Why Now Is Not the Right Time to Revamp Consumer Financial Protection

Let’s begin with a puzzle raised by the previous session on who should regulate consumer protection. We heard from a specialist in administrative law that the design of the current method of bank supervision is the worst regulatory system she has ever seen. The fact that the regulators are paid by the banks (that is how the agencies receive funding) and that the banks can shop for their regulators (by choosing their organizational form) makes the regulators too beholden to the banks. These bank regulators, of course, also have responsibility for safety and soundness regulation as well as consumer protection regulation and in fact prudential regulation is their main job. So here’s the odd thing. How is it that 18 months after the start of the financial crisis we are focused on debating having a single consumer protection agency but not a single one that is focused on prudential regulation? Surely if there is problem here the fact that we have a dysfunctional regulatory regime for safety and soundness is far more serious—certainly for the long-term well-being of the economy and averting and dealing to this.

The New York University-Federal Reserve Conference on consumer protection has provided a lot of food for thought. We’ve all learned a lot. Consumer protection regulation is necessary. It could be better. And the speakers have provided many insights on how it could be improved. But let us face the reality of the times. A specific set of proposals have been put forward by the U.S. Department of the Treasury that would create a massive increase in the stringency of consumer protection and in particular would use the findings of behavioral law and economics—more on this later—to develop new regulatory approaches such as the use of plain vanilla products. Congress has taken up those proposals. The House has passed a bill which embraces some of what the Administration has proposed and rejects other parts. The Senate is now taking up this debate.

I have six points most of which challenge the premises of this present obsession with reforming consumer protection. Nothing in my remarks should be taken as suggesting that consumer protection in financial services is not essential or that it can’t be improved. The issue is simply why we are devoting so much attention now to a particular set of proposals when there are and have been far more pressing issues.

First, the Treasury Department proposed a sweeping overhaul of consumer protection for financial services for the wrong reasons. It is widely reported that the Administration pushed consumer financial protection legislation because they thought it would be the “locomotive that would drive financial reform.” The idea is that the folks back home couldn’t get why their representatives would be working on obscure things like clearing houses for credit default swaps. But they could connect with plain old consumer protection. Hey, who wouldn’t want to be protected? Since we’re not in DC perhaps I won’t be laughed out of the room for saying this is pretty cynical.

Second, Treasury wrapped consumer protection in the flag of the financial crisis. Yet there is no credible evidence that failures in the current system were a significant factor in causing the financial crisis. Many of the consumer protection problems that people point to are mainly the result of our collective delusion—the madness of the crowds—that housing prices would go up forever. There are numerous accounts of the causes of the financial crisis from varying ideological perspectives. Not one of them that I know of blames the financial crisis on failed consumer protection.

Third, instead of being the locomotive for financial reform, consumer protection has deflected attention from problems that really were at the heart of the financial crisis. Remarkably, the Administration proposed no significant reforms of Fannie and Freddie. The Administration came forward with nothing on dealing with the credit rating agencies. There’s widespread support among economists for introducing competition into that business. And then there’s the point I started with. How can it possibly be that we’re focused on consolidating consumer protection into a single agency but largely leaving prudential regulation untouched? Going into 2010 Congress is going to be spending a lot of its scarce time on consumer protection issues that had little to do with the crisis and which, while there are no doubt problems to be solved, are hardly urgent ones.

Fourth, the Treasury Department and Congress have proposed this sweeping overhaul of the lending industry at just about the worst possible time. A massive credit crunch is holding back the economy. New businesses that drive most of the job growth in the economy can’t get loans. Small businesses have had their credit lines slashed. Consumers who need to borrow money can’t. Now is the time to focus on policies to encourage lending. It is not the time to impose a new layer of regulations and costs that will make it more expensive and legally risky for financial institutions to lend money to people and businesses who want to borrow it. Congress made a huge mistake in passing the CARD Act last year. That legislation makes it harder for banks to lend money to the high risk borrowers who need help during these difficult times. I’m not defending the credit card industry here. They engaged in a lot of stupid practices that irritated many people. But the CARD Act was an example of Congress and the Administration cutting off the noses of consumers to spite their faces and get their votes. Some versions of the CFPA Act—and certainly the one proposed by the Obama Administration—promise to do the same and further hobble the economic recovery.

Fifth, instead of dealing with financial reform and getting ourselves out of the economic crisis it looks like a lot of energy is going to be spent on the CFPA bill. So let’s talk about the merits of the proposals. The CFPA is the brainchild of several law professors including Professor Warren who spoke at lunchtime. If you look at the articles that they have written you will see that the proposed CFPA is based on three propositions.

1. The first proposition is that consumers often do not make rational decisions. According to the proponents of the CFPA the government should both deter consumers from making the wrong decisions and they should prevent businesses from exploiting the mental defects of consumers—particularly the fact that they are confused, innumerate, and shortsighted. They believe that regulation should be based in part on principles and findings that have emerged from what’s known as “behavioral law and economics.” I’m a fan of behavioral economics. However, much of the work that proponents of the CFPA rely on is based on studies that find that consumers are shortsighted in a particular technical sense known as hyperbolic discounting. Recent work has found that those studies confused shortsightedness with risk aversion. People act in ways that seem impulsive and shortsighted mainly, it seems, because bird in hand is better than two in bush. As a result I don’t believe we have a sound basis at least at this time for moving from regulations that are based on market failures in the provision of information (the intellectual basis for the current system) to market failures based on people making systematically stupid or shortsighted decisions (the intellectual basis for the new regime). The behavioral economics field has produced a rich and interesting theoretical and empirical literature. One should exercise caution, however, in unleashing these “new products” on the American consumer before they are more fully tested and vetted.

2. The second proposition is that existing regulations are not sufficient to deal with these behavioral problems. Their rationale for “plain vanilla financial products” is that consumers need to be pushed towards products that are different than the ones they would ordinarily choose and that businesses need to be forced to offer different products than businesses want to offer to make money. Even if you buy into behavioral law and economics this should trouble you. There are a lot of reasons to doubt that government regulators would make better decisions than consumers. They sure didn’t in the events that led up to the financial crisis.

Professor Warren’s lunchtime discussion of her venture into developing a new credit card deserves some mention here. As I understood it she and her colleagues had developed a “clean card”—one that did not have any fees besides an annual fee an APR—and at least got some banks excited about considering it. They soon learned that banks couldn’t introduce the card profitably. She also mentioned that Citi had introduced a more “consumer friendly” card and gotten a lot of great PR out of it. They eventually pulled it from the market because few consumers wanted it. So Professor Warren sees a problem. Banks can’t make money from a “good card” (I think that her explanation is that one bank can’t unless others also offer it) and consumers won’t take a “good card” (I think the story her goes back to our mental deficiencies). So regulation is needed. I find this very worrisome. I don’t believe that even extremely smart and well-intentioned people such as Professor Warren should be put in the position of telling—or prodding—businesses to offer products they don’t want to offer to consumers who don’t want to take them. The CFPA Act put forward by the Administration was set up to do just that.

3. The third proposition is that consumers would get better help if financial regulation were the focus of a single agency and if that agency was not conflicted by also worrying about the health of the financial institutions it regulations. Maybe this one is right. However, I wonder if proponents of the CFPA have really thought about the possibility that a single agency could end up being captured by the financial services industry.

I would like to make one other observation on the basis for the proposed massive increase in consumer financial products regulation and making that regulation based on the findings of behavioral law and economics. The backers of these proposals bear the burden of proof of showing why it is needed and businesses and taxpayers should pay for it. Repeatedly, we are told by the proponents in their articles and in their talks today that consumers are being lured into taking bad products. But at the point where we would expect to hear how serious these problems are we hear vague words like “some”, “a number”, and an unquantified “many”. They have provided no evidence on whether 10% of consumers are harmed, 1%, .1%, or any other number. The proponents of the CFPA Act need to demonstrate that the benefits of their proposals outweigh the costs. That shouldn’t be based on anecdotes about consumers being hurt by buying bad products since that is true in every market.

Here’s my sixth and final point. If we are going to have a single consumer financial protection agency I would give it to the Federal Trade Commission. They are a well run government agency, have significant expertise in consumer protection, and have first-rate economists. While the Chairman serves at the pleasure of the president the commissioners are drawn from both parties and serve long terms. That would provide greater certainty and stability than having a director whose policies would reflect the party in the White House.ouseHouHou I would have a Bureau of Consumer Financial Protection which would report up to the Chairman of the FTC. That Bureau would have an advisory council that would consist of the prudential regulators plus the Chairman of the FTC. This would be a lot easier than setting up a new agency.

Today’s conference has provided a lot of food for thought. I’m not convinced that the result is a meal that we could safely serve American consumers.

* Lecturer, University of Chicago Law School and Executive Director of the Jevons Institute and Visiting Professor, University College London. This note is based on remarks made at the New York Federal Reserve Board-New York University Conference on Regulating Consumer Financial Products, January 6, 2010, New York, NY.