A clear-cut case for regulatory reform

The Federal Reserve, the OCC, and the OTS have had the legal authority to protect consumers for decades. The agencies’ well-documented refusal to protect consumers — refusal that ultimately jeopardized safety and soundness of financial institutions and that brought the economy to its knees — results from two structural flaws in the current system.

The first flaw is that financial institutions can choose their own regulators, which causes regulators to under-regulate. By changing from a bank charter to a thrift charter, for example, a financial institution today can change from one regulator to another. In fact, an institution may decide to evade a federal regulator altogether by housing its operations in the states and forgoing a federal charter. Institutions can shop around for the regulator that provides the most lax oversight, and bank holding companies can shift their business from their regulated subsidiaries to those with no regulation — and no single regulator can stop them. The problem is exacerbated by the funding structure: Regulators’ budgets come in large part from the institutions they regulate. This regulatory arbitrage has triggered a race to the bottom among prudential regulators and has blocked real consumer protection.

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The second structural flaw is a cultural one: Consumer protection staff at existing agencies is small, last to be funded, and always playing second fiddle to the primary mission of the agencies. At the Federal Reserve, senior officers and staff focus on monetary policy. At the OCC and OTS, agency heads worry about capital adequacy requirements and safety and soundness. As the current crisis demonstrates, even when they have the legal tools to protect families, existing agencies have shown little interest in effective consumer protection.

President Obama’s proposal to create a new Consumer Financial Protection Agency (CFPA) represents a significant paradigm shift — a shift that will repair a structure that failed us.

First, the CFPA will bring existing federal consumer regulation under one roof. Similar regulations for similar products will apply across the board — whether those financial products are issued by a federally chartered bank, a state chartered thrift, or an unlicensed business. Financial institutions will be unable to shop around for the regulators that regulate least. Likewise, regulators will no longer have to choose between relaxing standards or watching haplessly as institutions choose to go outside the regulatory system altogether.

Consolidation will also allow for streamlined, smarter, and more consistent regulations — regulations that will reduce cost and burden but increase effectiveness. Instead of passing one law after another weeding out credit scams and dividing regulation among many agencies, a single agency can slice through the regulatory maze to create one consistent — and well-enforced — set of rules.

The CFPA would create a home in Washington for people who care about whether families are playing on a level field when they buy financial products. Canada created this structure by establishing its own version of a CFPA in 2001, and its policymakers swear by the results. By bringing economic experts who care about consumer financial issues under one roof, CFPA can develop as a smart agency with real expertise.

A smart agency with real expertise will develop safety standards that work for families and that, in turn, will promote stability among institutions and prevent the next crisis. It will focus on one, driving question: Are consumer financial products explained in a way that consumers can understand and that allows the market to work?

Today, mortgage disclosures are incomprehensible to — and unread by — virtually everyone. The average credit card contract is now 30 pages, up from only one page in 1980. While lenders promote a few highly visible features — nominal interest rates, free gifts, and warm and fuzzy branding — the real revenue enhancers are the tricks and traps buried in the fine print. The CFPA would ensure that contracts are comprehensible and that consumers can compare terms. When consumers are able to make informed choices and comparisons, the industry will begin to innovate around their preferences — not around more tricks and traps.

The CFPA will promote comprehensible disclosure by pre-approving templates for “plain vanilla” contracts designed to be read in just a few minutes — a regulatory safe harbor that would reduce regulatory burden. The lender would fill in the blanks — like the interest rate, when a penalty is triggered, how much the penalty will be, and so on.  Risk-based pricing would live on. And institutions could continue to offer complicated or risky products, so long as the risks and costs are disclosed in terms that can be read quickly and that can be clearly understood.

Of course, even with a CFPA, consumers who go on shopping sprees they can’t afford would suffer the consequences. Personal responsibility will be as important as ever. But the CFPA will allow for consistent, across-the-board safety standards that ensure borrowers can understand the costs of their credit and compare products. The health and vibrancy of the consumer credit market — and our economy — depend on that.

Defenders of the status quo have long tried to make financial regulatory reform sound complicated and dangerous. The result has been lax standards and little oversight. Big financial institutions lobbied against the establishment of FDIC insurance in the 1930s, but the resulting security strengthened families, banks and the economy. Once again, real regulatory reform is needed. Dangerous consumer products have destabilized families and injected huge amounts of risk into our economy. Real regulatory reform means more than making tweaks on the margins and perpetuating a status quo that failed us. It means permitting bank examiners to focus on their areas of expertise — safety and soundness — while building an agency that has real expertise on — and that really cares about — consumer protection.



Warren chairs the Congressional Oversight Panel. She is a Harvard Law Professor, teaching contract law, bankruptcy and commercial law. In May 2009, she was named one of Time magazine’s 100 Most Influential People in the World.