Saving Consumers from Themselves

The trouble with Obama's proposal for a Consumer Financial Protection Agency

When I first learned to drive as a teenager, my mother let me take the wheel on trips to the local grocery store. She was there in the passenger seat, arms flailing every time a squirrel or a piece of sagebrush came across the road, her left forearm pressing my chest back against the seat. It was instinct. She wanted to brace me for the impact of a crash. The only problem was that I needed both arms free to keep the van from crashing in the first place. While I appreciated my mother's concern, I hated the thought that she might protect me to death.

Which is the same attitude every American should have when it comes to the new consumer financial protection laws President Barack Obama and Rep. Barney Frank (D-Mass.) want to impose on businesses.

Later this afternoon, President Obama is scheduled to give a White House speech reiterating his support for the creation of a Consumer Financial Protection Agency (CFPA). Obama first proposed the idea in June as a part of his grand plan to overhaul Wall Street regulations. But it has come under considerable attack recently for fear it would smother businesses and end up hurting consumers.

If created, the CFPA would be tasked with ensuring that consumers who use financial products like bank accounts, mortgages, and credit cards are protected from the evil corporations that are out to get their money. In a sense, it is a noble idea, stemming from the mind of a noble woman, Congressional Oversight Panel Chair Elizabeth Warren. But it's going to protect us to death.

In its current form, the CFPA will pile on burdensome new rules, restrict innovation, hurt small businesses, increase the cost of doing business, spawn a massive bureaucracy, and create severe conflicts between state and federal law. Frank's proposed version would even allow the new agency to write and enforce laws beyond the scope of existing legislative authority. There are good ways of reforming consumer protection. The Consumer Financial Protection Agency is not one of them.

Currently, consumers are protected by a layering of federal agencies, depending on the type of financial institution and its corresponding regulator. Much of the consumer protection at banks lies in the Federal Reserve, but the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, along with other agencies in the alphabet soup of regulators, have mandates to watch out for consumers as well. By and large, this protection is supposed to prevent abuse, stop "predatory lending," ensure that banks give out the appropriate information, and stop companies from tricking consumers into buying something they don't want. In theory, that is all good stuff.

The free market needs a regulatory structure, there need to be rules to guide conduct, fraud and theft must be prevented. There's nothing inherently wrong with the government protecting consumers from actual destructive behavior. The problem is that the CFPA would try to protect consumers from themselves, at the expense of business.

Congress has already given in to this paternalistic urge by passing the credit card act in May 2009. That law tried to keep banks from charging high interest rates and fees, but instead has only served to restrict available credit, especially for low-income borrowers. The CFPA is looking to expand that disastrous initiative.

Congress approaches the issue as one of "systemic risk." From the point of view of the Democrats in the House Financial Services Committee (FSC)—the legislative body creating the CFPA—consumers need a single, all-knowing agency to protect them, one that has the power to scan the whole market and assess the dangers of different products. The Democrats argue that had a CFPA been in place, the dangers of subprime mortgages would have been spotted and regulators could have stopped the mortgages' hazardous growth.

In a way, it's a logical argument—but it only works if government agencies could be all-knowing.

The problem is that many people did see the danger in subprime mortgages, particularly their fragmentation into mortgage-backed securities, but it wasn't possible to know everything we know now in the heat of the moment back then. (Which is a reason no one acted.) Regulators are fallible, and there's nothing prudent about trusting a single, bureaucratic agency with managing the safety of the whole market.

Nevertheless, some positive strides have been made recently. Under pressure from the U.S. Chamber of Commerce (USCC)—vehemently opposed to the idea of a CFPA—and Blue Dog Democrats, House FSC Chairman Frank has backed down from some of the more extreme aspects of the original Obama/Warren design.

The Obama/Warren plan would have required financial institutions to offer certain products, including "plain vanilla" versions of checking accounts, mortgages, or IRAs. The Obama/Warren CFPA would also have received the power to create simplified products and force firms to sell those in addition to—or in place of—their own financial products. Those deadly provisions are now out.

The original plan also called for forcing all financial institutions to make their products easier to understand. This is a component of the credit card bill, which limits fine print to allow consumers to understand their purchases in four minutes or less. While Frank is still pushing for increased disclosure, he has taken out the vague and dangerous "Reasonableness" clause, which left it up to the CFPA to determine what was the "reasonable way" to understand a given financial product.

Frank also issued a memo listing the types of institutions that won't be subjected to CFPA regulation, including lawyers, auto dealers, telecom companies, 401(K) providers, and real estate brokers. However, the financial products these companies offer will be subjected to regulatory oversight by the CFPA, a rather significant sleight of hand.

Despite the capitulations, the CFPA will still wind up damaging companies and ultimately hurting consumers. What looks like movement in the right direction is largely a smoke screen to disguise the fact that a Frank designed CFPA will still have power to force the standardization of some products.

Furthermore, Frank has yet to deal with other significant concerns about what the new agency will do to businesses and the market.

In a report released on September 23, the U.S. Chamber of Commerce (USCC) revealed that the CFPA would cause significant harm to small businesses by imposing high fixed costs for complying with the new regulatory burden. These compliance costs are more easily handled by large firms, which have sophisticated legal staff to work through the piles of regulation.

Michael E. Fryzel, former chairman of the National Credit Union Administration said, "The proposed legislation could cause financial institutions to incur additional costs, including those for fees, staff training, and policy development. The higher operating expenses associated with compliance could have a negative impact on the availability of credit." Given that 70 percent of the USCC's 3 million-plus members are small businesses with less than 10 employees, it is easy to understand how overly burdensome new consumer protection rules could cripple growth and lead to many closures.

The USCC also argues that the CFPA would likely reduce small business access to credit, limit start-ups, damage employment opportunities, and favor large financial firms with "one-size-fits all" rules. As Federal Reserve Chairman Ben Bernanke has warned:

There are many issues to consider, including that overly restrictive or burdensome regulations can lead to increases in product pricing or product withdrawals that would overly constrain credit, or in extreme cases, severely impact the availability of responsible credit for consumers.

In addition to limiting credit and expansion opportunities for small businesses, the CFPA would create brain-knotting problems for large firms. Frank's CFPA, like the Obama/Warren version, would require banks to follow both national and state rules for consumer protection. The Wall Street Journal noted that "each state could impose different rules for pricing, product features, repayment schedules, bank capital requirements, consumer disclosure, regulatory reporting requirements, and so on. If each state can set its own rules, expect endless legal confusion over which law prevails when a bank in one state serves a customer in another."

Consider this complication: If Maryland declares a financial product unsafe, could it still be advertised on television in the northern Virginia and Washington D.C. markets where the signal stretches into Maryland? Would someone living in Virginia and working in D.C. not be allowed to use an IRA or 401(k) plan deemed too dangerous by one of those jurisdictions? Without clearly defined federal preemption, large financial institutions could suddenly find themselves subjected to oversight from the attorneys general in every state they do business, a radical shift from the current paradigm.

Unfortunately, the problems with the CFPA go even deeper than that. Consolidating all federal consumer financial protection regulation would divorce "safety and soundness" regulatory oversight from consumer oversight of financial institutions. There is an important complementary relationship between the two that the CFPA would rip apart. As John Bowman, acting director of the Office of Thrift Supervision (a division of the Tim Geithner-run Treasury Department), has said:

Dividing the regulation of safety and soundness and consumer protection would undermine the safety and soundness of the banking system and weaken a regulator's ability to formulate a complete assessment of a financial institution's risk profile.

Fed Chairman Bernanke, recently reappointed by President Obama to another term, has also pointed out this flaw in the CFPA's design:

In the Reserve Banks, the consumer compliance examiners, while specially trained, often share senior management with the prudential examiners. So, at that level, it would not necessarily be a clean transfer. Additionally, the Reserve Bank examiners draw on expertise and knowledge from other areas of the organizations. Those knowledge centers would not be part of the transfer to a new agency… We believe that prudential supervision and consumer compliance are complementary and should not be separated."

This was a proven bad practice at Fannie Mae and Freddie Mac. James Lockhart, the former head of the Federal Housing Finance Agency, has testified that a separation of consumer protection from financial safety and soundness regulation at those government-sponsored enterprises was a definite cause of their downfall.

Smarter, more effective regulation is the answer to fixing consumer financial protection problems. Consumers don't need new layers of regulation leading to more confusion, uncertainty, and lost value. Instead, regulators should focus on vigorous, effective enforcement of current laws against predatory practices and abuse. There is also room for making sure the existing web of agencies covers all regulatory gaps.

As the Consumer Financial Protection Agency stands now, it is President Obama, Elizabeth Warren, and Barney Frank collectively slamming an arm across the collective chest of the nation's businesses and consumers. We're trying to drive an economy here! We don't need to be protected to death.

Anthony Randazzo is a policy analyst for Reason Foundation.