Post-Crisis Consumer Financial Protection: Did it Help?

Courtesy of Javier Garcia Gonzalez

After the financial crisis of 2007-2008, there was a wave of regulatory changes in the US regarding consumer financial protection that mostly applied to mortgages and student loans. These new regulations granted consumers additional disclosures, banned abusive practices and fought deceptive practices. It was consistent with the narrative that consumers were being exploited by banks and financial companies.

I studied the effects of these regulatory changes in Garcia Gonzalez (2018). [1] I used a difference-in-differences model to measure how market equilibrium changes in terms of credit supply and credit costs. The data used in this study was the Survey of Consumer Finance dataset of 2013 from the Federal Reserve to measure credit costs, and the Home Mortgage Disclosure Act dataset from the FFIEC to measure credit supply. Out of all the regulations considered in the study, I found significant results for three of them. However, only a rule outlawing mortgage abuses was found to be effective, the FTC advertising rule of 2011. This rule decreased equilibrium credit costs without constraining credit availability.

For each regulation, I interpret changes in credit supply and credit cost according to the literature on consumer exploitation.[2] A cornerstone paper in this literature is Gabaix and Laibson (2006). The model considers two types of consumers, some are sophisticated and others are naïve. Firms can offer a single (financial) product at a single price, or they can split the product into the base product and an add-on. The price of the base product is public but the price of the add-on is shrouded. Naïve consumers can only observe the price of the base product and are unable to infer the price of the shrouded add-on. In equilibrium, naïve consumers are exploited by firms through shrouded add-ons.

Proposed regulation falls into two categories. The first one consists in giving timely disclosures to consumers so they can make better decisions. The alternative is to forbid the mechanisms that allow exploitation, for instance declaring certain contract clauses void and null, or forbidding certain practices. Coming back to the add-on model, regulation could mandate the disclosure of the add-on price, or it could forbid selling the base product and the add-on separately.

If consumers were being exploited in the marketplace and regulation was effective, we should witness a credit cost decrease and/or a credit supply increase. The alternative scenario is that regulation was not effective or there was no exploitation. In this case credit supply decreases, credit costs increase or there is a trade off between credit supply and credit costs.

The earliest regulation studied is the “Home-Ownership Equity Protection Act”(HOEPA) rule of 2008. I evaluated the high-cost mortgage provisions of this act. It extended high-cost coverage from non-purchase mortgages secured by the main dwelling to home-purchase mortgages secured by the main dwelling. The high-cost provisions grant consumers additional disclosures and restrict certain loan terms. Additionally this rule prohibited prepayment penalties, mandated stricter verification for ability to repay and changed the threshold to identify high-cost mortgages. Results show worse credit availability for newly covered mortgages, which I interpret as ineffective regulation. It is also associated with an increase in credit costs for newly covered mortgages, but this part is not significant.

The “Higher Education Opportunity Act”(HEOA) of 2008 regulated private education loans and preferred lender agreements. Before loan consummation, students have to obtain a self-certification form provided by an educational institution, sign it and hand it to the lender. The form contains disclosures and information about government loan programs. The regulation also prohibits co-branding with educational institutions, revenue sharing or gifts. Results show that the imposition of this regulation caused implicit credit costs for educational loans to increase significantly. One possible explanation is that the required procedures and paperwork were excessively cumbersome for lenders.

The last regulation with significant results is the FTC advertising rule of 2011, which was shown to be effective. This rule outlawed deceptive claims and material misrepresentations about consumer mortgages. More importantly, the FTC was allowed to collect the penalties specific to mortgage abuses. This incentive is key since most abuses were already illegal. Results show that implicit credit costs decreased, and credit supply increased, after the regulatory change for covered mortgages. These results indicate that deception was present in retail financial markets prior to the regulation’s establishment. Traditionally, the academic literature assumed that market agents were completely rational; in that framework, it is very difficult to fool consumers twice. The presence of deception in retail financial markets supports alternative theories, e.g. behavioral finance and bounded rationality, in which consumers are not fully rational.

Although there are no significant results associated with the compensation ban rule of 2011, it is worth briefly mentioning. This rule prohibited payments from lenders to loan originators on terms other than the amount loaned. However, according to the theoretical model of Inderst and Ottaviani (2012), this regulation is futile.[3] In that framework, the required regulatory change is to ban any form of compensation between lender and originator, which is likely why the limited ban proved ineffective.

After evaluating the impact, or lack thereof, of these new regulations, it is clear that policymakers and regulators need to think more critically about potential unintended consequences during the rule making process. Of the regulations mentioned above, two have been counterproductive due to excessive complexity and burdensome requirements.

This not the first study that uncovered regulatory frictions in consumer financial markets. For instance, Stango and Zinman (2011) found that enforcement of the Truth in Lending Act (TILA) was a source of friction in the US consumer credit market. Stricter TILA enforcement was associated with costlier loans on average. On the other hand, stricter enforcement diminished the difference in interest rates paid by more and less sophisticated borrowers.

Consumers are not completely rational agents. If consumers are rationally bounded, regulators should push towards simplicity; for example, by making disclosures easier to understand, even if they are not complete. Overly complex regulation can have counteracting effects and give an advantage to sophisticated lenders, who can use this advantage in ways that reduce market efficiency. [4]



[1] Garcia Gonzalez, J., 2018. Effects of Consumer Financial Protection Introduced after the Financial Crisis of 2007-2008.

[2] Gabaix, X. and Laibson, D., 2006. Shrouded attributes, consumer myopia, and information suppression in competitive markets. The Quarterly Journal of Economics, 121(2), pp.505-540.

Heidhues, P., Kőszegi, B. and Murooka, T., 2016. Inferior products and profitable deception. The Review of Economic Studies, 84(1), pp.323-356

Inderst, R. and Ottaviani, M., 2012. How (not) to pay for advice: A framework for consumer financial protection. Journal of Financial Economics, 105(2), pp.393-411.

[3] Inderst, R. and Ottaviani, M., 2012. How (not) to pay for advice: A framework for consumer financial protection. Journal of Financial Economics, 105(2), pp.393-411.

[4] Stango, V. and Zinman, J., 2011. Fuzzy math, disclosure regulation, and market outcomes: Evidence reform. The Review of Financial Studies, 24(2), pp.506-534.

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