September 25, 2009
The following column by Harvard Law School Professor Hal Scott,“Regulatory reform needs rethink,” appeared in the Sept. 21, 2009, edition of Financial News Online. Scott is the Nomura Professor of International Financial Systems at Harvard Law School and the director of the Committee on Capital Markets Regulation and Harvard Law School’s Program on International Financial Systems. This column is the first of a regular series of columns by Hal Scott to appear in Financial News.
The Obama administration has made the creation of a new Consumer Financial Protection Agency, now embodied in the act introduced by House Financial Services Committee Chairman Barney Frank, a central part of its regulatory reform plan. It was to be the hook for securing support from the Democratic majority in Congress. Predictably, it has been opposed by industry: the US Chamber of Commerce launched an all-out attack. But even some favouring stronger consumer protection have found weaknesses in the proposal.
The US regulatory structure is highly fragmented and ineffective. While other big economies, such as Germany, Japan and the UK, have consolidated regulation, the US has more than 100 financial regulators. At the federal level, consumer protection is spread among several sectoral regulators, including the bank regulators and the Securities and Exchange Commission and Commodity Futures Trading Commission. Further, coverage of transactions is patchy, with some practices falling in gaps in oversight, like mortgage origination. There is no federal consumer protection for purchasers of insurance –this is done entirely at the state level.
Consumer protection should be consolidated along with other areas of regulation. The Committee on Capital Markets Regulation recommended in its May report that consumer and investor protection with respect to all financial services be either part of a division of a new US Financial Services Authority (in the model of the UK’s FSA) or be part of a separate consumer/investor protection agency, or CIP. The first option ensures an internal government trade-off between investor and consumer protection and other policy objectives such as competitiveness or safety and soundness.
The CIP option might, however, ensure stronger enforcement. The Committee on Capital Markets Regulation envisioned that any policy conflicts between the CIP and the US FSA would be resolved by the US Treasury.
The Obama administration has taken a very different approach. It has not recommended the creation of a US FSA. Since it sought to preserve the jurisdiction of other agencies, the Consumer Financial Protection Agency would have authority over only some areas of consumer protection and very little jurisdiction over investor protection.
The distinction between consumer and investor protection is artificial. It makes no sense to have one agency regulating the purchase of real estate and another investment in real estate investment trusts. Nor to have one agency monitoring loans from banks to purchase homes, with another supervising loans from brokers to purchase stock.
Yet the Obama administration has made an important point in stating that leaving consumer protection to the banking agencies is problematic. Banking regulators have traditionally seen safety and soundness of banks as more important than consumer protection. However, lodging consumer and investor protection in a financial services agency that is responsible for much more than banking regulation is likely to avert this problem.
The case of the UK’s FSA is instructive. Consumer protection is one of the four statutory objectives of the FSA. Indeed, Charles Goodhart, a UK economist, has argued the FSA was established with a higher priority placed on consumer protection than safety and soundness or competitiveness. In practice, the FSA has brought several disciplinary actions against wrong-doers for violations of consumer protection rules. In the current crisis, it has taken disciplinary action against firms and their officers found to have engaged in mortgage fraud and deceptive sales practices against consumers.
The Obama administration has not, as it claims, consolidated consumer protection in one agency. In effect, it has only proposed a banking consumer protection agency, thereby ensuring a direct conflict between the policies of the banking regulators and the Consumer Financial Protection Agency. The proposed legislation attempts to deal with this conflict by mandating that the fivemember CFPA board include one representative from the banking regulators. This is not an effective mechanism to resolve conflict.
There are also serious issues with the design of powers for the CFPA. First, the proposed legislation gives the CFPA the authority to designate products as being low risk and plain vanilla, and requires firms to offer these alongside more risky alternatives.
Such a provision would only increase the costs of financial services. If the objective is to allow a consumer to compare different products, this can be accomplished by requiring the sellers of sophisticated products to make disclosures about more simple products offered by other firms.
Second, the proposed legislation gives the CFPA broad authority to ban particular products that it considers unfair or deceptive. While the act requires that the CFPA consult federal banking and other regulatory agencies before taking such action, this does not go far enough in ensuring that such bans be treated as truly exceptional. Such bans should require extensive cost-benefit analysis and a super majority vote of the CFPA Board.
Third, the Obama proposal involves significant weakening of the pre-emptive effect of federal consumer regulation on state regulation with the aim of giving consumers greater protection. This will increase the costs for national banks whose business will have to conform to different state rules. While a case for such action could be made if consumer protection had continued to be lodged in banking agencies that made it a secondary priority, this concern should disappear with the creation of a new strong and independent CFPA.
The creation of such an agency should result in stronger, not weaker, federal pre-emption. Consumer and investor protection should play an important part in the regulation of financial services. To ensure this, all protection should be consolidated, either as part of a division of a new US FSA or in a separate agency. The current approach is seriously flawed, thus making the proposal more vulnerable to general industry opposition.