Structuring the Consumer Financial Protection Agency

Douglas J. Elliott
Douglas J. Elliott Former Brookings Expert, Partner - Oliver Wyman

July 1, 2009

The Obama administration on June 30th released a more detailed legislative proposal for its proposed Consumer Financial Protection Agency (CFPA). It appears to retain the intended benefit of a clear focus on consumer protection while addressing seriously my own two principal concerns: (a) the potential for crushing useful products by attempting to banish everything carrying risk even when the rewards would outweigh the risks and (b) the possibility of encouraging an agency consumed with empire building. The administration’s attempts seem sensible, although the key will be how they play out in practice. It is not easy to predict in advance how a new bureaucracy will behave as time goes by. In addition, the constraints being proposed for the agency may also be watered down by Congress out of a concern that they would weaken the CFPA.

The CFPA is intended to answer the clear need for better consumer protection which was underlined by the massive problems with mortgages originated during the late years of the bubble, particularly sub-prime ones. The administration believes that having a financial regulatory agency with a sole mission of protecting consumers will be more effective than the present system of making that role part of a wider range of functions at the Federal Reserve and other regulatory bodies. Many observers have concluded that consumer protection got short shrift at agencies that were primarily interested in maintaining sound finances at the lending institutions.

When the original white paper on financial regulatory reform came out on June 17, I wrote that the proposal answered the clear need for more focus on consumer protection, but brought with it two major risks. First, the CFPA might model itself on the common perception, which may or may not be true, of the Food and Drug Administration as turning down potentially useful drugs if there is even a very small chance of harm. Useful financial products frequently carry with them some risk, so there is the potential for a substantial loss of economic efficiency if they are engineered to be totally safe. For example, it would not be helpful if we protect lower-income households from the risks of subprime mortgages by guarding them so heavily that financial institutions are not willing to offer such mortgages.

Consumers deserve to have products that they can understand and that do not carry unreasonable risks, but they also deserve the chance to use products that meet their needs, such as allowing them a reasonable opportunity to take a first step up the economic ladder by buying a home. Availability of financing for lower-income households was used as an excuse in the recent past for allowing bad mortgage products and overlooking dangerous behavior. However, we would not want to overshoot in the other direction by cutting off the availability of mortgages for those with lower incomes who are quite likely to be able to carry the mortgage burden, but are at some risk of failing in the attempt.

The administration is attempting to deal with this potential cultural flaw in multiple ways:

An overall focus on unfair, deceptive, and dangerous practices, rather than risk, per se. The Act could have been constructed to try to minimize consumer risk altogether, even at the expense of lost opportunity. Instead, the focus is on ensuring that consumers are in a position to make their own choices with clear information and without undue pressure. This overall tone of the Act will be an important determinant of future behavior.

Instruction to weigh economic costs and benefits. The agency is specifically ordered to consider the economic loss from banning or limiting a product. This still gives the agency considerable scope to decide that the costs of a product outweigh its benefits, but the agency will almost certainly take this admonition seriously, which does provide some comfort.

Instruction to place a significant value on access to financial products by traditionally underserved consumers. The proposed Act specifically calls on the agency to try to ensure access to products for those who have traditionally had problems getting loans or other services. This would presumably include minorities and those with lower incomes.

Prohibition against establishing usury limits. One way to limit financial behavior is to introduce a price cap, such as a limit on the allowable interest rate that can be charged. The Act specifically forbids the agency itself to impose usury limits.

Option to consider previous practice in regard to financial products. The agency is allowed, but not required, to give weight to what other regulators and policymakers have decided in the past in regard to fair behavior in designing and marketing financial products. The optional nature considerably reduces the impact of including this provision, but at least provides room to consider precedent.

All in all, these instructions go a long way towards encouraging the new agency to be balanced in its judgments of risks and rewards. However, they would still leave substantial discretion to the new agency. The good and the bad news is that the agency represents a fresh start, potentially reopening many questions. There is a lot to be said for this, since the previous system proved inadequate. But, it also means many seemingly settled questions are up for grabs again.

Here are two examples of the broad types of risk/reward tradeoffs that the agency might have to make. They are stylized examples since it does not seem likely in either case that the new agency would choose to make a major change from current policy, but they should give a sense of the thought processes the agency will need to go through.

Traditionally mortgages required the home buyer to make a downpayment of 20% of the purchase price and do so out of their own resources, without borrowing from a family member, for example. Downpayments are intended to protect lenders by ensuring borrowers have skin in the game and by reducing the loss on any foreclosures by increasing the likelihood there is still equity left in the house. They are also intended to protect consumers by creating a cushion of equity that might allow them to sell the house and repay the full mortgage if they ran into financial problems. It may also be the case that the ability to find a 20% cash downpayment is correlated with other sources of financial security, such as superior job skills or tenure.

Unfortunately, the 20% cash downpayment can be an insurmountable barrier to buying a house for a lower income family even if they could support the monthly mortgage payments. So, mortgage insurance was invented and then lower downpayment mortgages were introduced. In both cases, there is generally a substantially higher default and foreclosure rate for those families that made downpayments of less than 20%. In theory, the new agency might decide that the social and economic costs of foreclosures are too serious to allow families to take the risk of buying a house without a full 20% downpayment. I would not expect them to decide this, since it would slam the door shut on many lower income families, but it would not be a crazy decision should the agency prove to be highly averse to risk.

Similarly, one reason that credit card rates are so high is that the providers suffer from significant default rates, even in relatively good times. Some sub-groups represent such high risks that lenders in the past have bumped into state usury limits on the maximum rate they can charge as they look at a way to profitably service the customer base. Perhaps customers who carry a 5% or 10% chance of defaulting on their credit card debts are being allowed to take too high a risk by having credit cards or carrying the level of balances that they are allowed to do. It would not be out of the question for the agency to require some sort of suitability testing for new credit card applications to ensure that cards were not offered or limits increased that would tempt consumers into taking on excessive debt.

On the other hand, this could mean that some consumers for whom credit cards have become an essential part of their life might find themselves severely limited. Drawing the line on who was affected and what the credit limits would be could be very difficult. Dumping the question on the lenders themselves would not solve the problem, since ultimately the agency would have to police the decisions of those lenders. Again, this example may be too extreme, but it represents the types of trade-offs that would need to be considered.

The second risk I saw was that the new agency might consume its energies in empire building, by trying to lay claim to a much wider range of financial product oversight than is currently intended. As extreme examples, the agency could define small businesses as “consumers” for this purpose or treat all individuals as consumers even if they are in fact so wealthy as to be sophisticated investors who use products more often associated with hedge funds or other institutions.

The aministration’s approach to dealing with this issue is to: (a) define consumer in a relatively limited way consistent with past legal definitions; (b) provide a fairly specific list of product types; and (c) to attempt to limit the ability to add other products to those innovations that are most like those already on the laundry list. In addition, the SEC and CFTC retain regulatory authority over those people and products that they already regulate. In some cases, the new agency would be regulating products that compete with, or could be offered as, SEC or CFTC-regulated products. It is instructed to consult with those agencies, and vice versa, in establishing regulations on such products. Taken together, the various provisions appear to do a good job of establishing the set of products and actors to be regulated by the new agency. There is always room for empire-building at any bureaucracy, but this does not appear likely to be a serious problem for some time at the CFPA.

All in all, the administration appears to have done a good job of addressing my two largest concerns. However, we need to see what comes out of Congress in the end and then see how the CFPA operates initially before being altogether confident that the new agency will succeed in avoiding those pitfalls altogether.

The whole issue is complicated and there are other points beyond these two to consider, especially the issue of pre-emption of state law, or lack thereof, but I will leave those for future papers.