Monday, September 14, 2009

A Consumer Financial Protection Agency Would Fail

Odysseas Papadimitriou argues that a Consumer Financial Protection Agency would do little to address the real problems faced by consumers. For instance, it assumes that consumers will make rational decisions if the terms of financial products are explained to them in plain English, but this is just not the case. The following, from The Street, discusses why creating the CFPA would be a tragic mistake.

As chairwoman of the Congressional Oversight Panel, which has been charged with reviewing the state of financial markets and the regulatory system, Harvard professor Elizabeth Warren has been vocal in her support of the administration's proposal for a Consumer Financial Protection Agency (CFPA).

The CFPA would be the regulatory body that ensures that financial institutions provide clear and simple disclosures, which would ostensibly deter consumers from opting for risky and "exotic" financial products, and would be the eighth agency involved in consumer credit regulation. While I agree that there has been little effectiveness in the regulatory system as far as consumer financial protection is concerned, this is no reason to create yet another agency.

The CFPA, which was actually conceived by Warren several years ago, would separate the regulation that provides consumer financial protection from laws that ensure the banks that serve these consumers are solvent, and do not introduce toxic products to the market. If our hope is for a solid financial system, it must be understood that these two areas of regulation go hand-in-hand. Warren is right in saying "the credit market is broken," but she herself proves that the CFPA won't fix it.

Warren lays out her arguments for the CFPA in two articles that appeared in Business Week and in The Baseline Scenario. While she is spot on in her analysis of the nature of the problems that plague our financial system, her solutions do not address the problems that she identifies. It's true that traditional financial products cannot compete with "exotic" products whose terms seem attractive up front, but hide surprises and changes that are revealed only after the consumer has committed. Further, the more complex these "exotic" financial products become, the less able consumers are to make comparisons. Right now our financial system lacks a level-playing field, transparent in its operation, which encourages competition, and also engenders product innovation.

I am in agreement with Warren about the backwardness of our current regulatory system, which is most ineffective because it is structured by business type rather than financial-product type (i.e., credit cards, home loans, etc.), and allows financial institutions to essentially choose their own regulators, simply by changing their organizational structure. There is also a conflict of interest in the current system that is perpetuated by the fact that the regulatory budget comes, in large part, from the financial institutions that need regulation.

Warren insists that the solution to these problems is the CFPA. This new agency would promote clear disclosure of the risks and costs for everything from mortgages to credit cards, from payday loans to bank overdraft fees. Disclosure is the biggest part of Warren's argument for the CFPA. She believes that, if people were aware of the facts surrounding financial products, they would make rational decisions concerning which product to choose. This is simply not the case.

For instance, in the case of the housing market, it's easy to say that all of the people who took out subprime loans were victims who had no idea what they were getting into, but the reality of the situation is that many got caught up in a bubble mentality. They believed that they could sell their homes at inflated prices if they became unable to afford their mortgage payments once they doubled. This segment of consumers failed to weigh risk properly, because they assumed that housing prices would continue to appreciate. The core of the problem was extensive speculation on the parts of lenders and borrowers, and not insufficient disclosure.

The truth is that regardless of the thoroughness of disclosure, consumers aren't always realistic about their home's future success on the housing market, or their ability to consistently make payments on their credit card accounts on time. It's human nature for people make decisions that are unrealistically optimistic. Full disclosure won't fix this problem.

Moreover, the proposed CFPA fails to address the problem that lies at the core of the misfortunes our financial system faces, and that is product structure and underwriting standards. As a result of her belief that the marketing of and disclosure around financial products can be separated from the design of the products themselves, Warren's conceived CFPA would allow banks and other lenders to continue offering complicated or risky products, so long as the risks are disclosed so that consumers can reasonably understand them. These kinds of products simply should not be allowed to exist. Plans for the CFPA fall short because mandating full disclosure does nothing to mitigate the danger for banks and consumers that exotic financial products represent.

Continuing to allow complex financial products to be sold on the market will, by necessity, imply some complexity in terms and contracts, making "clear disclosure" an extraordinarily subjective term. Additionally, the same regulators who are to be responsible for the terms of disclosure should also be responsible for the structure of financial products. In the financial products market, these two things are intrinsically intertwined.

Lastly, the CFPA does nothing to address the conflict of interest that exists within the current regulatory system. Banks will still be able to shop around for the regulators that best suit their needs even after the CFPA is established, and the agency would do nothing to address the structural deficiencies that make the regulatory bodies that currently preside over financial institutions ineffective.

What is most bothersome is how well and clearly Warren identifies the problems we face. She then proceeds to describe her plan, which has been adopted and endorsed by the administration, as a solution even though it fails to sufficiently address any of the problems that she has described. The result is a disquieting disconnect between what needs to be done, and what Warren and now President Barack Obama are proposing. In my estimation, the Obama administration is being pulled thin as it tries too hard to solve all of America's problems with equal expediency and equal force. The result is that the solutions offered are slap-dash and unproductive.

The tragedy here is that the ways in which the CFPA falls short aren't the result of ignorance, but instead due to the desire for a quick fix. The answer to America's broken markets is a streamlined regulatory system in which financial products are controlled by type and not institution. Further, the regulation that ensures the solvency of each bank, and the regulation of financial products should be combined for the protection of both consumers and financial institutions. Adding another regulatory agency made up of patchwork pieces will only add to the larger regulatory maze, which as we have seen, has completely failed to protect us.

This post was republished from The Street, an investment news and analysis site.

1 comment:

x said...

Persuasive. Esp. the recognition that regulation by business type, as opposed to product type, is the fundamental flaw in our regulatory framework. That is very well-put.

The CFPA seems a proposal in search of a reason. While inadequate intra-agency dialogue, uneven enforcement, and agency "shopping" are prevalent, the CFPA does nothing to stop these practices. More problematic is the potential interaction of the CFPA with the state regulatory bodies. Who's voice will rule? Will we be able to create a coherent national enforcement scheme given the competing industry and state voices?

Systemic change is necessary, not more band-aiding. Let's get serious about changing the present (short-term) incentives of the financial intermediaries rather than creating another dithering, inert agency. I greatly respect Elizabeth Warren (she's awesome) but I believe she has the wrong proposal in the CFPA.