Regulating consumer credit

Journal of Economics and Business 84 (2016) 1–13 Contents lists available at ScienceDirect Journal of Economics and Business Editorial Regulating consumer credit夽 a r t i c l e i n f o Keywords: Consumer credits Regulations Mortgages Consumer protection Financial crisis JEL classification: G21 G28 G18 1. Introduction Problems arising from the consumer credit market were at the heart of the financial crisis generating the Great Recession. The housing market boom was accompanied by a rapid expansion of easy mortgage credit, and the strong period of economic growth after 2002 through 2006 was characterized by credit expansion in virtually all other forms of consumer credit: home equity loans and lines of credit, credit cards, auto loans and student loans. This expansion of mortgage and consumer credit contributed to bubble conditions in housing markets and raised household ratios of debt payment-toincome to levels that proved unsustainable. When home prices reversed direction and credit tightened, the foreclosure crisis ensued and consumers began a prolonged process of deleveraging. The combination of collapsing home prices, a severe reduction in household wealth and spending, and contraction of bank credit supply and other financing channels generated the Great Recession and the subsequent period of sluggish economic growth.1 夽 The views and opinions expressed in this paper are those of the authors and not necessarily the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. 1 Gorton and Metrick (2012) provided an overview of the role of bank liquidity shortfalls and credit contraction in fueling the downturn. Kahle and Stulz (2013) questioned this role, while Mian and Sufi (2014) emphasized the role of household debt and associated impacts on consumer wealth and spending as a cause of the Great Recession. http://dx.doi.org/10.1016/j.jeconbus.2016.02.008 0148-6195/© 2016 Published by Elsevier Inc. 2 Editorial / Journal of Economics and Business 84 (2016) 1–13 As a result of this experience there has been a significant increase in consumer credit regulation. The largest banking organizations now are required to conduct annual stress testing of their ability to withstand severely adverse economic scenarios, which incorporate simulation of credit losses from mortgages, credit cards, auto loans, and other retail portfolios. Their capital planning is contingent on the outcome of these stress tests and of supplementary supervisory stress tests conducted by the Federal Reserve. In addition, consumer financial protection regulation has been strengthened and expanded, most significantly through the establishment of the Consumer Financial Protection Bureau as part of the Dodd–Frank Act in 2010. Levitin (2013), provides a detailed discussion of the CFPB’s rulemaking, supervisory, and enforcement powers along with an overview of the historical, legal, and political context out of which it arose. As described by Levitin (2013), “the agency exists with a high degree of independence and significant regulatory power over the consumer financial services industry (excluding most types of insurance and securities/commodities investment.)” Thus, the Great Recession and its aftermath have brought increased attention to the role of consumer credit in economic activity and the appropriate framework for regulation of consumer credit. On April 30–May 1, 2015, the Federal Reserve Bank of Philadelphia, the Fox Business School of Temple University, and the Journal of Economics and Business convened a conference in Philadelphia on “Regulating Consumer Credit.” The conference brought together experts from the academic, public policy and industry sectors to share knowledge and present and discuss new research on topics in consumer financial regulation. Consumer credit regulation is an immensely varied subject that ranges from direct consumer protections such as fair lending laws and certain rules governing real estate settlement procedures to indirect protections such as requirements around disclosure of loan terms. The web of consumer financial regulation also includes laws and regulations impacting the resolution of defaulted mortgages and consumer debt, including bankruptcy and foreclosure laws; and laws and regulations governing consumer credit reporting. It further encompasses regulation primarily aimed at ensuring the safety and soundness of financial institutions, such as stress testing requirements. Viewed more broadly, consumer financial regulation also extends to various government interventions in credit markets aimed at making mortgages, student loans, and small business loans more widely available, such as the Federal Housing Administration mortgage insurance program and the Small Business Administration’s loan guarantee programs.2 Needless to say, a 2-day conference can only effectively address a sampling of topics from such a diverse inventory. The Philadelphia conference had a concentration of papers in two particular areas of consumer financial regulation: the structure and regulation of mortgage contracts and supervisory stress testing of retail credit portfolios. The various other papers presented at the conference addressed topics related to the regulation of retail banking relationships. This special issue includes selected papers from the conference. 2. The dual goals of consumer credit regulation As background for reading the papers in this special issue, it may be helpful to briefly consider the broad goals of consumer credit regulation. Consumer credit regulation can be characterized as having two broad and overlapping objectives: (1) improving consumer welfare by expanding household access to credit or protecting consumers from unsuitable credit products or unfair and deceptive practices and (2) protecting the safety of financial institutions. At various times, one or the other objective has received a greater emphasis, depending on the particular historical context associated with the legal or regulatory intervention. According to Levitin, 2013, early consumer credit regulation, both state and federal, was aimed at promoting the 2 Levitin and Wachter (2013) characterized such “public options,” whereby the federal government competes in the market against private enterprises, as a form of regulation. They contend that “since the New Deal (and with roots going back to at least World War I), the fundamental approach of the U.S. housing finance regulation has been the p̈ublic option. . . By having the government as a market participant with substantial market presence, the government has been able to set the terms on which much of the market functions.” Editorial / Journal of Economics and Business 84 (2016) 1–13 3 financial health of state or federally chartered banking organizations and preventing them from bearing excessive risk. For example, “the federal government’s intervention in housing finance, including interest rate caps on mortgages insured by the Federal Housing Administration or Veterans’ Administration, was deliberately aimed at fostering the use of long-term, amortized mortgages because of their macroeconomic stability benefits” (Levitin, 2013, p. 325). Other regulatory initiatives have been more directly aimed at protecting individual borrowers. According to Levitin, 2013, the Consumer Credit Protection Act of 1968 was a landmark event in this respect. In particular, it established requirements for disclosure of credit terms to consumers; restricted garnishing of wages; and prohibited discrimination with respect to any aspect of credit transactions on the basis of specified protected factors such as race and marital status.3 A more recent example is the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009. The CARD Act was aimed at protecting consumers against potentially harmful practices of financial institutions that issue consumer credit cards, such as retroactive or unfair rate increases and late fees that result from bills that arrive close to the due date.4 Traditional arguments favouring regulation to protect consumers in financial transactions emphasize market failures or divergence between private and social interests. Belsky and Wachter (2010) attributed to consumer credit regulation “the goals of correcting market failures, promoting positive externalities, and pursuing equity and equal treatment.” They contended that consumer and mortgage credit markets “are prone to market failures that the market itself is unlikely to correct.” Significant sources of market failure in mortgage and consumer credit markets may include information asymmetries; misaligned incentives; and consumer search and switching costs that may enable lenders to exercise a degree of market power over borrowers (Campbell, Jackson, Madrian, & Tufano, 2011). The field of behavioural economics has given increased impetus to economic arguments supporting consumer credit regulation.5 Campbell et al. (2011) emphasized “mounting evidence” that many consumers diverge from time-consistent, rational decision-making. In particular, consumer financial decisions may reflect cognitive biases such as downplaying the likelihood of potential adverse outcomes or exercising short-term impatience that conflicts with long-term preferences (present bias).6 Some consumers “may lack the cognitive capacity to optimize their financial situation even if presented with all the information that in principle is required to do so.” Moreover, “these considerations provide a rationale for consumer financial protection that goes beyond the standard market failures, both because unregulated financial markets may be inefficient and because they may generate undesirable distributional outcomes.” The dual goals of fostering the safety and soundness of financial institutions and protecting the interests of individual borrowers have often been mutually supportive, and the events of the Great Recession clearly demonstrate this interrelationship. These events have brought increased focus on how the safety and soundness of financial institutions is intertwined with protecting the financial interests of individual and household borrowers. Thus, for example, the stress testing mandated by the Dodd–Frank Act is a means of ensuring that banks hold appropriate levels of capital in relation to credit risk. At the same time, by requiring higher levels of capital for riskier lending activities, stress testing provides a disincentive to engage in lending practices that lure households into levels of indebtedness contrary to their long-run financial interest. As another example, Title XIV of the Dodd–Frank Act (and the rules issued by the CFPB implementing these requirements), requires creditors to make a reasonable, good faith determination of a consumer’s ability to repay a mortgage loan.7 While primarily a protection for consumers against being lured 3 See https://www.law.cornell.edu/uscode/text/15/chapter-41 for a detailed summary of the provisions of this law. See https://www.law.cornell.edu/wex/consumer credit. 5 Barr, Mullainathan, and Shafir (2009) provided a comprehensive discussion of behavioral views on consumer financial decisions and the regulation of consumer credit. For a recent review of theories and evidence on inefficient credit supply arising from either market failures or behavioral factors, see Zinman (2014). 6 Kuchler (2013) emphasized the importance of distinguishing between borrowers who are aware of their present bias, and those who are not, in analyzing consumer credit behavior and formulating regulatory policy. 7 See http://files.consumerfinance.gov/f/201509 cfpb readiness-guide mortgage-implementation.pdf. 4 4 Editorial / Journal of Economics and Business 84 (2016) 1–13 into an unsustainable debt situation, it also represents a barrier to excessive risk taking by financial institutions. As Loretta Mester stated in her keynote speech at the Philadelphia conference8 : “The significant toll that the financial crisis and Great Recession have taken on the economy underscores the need for improving our knowledge of the important linkages between the health of the consumer financial sector and the health of the broader macroeconomy and financial markets.” 3. Balancing the costs and benefits of consumer credit regulation Our background discussion thus far is incomplete, insofar as we have reviewed the goals—the “why”—of consumer credit regulation, but have not considered the “how.” It is important to recognize the challenges involved in developing an effective regulatory response to a particular failure or inefficiency in consumer credit markets. The design of a regulatory response may be critical in determining how effective it will be. For example, Campbell et al. (2011) advised, with respect to the design of disclosure requirements, that disclosure needs to “be salient and easy to understand” and should reflect “how consumers actually use information to make decisions” or the “average customer experience.” The calibration of the response is also important. Regulations can be costly for lenders to implement and or regulators to enforce; thus, regulations that are too weak or ineffective to produce the desired result impose a net social cost. Along these lines, Campbell et al. (2011) argued that the CFPB “should monitor the effectiveness of disclosures” and if “disclosures are only weakly effective, then the bureau can consider more intrusive regulation, for example by requiring an explicit opt-in for features of financial products that appear difficult to understand.” However, when too restrictive, regulations aimed at protecting consumers from unsuitable products might impede individuals’ access to credit to a degree inconsistent with the consumer’s long-run interests.9 For example, Zinman (2010) presented evidence that restrictions on payday lenders in Oregon had adverse impact on the financial condition of borrowers (as measured by employment status and subjective assessments). Carrell and Zinman (2014) found that restrictions on payday lending to military personal had adverse impact on their job performance. Likewise, regulations aimed at precluding excessive risk taking by financial institutions, if not calibrated carefully, could lead to excessive credit tightening that could slow housing market activity and consumer spending with adverse effects on economic growth. Despite such challenges, consumer credit regulations can be effective. For example, Agarwal, Chomsisengphet, Mahoney, and Stroebel (2014) evaluate the effectiveness of the 2009 Credit Card Accountability Responsibility and Disclosure (CARD) Act. They found that regulatory limits on credit card fees has been effective in reducing the overall borrowing costs to consumers-an average annualized 1.7% of average daily balances. The saving is even larger for consumers with lower credit ratings-more than 5.5% for consumers with FICO scores below 660. Furthermore, they find no evidence of reduction in volume of credit. Overall, they estimate that the CARD Act fee reductions have saved U.S. consumers $12.6 billion per year.10 Ongoing research, such as the papers cited above and those presented at the April conference at the Federal Reserve Bank of Philadelphia, is vital for developing consumer credit regulations that protect consumers and foster financial market stability without significant unintended consequences. 8 Loretta Mester is President and CEO of the Federal Reserve Bank of Cleveland. Her speech titled “Consumer Credit: Suggested Directions for Policy-Relevant Research” is also available online at https://www.clevelandfed.org/newsroom%20and%20events/ speeches/sp%2020150501%20consumer%20credit%20suggested%20directions. 9 In addition, consumer credit restrictions imposed by laws could also harm consumers that do not use any form of consumer credit. For example, consumer credit regulations could provide incentives for banks to increase fees on bank accounts, ATM transactions, and other services to offset the loss of fee income from regulated activities, resulting in some consumers having to leave the traditional banking system altogether as simple checking accounts become less affordable for them. 10 Bar-Gill and Bubb (2012), however, find that the Card Act had limited impact on the overall cost of card debt to consumers, because it did not address the high interest rates that arise from imperfect competition due to consumers’ switching costs or behavioral biases. Editorial / Journal of Economics and Business 84 (2016) 1–13 5 As noted by Loretta Mester in her keynote speech at the conference, “conferences like this one help us identify what we know and what we do not know, a necessary step on the road to more effective regulation and policymaking.” 4. Regulation of mortgage contracts Particular types of mortgage contracts that proliferated during the boom period in the housing market, and various rigidities in mortgage contracts or in the laws and regulations governing them, significantly exacerbated the mortgage crisis. Innovation and improvement in the design and regulation of mortgage contracts might be an effective way to mitigate risk in mortgage lending, protect consumers from harmful lending practices, and promote sustainable homeownership. The literature on the mortgage crisis generally points to an unsustainable rise in house prices in conjunction with overly lax credit standards as primary causes of the crisis. In particular, the period of rising prices was characterized by the proliferation of subprime and non-traditional mortgages that were priced too low and were allocated insufficient capital in relation to their risk of default. Lenders’ expectations of sustained house price increases may have enabled this accumulation of risk, and the expansion of high risk lending in turn may have enabled the continued rise in house prices.11 Davidson, Levin, Pavlov, and Wachter (2016), in this special issue) sheds new light on the role played by expansion of non-traditional mortgage products.12 This study separates the growth in nontraditional mortgage lending into two components, one associated with mispricing and the second associated with other characteristics of these mortgages; namely, lax underwriting requirements and aggressive marketing practices. The study finds that states with more rapid expansion of nontraditional mortgage lending experienced larger house price declines during the subsequent crisis period, mostly attributable to the latter (underwriting and marketing) component.13 Thus, the study suggests that it was the eased credit standards and aggressive marketing of non-traditional products rather than the mispricing that was most closely tied to house price volatility. 4.1. Foreclosure rules Cordell and Lambie-Hanson (2016), in this special issue, examined the lengthening of the foreclosure timelines over the course of the mortgage crisis period.14 This research suggests that some rules governing the foreclosure process have had undesirable impacts and ought to be reconsidered. The paper particularly focuses on the impact of the judicial review process, which is one of the mortgage credit regulations that intend to protect consumers by allowing them sufficient amount of time to cure after being delinquent on their mortgage before lenders are allowed to start the foreclosure process. They concluded that the judicial review imposes large costs with few, if any, offsetting benefits. They found no supporting evidence that foreclosure delay enables more consumers to cure their delinquent mortgage or to receive mortgage modification. They also examined the impact of similar rules imposed by the CFPB, which strictly prohibit a foreclosure filing before 120 days. Similarly, they find that these rules have effectively lengthened foreclosure timelines without significant offsetting benefits. Cordell and Lambie-Hanson (2016) also found that foreclosure delay has slowed house price recovery and caused greater house price depreciation in the nearby geographic areas. In addition, they 11 See, for example, Goetzmann, Peng, and Yen (2012), Anderson, Capozza, and Van Order (2011), Berkovec, Chang, and McManus (2012), Brueckner, Calem, and Nakamura (2013), and Brueckner, Calem, and Nakamura (2015). In addition, Mian and Sufi (2009) pointed to the role of securitization in expanding the supply of subprime mortgages. Lang and Jagtiani (2010) emphasize failure of risk management, especially in failing to address the risk of a major house price decline. 12 Susan M. Wachter, the presenter, is the Richard B. Worley professor of financial management, a professor of real estate and finance at the Wharton School, and co-director of the Penn Institute for Urban Research. 13 Davidson, Levin, and Wachter (2014) presented evidences that credit risk in nonprime-quality loans was generally mispriced going into the 2004–2006 housing bubble. 14 Larry Cordell, the presenter, is Vice President of the Risk Assessment, Data Analysis and Research (RADAR) Group at the Federal Reserve Bank of Philadelphia. 6 Editorial / Journal of Economics and Business 84 (2016) 1–13 examined the impact of the new mortgage servicing rules, which were recently enacted by the Consumer Financial Protection Bureau (CFPB) in 2014, with the intention to protect consumers from detrimental actions by mortgage servicers and to provide consumers with better tools and information when dealing with mortgage servicers. The CFPB rule requires mortgage servicers to quickly approve or deny modifications. They found these rules to have contributed to the lengthening of foreclosure timelines, while providing little benefit in in the form of improved cure rate or frequency of loan modification.15 4.2. Ease of refinancing Bond, Elul, Musto, and Garyn-Tal (2013) noted that in most of the US states, mortgage seniority is based on timing of origination, whereby seniority is granted to the older mortgage.16 Such prioritization of the older mortgage may impede refinancing of a senior mortgage in the presence of a junior lien—the replacement will have to surrender seniority to the pre-existing junior mortgage (unless the existing junior lienholders sign subordination agreements.) Because refinancing at lower interest rates reduces a borrower’s monthly payment obligation, this institutional rigidity may adversely impact mortgage delinquency risk. In this research, the impact on refinancing of prioritizing the older mortgage is explored by contrasting states that do and do not require consent of the junior lienholders. The study finds a significant negative impact of the prioritization rule on likelihood of refinancing the first lien. The effect is largest for first-lien mortgages with relatively small balances and for those close to the conforming limit. The study also shows that successful refinancing reduces future mortgage delinquency. Tracy and Wright (2014) also analyzed the relationship between the ability to refinance and future credit performance, by focusing on the impact of the Home Affordable Refinance Program (HARP). The paper estimates a competing risk model quantifying the sensitivity of default risk to downward adjustments of borrowers’ monthly mortgage payments for a large sample of prime adjustable-rate mortgages. The estimated model implies that the HARP average monthly payment reduction of 13.8% lowers the cumulative 5-year default rate on prime conforming adjustable-rate mortgages with loanto-value ratios above 80% by 160 basis points. Thus, the study demonstrates that refinancing reduces mortgage defaults and credit losses, and that programs such as HARP that facilitate refinancing can be effective for mitigating mortgage credit risk. 4.3. Home equity line of credit (HELOC) contracts Emerging issues around home equity products have been mainly focused around the home equity line of credit. HELOCs are structured such that there is a fixed period (typically 10 years) during which the line can be drawn on and the required monthly payment is the interest on the outstanding balance. At the expiration of this period, known as the end-of-draw date (EOD), the line converts to a closedend, amortizing loan.17 At that point borrowers who have not already closed their HELOC are required either to pay off the remaining balance (balloon payment), or to convert the balance into an amortizing loan. In either case, borrowers typically face a substantial increase in their required payment. In the past, almost all borrowers reaching end-of-draw were able to roll their balances over into a new HELOC and avoid the increased payment. Because of the significant decline in house values during the Great Recession, many borrowers now approaching end of draw have such high loan-to-value ratios that they are precluded from taking out a new HELOC. 15 While the foreclosure delay may not have improved the cure rate, Calem, Jagtiani, and Lang (2015) found that the longer foreclosure timeline enabled consumers to improve their performance on non-mortgage credit, such as cure delinquent credit cards. 16 Ronel Elul, the presenter, is a senior advisor and economist in the research department at the FRB Philadelphia. 17 In some cases, the conversion from interest-only to amortizing occurs later than the date at which the line is closed to additional borrowing. Editorial / Journal of Economics and Business 84 (2016) 1–13 7 Given that a large share of outstanding HELOCs will reach EOD in the next several years, an important question is how the increase in required payments will affect future default rates. Two research papers providing analyses of this issue were presented at the conference. Sarama and Johnson (2014) estimated a competing hazard model of default and payoff for HELOCs still in their draw period, using account-level data on HELOC repayment performance covering the period January 2002 through June 2012, collected by a private vendor from several large banks. The authors apply the model to predict cumulative repayment performance between October 2012 and October 2014 of HELOC accounts comprising the Y-14M HELOC regulatory data, which have been collected from large banking organizations (greater than $50 billion in assets) since June, 2012.18 They found that the model does a good job of predicting default for HELOCs that did not reach EOD during the observation period, but it significantly underestimates default for HELOCs that hit EOD.19 The underestimate is greater for HELOCs originated to borrowers with lower credit scores and higher combined loan to value ratios as they approach EOD, and is particularly large for HELOCs with balloon payments at EOD. Epouhe and Hall (2016), in this special issue, also analysed the impact of the payment increase on HELOC borrowers approaching end-of-draw, by estimating default and prepayment models capturing end-of-draw behaviour. They confirmed the significant impact demonstrated in Sarama and Johnson (2014), while also identifying mitigating factors. Epouhe and Hall (2016) found that some borrowers are able to either pay off or refinance their HELOCs, and this leads to a spike in prepayments timed around the end-of-draw date. Among those who do not prepay, they find a later spike in defaults that peaks 3 months after end-of-draw and stays elevated relative to the level prior to end-of-draw. They find that the degree to which the default rate increases is related to the size of the payment increase. Balloon payment requirements cause increases in default probability but the effect is smaller than might be expected perhaps because many of those borrowers reduced balances in anticipation of the balloon payment requirement. Epouhe and Hall (2016) used their estimated default and prepayment models to simulate the behaviour of cohorts of HELOCs approaching end-of-draw. In particular, they show that, for borrowers with higher credit quality, the effect of higher default rates after end-of draw is considerably reduced by substantial anticipatory prepayment. It is well documented that consumer behavior is difficult to predict, as consumers face multiple incentives and constraints-see Campbell (2006). Predicting consumer credit performance around HELOC delinquency has become even more complex since the recent financial crisis. Jagtiani and Lang (2011) and Andersson, Chomsisengphet, Glennon, and Li (2013) find that consumers changed their payment priorities over the course of the deep downturn, tending to prioritize HELOC payments over paying their first mortgage.20 Jagtiani and Lang (2011), Andersson et al. (2013), and Calem and Sarama (2016) developed a variety of motivations for this prioritization, including attempt to maintain access to credit, ability-to-pay considerations, and strategic default (on first mortgage) as a response to market conditions (declining home values). 4.4. New contract designs for risk mitigation Karamon, McManus, and Yannopoulos (2016), in this special issue, proposed a new type of mortgage product-the continuous forbearance mortgages (CFM), which has an embedded insur- 18 The regulatory data used here is the loan level FR Y-14M data, which is reported monthly by CCAR banks to the Federal Reserve. 19 For this analysis, they single out accounts that hit EOD between June and December of 2013. 20 This is opposite to the traditional expected behavior where of keeping the first lien mortgage current to avoid losing their home. 8 Editorial / Journal of Economics and Business 84 (2016) 1–13 ance contract at origination.21 The embedded contract would reduce the interest bearing balance to the smaller of the unpaid balance and an estimate of the current home value, in exchange for an additional premium in the mortgage note rate. Robert Avery, who discussed the paper at the conference, expressed support for the new product.22 The paper considers a counterfactual in which all the US mortgages had this CFM feature at the start of 2006. The CFM mortgage payment is reduced in periods in which the estimated home value falls below the unpaid balance, and is reduced fractionally based on the ratio of home value to loan balance. The authors estimate that CFM mortgages would have resulted in significant mortgage payment savings and a substantial reduction in the frequency of default. Hancock and Passmore (2016), in this special issue, evaluated the costs and benefits associated with their proposal for a new adjustable-rate mortgage product with interest rates tied to a nationwide bank cost of funds index (COFI), that would be eligible for government-backed insurance to cover only catastrophic losses (Cat insurance). They examine the costs and benefits of these COFI-Cat mortgages from the perspective of consumers, lenders, and policymakers. Mortgage rates tied to COFI would eliminate the need for households to refinance when market rates decline, thereby saving them the costs of refinancing. The benefit of lower market rates would also be passed along to households with little or no home equity and/or low credit scores, who ordinarily might be unable to refinance to a lower rate mortgage. As a result, the need for special federal programs to facilitate refinancing by such borrowers, such as the Home Affordable Refinance Program or the Home Affordable Modification Program is potentially reduced. Moreover, Hancock and Passmore (2016) argued that COFI contracts in combination with credit risk transfer transactions structured in a manner that the government backs only catastrophic risks imply guarantee fees that are lower than those actually charged by Fannie Mae and Freddie Mac during 2012–2014. 5. Stress testing of retail portfolios Some banks that failed during the crisis actually met the regulatory definition of “well capitalized” in the year prior to their failure, suggesting that the capital standards at that time failed to maintain sufficient capital in the banking system. Under the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) regulations, the largest banking organizations (greater than $50 billion in assets) annually undergo a rigorous capital stress testing process. All banking organizations greater than 10 billion in assets are subject to mandatory, annual stress tests under the Dodd Frank Act. The CCAR stress testing process comprises four primary areas of assessment. First, the Federal Reserve conducts supervisory stress testing of each institution using supervisory models of credit, market, and operational risk, and models of revenues and expenses, and balance sheet growth, in relation to supervisory scenarios for macroeconomic stresses. Second, institutions apply their proprietary models to assess their ability to withstand the supervisory scenarios and institution-specific scenarios developed internally. Third, supervisors review and assess each institution’s capital plan in light of the various stress test results.23 Fourth, the regulatory agencies assess each institution’s risk models, model validation and risk management process, and risk governance structure. Those deemed by supervisors to have insufficient capital or significant inadequacies in their capital planning processes may be directed to revise their capital plans, such as to reduce or eliminate planned dividend payouts.24 21 Doug McManus, the presenter, is the Director of Financial Research in the Office of the Chief Economist at Freddie Mac where he has worked on issues related to financial markets, credit scoring, credit loss forecasting, fair lending testing, and house price modeling. 22 Robert Avery is the Project Director of the National Mortgage Database at the Federal Housing Finance Agency. 23 See Allen, Goldstein, Jagtiani, and Lang (2016) for discussion of the objectives and design of bank stress tests. 24 An institution is granted a one-time opportunity to adjust its planned actions after being informed of the results from the Federal Reserve’s supervisory stress test. An institution that receives a supervisory objection to its capital plan can make only those distributions pre-approved by the Federal Reserve. Editorial / Journal of Economics and Business 84 (2016) 1–13 9 Papers presented at the conference addressed several important issues related to the effectiveness of stress testing as a supervisory tool for promoting the stability of financial institutions markets. These include the elements of an optimal capital plan in relation to bank risk exposure; concerns around the potentially pro-cyclical nature of stress testing, and concerns for stress testing to have pro-cyclicality impacts; and concerns that models will not “keep up” with dynamic developments in mortgage and consumer credit markets. Hirtle (2014) spoke at the conference about her paper, which analyzes timing and size of dividend payouts during the crisis period in relation to ex-ante (pre-crisis) stock repurchase activity, among institutions with at least $5 billion in assets.25 The study documents that while many large US bank holding companies (BHCs) continued to pay dividends during the recent financial crisis, their share repurchases by these BHCs dropped sharply in the early part of the crisis. In addition, the paper provides some evidence suggesting that greater reliance on repurchases for capital and liability management reduces the variability of dividend payouts.26 Overall, the analysis suggests that greater reliance on stock repurchase strategies ex-ante enhances an institution’s flexibility in capital planning, particularly in responding to adverse shocks to capital. From a policy perspective, according to Hirtle (2014), “the results suggest that bank holding companies could be encouraged to make more of their capital distributions in the form of share repurchases, due to the greater flexibility and market tolerance for variability in this form of distribution.” The paper by Smith, Fuller, Bogin, Polkovnichenko, and Weiher (2016), in this special issue, critiques the pro-cyclical nature of the recent CCAR and DFAST stress test scenarios for mortgage portfolios, and of the Basel III risk-based capital rules.27 This paper evaluates an alternative countercylical approach initially proposed in Smith and Weiher (2012). The paper published in this special issue demonstrates that Smith and Weiher (2012) countercyclical capital regime would produce capital requirements sufficient to ensure that an entity would remain solvent during severe house price cycles. They add that if the countercyclical capital requirement had been in place during the run-up to the recent house price bubble, Fannie Mae would have been sufficiently capitalized to withstand losses it sustained in the subsequent housing crisis. Kris Gerardi and Paul Willen presented their analysis, Frame, Gerardi, and Willen (2015), of how the Office of Federal Housing Enterprise Oversight’s (OFHEOs) risk-based capital stress test for Fannie Mae and Freddie Mac failed to indicate the scope of potential credit losses.28 They find two key problems with the OFHEO stress test model, which provides a sobering lesson on the potential pitfalls of stress testing. First, similar to the above concern about using stress scenarios appropriate to current market conditions, the house price stress scenario used in the OFHEO model was fixed. As a result, the house price scenario was not sufficiently stressed during the pre-crisis period, despite indications that the housing market might be in the midst of a price “bubble.” Second, OFHEO had left the model specification and parameter estimates unchanged from the original model development, despite the loosened underwriting and proliferation of non-traditional mortgage products during the pre-crisis period. 25 Beverly Hirtle is a Senior Vice President of the financial intermediation function in the Research and Statistics Group at the Federal Reserve Bank of New York. 26 In particular, among smaller institutions (less than $25 billion assets), those with higher levels of repurchases before the financial crisis reduced dividends more slowly and by smaller amounts ex-post. Thus, those with higher ex-ante repurchases were able to cushion the impact of the crisis on their dividend payouts, thereby mitigating adverse signalling effects of dividend cuts. 27 Scott Smith, the presenter, is a Senior Executive at the Federal Housing Finance Agency (FHFA) responsible for capital policy. Larry Wall is the executive director of the Center for Financial Innovation and Stability in the Research Department of the Federal Reserve Bank of Atlanta. 28 Kris Gerardi is a financial economist and associate policy adviser in the research department of the Federal Reserve Bank of Atlanta. Paul Willen is a Senior Economist and Policy Advisor in the Research Department at the Federal Reserve Bank of Boston. 10 Editorial / Journal of Economics and Business 84 (2016) 1–13 6. Regulation of retail banking relationships Lender “steering” of borrowers to high cost loans during the housing boom of the 2000s is said to have generated significant social costs, associated with borrowers who were misled into accepting loans with inferior characteristics relative to the mortgages they could have qualified for. In 2013, the CFPB issued a set of rules aimed at prevent steering behavior by mortgage originators.29 Evanoff in Agarwal, Amromin, Ben-David, and Evanoff (2015) investigated steering by mortgage originators during the housing boom.30 This paper presents evidence that lenders steered higherquality borrowers to affiliates providing subprime-like loans. These borrowers were charged 40–60 basis points higher APR. Further, they find that the steered borrowers were more likely to obtain loans with less desirable characteristics such as prepayment penalties. Their findings provide support for tighter regulation of mortgage origination activities, such as the rules issued by the CFPB in 2013. Many observers believe that payday lending, like steering, generates significant social costs, associated with less sophisticated borrowers overpaying for credit. Payday lenders extend short-term, high-interest loans to people in need of immediate cash who are willing to borrow against their future paychecks. Some consumers pay extremely high fees and interest on payday loan; annual percentage rates as high as 400% have been reported. John Jahera discussed at the conference how state regulations could impact payday lending.31 A challenge in conducting research on payday lending has been a lack of official payday lending data. Barth, Hilliard, Jahera, and Sun (2016), in this special issue, analyzed regulatory impacts on payday lending based on a unique dataset from state regulatory agencies. The paper assesses the concentration of payday lenders in a given county in relation to the regulatory environment, as well as to various financial and demographic variables.32 Results are consistent with a significant impact of regulation on the geographic distribution of payday lenders in the United States. Another paper presented at the conference provides a perspective on why some consumers may turn to high-cost, nonbank sources of credit such as payday lenders—thereby either severing or precluding bank checking account relationships as a result of high fees or involuntary closures. Critchfield and Samolyk (2015) used confidential supervisory data from a large random sample of checking accounts from a few large US banks to examine the costs associated with checking account ownership and the determinants of involuntary account closure. They find that monthly fees on checking accounts are very unevenly distributed across account holders. Much of the variation in account fees reflects fees associated with having insufficient funds to cover transactions (NSF-related fees). Their analysis also indicates that higher account fees or a lack of account activity are important factors associated with a higher likelihood of involuntary account closure. Controlling for account-related factors, the authors find that higher fees and higher rates of involuntary closure tend to vary with geographic location of the household. In particular, higher fees and higher rates of involuntary closure are associated with Census tract demographic characteristics similar to the demographic characteristics of households that tend to be unbanked or underbanked. Consumer search costs, switching costs, or other aspects of imperfect competition in credit markets are sometimes pointed to as rationales for regulation of consumer credit. Ciciretti, Brunetti, and Djordjevic (2014) investigated the factors associated with a more competitive environment in the sense of consumer search and switching. They investigate the determinants of households’ bank switching in the 2006–2012 period exploiting a unique representative dataset from Bank of Italy Survey on Household Income and Wealth that follows households and their bank(s) over time. 29 http://www.consumerfinance.gov/newsroom/consumer-financial-protection-bureau-rules-to-prevent-loanSee originators-from-steering-consumers-into-risky-mortgages/. 30 Douglas Evanoff is a vice president and senior research advisor for banking issues in the Economic Research Department of the Federal Reserve Bank of Chicago. 31 John Jahera, Jr. is the Lowder Professor of Finance at Auburn University and co-editor of the Journal of Financial Economic Policy. 32 The study reports that ten states and the District of Columbia prohibit the operation of payday loan stores, and thirty-one other states have imposed regulatory restraints on payday lending. Editorial / Journal of Economics and Business 84 (2016) 1–13 11 Focusing on the features of household–bank relationship, they find that exclusivity (using a single bank), intensity (number of services used), and scope (variety of bank services used) of the banking relationship play a role in shaping households’ decision to switch banks. They also find that this decision to switch is strongly and positively correlated with both taking out and paying off a mortgage, and that switching activity increased in the wake of the financial crisis. Gurley-Calvez, Kapinos, and Kapinos (2016), in this special issue, examined small business access to capital in relation to house price change over the period 2004 through 2011, using data on small business borrowing from a longitudinal survey comprising 5000 small businesses (the Kauffmann Firm Survey). The paper notes that residential real estate is an important source of collateral for small business financing, and thus that house price declines tend to adversely impact small business access to credit. The paper finds that “small business owners appear to absorb housing price shocks through relatively expensive sources of credit, such as unsecured credit card debt.” The authors conclude that government-supported programs administered through the banking system, such as the SBAguaranteed lending programs, are useful for mitigating the negative effects of housing downturns. 7. Conclusions The conference on “Regulating Consumer Credit” demonstrated that this area is both tremendously important from a policy perspective as well as fertile ground for ongoing research. The events of the last decade provided a clear indication of the importance of making progress on questions related to the role of regulation in protecting consumer welfare on the one hand while maintaining access to credit on the other. Moreover, the mortgage and financial crisis provided an important lesson in the nexus between the health of the consumer credit market and the health of the financial sector more broadly. Thus, understanding the state of the consumer credit market and regulations to insure that market is appropriately serving the consumer are important for avoiding broad problems for the financial sector and the macroeconomy. On the other hand, regulations that ensure that the financial sector is avoiding excessive risk-taking also will provide protections for consumers against problematic lending practices. Regulations that require financial institutions to accurately measure risk and to hold sufficient capital and liquidity given the risks that are taken also promote a healthier consumer credit market. The conference and this special issue are important contributions to this research agenda which will be a key focus for researchers and policy-makers in the coming years. We are especially indebted to the following discussants and referees for their many helpful comments and suggestions: Javed Ahmed (Federal Reserve Board) Linda Allen (Baruch College, City University of New York) Robert Avery (Federal Housing Finance Agancy) Lamont Black (DePaul University) Paul Calem (Federal Reserve Bank of Philadelphia) José Canals-Cerdá (Federal Reserve Bank of Philadelphia) Michael Carhill (Office of the Comptroller of the Currency) Fang Du (Federal Reserve Board) Jill Fisch (University of Pennsylvania) Scott Frame (Federal Reserve Bank of Atlanta) Laurie Goodman (Urban Institute) Ryan Goodstein (Federal Deposit Insurance Corporation) Chris Henderson (Federal Reserve Bank of Philadelphia) Joe Hughes (Rutgers University) Ken Kopecky (Journal of Economics and Business) John Krainer (Federal Reserve Bank of San Francisco) Wenli Li (Federal Reserve Bank of Philadelphia) Nada Mora (Federal Reserve Bank of Richmond) Leonard Nakamura (Federal Reserve Bank of Philadelphia) Min Qi (Office of the Comptroller of the Currency) 12 Editorial / Journal of Economics and Business 84 (2016) 1–13 Richard Rosen (Federal Reserve Bank of Chicago) Robert Sarama (Federal Reserve Board) Sherrill Shaffer (University of Wyoming) James Vickery (Federal Reserve Bank of New York) Larry Wall (Federal Reserve Bank of Atlanta) Akhtarur Siddique (Office of the Comptroller of the Currency) Paul Willen (Federal Reserve Bank of Boston) References Agarwal, S., Chomsisengphet, S., Mahoney, N., & Stroebel, J. (2014). Regulating consumer financial products: Evidence from credit cards. Quarterly Journal of Economics, 130(1), 11–164. Agarwal, S., Amromin, G., Ben-David, I., & Evanoff, D. (2015). Loan product steering in mortgage markets. Federal Reserve Bank of Chicago. Working Paper. Allen, F., Goldstein, I., Jagtiani, J., & Lang, W. W. (2016). Enhancing prudential standards in financial regulations, Federal Reserve Bank of Philadelphia. Journal of Financial Services Research, 49 (forthcoming, Working Paper #14-36) Anderson, C. D., Capozza, D. R., & Van Order, R. (2011). Deconstructing a mortgage meltdown: A methodology for decomposing underwriting quality. Journal of Money Credit, and Banking, 43(4), 609–631. Andersson, F., Chomsisengphet, S., Glennon, D., & Li, F. (2013). The changing pecking order of consumer defaults. Journal of Money, Credit and Banking, 45(2–3), 251–275. Bar-Gill, O., & Bubb, R. (2012). Credit card pricing: The card act and beyond. Cornell Law Review, 97(5), 967–970. Barr, M., Mullainathan, S., & Shafir, E. (2009). The case for behaviourally informed regulation. In D. Moss, & J. Cisternino (Eds.), New perspectives on regulation (pp. 25–62). Cambridge, MA: The Tobin Project. Barth, J. R., Hilliard, J., Jahera, J. S., Jr., & Sun, Y. (2016). Do state regulations affect payday lender concentration? Journal of Economics and Business, 84, 2. Belsky, E. S., & Wachter, S. (2010). The need for government intervention to protect and advance the public interest in consumer and mortgage credit markets, Joint Center for Housing Studies. Boston: Harvard University. http://www.jchs.harvard.edu/sites/jchs.harvard.edu/files/mf10-15.pdf. Berkovec, J., Chang, Y., & McManus, D. (2012). Alternative lending channels and the crisis in U.S. housing markets. Real Estate Economics, 40(s1), s8–s31. Bond, P., Elul, R., Musto, D. K., & Garyn-Tal, S. (2013). Does junior inherit? Refinancing and the blocking power of second mortgages. Federal Reserve Bank of Philadelphia. Working Paper #13-3-R. Brueckner, J. K., Calem, P. S., & Nakamura, L. I. (2012). Subprime mortgages and the housing bubble. Journal of Urban Economics, 71, 230–243. Brueckner, J. K., Calem, P. S., & Nakamura, L. I. (2015). House price expectations, alternative mortgage products, and default. Journal of Money, Credit, and Banking, 48(1), 81–112. Calem, P., Jagtiani, J., & Lang, W. W. (2015). Foreclosure delay and consumer credit performance. Federal Reserve Bank of Philadelphia. Working Paper #15-24-R. Calem, P., & Sarama, R. F. (2016). Why mortgage borrowers persevere: An explanation of first and second lien performance mismatch. Real Estate Economics, 44 (forthcoming). Campbell, J. Y., Jackson, H. E., Madrian, B. C., & Tufano, P. (2011). Consumer financial protection. Journal of Economic Perspectives, 25(1), 91–114. Campbell, J. Y. (2006). Household finance. Journal of Finance, 61(4), 1553–1604. Carrell, S., & Zinman, J. (2014). In Harm’s way? Payday loan access and military personnel performance. Review of Financial Studies, 29(9), 2805–2840. Critchfield, T., & Samolyk, K. (2015) Checking-account fees, involuntary account closure, and neighborhood demographics. Consumer Financial Protection Bureau. Working Paper. Ciciretti, R., Brunetti, M., & Djordjevic, L. (2014). The determinants of household’s bank switching. Rome: University of Rome (Working Paper). Cordell, L., & Lambie-Hanson, L. (2016). A cost-benefit analysis of judicial foreclosure delay and a preliminary look at new mortgage servicing rules. Journal of Economics and Business, 84, 2. Davidson, A., Levin, A., Pavlov, A., & Wachter, S. (2016). Why are aggressive mortgage products bad for the housing market? Journal of Economics and Business, 84, 2. Davidson, A., Levin, A., & Wachter, S. (2014). Mortgage default option mispricing and procyclicality’. In E. S. Belsky, C. E. Herbert, & J. H. Molinsky (Eds.), Homeownership built to last balancing access, affordability, and risk after the housing crisis (pp. 290–316). Cambridge, MA: Brookings Institution Press and the Harvard University Joint Center for Housing Studies. Epouhe, O., & Hall, A. (2016). Payment shock in HELOCs at the end of the draw period. Journal of Economics and Business, 84, 2. Frame, W. S., Gerardi, K., & Willen, P. S. (2015). The failure of supervisory stress testing: OFHEO’s risk-based capital model for Fannie Mae and Freddie Mac. Federal Reserve Bank of Atlanta. Working Paper #2015-3. Goetzmann, W. N., Peng, L., & Yen, J. (2012). The subprime crisis and house price appreciation. Journal of Real Estate Finance and Economics, 44(1–2), 36–66. Gorton, G. B., & Metrick, A. (2012). Getting up to speed on the financial crisis: A one-weekend-reader’s guide. Cambridge, MA: National Bureau of Economic Research (NBER Working Paper #17778). Gurley-Calvez, T., Kapinos, K. A., & Kapinos, P. (2016). (Un)expected housing price changes: Identifying the drivers of small business finance. Journal of Economics and Business, 84, 2. Hancock, D., & Passmore, W. (2016). Cost of funds indexed mortgage contracts with government-backed catastrophic insurance (COFI-Cats): A realistic alternative to the 30-year fixed-rate mortgage? Journal of Economics and Business, 84, 2. Editorial / Journal of Economics and Business 84 (2016) 1–13 13 Hirtle, B. (2014 March). Bank Holding Company Dividends and Repurchases During the Financial Crisis FRBNY Staff Report No. 666. Jagtiani, J., & Lang, W. W. (2011). Strategic default on first and second lien mortgages during the financial crisis. Journal of Fixed Income, 20(4), 7–23 (Spring). Kahle, K. M., & Stultz, R. M. (2013). Access to capital, investment, and the financial crisis. Journal of Financial Economics, 110, 280–299. Karamon, K., McManus, D., & Yannopoulos, E. (2016). Spillover effects of continuous forbearance mortgages. Journal of Economics and Business, 84, 2. Kuchler, T. (2013). Sticking to your plan: Hyperbolic discounting and credit card debt paydown. Stanford Institute for Economic Policy Research Discussion Paper 12-025. Lang, W. W., & Jagtiani, J. (2010). The mortgage and financial crises: The role of credit risk management and corporate governance. Atlantic Economic Journal, 38(3), 295–316. Levitin, A. J. (2013). The consumer financial protection bureau: An introduction. Review of Banking and Financial Law, 32, 321–369. Levitin, A., & Wachter, S. (2013). The public option in housing finance. U.C. Davis Law Review, 46(4), 1111–1173. Mian, A., & Sufi, A. (2014). House of debt Chicago. Chicago: University of Chicago Press. Sarama, R., & Johnson, K. (2014). The end of the line: Behavior of HELOC borrowers facing payment changes. Federal Reserve Board. Working Paper. Smith, S., Fuller, D. L., Bogin, A., Polkovnichenko, N., & Weiher, J. (2016). Countercyclical capital regime revisited: Tests of robustness. Journal of Economics and Business, 84, 2. Smith, S., & Weiher, J. (2012). Countercyclical capital regime: A proposed design and empirical evaluation. Federal Housing Finance Agency. Working Paper #12-2. Tracy, J., & Wright, J. (2014). Payment changes and default risk: The impact of refinancing on expected credit losses. Federal Reserve Bank of New York. Working Paper. Zinman, J. (2010). Restricting consumer credit access: Household survey evidence on effects around the Oregon rate cap. Journal of Banking & Finance, 34(3), 546–556. Zinman, J. (2014). Consumer credit: Too much or too little (or just right)? Journal of Legal Studies, 43(S2), S209–S237. Paul Calem a Julapa Jagtiani a,∗ William W. Lang b a Federal Reserve Bank of Philadelphia, USA b Promontory Financial, Previously, Federal Reserve Bank of Philadelphia, USA ∗ Correspondence to: Federal Reserve Bank of Philadelphia, Ten Independence Mall, Philadelphia, PA 19106, USA. Tel.: +1 215 574 7284. E-mail address: [email protected] (J. Jagtiani) Available online 28 February 2016