The Proposed Consumer Financial Protection Agency Act of 2009

By Richard A. Posner

On June 24, in "Financial Regulatory Reform: III," I blogged on the proposal in Financial Regulatory Reform--the Administration's blueprint for revamping the regulation of the financial industry--that Congress create a Consumer Financial Protection Agency. A few days ago the Administration issued a 152-page draft of a proposed statute establishing such an agency, and the draft helps to clarify the Administration's thinking and in doing so it reinforces the doubts I expressed in my earlier blog entry. The length of the draft is deceptive; pages have only 23 lines, the print is large, and the margins are generous; more important, most of the draft is taken up with bureaucratic details, involving for example the transfer of staff from other agencies. I shall ignore those details (though they may be minefields) and focus on what seem the key provisions of the proposed statute.

The objectives of the proposed statute are stated broadly, and to a degree inconsistently, as well as (of course) redundantly. The principal objectives are that "consumers [of financial products] have, understand, and can use the information they need to make responsible decisions," and "are protected from abuse, unfairness, deception, and discrimination," but also that "markets for consumer financial prodducts or services operate fairly and efficiently with ample room for sustainable growth and innovation" and that "traditionally underserved consumers and communities have access to financial services." The inconsistency lies in the fact that the more consumers are protected (largely from themselves) from being abused, deceived, and so forth in the purchase of financial products, the more those products will cost and so the less rapidly the market will grow and underserved consumers--a disproportionate number of whom are poor credit risks--will have access to it. The clearest example is a separate provision of the proposed statute that authorizes the agency to forbid arbitration clauses in consumer finance contracts. These arbitration clauses are inserted by the credit-card companies or other lenders, and so presumably--since consumer finance is a competitive industry--the clauses reduce the lenders' costs and therefore interest rates.

Oddly, although high credit-card interest rates are a focus of complaints about consumer credit, the proposed statute forbids the agency to establish a "usury limit," that is, to limit interest rates, unless explicitly authorized by law to do so.

The proposed statute confers the broadest possible authority on the new agency to require reports from providers of consumer financial products and to conduct surveys, for example of the consumers themselves, to determine the risks to consumers and consumers' understanding of those risks. Given the number of sellers of financial services to consumers, not to mention the number of consumers, the potential costs of the reporting and monitoring function, both to those providers and to the agency, are likely to be very high.

The statute authorizes the agency to prevent, both by rulemaking and in administrative enforcement actions, "unfair, deceptive, or abusive acts[s] or practice[s]." To declare a practice "unfair," the agency must determine that it "causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers and such substantial injury is not outweighed by countervailing benefits to consumers or to competition." This vague standard confers enormous discretion on the agency; and there is no attempt to define "abusive" ("deceptive" is reasonably self-evident).

Of particular significance, the agency may prescribe rules to ensure "effective disclosure or communication to consumers of the costs, benefits, and risks associated with" any consumer financial product; risks and costs must be communicated in a manner "designed to promote a consumer's awareness and understanding of the risks and costs, as well as to use the information to make financial decisions." The agency is to "consider available evidence about consumer awareness, understanding of, and responses to disclosures or communications about the risks, costs, and benefits of" consumer products.

In an earlier era, all this could probably have been dismissed as hot air. Ever since the late 1930s, the Federal Trade Commission has had the authority to prevent "unfair or deceptive acts or practices," but in practice this has usually meant nothing more than preventing false labeling and advertising. What is new in the proposed CFPA statute though not mentioned in it is "behavioral economics," which is the application of cognitive psychology to economic phenomena. The literature of behavioral economics, which appears to be influential with the Administration, emphasizes cognitive deficiencies that make it difficult for even people of normal intelligence and good education to act in their best interest even when fully informed. One can easily imagine the insights of behavioral economics being used by the new agency to go far beyond typical consumer protection measures, which involve forbidding false information, and often also requiring true information, to be provided to consumers.

That this is likely to happen is suggested by the grant of authority to the new agency to create "standard" consumer financial products, which means products designed by the agency itself. These products (a mortgage for example) are not only to be "transparent to consumers" and "facilitate[] comparison with and assessment of the benefits and costs of alternative consumer financial products or services," but they are also to "contain[] the features or terms defined by the Agency for the product or service." If this language is taken literally, it means that the CFPA could draft a mortgage loan contract that provided for a 30-year nonrecourse 100 percent (that is, zero equity) fixed-rate mortgage loan, or for that matter a 25-year fixed-rate 80 percent loan. The mortgage banker or other seller of the mortgage would be required to offer the prospective mortgagor the agency-created mortgage at or before offering its own alternative financial product. One concern the "standard" creates is that the seller's own financial product, if it departed substantially from the standard product, might be deemed abusive or unfair.

The agency is also authorized by the statute "to prescribe rules establishing duties regarding compensation practices" of all the firms that it regulates, although it is not to "prescribe a limit on the total dollar amount of compensation paid to any person."

The statute transfers consumer financial protection powers and staff of the Federal Reserve, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Trade Commission to the new agency, but allows state consumer protection laws to apply, even if they provide greater protection than the Consumer Financial Protection Agency Act, as long as they are not in conflict with requirements imposed by the proposed act or the rules that the CFPA adopts. But the proposed statute does not apply to financial products regulated by the Securities and Exchange Commission or the Commodity Futures Trading Commission. 

The objections to the proposed statute are obvious and, it seems to me, compelling. The statute is intended to prevent a repetition of the current financial crisis, yet has been drafted and proposed in advance of evidence that deception or cognitive deficiencies played an important causal role in the crisis. Even if the sort of deficiencies identified in the literature of behavioral economics did play a significant role, there is no reason to think that differently drafted mortgage forms, payday loan forms, credit-card solicitations, etc., would influence consumer behavior. When interest rates are low and credit therefore abundant, Americans borrow. If the new agency's "standard" financial products result in lower interest rates, Americans will borrow more, setting the stage for a future financial crisis, while if the products result in higher interest rates, they will delay the recovery from the present crisis.

The latter--higher interest rates--are the likelier consequence, because the thrust of the proposed statute is to pile more rights on consumers, which will raise the costs of the finance companies. This may or may not reduce the amount of consumer indebtedness (which would be a good effect, since overindebtedness is one of the circumstances that has contributed to the economic crisis). The amount of debt that consumers take on will be less, but the burden may be greater because debt will be more costly.

As pointed out by Robert C. Pozen in an important book, Too Big to Save? How to Fix the US Financial System (to be published in the fall by John Wiley & Sons, Inc.), the new agency will complicate, by dividing, the regulation of banking between the banking agencies and the CFPA. This would not be a problem if the new agency were just concerned with protecting consumers against deception (although if that were all it were concerned with there would be no need to create it). But its immense discretionary authority over the marketing of consumer financial products ranging from mortgages to credit cards could if exercised aggressively have significant effects on the economics of the finance industry--effects that could increase systemic risk and could thus bring it into conflict with the Federal Reserve and the other banking regulators. 

At a time when the entire credit system is fragile, the very proposal of such a statute (coming hard on the heels not only of a raft of other proposals for the regulation of the finance industry but also of a hastily enacted statute regulating credit-card credit--the Credit Card Accountability, Responsibility and Disclosure Act of 2009, which may substantially increase the costs of credit-card issuers) is likely to retard the economy's recovery from its present sickness, if only by further unsettling the economic environment of the finance industry. The statute if enacted would as I have said increase the costs of providers of consumer credit, and the prospect that it will be enacted in some form close to that proposed will cause the credit industry to mobilize its resources to oppose enactment, when the industry should be devoting all its time and energy to self-repair.

A more moderate approach would be to transfer the consumer financial product regulatory staffs of the Federal Reserve, the Comptroller of the Currency, and the FDIC to the Federal Trade Commission, and to further enlarge the resulting combined staff, thus both consolidating and strengthening the enforcement of the existing federal laws (which are numerous, such as, besides the new credit card law, the Truth in Lending Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, and the Real Estate Settlement Procedures Act, for the protection of the financial consumer. That might accomplish most of what the proposed Consumer Financial Protection Agency Act is intended to accomplish, and at far lower social cost.

The proposed statute is one more example of an emerging regulatory philosophy that, in understandable but not excusable reaction against the recent history of lax, ineffectual financial regulation, can be summed up as too much, too soon, too costly.

This article available online at:

http://www.theatlantic.com/business/archive/2009/07/the-proposed-consumer-financial-protection-agency-act-of-2009/20641/