Baseline Scenario

The Baseline Scenario
Three Myths about the Consumer Financial Product Agency
Posted: 21 Jul 2009 03:00 AM PDT
This guest post was contributed by Elizabeth Warren, chair of the Congressional Oversight Panel and the Leo Gottlieb Professor of Law at Harvard University. (Update: more on the case for a CFPA in her YouTube video, released yesterday.)
I’ve written a lot about the creation of a new Consumer Protection Financial Agency (CFPA), starting with an article I wrote in the Democracy Journal in the summer of 2007. My writing has helped me work through the idea and has advanced a conversation about what kind of changes in financial products would be most effective. A couple of weeks ago, I testified before the House Financial Services Committee about why I think a new consumer agency is so important, and I’ve argued the case many times.
Today, though, I’d like to post specifically about some of the push back that has developed on this issue. In particular, I’d like to focus on three big myths – myths designed to protect the same status quo that triggered the economic crisis.
MYTH #1: CFPA Will Limit Consumer Choice and Hinder Innovation
At a recent hearing on the CFPA, Rep. Brad Miller challenged an industry representative to identify one consumer who chose double-cycle billing to be included within the terms and conditions of his or her credit card contract. It was a great moment. If the status quo is about choice, then explain why half of those with subprime mortgages chose high-risk, high-cost loans when they qualified for prime mortgages. If the status quo is about choice, then explain why Citibank declared itself consumer friendly, dropped universal default, then quietly picked it up again the following year because they said consumers couldn’t tell whether they had the term or not.
The truth, of course, is that no consumer “chooses” to accept the tricks and traps buried within the legalese of financial products. Rather, consumers must choose among various products with one feature in common: dozens of pages of incomprehensible fine print.
The CFPA will not limit consumer choice. Instead, it will focus on putting consumers in a position to make choices for themselves by streamlining regulations, making disclosures smarter, and making financial products easier to understand and compare. The Agency will promote plain vanilla contracts—short, easy to read mortgages and credit card agreements. The key principle behind the new agency is that disclosure that runs on for pages is not real disclosure—it’s just a way to hide more tricks. Real disclosure means that a lender has to be able to explain what it is selling so that the customer can read it and understand it. Once consumers can understand the risk and costs of various products – and can compare those products quickly and cheaply – the market will innovate around their preferences.
Daniel Carpenter, a Professor of Government at Harvard University, has written a great deal about the modern pharmaceutical industry. While anyone with a bathtub and some chemicals could be a drug manufacturer a century ago, Carpenter points out that drug companies were willing to invest far more in research and development to bring good drugs to the market once FDA regulations drove out bad drugs and useless drugs. Good regulations support product innovation.
MYTH #2: The CFPA Will Add Another Layer of Regulation and Increase Regulatory Burden
Current regulations in the consumer financial area are layered on like pancakes—see a problem and fry up a regulation, but don’t integrate it with the earlier regulation. Today, seven different federal agencies have some form of regulations dealing with consumer credit. The result is a complicated, fragmented, expensive, and ineffective system. With consolidated and coherent authority, the CFPA can harmonize and streamline the regulatory system—while making it more effective.
But the real regulatory break-through for the CFPA would be the promotion of “plain vanilla” contracts that would likely meet the needs of about 95% of consumers. These contracts would have a regulatory safe harbor. By using an off-the-shelf template for a plain vanilla contracts and filling in the blanks for interest rates, penalty rates and a few other key terms, a financial institution can legally satisfy all its federal regulatory requirements—no need to do more.
Of course, some banks would want to offer more complicated products. For many, they could file-and-use, so long as they met the same regulatory standards of adequately disclosing risks and explaining costs—briefly enough and clearly enough for people to understand them.
A streamlined new regulatory regime would have a serious impact on the credit industry. Today’s complicated disclosure system favors big lenders that can hire a legion of lawyers to navigate the rules—and spread the costs among millions of customers. Those complex rules fall much harder on a smaller institution that must navigate the same regulatory twists and turns, but with far smaller administrative staffs. Plain vanilla contracts will be particularly beneficial for community banks and credit unions that will be able to divert fewer resources toward regulatory compliance and more toward customer service and innovation.
MYTH #3: Prudential and Consumer Regulation Cannot Be Separated
Make no mistake: This is a fancy claim for the status quo. If the CFPA can be left with the current bank regulators, then it can be smothered in the crib. For decades, the Federal Reserve and the bank regulators (the OCC and the OTS) have had the legal authority to protect consumers. They have brought us to this crisis by consistently refusing to exercise that authority.
The agencies’ well-documented failures – discussed in detail by Travis Plunkett and Ed Mierzwinski here and by Professor Patricia McCoy here — are largely the result of two structural flaws. The first is that financial institutions can now choose their own regulators. By changing from a bank charter to a thrift charter, for example, a financial institution can change from one regulator to another. The regulators’ budget comes in large part from the institutions they regulate. If a big financial institution leaves one regulator, the agency will face a budget shortfall and the agency will likely shrink. Knowing this, financial institutions can shop around for the regulator that provides the most lax oversight, and regulators can compete by offering to regulate less. Regulatory arbitrage triggered a race to the bottom among prudential regulators and blocked any hope of real consumer protection.
The second structural reason that prudential regulators failed to exercise their authority to protect consumers is a cultural one: consumer protection staff at existing agencies find themselves at the bottom of the pecking order because these agencies are designed to focus on other matters. At the Federal Reserve, senior officers and staff wake up every morning thinking about monetary policy. At the OCC and OTS, agency heads wake up thinking about capital adequacy requirements and safety and soundness. Consumer protection issues are—at best—an afterthought. The CFPA would create a home in Washington for people who wake up each morning thinking about whether American families are playing on a level field when they buy financial products. By bringing economic experts who care about consumer financial issues under one roof, CFPA can develop as a smart agency that develops real expertise.
A single consumer agency would also be able to make sure that the same products face the same regulations. Today, mortgages are regulated differently depending on whether they are issued by a bank, a nationally-chartered thrift, a nationally-chartered credit union, and so on. Imagine for a moment if toasters or toys had different safety standards depending on who manufactured them. Or, even worse, imagine if some manufacturers could bypass safety standards almost in entirety – as is now the case for non-depository financial institutions. It is time for one Agency to regulate financial products in a consistent manner across the board.
In 2001, Canada created an independent agency much like the proposed CFPA. I recently spoke with some Canadian economists, and they not only said the system works, they also expressed bewilderment about the idea that prudential and consumer regulation would be combined. As one said, they “have different ways of thinking about the world.”
At the end of the day, industry lobbyists try hard to invent myths and make things sound confusing to intimidate the public and to keep policymakers from acting. But this issue is simple: keeping safety and soundness and consumer protection together has not ensured safety and soundness, has not protected consumers, has not fostered choice and innovation, and has not minimized regulatory burden. In fact, the current regulatory structure that combines consumer protection with other bank oversight responsibilities has led to the kind of bad regulatory oversight that has led us to this crisis. The CFPA would put someone in Washington—someone with real power—who cares about customers. That’s good for families, good for market competition, and good for our economy.
Update: Fixed link to Democracy article in first paragraph. Thanks to Uncle Billy vs. Mont Pelerin.
By Elizabeth Warren