Vanilla

Robert Waldmann

A proposed reform (already shelved) is to require banks to offer “plain vanilla” products. I am very confused about this proposal, so this is a semi bleg. I can’t see any possible benefit from the regulation (probably because I haven’t read the fine print of the draft bill).

My thoughts after the jump.

Bottom line — a vanilla option must include the rule that at least x% of a bank’s business must be vanilla or they pay a fine to work.

Also, I propose calling non vanilla products “fudge swirl” products unless anyone has ever scene “fudge twist” or “fudge spin” ice cream.

I will criticize a proposal which might exist only in my imagination. A very silly vanilla rule that just says banks must offer a plain vanilla product — say a 30 year fixed rate mortgage.

explanation by interfluidity via rortybomb

Vanilla products would turn basic financial services into a commodity business, and force providers to compete on price…. Since vanilla financial products would be commodities, banks would have to universally collude to offer them at inflated prices in order to bilk consumers. Competing vanilla project offerings would (at least they should) vary only on a single dimension (e.g. an interest rate). Points, fees, penalties, etc. would be homogeneous or uniformly pegged to the core price.

This argument does not apply to a simple requirement that banks offer vanilla products. Forcing them to offer the product does not force them to compete to sell the product.

Consider the case in which all banks offer fixed interest 30 year mortgages at 100% interest per year. Technically they have fulfilled the silly vanilla requirement. There is no improvement in anything as offering a fixed rate mortgage at 100% is just like not offering a fixed rate mortgage.

So, in the absense of collusion, is this alleged equilibrium vulnerable to deviation
by a firm which offers a reasonably priced fixed rate mortgage ? It might or might not be. If it isn’t then the silly vanilla rule will not be effective. If it is, then the silly vanilla rule is not needed and will make no difference.

Since offering fixed rate mortgages at 100% is just like not offering them, the equilibrium profits and profits to deviators are just the same as in the case in which there are no vanilla products and one bank can deviate by introducing one.

If compliance with the regulation implies no real change at all, then a bad equilibrium with technical compliance will be identical to a bad equilibrium with no regulation, one is a Nash equilibrium if and only if the other is and payoffs to all agents are just the same.

So “forced to compete” only makes sense if the vanilla rule is not the silly vanilla rule. It makes sense if there is a requirement that say at least 10% of a bank’s mortgage lending must be fixed rate 30 year. Then banks will compete to issue fixed rate mortgages even if they are not as profitable as option ARMs etc , because by loaning a dollar at a fixed rate for 30 years they win the valuable right to loan 9 dollars as option arms.

I have no idea if the proposed now shelved rule was the silly vanilla rule (hence the bleg)

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