RTTNews - Federal Reserve Board Governor Elizabeth Duke addressed the consumer side of the financial crisis Wednesday, explaining how the imbalanced incentive system has shaken consumer confidence and suggesting that a more balanced approach will be the best way to go forward.
Speaking at the Cleveland Federal Reserve's 2009 Community Development Policy, Duke explained the close relationship between consumer protection and consumer confidence, calling for more protections in order to boost confidence.
If we have learned nothing else in this crisis, we have learned that consumer protection is not just good for consumers; it is also necessary to restore investor confidence and promote a strong and stable economy, Duke said.
She noted that one of the ripple effects of the loss of investor confidence was the loss of consumer confidence, particularly in the housing system. The housing crisis revealed significant predatory lending practices that were not consumer-friendly, Duke said, shaking consumer confidence.
Some lenders, brokers, appraisers, and investment banks were clearly motivated by transaction fees and had little incentive to ensure that borrowers would be able to sustain homeownership, she said.
In order to shore up their balance books, banks cut back lending and increased prices of loans. This contributed to a negative feedback cycle as consumers cut spending in the face of rising unemployment and an economy in recession.
The effect of these practices, combined with the impact of job losses and other ramifications of a shrinking economy, have had a significant impact on consumer confidence, Duke noted. Consumer spending has fallen off as a result, further exacerbating the negative cycle.
In order to reform the system, Duke called for more balanced incentives, i.e. lessening the focus on immediate profits and including a larger focus on longer-term prosperity.
While I don't necessarily believe we need to return to a time when all loans are held on balance sheet, I do believe we need a system of balanced incentives for the longer-term prosperity of all, Duke explained.
Going further into the topic of front-loaded compensation, Duke discussed how the current financial crisis was sparked by a misalignment of incentives.
Compensation structures were.problematic, she explained.
Specifically, compensating loan originators on the number of loans rather than the quality of the loans opened the door for consumer abuse, she said.
Recognizing that, Duke explained a crucial problem in fixing the financial markets. The effectiveness of consumer protection laws will be tempered as long as the structure remains front-loaded, she explained.
Consumer protections cannot be viewed as an ancillary component of a scheme to regulate for safety and soundness, she said. Rather, they are fundamental to the quality of the credit upon which the economy is built.
Still, discouraging compensation can negatively impact the dynamic nature of the economy, she said, one of its features that makes it so strong.
The tension between protecting consumers and making credit broadly available is one that is as important in making an individual loan as it is to ensuring the stability of the economy, she said.
In order to address these issues, Duke called for consumer protections to be put into place in order to restore consumer confidence. Because, she explained, the economy will only recover if consumer confidence is restored.
The Federal Reserve has taken several steps in order to boost confidence, Duke said, focusing on credit card reform advocated by members of the Fed. Increased transparency and more disclosures are central tenants of this reform, she explained.
The Federal Reserve has used its regulatory authority to develop extensive new disclosures for a variety of financial products, including credit cards, Duke said. We are currently in the midst of a major overhaul of mortgage disclosures.
For an example, she offered the Fed's revised rules on credit card disclosures, which will require companies to be more transparent, shifting from dense, jargon ridden language for the terms and conditions to a simpler table format that contained the same information.
The goal of the efforts to enhance consumer protection is to restore consumer confidence, Duke said.
Being attentive to the interconnection between meaningful consumer protections and broad access to credit will ensure a more lasting and sustainable economic recovery, she said.
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