Why Bans Will Not Encourage "Responsible Innovation"

CFPB, financial innovation, permissionless innovation, consumer finance

CFPB, financial innovation, permissionless innovation, consumer financeTwo recent announcements by the Consumer Financial Protection Bureau have proponents of increased financial regulation up in arms.

The first is the Bureau’s expansion of its no-action letter policy to include a regulatory sandbox. A sandbox is a program which allows firms to offer new products under a modified regulatory regime and with oversight from financial regulators. No-action letters, for their part, are assurances from a regulator that it will not take adverse actions in response to a specific new practice by a regulated firm. Neither policy heralds the advent of a regulatory Wild West.

The second announcement involved changes to the CFPB’s payday lending rule, which in its original form (published in 2017) would have made most high-cost short-term lending of this kind unprofitable, reducing loan volumes by more than 65 percent. The Bureau’s modified rule removes an underwriting provision that would have made it very difficult for borrowers to access short-term credit, as they currently do in the 33 states where payday lending is legal. The Bureau has re-considered the costs and benefits of this provision, finding that the loss of access to credit would not be sufficiently offset by an increase in borrower well-being. This finding is bolstered by the fact that Professor Ronald Mann, author of an academic study on which the CFPB heavily relied in its original rule, strongly disavowed the Bureau’s use of his work.

In its original form, the payday rule would have banned much existing high-cost short-term credit, which typically flows to borrowers with few alternatives. Opponents of the industry, as well as some state officials, have – perhaps unsurprisingly – criticized both of the CFPB’s announcements. They ostensibly favor “responsible innovation,” without necessarily specifying what behavior warrants the “responsible” tag. They seem to view a strong stance against payday lending as fully compatible with dynamic and innovative credit markets. But this view is questionable, for three reasons.

  1. Bans make it more difficult to gauge consumer demand and profitability.

The first step to innovating is identifying an explicit or latent consumer need. Sometimes innovation involves incremental improvements on an existing product – such as more powerful microchips – and other times it entails entirely new products – such as the iPhone or the retail index fund.

A key way to identify consumer need is to be able to analyze what consumers are currently doing. The CFPB estimates that as many as 12 million U.S. individuals use payday loans. These are costly products – much costlier than other forms of credit, such as credit cards, personal bank loans, and student loans, which many more Americans use. Who are payday borrowers, why are they willing to borrow at high cost, why don’t they resort to alternatives, and is it profitable to lend to them?

The availability of high-cost credit makes potential challengers – interested in offering substantively the same service at lower cost – better able to estimate whether entering the market is viable and attractive. If there are no incumbents to replace, it is more difficult to gauge the likely demand for new products, and the related profit margins. Even Henry Ford, when he invented the Model T, had two pieces of evidence to go by: the rich used fast and expensive cars, the poor used cheaper and slow horses. What was needed was an inexpensive and fast car, so he set about building one.

  1. Bans increase regulatory uncertainty.

Innovating involves significant upfront investments. The innovator hopes that, if the product is successful, it will quickly become a consumer favorite, producing a stream of profits stretching into the future that will more than cover the initial outlay.

But existing bans force potential innovators to reckon with an unknown quantity: the chance that their own product, even if offering a marginal improvement over banned alternatives, might also face prohibition. This probability is hard to quantify but obviously has critical implications for the profitability of an investment. Faced with the chance of a potential ban that has regulatory precedent, many innovators will simply refrain from entering the market at all.

A recent example of the chilling effect that regulatory uncertainty can have is the 2013 “guidance” from the Office of the Comptroller of the Currency (OCC) discouraging banks from offering cash advances to their depositors. Whether wittingly or unwittingly, it led banks to retreat from the market for small-dollar loans. Now, new leadership at the OCC and the Federal Deposit Insurance Corporation is trying to lure banks back into the business of small unsecured loans. Banks, understandably, are skeptical.

Innovation, even without regulatory meddling, involves a great deal of business uncertainty. That’s why successful innovators reap ample financial rewards. But the chance of a ban is difficult to enter into the innovator’s profit equation. It makes innovation, which is socially beneficial, privately very costly and therefore unattractive.

  1. Bans give incumbents more leverage to regulate.

No ban is just the work of a do-gooder. Every prohibition in history involved an alliance – implicit or open – between people concerned about a product for moral reasons, and those who stand to benefit from the ban. Bruce Yandle dubbed this confluence of interests “bootleggers and Baptists.”

Many people stand to profit from a ban on high-cost credit. In particularly stringent jurisdictions, a credit ban will drive people in need to loan sharks. In other places, borrowers will resort to pawn shops, which also charge high implicit prices and require customers to leave prized possessions behind. For those borrowers lucky enough to have access to other forms of credit, the unavailability of products such as payday loans can mean increased overdraft charges. In other words, borrowers will pay the cost of a ban, but other lenders will benefit from the absence of competition.

That opportunity for rent extraction creates strong incentives to support a ban. Incumbents will expend resources to try and persuade policymakers not only of the wisdom of the ban, but of the danger involved in allowing any new innovation. Bans make innovation less rewarding and political maneuvering more attractive.

Proponents of credit bans, among them church groups, community groups, and progressive politicians, seem to divide the world into one of “responsible” lenders and innovators, who should be allowed to operate, and “irresponsible” characters who must be driven out. This Manichaean view of the credit landscape may reassure its adherents that they’re doing God’s work. But it does a scant favor to borrowers who willingly use the products that prohibitionists wish to ban, usually because it’s their best available alternative.

Recent experience suggests that an enthusiastically interventionist stance doesn’t work. The CFPB’s previous attempt to encourage innovation, dubbed “Project Catalyst,” failed because the Bureau didn’t offer sufficient assurance that it wouldn’t come after innovators once they’d launched a new product. The original payday lending rule, for its part, aroused not just forceful opposition from lenders, but a livid response from an academic who saw his work misused to justify a draconian regulation.

Anti-payday loan activists claim to be defending hard-pressed borrowers from abuse. Yet, foreclosing access to the few options these people have is not a responsible approach. Instead, policy should encourage an environment in which more firms can offer borrowers more and better products without fear or favor. Calls for bans, or effective bans like the old payday rule, coupled with vague promises that a “responsible” lender will eventually emerge, amount to mere grandstanding.