Plain-vanilla finance and the commodification of financial services markets

The point of requiring every institution that offers a class of financial products to offer a plain-vanilla version (e.g., a simple 30-year fixed mortgage with a fixed set of closing costs) is to facilitate comparison shopping.

I think that Megan McArdle, like  other critics of the proposed “plain vanilla” rule in consumer finance, mostly misses the point of the exercise.

It’s not a terrible idea, necessarily, but if it’s an actual option, I doubt it would accomplish much.  Banks will find ways to steer you into the more lucrative product–unless, of course, you’re the sort of highly informed, financially disciplined consumer who doesn’t need a vanilla option, and is in fact better off in the current system.

Yes, the banks will have an interest in steering people into options that are more lucrative for the banks and worse for the consumers.  But competitive pressure will limit their capacity to do so.

The problem with fancy financial products is that the product from one source isn’t directly comparable to the product from a differetn source.  That makes it hard for consumers to comparison-shop.  But if it’s possible to define a plain-vanilla checking account or 6-month CD or 30-year fixed-rate mortgage, then those products become commodities, varying from institution to institution only on service characteristics such as how long it takes the bank to answer a phone call.

Given commodity financial products, comparison shopping is trivial:  which plain-vanilla 30-year fixed mortgage has the lowest APR, assuming that the law defines “plain vanilla” in terms of a default set of closing costs and penalties for various unforseen events?

Thus the plain-vanilla markets will be highly competitive.  And the  prices of the plain-vanilla products will discipline the rest of the pricing structures, by acting as benchmarks.  A bank that tries to make its vanilla product unattractive, in order to push consumers into fancier products, will lose out to rival institutions in the comparison-shopping process.   And to sell a fancier product will require pricing that makes it at least seem attractive by comparison with the same bank’s vanilla.  Unsophisticated consumers could safely adopt the decision rule, “For each type of product, find the low-cost supplier of the vanilla version, and buy it.”  More sophisticated consumers could compare whatever fancy product they’re offered with that same least-cost vanilla version.

The vigorous opposition of the banks to the requirement to offer “plain-vanilla” makes it clear how much they fear the commodification of their business.  That’s an excellent reason for the rest of us to like the idea.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: Markarkleiman-at-gmail.com