The Consumer Financial Protection Bureau: A Five Year Retrospective

This post provides a 5 year review and evaluation of the Consumer Financial Protection Bureau (CFPB) which was established under the Dodd-Frank Act. The Dodd-Frank Act and the CFPB were a response to the financial and economic crisis that began in 2007. The length and depth of the ensuing recession was only exceeded by the Great Depression of the 1930’s. Researchers at the Federal Reserve Bank of Dallas put the cumulative loss (up to 2012) of real GDP as somewhere between $6 and $14 trillion.

Our evaluation of the CFPB is centered on two issues. The first is the philosophy of regulation underlying the CFPB. The second is describing the conflict between the goals of the CFPB and the goals of other parts of the Dodd-Frank Act. Each will be discussed in turn

Prior to the CFPB the philosophy of regulation in the area of financial products was dominated by Neo-Classical economic theory. Neo-classical economics assumes that consumers are rational decision-makers but need help in overcoming the problem of asymmetric information between the buyer and seller of financial products. According to this theory the job of the regulatory authority was to eliminate fraud and make sure that consumers of financial products had full information regarding those products. Regulation provided that help. The courts enforced this approach to regulation, and plaintiffs successfully suing the seller of financial products were generally required to prove fraud was involved. The philosophy of regulation underlying the CFPB borrows elements from what has become known as Behavioral economics. Behavioral economics takes the view that some consumers are not fully rational and even when in possession of full information they make poor choices that can harm both themselves and if widespread can harm the financial system. The implication of this is that the regulatory authority should not only require sellers of financial products to provide full information, but also to “nudge” the sellers of certain financial products that are potentially toxic to the individual and the financial system to reduce the supply of these products. An important example of this is the distinction between Qualified and non-Qualified mortgages. In general it would be safe to say that Qualified mortgages are of higher investment quality than non-Qualified mortgages. In large measure it was the non-Qualified mortgages that played a bigger role in triggering the Great Financial and Economic crisis than the Qualified mortgages. Rather than banning non-Qualified mortgages the CFPB establishes the standards for a Qualified mortgage contract. All mortgage contracts not meeting the standards of a Qualified mortgage are then classified as a non-Qualified mortgage. What is the difference between the two? A Qualified mortgage is granted a so-called “safe harbor” for the issuing financial institution protecting it from future liability under the Truth-in-Lending laws. Non-Qualified mortgages do not have this protection. In this way the CFPB “nudges” suppliers of mortgages to supply more Qualified mortgages and fewer non-Qualified mortgages.

The second theme around which this paper is oriented is the consistency between the goals of the CFPB and other government policies including parts of the Dodd-Frank Act. Consumer protection via the CFPB is not the only goal of government policy in the Dodd-Frank Act nor other government policies. The question is whether these goals are compatible with each other. The answer for the most part is: No. For example, one policy outside the Dodd-Frank Act is that since the early 1980’s the U.S. government has allowed the distribution of income to become more skewed towards the rich (Piketty and Saez, 2003). One government mechanism by which this was achieved was to reduce the progressivity of the U.S. personal income tax. Because the rich have a high propensity to save (Dynan et al., 2004), it is necessary for the lower income groups to have access to affordable credit in order that they might spend at a sufficient rate to maintain aggregate demand and relatively full employment. Government policy accommodated the credit needs of low and medium income families in various programs. Some were oriented around housing and took the form of government sponsored financial institutions such as the Federal Home Loan Banks, FHA, Fannie Mae and Freddy Mac. Another way these borrowing needs were met was through the Community Reinvestment Act which required banks to reinvest in the communities in which they were located. If lower income households could not earn the necessary income to buy homes and other products on conventional credit terms, then they should have access to government subsidized credit. The policies that enabled low and medium income households to expand their borrowing to buy housing assets and other durables led to a speculative bubble, particularly a bubble in housing assets. To sustain this borrowing it was necessary for housing assets to appreciate in value. When house prices levelled out and eventually fell the bubble burst and home owners defaulted on their mortgages. Since the private financial institutions that held these mortgages were heavily levered themselves, they too began to default on their borrowings from still other financial institutions. In this way the losses spread through the financial system and the financial intermediation process began to breakdown which along with the growing income disparity contributed to the Great Financial and Economic Crisis. With this crisis came the re-regulation of the financial system designed to promote financial stability. In other words, government policies that: (i) allowed the growing disparity in income; (ii) facilitated access to credit; (iii) encouraged housing for all; (iv) protect consumers from fraud and complicated contract forms in their borrowing; and (v) stabilize the financial system are incompatible with one another. The end result is that the vigorous pursuit of (i) – (iii) will eventually destabilize the financial system and result in a recession with large costs of lost real output. The government will then respond with policies that stabilize the financial system and protect consumers partly from themselves and sacrifice the goal of housing and credit access for all. Seemingly this cycle will continue to repeat itself adding to the volatility of the real economy.

Can this cycle be broken? Kumhof et al. argue that a reversal of the growing inequality of income would reduce the financial leverage of medium and low income families and reduce the probability of a future financial and economic crisis. In the absence of reversing the growing inequality of income we (see Krainer, 2016) suggest a way to side-step this incompatibility across government policies. That suggestion would take the financing of government social policies of access to credit and housing for all out of the private banking and shadow banking sectors and put them into a newly created government enterprise (GSE). Access to this new government financial institution would only be available to individuals below some predetermined income level. Low income households would apply directly to this government entity for a home loan and if the application was successful the loan would remain on the books of this government institution. The end result is that risky subprime mortgage loans of low income families would not be on the balance sheet of a private financial institutions and potentially weaken the private financial system. We further recommend that the financing of this government enterprise be put in the government budget so that the executive and legislative branches would be required to prioritize it relative to competing uses of government funding.1

ENDNOTES

  1. In a way our proposal might seem like the “good” bank “bad” bank under the TARP program. However there are important differences. Under our plan the GSE would initiate and hold the mortgages, and the volume of these mortgages would be limited to the amount budgeted by Congress rather than by “Hustle” like programs of private banks.

REFERENCES

Atkinson, T., D. Luttrel, and H. Rosenblum. 2013. “How Bad Was It? The Costs and Consequences of the 2007-2009 Financial Crisis.” Staff Papers, Federal Reserve Bank of Dallas.

Krainer, R. 2016. “The Consumer Financial Protection Bureau: A Five Year Retrospective.” Unpublished manuscript, forthcoming in the Journal of Law and Public Policy at the University of Saint Thomas Law School.

Kumhof, M. R. Ranciere, and P. Winant. 2015. “Inequality, Leverage, and Crises.” American Economic Review 105 1217-1245.

Piketty, T. and E. Saez. 2003. “Income Inequality in the United States, 1913-1998.” Quarterly Journal of Economics 118 1-39.

The preceding post comes from Robert E. Krainer, professor of Finance, Investment, and Banking in the Wisconsin School of Business. The post is based on his article, which is entitled “The Consumer Financial Protection Bureau: A Five Year Retrospective”, forthcoming in the Journal of Law and Public Policy at the Law School of the University of St. Thomas and available here.