The Financial Fairness Revolution

My friend Jo Ann Barefoot, the dean of bank consumer compliance consulting, warns bankers against eight dangerous words: "Where does it say I can't do that?" It used to be that Jo Ann's clients -- and frequently mine as well -- asked that question a lot. It was similar to the statement, "Everyone else does it that way." We always knew the client was on the wrong track when they said such things. And, to be frank, bankers said such things so often that it is not surprising that they have got themselves into such a pickle with Congress, the regulators and the public.

But now Congress has given the regulators new weapons, and smart bankers are trying to change their ways and attitudes. Jo Ann has called the change "The Financial Fairness Revolution." Its principal goal is to eliminate unfair, deceptive, and abusive acts and practices (UDAAP), and the new Consumer Financial Protection Bureau that was established under the Dodd-Frank Act is the implementer.

Why did this new form of regulation have to happen? I will try to provide the history in a few paragraphs. Way back in days of the Nixon administration of the late 1960s and early 1970s, banks offered very few products to their retail customers. You could have a checking account or a savings account. You could get a plain vanilla 30-year mortgage loan, perhaps a "home improvement loan," and in special cases, a "revolving line of credit." You also could get a credit card, but for most people, that was really a payment card. Few people carried credit card balances, and the credit limits were low, anyway.

Inflation was the first thing that changed the landscape. Banks started offering certificates of deposit (CDs) of varying maturities and rates of interest. Then money market accounts came along to compete with money market mutual funds. Then the rates of interest that banks (and others) could charge on loans were lifted or significantly modified. Now consumer banking was off to the races. By the mid-1980s, banks also were selling (through subsidiaries or affiliates) annuities, mutual funds and stock brokerage.

Consultants to the banking industry advised the banks to cross-sell and to incentivize branch and call center personnel to sell the most profitable products. We all know what happened. The nice lady in the branch who knew your first name and the names of your children got paid more to sell you a high-margin product than a low-margin product. Free checking added to the pressure on the sales staff because it was a loss leader that was supposed to attract customers so the branch staff could cross-sell the profitable stuff.

Then all the products got more complex. They got more complex because complexity hid from customers what they would be paying. The products got more complex because the banks started making money from the fees that people paid when they violated the rules or asked for special service. Bank marketing gradually became the art of obfuscation. The only real innovations in consumer banking over the 30 years from 1975 to 2005 were made by technology, not by bankers. The bankers paid attention to their own short-term bottom lines, not their customers' welfare, and they did so for one simple reason: That is what they were paid to do.

And the consumer compliance officers in the banks-and their lawyers and consultants-made sure the technical compliance i's were dotted and t's were crossed. They knew how to comply with the letter of the law while skirting some of its basic objectives.

In the beginning, I thought the cross-selling and product diversification were good things. I did not see for a number of years how different it was to sell financial products rather than socks. When a consumer goes to buy socks, there is no great disparity of knowledge between the salesperson in the department store and the consumer buying the socks. The consumer knows socks because the consumer wears socks every day. But the consumer does not know financial products.

That is too bad, but that is the way it is. Our schools do not teach financial analysis. Therefore the nice lady selling the annuity or the mortgage loan knows a great deal more than the customer. The customer therefore needs to rely on the banker to sell the customer a product that is suitable for that customer. But because the banker is incented to sell the profitable product, the banker's focus is not on the customer but on the banker's next paycheck.

Economists call this situation "information asymmetry." Information asymmetry usually is a bad thing because the idea of competitive markets assumes that everyone has the same information-or at least the capacity to acquire the same information. When that is not true, the party with the advantage can take unfair advantage. Thus, information asymmetries make a mockery of the idea of free markets.

The Congress does not understand all that, but it does understand that the banks have not been serving their customers properly. And that is sufficient to cause regulation of banks' conduct vis-à-vis their retail customers-and hence the creation of the Consumer Financial Protection Bureau (CFPB, another horrible acronym that few people will remember). I believe that such a regulator was needed, although, like every other regulator with a cause, it is likely to regulate more than it has to.

That regulator will enforce UDAAP: the elimination of unfair, deceptive, and abusive acts and practices, regardless of whether the bank complies with the letter of the law. The new standard is quite subjective because the banks ran rings around the regulators that had to enforce the old, more objective standards.

The banks now have to reform the way they approach their customers. That will, in my opinion, be better both for the banks and for their customers, except that, for a few years, the banks will continue to pay a price, as the new agency forges its identity at the banks' expense. In addition, the new agency will be under pressure to support the worst of bank regulation: That is the regulation that seeks to force banks to make loans to "underserved" borrowers.

Fair lending regulations and Community Reinvestment Act rules are the predicate for this kind of regulation. I call them a stealth tax in exchange for deposit insurance. But they are for now-and for the foreseeable future-a cost of being an insured bank. Word has it that this style of regulation will be extended to small business lending. Oy vey!

In 2012 and 2013, all this new regulation is going to cost banks a pretty penny, even if they manage to comply. Although the focus will be on large banks, they have the economies of scale to pay the freight. Smaller banks will have an even harder time in terms of a percentage of overall costs. I hope that the CFPB will have the good sense to create "safe harbor" documents quite soon and that the smaller banks will have the good sense to adopt those "vanilla" documents and abandon their attempts to be product-creative. That would save them a lot of money and help them to be competitive.

Which banks will have the management and the foresight to flourish in this new world of Financial Fairness? I do not like the chances of banks that have large legacy brokerage businesses. Those businesses have a different historical philosophy and a different culture from what the new paradigm will require. That suggests that Bank of America (BAC) will have a hard time, as will Citi (C), with Merrill Lynch and Salomon Smith Barney hanging around their necks.

Well Fargo (WF) and JPMorgan Chase (JPM) have a better chance, it seems to me, because they have large consumer franchises and no dominant retail broker. PNC (PNC) should be able to adapt because its wealth management arm is strong. Northern Trust (NTRS) and its ilk, having little consumer exposure, should be able to adapt quite readily.

I do not see what some of the medium-sized banks will be able to do. SunTrust's (STI) management, from what I have seen, is unlikely figure things out. They deserve to be acquired at a low price. The only thing that will prevent that is the probability that the Big Four will not be permitted to make any additional acquisitions for antitrust reasons. Some of the second tier banks will have to get together.

Then they will have to cut branches and figure out a consumer strategy based on service and customer needs. The strategy cannot be based on new products because financial products are fungible and fooling the customer will be out of fashion. The new strategy will have to be based on a new, service-oriented, technologically based Financially Fair program. With such a new strategy, bankers will never again have to ask "Where does it say I can't do that?"

Disclosure: I am long JPM.