costs and terms, when they need it, in a form they can use. In addition, as Chairman Bernanke indicated in testimony..., the Board plans to use authority under the Federal Trade Commission Act (FTC Act) to propose rules prohibiting unfair or deceptive credit card practices. The proposal will be issued this spring. ...

Implications for Consumers of Increased Credit Card Complexity In the early 1980s, less than half of American families had a general purpose credit card (43 percent in 1983). Currently close to three-quarters have at least one card (71 percent in 2004). The increase in credit card holdings was sharpest among lower-income families: from 1983 to 2004, the share of families in the lowest income quintile that hold such cards jumped from 11 percent to 37 percent.[1] In addition, consumers are using their cards more both as a payment device and as a source of credit. Total charges on bank credit cards increased by about five times and total debt outstanding as of year-end by almost four times from 1991 to 2006.[2] This growth is explained by several factors, including substitution of cards for cash and installment credit and the development of credit scoring and risk-based pricing, which have made credit cards available to more people.

As consumers have relied more on credit cards, card plans have become more complex.

Once, a card may have allowed the user to make purchases or obtain cash advances and applied a single, unchanging annual percentage rate, or APR, to each feature. Fees were typically limited to an annual fee, a charge for cash advances, and perhaps fees for paying late or exceeding the credit limit. Today's more complex products offer balance transfers and treat different classes of purchases and cash advances as different features, each with its own APR... In addition, APRs adjust much more frequently to changes in the market, in a borrower's credit risk profile, or in other factors the creditor considers important. The typical card no longer has an annual fee, but it can have many other fees tied to a variety of features, requirements, or services.

These more complex plans hold significant potential benefits for consumers. Pricing that is sensitive to consumers' preferences for services likely increases the availability of the services that consumers find most valuable. Pricing that is sensitive to consumers' credit risk profiles can increase the availability of credit and lower its cost for many consumers. Growing complexity, however, has increased the risk that consumers will not understand or notice key terms that affect a plan's cost. With so many rates, fees, and features, it has become more likely that even reasonably diligent consumers make costly mistakes. Moreover, when complexity reaches the point of reducing transparency, it impedes competition and creates inefficiencies.

Even when credit card plans were simpler, ensuring that consumers understood the cost of using the plan or of using it for a particular purpose was a challenge. Key variables that affect a consumer's costs, such as the amount of credit the consumer will use or the timing and amount of the consumer's payments, are not known in advance to the card issuer. TILA, therefore, does not require advance disclosure of a single, effective rate. It requires the issuer to disclose a nominal rate and other terms that determine the cost of the plan, such as fees, any grace period, and the balance calculation method. Clear disclosure of these terms and how they determine what the consumer will pay has always been a challenge. The disclosure challenge has grown substantially with the increase in the complexity of credit card plans.

The Board has sought to meet this challenge with a systematic and comprehensive review of TILA disclosures based on extensive consumer testing. We believe that our June 2007 proposal will lead to disclosures that are more effective for today's more complex credit plans. Those who have commented on the proposal have generally agreed. At the same time, over two thousand comments from individual consumers, a growing body of behavioral research, and our own consumer testing provide evidence that it is increasingly difficult to use disclosure alone to help reasonably diligent consumers avoid incurring unnecessary costs on their increasingly complex credit card plans. Careful measures that would restrict credit card terms or practices may in some instances be more effective than disclosure to prevent particular consumer injuries. At the same time, such restrictions can have unintended adverse consequences for consumers, such as reducing the availability of credit or increasing its cost.

Mindful of the advantages and limitations of both disclosure and stricter approaches, the Board is developing a second set of rules to supplement the June 2007 disclosure proposal with new targeted requirements and restrictions on credit card terms. ...

    Posted by on Friday, April 18, 2008 at 12:17 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (14)

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