Report

Consumer Financial Protection: Advantages, Dangers and Should it be a New Agency?

Martin Neil Baily

Summary

Widespread consumer credit defaults help makes it clear improved consumer protection is needed. Had there been better protection prior to the financial crisis this would have ameliorated the severity of the crisis and might even have forestalled it.

However, there are dangers in a Consumer Financial Protection Agency (CFPA), dangers of over regulation and of stifling innovation.  Proposals for blanket prohibitions and for compulsory provision of plain vanilla products are probably a step too far. The emphasis should be on improved transparency and on solving the market failure of inadequate information.

Many consumers lack knowledge and understanding in the financial area, so that disclosure alone is unlikely to be enough to solve the market failures in some areas. Even if it avoids ex ante prohibitions, the consumer protection agency should look for situations where companies are exploiting the lack of consumer knowledge. They should stop sharp practices and perhaps exact penalties on companies that have used them.

As a first choice, U.S. should have single conduct of business regulator covering both the protection of small shareholders and protecting consumers of financial products. The SEC is the natural choice to be the conduct of business regulator and the home for a consumer financial protection agency. As a second choice, a separate agency could serve, provided it has the appropriate structure and a staff that is balanced and knowledgeable about markets. This short paper makes these points by identifying key structural provisions of the Treasury’s proposed CFPA, enumerating some concerns that have been raised about it, arguing for a more balanced perspective on consumer protection, and offering some recommendations.

Introduction

One important cause of the financial crisis was the housing bubble: individuals and families borrowed heavily to buy houses they could not afford and subsequently defaulted on their mortgages. There was also speculation in the housing market as people bought residential properties hoping to sell them at a profit. And families that already owned homes borrowed against the equity that they had built up and then were unable to meet their debt obligations. This latter problem became much worse as a result of the subsequent decline in home prices and the loss of household income in the recession.

Difficulties in meeting credit card payments have also contributed to the financial crisis. A source of these problems arose when some credit card companies engaged in sharp practices. For example, some companies changed the due date for payment without warning, so that customers missed a payment deadline and incurred fees or penalties, including perhaps a sharp upward adjustment of the interest rate on outstanding balances. 

In response to these experiences, it is appropriate to seek out policies to make sure that the same thing does not happen over again. Any future financial crisis will likely be different from the one we are going through, but it is still important to learn the lesson of history and not repeat it. Reasonably, therefore, the Obama administration has made consumer protection a major facet of its financial regulatory reform plan, proposing a new agency, the Consumer Financial Protection Agency (CFPA) as one of its reform proposals. 

In the Senate, the Chair of the Banking Committee, Christopher Dodd has expressed support for measures to provide greater consumer protection. Barney Frank, chair of the House Financial Services Committee, sponsored a version of the CFPA, named the “Consumer Financial Protection Act of 2009”, or HR 3126. While major facets of the bill are quite similar to the administration’s proposal, a major difference between the House bill and the Obama plan is that the House bill “preserves the current federal banking regulators’ role to enforce the Community Reinvestment Act (CRA).”  It should be noted, however, that at the time of the writing of this paper Chairman Frank is circulating a new version of the bill that may in part exempt nonfinancial businesses that are acting in their traditional capacity, as well as other modifications. Similarly, in testimony before the House Financial Services Committee on September 23, Secretary Geithner expressed a willingness to work with congressional and industry opponents to soften some of the part of the proposal these stakeholders deemed most objectionable.

Still, the stated rationale for this proposal certainly raises the question of whether or not the best way to protect consumers and to protect taxpayers from the consequences of widespread consumer credit defaults is to create a new consumer protection agency. This short paper will identify key structural provisions of the Treasury’s proposed CFPA, enumerate some concerns that have been raised about it, argue for a more balanced perspective on consumer protection, and offer some recommendations.

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