How to Make the Bureau of Consumer Protection More Consumer Friendly:

From the beginning of the financial reg reform debate I’ve supported the idea of a more coherent and integrated institutional approach to consumer financial protection.  I’ve also consistently argued that a failure of consumer protection was not a major cause of the financial crisis, misaligned incentives were the problem.  In my view the two questions are distinct–I think we need streamlining of the system of consumer protection regardless of whether it caused the crisis, in order to make it more responsive to market dynamics and consumer choice.

And, in fact, there are a few things in the legislation that do that–for example, there is a requirement that the new agency create a new, single form for mortgage disclosures that should help consumers.

So what’s my gripe?  Mainly that the philosophy of the CFPB is predicated on bad economics and a faulty understanding of consumer behavior and that the overall effect of the agency will be negative for consumers–higher prices, less innovation, less competition, less access to mainstream credit and greater use of “fringe” lending products, and ironically, increased threats to the safety and soundness of the banking system.  The fact that the House and Senate appear to be headed for the enactment of some sort of legislation is pretty strong evidence that the Democratic majority in Congress disagrees with me.

I’ve not heard any supporters of the CFPB credibly argue that the overall effect of the new bureaucracy will be to make credit cheaper or more widely available.  Some have argued about the size of the effect–whether it will make consumer credit a lot more expensive or just a little bit more expensive.  But I don’t know of anyone who has contested the sign of the effect–that it will make credit more expensive.

So with that in mind, here’s three things that I’d like to see the conference committee do to further the Bureau’s consumer protection mission while protecting consumers and small business from the unintended consequences of higher credit costs and regulatory overreach.

Better Supervision and Accountability: First, although the current version of the consumer protection regulator has been moved from an independent stand-alone agency into the Federal Reserve, it remains largely unaccountable to oversight by the Federal Reserve Board or any other entity except through a cumbersome and limited oversight process by a council of regulators.  Moreover, it is headed by a single head appointed by the President rather than a commission, leaving the agency’s actions subject to the whims of a single individual.

As an unaccountable bureaucracy with single head, the Bureau will be susceptible to bureaucracy’s worst pathologies: a tunnel vision focus on the agency’s regulatory mission, undue risk aversion, and agency overreach.  While a more coherent consumer protection regime is needed, consumer protection goals can often conflict with other goals such as the promotion of competition, lower prices and expanded choice for consumers, and ensuring safety and soundness.

For example, the law gives the Bureau new authority to regulate slippery mortgage brokers.  But brokers can also provide a salutary competitive check on traditional bank lenders.  Research by economists Morris Kleiner and Richard Todd finds that overly restrictive regulation that reduces the number of mortgage brokers results not only in higher prices for consumers but also lower quality service and higher foreclosure rates.  Thus, while stricter regulations on mortgage brokers could theoretically reduce fraud by brokers (although there is no evidence that is the case), this greater security could come at the expense of higher prices and reduced consumer choice.  An effective consumer protection regulator must be able to balance consumer protection against other benefits to consumers and the economy of greater competition, lower prices, and enhanced safety and soundness.  Even leaving aside bureaucratic pathologies, the current CFPB is not structured to weigh those broader trade-offs between the benefits to consumers of greater competition and consumer protection.

A better model is the Federal Trade Commission, the primary consumer protection regulator for most of the American.  At the FTC (where I was the Director of the Office of Policy Planning from 2003-04), the mission of the Bureau of Consumer Protection is virtually identical to that of the CFPB, focusing particularly on unfair and deceptive marketing.  But the final decision whether to act rests not with the director of the consumer protection bureau but with the five member bipartisan Commission to which the bureau reports.  Moreover, by combining under its roof the Bureau of Competition and the Bureau of Economics, the FTC has a broader scope to weigh the consumer protection bureau’s narrow focus on consumer protection against the larger impacts on competition and economic efficiency (and vice-versa).  Yet no one contends that this larger focus, greater accountability, and internal checks and balances weakens the FTC’s effectiveness as a consumer protection watchdog.

More fundamentally, no FTC veteran believes that consumers would be made better off if the Director of the Bureau of Consumer Protection were unleashed with unilateral authority litigate and regulate without accountability to the Commissioners.  Having located the new bureau inside the Fed, I think that Congress’s conferees would do well to model the relationship between the Federal Reserve Board on the FTC’s structure.

Eliminate the “abusive” standard. Second, the CFPB would have the power to regulate and punish not only “unfair” and “deceptive” lending practices (the FTC’s standard) but also the apparently novel authority to punish “abusive” acts.  The contours of this new basis for liability are vague, but it seems to make lenders responsible for a subjective standard of understanding and competency by the borrower in at least some circumstances.  The House version provides no definition at all, but leaves it solely up to the head of the agency to define.

Here’s the definition of “abusive” in the Senate bill:

The Bureau shall have no authority under this section to declare an act or practice abusive in conneciton with the provision of a consumer financial product or servvice, unless the act or practice:

(1) materially interferes with the ability of a consuemr to understand a term or condition of a consumer financial product or serive;

(2) takes unreasonable advantage of–

(A) a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service:

(B) the inability of the consumer to protect the intersts of the consumer in selecting or using a consumer financial product or service; or

(C) the reasonable reliance by the consumer on a covered person to act in the interests of the consumer.

What does this mean?  Under the “abusive” standard. the new super-regulator would seem to have power to ban loan terms and products if the Bureau chief considers certain products to be simply too risky or too complicated for some or all consumers, even if (by definition) they are not unfair or deceptive.  Since the definition of “unfairness” tracks the FTC’s definition, it permits the regulator to declare a product to be unfair only if it “causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers” and that “such substantial injury is not outweighed by countervailing benefits to consumers or to competition.”  (The House version of the legislation resuscitates an older, broader FTC standard that was abandoned 30 years ago because of its problems.  I assume that the Senate version that adopts the new FTC standard will be the one that prevails in conference).  As I read the juxtaposition between abusive and unfair, this suggests that under the “abusive” standard certain products could be illegal even if they would be otherwise justified under a cost-benefit analysis of unfairness.  In particular, what this seems like it could reach would be terms that would be justified under an efficient risk-based pricing rationale, but which consumers find too confusing (in the view of the regulator).  How this tradeoff would be determined without the type of analysis contemplated by the unfairness standard is not clear.

If that’s not what “abusive” means, I’d be interested in hearing alternative interpretations.  It is a novel term and I’ve not read any good explanations as to the limits of the term.

The second possible interpretation is potentially more pernicious–it could be read to create certain classes of consumers who are believed to be systematically less able to protect themselves than others.  This is one reading of (2)(B) above.  If so, and its not clear to me that is the case, it raises a whole host of other issues.  But I’ll assume this is not what is meant.

What might this mean?  It seems like the “abusive” standard could give the Bureau chief the authority to ban many non-traditional lending products such as payday lending.  The statute itself provides that the Bureau head is not permitted to impose usury ceilings.  That’s good.  But consider a product like payday lending, where borrowers often roll over their loans from one period to the next.  Empirical research indicates that payday loan customers value highly the option of rolling over their loans.  But so-called consumer advocates are often critical of the rollover option, saying that it creates a “cycle of debt.”  Well, the rollover option is plainly not deceptive (all payday loan customers know about it and is almost certainly not unfair (most borrowers prefer the option).  But could the new super-regulator say that many payday loan customers tend to systematically overestimate their belief that they will pay off the loan at the end of the period and thus underestimate the likelihood that they might end up rolling over their loan?  It seems like it.  Would this qualify as taking “unreasonable advantage of a lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service”?  I think so.

One could extend this logic to almost any non-traditional lending product.  Auto title loans, for example, have an obvious risk that the borrower will lose his car.  Does the borrower fully understand and appreciate his potential that he will fail to pay the loan or the hardship of losing his car?  Virtually every product has this sort of inquiry attached to it.

This suggests that even though the CFPB couldn’t regulate interest rates, it could regulate through the abusive standard virtually every other provision of consumer credit contracts and essentially abolish many of these alternative products.

The big picture here to me is that deceptive and unfair are well-defined and well-understood words from the FTC.  I don’t see what “abusive” adds that is going to be beneficial to consumers.  Instead, it seems to be a largely empty term that empowers the super-regulator to make purely subjective evaluations of certain products and terms.  If we want to have a super-regulator enacting purely paternalistic regulations, as opposed to regulating objectively unfair and deceptive practices, then I think Congress should be more clear that is what it is voting for.

Preemption. Third, the conference committee should reject the legislation’s plan to make it more difficult for federal regulators to preempt state regulatory and enforcement authority over federally chartered banks.  The problem addressed by preemption is longstanding—the effort of populist state legislatures and politically-ambitious Eliot Spitzers to score political points by attacking out-of-state federally chartered banks.  But the consequences are heightened by the national character of the modern banking system which has grown in large part because of the power of federal regulators to preempt parochial state laws.  Moreover, to the extent that the financial crisis supports redundant state authority, the creation of the Bureau seemingly eliminates the primary justification for additional state authority.  Instead, it threatens a nightmare regulatory scenario: a new federal regulator that reaches down to the level of local payday lenders and small merchants while simultaneously empowering state regulators to attack national banks.

This is a very fluid part of the legislation and I expect movement on this issue in conference.

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