Evaluating the "veto" on consumer protection

Policy-makers often sagely observe that we should be careful, in trying to craft reforms, not to “fight the last war”.  Unfortunately, when it comes to consumer financial protection, the Senate financial reform bill risks fighting the last war, and losing it anyway.

The Senate proposal calls for the creation of a new Bureau for Consumer Financial Protection (“Consumer Bureau”) within the Federal Reserve System.  Despite being housed within the Fed, the new Consumer Bureau would benefit from significant functional and financial independence from the Fed and other prudential regulators like the OCC (that is, regulators who primarily watch over banks’ safety and soundness).

This is a substantial improvement.  Curiously, though, the Senate proposal sacrifices a significant measure of Consumer Bureau independence by permitting the newly created Financial Stability Oversight Council (the “Stability Council”) to override Consumer Bureau regulations, if the Stability Council finds, by a two-thirds vote of its nine voting members, that those regulations would threaten the safety and soundness of the banking system, or the financial sector’s stability. 
As a threshold matter, it is not clear what problem this veto provision is meant to solve.  Although it is presumably possible to be too protective of consumers, it is hard to imagine how consumer over-protection ever creates massive risks to the entire financial sector. 

But this veto provision is not merely pointless; it does affirmative harm to an otherwise sensible proposal.  To see why, consider what would have occurred during the credit bubble if the Senate proposal had been in place at that time.
Perhaps bank regulators’ most tragic errors in the run-up to the crisis (and, sadly, there are several contenders for that title) related to non-traditional prime mortgages, like interest-only loans and Option-ARM’s.  These are products that were demonstrably non-transparent to prime borrowers, and exhibited several warning signs of consumer abuse (complex structures, broker-driven sales, sudden mass market growth despite previously being niche products).  Despite those warning signs, regulators watched as the explosion in (and later, the explosion of) these mortgage products helped artificially inflate a credit-fueled housing bubble.  It wasn’t until late 2006 -- more than three years after the products started their breathtaking growth -- that prudential regulators got around to issuing final “guidance” to rein them in.  This was almost exactly too late.
The good news is that if the Consumer Bureau were around during the credit bubble, it almost certainly would have moved earlier, and more decisively, than the prudential bank regulators. 

The Consumer Bureau would not have had the perverse incentive to protect abusive products precisely because they are so profitable.  The Consumer Bureau would not have had to compete for, and therefore cater to, industry interests in order to attract fees away from competing regulators. 

By contrast, bank prudentially regulators are first and foremost (and appropriately) concerned with bank profitability and viability.  They see consumer protection and bank safety as trade-offs to be weighed against each other, rather than as two separate requirements.  As a result, prudential regulators are not structurally suited to say the obvious:  if you are a banker who must use some measure of consumer abuse and deception to make money, then you should find a different line of work, and make way for better bankers.  All this is made worse by the fact that prudential regulators are (especially before the Senate bill, but even afterwards) a fragmented bunch, who compete with each other to attract banks to their charters.
Unfortunately, as sure as the Consumer Bureau could have moved early to rein in abusive products, it is just as probable that the Stability Council, if it had existed before the crisis, would have vetoed those consumer protection efforts.  As contemporaneous evidence strongly suggests, at least six of the nine voting members of the Stability Council, if it had existed at the time, would have voted against the regulation of non-traditional mortgages during the bubble.  The Consumer Bureau chief, the FDIC Chairman, and the FHFA (then, OFHEO) Chairman all would likely have supported regulation.  But the Treasury Secretary (John Snow), Fed Chairman (Alan Greenspan), OCC chief (John Dugan), and SEC Chairman (Christopher Cox) almost certainly would have voted to prevent regulation.  And the last two voting members (the CFTC Chairman, and an insurance industry expert), because they lack any institutional competence in bank consumer credit, would likely have followed the lead of the Fed and the Treasury.  Three votes for regulation; six against.

The veto power, then, would likely have led to precisely the wrong substantive outcome with respect to the most serious systemic risks created by abusive consumer products and practices during the run-up to the crisis.  Battle joined, and lost.
Politics sometimes requires that we compromise; but sometimes common sense requires that we don’t.  The veto provision should be eliminated.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.   Cambridge Winter is a non-profit, non-partisan think tank focused exclusively on financial institutions policy.