Giving colleges some skin in the game

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Article Highlights

  • @AndrewPKelly asks how giving colleges skin in the game would work in practice

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  • Progress in getting skin in the game policy enacted could be easily undone if the measures are no good

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  • @AndrewPKelly looks at important design principles of any skin in the game policy for higher ed

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  • Goals, penalties, and rewards: @AndrewPKelly tackles higher ed's student loan problem

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American colleges and universities love to complain about the regulatory burden they face. Accreditation reviews cost millions of dollars, we’re told, and all those federal regulations governing financial aid and data reporting cost even more. That’s why college costs so much, they say, because colleges have to comply with so much red tape.

Compliance does cost money, and Congress is far better at adding new reporting requirements than deleting them. Remember, though, that colleges get a sweet reward in return for that compliance: largely unfettered access to over $150 billion in federal student aid money every year. As long as a college is accredited and keeps its three-year loan default rate under 40 percent in any given year, it can reap millions in student aid regardless of whether it helps its students succeed.

Put simply, colleges lack “skin in the game:” they bear very little risk if their students aren’t successful. As my colleague Alex Pollock has written, other markets require lenders to retain some of the credit risk on every loan they make, which helps align the interests of those who make the loans and those who guarantee them—taxpayers, in the case of federal loan programs. Lenders who make bad loans are on the hook when those loans go south. In contrast, colleges are largely held harmless when their students default.

That may be about to change, though. There’s a growing movement afoot to hold colleges responsible for a portion of loans their students default on. In the Senate, Democrats Jack Reed, Elizabeth Warren, and Dick Durbin introduced a bill that would force colleges with high default rates to pay back a percentage of the defaulted dollars, and that percentage would increase as the default rate increased. On the conservative side, Rep. Paul Ryan recently called for policies that give colleges skin in the game as well.

On its face, this sounds like a good idea. But how would it work in practice?

Discussions of risk-sharing tend to either be general debates about the concept writ large or technical discussions of a given proponent’s pet formula. In the latter case, analysts typically pick a formula out of thin air—a favorite strategy of federal education regulators that wound up sinking their attempt to regulate for-profit colleges.

But before we get around to debating specific formulas, shouldn’t we ask some basic design questions?

1. What are we trying to accomplish?

First, a question that’s often taken for granted: what are we trying to accomplish with such a policy? Do we want to put bad colleges out of business? Or do we want to lower the probability that the average student defaults? These aren’t mutually exclusive, and each has merit. But how you answer has implications for policy design.

If your primary goal is to put bad colleges out of business, you’d create a system where the worst actors are subject to increasingly harsh penalties and other colleges are left alone. The Reed bill, for instance, would put colleges on the hook for an increasingly large chunk of defaults once their default rate exceeds 15 percent. At the top of the scale, those with default rates above 30 percent would have to pay back 20 percent of defaulted dollars. The bill also exempts lots of institutions, including Historically Black Colleges, two-year schools, and those where less than 25 percent of students borrow. Under this plan, then, only below-average colleges actually have skin in the game.

If, on the other hand, you wanted to reduce the likelihood that any given student defaults, you’d create a system that puts all colleges on the hook for a percentage of defaulted loans. Such a system would encourage individual institutions to minimize the probability that their students default, either through improving their practices or by being more careful about who they let in (the more likely outcome). This is closer to how “skin in the game” works in other markets; because all lenders are exposed to risk, they think more carefully about who they lend to.

 2. Should penalties ratchet up as default rates do?

That brings up the second design question: should the size of the penalty ratchet up as a school’s default rate gets higher? Or should the penalty formula be smooth and continuous? To see why this is important, think about two colleges, one with a default rate of 29.9 percent and another with one of 30.1 percent. Statistically, the two schools are probably performing equally poorly. Yet under the Reed bill, the latter would be on the hook for a much larger proportion of defaults than the former. Such a system begs schools to game their default rates and invites potential legal challenges.

In contrast, if the penalties increased proportionally with defaults, these two schools would pay a very similar penalty. The simplest option would be to put all colleges on the hook for a fixed percentage of defaulted dollars. This way, the colleges with more defaulted dollars would still pay larger penalties, but without the threshold problems. Granted, it would be politically difficult to put colleges with low default rates on the hook for anything. In that case, limiting the sanctions to schools whose default rates exceed a particular level and then applying a sliding penalty scale to those schools would be the way to go.

Policymakers must also ask how large the penalty has to be in order to change institutional behavior. In theory, large penalties might be most likely to catch colleges’ attention. However, they may also force colleges that could have improved out of business before they’ve even had a chance to. In particular, tuition-dependent colleges may not have the cash flow to pay a large fine. But that doesn’t necessarily mean that they’re incapable of improving.

For this reason, it’s not clear that the penalties need to be all that large to get colleges to pay attention. And more moderate sanctions could conceivably do a better job of sorting those campuses that are willing and able to improve from their head-in-the-sand counterparts.

3.     What about rewards?

While skin in the game proposals have mostly focused on penalties, it’s also worth thinking about how federal policy could influence the other side of the ledger as well. In isolation, colleges will likely respond to this kind of policy by becoming more selective on the front-end. That’s not necessarily a bad thing, so long as they can effectively sort students who are likely to benefit from those who are not. More likely, though, colleges would use proxies like income or zip code to make those decisions, potentially locking out students that would benefit from education

To balance this out, federal policy could pay colleges a bonus for every Pell Grant student they graduated. You could even use the proceeds from the risk-sharing payments to pay for the Pell bonuses. These rewards would help to balance out the risk of taking on low-income students under a “skin in the game” policy, helping to keep the doors open for hard-working, disadvantaged Americans who deserve a shot.

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Of course, policymakers must also figure out how to implement risk-sharing as income-based repayment makes cohort default rates (and any policies attached to them) increasingly irrelevant. Unless reformers specify alternatives, any short-term progress in getting a skin in the game policy enacted could be easily undone if the measures are no good.

Building a risk-sharing policy that improves the incentives for colleges will require answers to these (and other) basic questions. Rather than debating specific risk-sharing formulas—the wonk’s version of how many angels can dance on the head of a pin—let’s think harder about the design principles that must guide policy development.

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Andrew P.
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