Senate Banking Committee Chairman Chris Dodd (D-CT) this week begins the arduous process of negotiating his latest version of financial regulatory reform legislation through his committee and then onto the floor of the Senate. Sen. Dodd’s bill would correct the deficiencies in the regulatory structure that led to 2008 financial crisis, including the failure to prevent abusive, unsustainable, and risky loans that weakened the mortgage-based securities into which these loans were packaged so badly that they triggered the global financial crisis and deepened the Great Recession.
Despite the direct link between lending abuses and the housing and financial crises and sharp economic downturn, one of the most contentious aspects of regulatory reform is consumer protection. Currently, various bank regulators, including the Federal Reserve, Office of Thrift Supervision, and the Federal Deposit Insurance Corp., are charged with monitoring both bank "safety and soundness" and consumer protection, but the regulators historically emphasized the former over the latter.
In order to change this, the Obama administration wants to create an independent Consumer Financial Protection Agency that would be charged with rule writing and policing consumer abuses in the financial system. The aim behind creating an independent agency is to have one entity solely focused on protecting consumers in the financial system. Such an agency was included in the Wall Street Reform and Consumer Protection Act of 2009, which passed the House of Representatives last year.
Dodd’s bill instead creates a Bureau of Consumer Financial Protection housed within the Federal Reserve. Dodd’s original reform bill, released last November, included an independent CFPA, but he could not sell enough of his colleagues on the administration’s recommendation. The Fed, of course, distinguished itself in the eyes of its regulatory charges by neglecting its consumer protection duties in the run-up to the financial crisis. That’s why consumer advocates are wary of Dodd’s legislation.
And this hesitancy is well deserved. The Fed was granted the power to regulate mortgage lending by the Home Ownership and Equity Protection Act 1994, yet despite repeated warnings from economists, Treasury officials, and consumer watchdogs, it didn’t act to rein in subprime lending in time. Even Fed Governor Edward Gramlich warned his colleagues about the growing threat posed by subprime mortgages, to no avail.
It wasn’t until 2006, in fact, that the Fed even released guidelines on "nontraditional mortgage risks." It refused to ban the worst practices of subprime lenders, such as "stated income loans" or exorbitant prepayment fees, until 2008, at which point it was far too late to prevent the financial system from imploding. Even Dodd himself has said that the Fed was an "abysmal failure" when it came to protecting consumers.
Still, Dodd’s bureau seems to have been crafted to keep its independence intact and to keep the influence of the Fed’s "safety and soundness" responsibilities in proper perspective. Consumer advocate Elizabeth Warren has listed four criteria necessary for an effective consumer financial protection regulator:
- An independent director appointed by the President and confirmed by the Senate
- Independent source of funding
- Independent rule-making authority
- Independent enforcement powers.
The bureau largely meets these standards.
The bureau’s director would be appointed by the president and confirmed by the Senate. Its funding would come from the general Federal Reserve system budget (limited to no more than 10 percent of the central bank’s total budget), which wisely removes the bureau’s funding stream from the appropriations process and the whims of congressional appropriators, and ensures that Federal Reserve governors can not use the budget process as a tool to defang the bureau.
The bureau’s rules, meanwhile, would apply to all banks, nonbank mortgage lenders, and other "significant" nonbanks regulated by the Federal Reserve. The bureau would directly examine and enforce rules for financial institutions with more than $10 billion in assets, while smaller banks would still be overseen by their current regulator for compliance with the bureau’s rules.
The bureau would be charged with consulting bank regulators for all regulations that it writes, but it would be able to unilaterally implement rules aimed at protecting consumers. Importantly, though, the nine-member Financial Stability Oversight Council, which Dodd is creating to monitor systemic risks in the financial system, can overturn the bureau’s rules with a two-thirds vote if it feels that the rule is a threat to "safety and soundness." The new FSOC does include the bureau’s director.
The upshot: the bureau measures up pretty well. Warren herself offered Dodd’s legislation some cautious support, saying that it’s "an important step" toward "advancing new laws to prevent the next crisis."
Because the bureau is going to be housed in the Fed, however, it is going to need every single one of those robust independence measures to ensure that it is not co-opted by a larger regulatory body that hasn’t historically been sympathetic to consumer concerns. The bureau is going to be surrounded by an entity with which it may find itself in direct conflict, and if the Fed’s deregulatory culture permeates into the bureau, consumers will lose what is supposed to be their sole voice.
A bevy of financial services lobbyists are all over Capitol Hill, aiming to water down or completely block the bureau (and Dodd’s wider bill) from ever coming to pass. The U.S. Chamber of Commerce alone has pledged $3 million to derailing the bureau, while various industries are looking to exempt themselves from its rules.
But for the bureau to be effective, it simply cannot be weakened any further. Dodd’s proposal already represents a significant compromise from the completely independent CFPA in the House. Still, it is a definite step forward from the status quo. But it could easily be weakened to a point where it provides only the veneer of protection. That would enable lenders to resume some of their pernicious consumer finance practices, which of course is no reform at all.
Pat Garofalo is an Economics Researcher at the Center for American Progress and a Blogger at the Center for American Progress Action Fund.