Consumer Protection Could Derail Financial Reform

In the early proposals from the Senate Banking Committee, the creation of an independent Consumer Financial Protection Agency (CFPA) was a centerpiece of the proposed Restoring American Financial Stability Act. The CFPA has drawn such fierce opposition that it is threatening to become like the public option was for health-care reform, a lightning rod for competing views about the proper role of government and a distraction to practical law-making. The media attention and financial-market reaction to the accusations that Goldman Sachs deceived investors about the nature of the synthetic collateralized debt obligations (CDOs) make one thing very clear: we need more transparency in financial markets. We have to get financial reform right so we mitigate the risk of future meltdowns of the system. The outrage over this case seemingly strengthens the hand of the Obama administration in getting the legislation it wants. In his speech to Wall Street on Thursday, President Obama stated, "It is essential that we learn the lessons of this crisis so we don't doom ourselves to repeat it. And make no mistake, that is exactly what will happen if we allow this moment to pass—an outcome that is unacceptable to me and to the American people." Fair enough. But it is surprising that they have courted failure by lumping regulatory reform together with consumer protection.

There are many different views about the origins of the financial crisis: excessive credit creation by the fed, global imbalances, the unregulated shadow banking system, the concentration of systemic risk (which was abetted by the financial vehicles like the one Goldman created), and so on. The notion that consumers were somehow unprotected by their government is not on anyone's top-10 list of proximate causes of the crisis. And yet the White House has insisted that the creation of a new consumer-protection agency be a centerpiece of its financial reforms. By so doing they jeopardize the far more important problem of actually addressing the causes of the financial meltdown.

There can be no doubt that many consumers have been battered by bad decisions that they made about mortgages, credit-card debt, auto loans, and so on. And there is no doubt that some of these bad decisions were encouraged by the originate-to-distribute model of mortgage finance, and by some very unscrupulous business practices. Alarms should have been raised about some of the lending practices that drove the increase in household leverage.

But what exactly is the role of the government in protecting people from their own bad decisions? For the past 30 years we have been in the midst of a major social transformation in which responsibility for risk management has shifted to individuals. In the past, the government and employers often made financial decisions for households, for example by providing health insurance, defined benefit retirement plans, and Social Security; today, households are on their own more than ever.

Now we want the government to intervene. Is this a legitimate role for Washington? One answer might be that the government needs be involved because, when so many individuals make bad financial decisions, it creates an externality that affects the many (neighborhoods virtually empty of residents because of wholesale foreclosures, for example).

But this set of issues isn't going to bring down the global financial system. Financial regulatory reform is a larger, more pressing issue and ultimately at the center of restoring the financial health of consumers. Unfortunately, the energy spent on one cause is undermining the likelihood of strong legislation on more-important problems.

We do need a new regulatory architecture for the financial system. We need to be able to measure, price, and contain the systemic risk that generates enormous externalities for the financial commons. We need greater transparency in the credit derivatives markets. We need to eliminate the risks and distortions created by the fact that some firms are too big to fail. The share of the U.S. financial system in the hands of financial firms deemed too big to fail is substantially larger than it was before the crisis. So unless the basic flaws that created the crisis have magically gone away, we are more vulnerable than ever to a new disaster. We can't hold off on addressing these problems.

Unfortunately, these more urgent needs are being held hostage by the proposed Consumer Financial Protection Agency, said to be the pet project of Elizabeth Warren, the Harvard law professor who leads the TARP oversight commission and is the populist scourge of bankers. There is a staggering amount of lobbying taking place to limit the scope of financial reform. Everyone from pay-day lenders to major financial institutions, small community banks, insurance companies, credit-card companies, retailers, car dealers, telephone companies, real-estate companies, credit unions, and mutual funds have argued their interests on Capitol Hill. It has been effective.

Just look at the carve-outs that were accomplished in the House of Representatives version of reform: House bill H.R. 3126 exempts financing provided by automobile dealers, any person regulated by the Securities and Exchange Commission, any person regulated by a state insurance regulator, smaller banks and credit unions (those with $10 billion or less in assets), mortgage, title, credit insurance, real-estate brokers and agents, attorneys, and most retail transactions involving credit.

Consumer protection is inherently highly politicized because there are so many constituents—both businesses and consumers. That's why it has such populist political appeal. The current logrolling circus should be evidence enough that politicians can put tremendous pressure on regulators to protect consumers and business interests in particular ways without concern for the larger consequences.

More disturbing are reports that opponents may now be willing to consider accepting a CFPA (suitably muzzled, no doubt) in exchange for much weaker regulations on credit derivatives. This is a terrible tradeoff, and the Obama administration seems to be holding firm. Who knows what else is on the trading block?

Consumer protection is a topic worthy of a serious policy debate. But it is a wholly different issue from providing stability to the financial system. Lumping them together is further evidence of the fuzzy thinking of the administration. One would hope that on such important issues we could get beyond the cynical populism and address the fundamental issues that put us all at risk.