The Consumer Financial Protection Agency

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Given the role played by the financial sector in the Great Recession of 2008-2009, the case for reform of the financial sector is strong. The Obama Administration has proposed that a key element of reform should be the creation of a new and independent Consumer Financial Protection Agency, whose primary mission would be to look out for the interest of consumers.

Advocates of this approach argue that it was the proliferation of deceptive, unfair, and predatory financial products which hurt consumers and ultimately undermined the larger economy. The House of Representatives has passed a sweeping financial reform bill that includes the establishment of a robust agency with rulemaking and enforcement powers.

As policy deliberations unfold, the specifics of this proposal deserve scrutiny—especially with an eye toward the policy features which would be most effective in protecting consumers and creating a safer and sustainable marketplace for financial services.

Federal Reserve Chair Ben Bernanke recently wrote that “strengthening our financial regulatory system in ways that take the appropriate lessons from the crisis is essential for the long-term economic stability of our country.”[1]

The far reaching impact of the greatest economic downturn since the Great Depression and the subsequent policy response of the newly-created Office of Financial Security—in charge of administering the $700 billion Troubled Asset Relief Program (TARP)—have generated considerable discussion as to the precise nature of those lessons and future prescriptions for reform.[2]

What does seem clear is that the previous regulatory regime did not include sufficient safeguards to prevent a near total collapse of the national economy. Indeed, the performance and governance of the financial sector appeared to exacerbate the risks of financial instability rather than mitigate them.[3] It is difficult to argue against the imperative nature of a major overhaul of the rules which govern the financial sector.

n the spring of 2009, the Obama Administration released its framework for financial regulatory reform.[4] It was a far-reaching plan that included a focus on improved supervision of individual firms, comprehensive regulation of financial markets, new policy tools to manage financial crises, and a bold proposal to protect consumers and investors from financial abuse through the creation of a new Consumer Financial Protection Agency.

In recent years, with the spread of subprime mortgages and other financial products that gained market share even though they were mismatched to consumers, the concept of a government watchdog agency emerged that would focus specifically on financial products.

Elizabeth Warren, a Harvard Law professor, is credited with articulating an initial version of the proposal in a 2007 article in the Democracy Journal, arguing that consumer protections should apply to financial products.[5] During the presidential primaries, the idea was incorporated into the campaign platforms of several of the Democratic aspirants before finally appearing as one of the centerpieces of the Obama Administration’s financial reform program.

Senator Chris Dodd (D-CT) and Representative Barney Frank (D-MA) were both early supporters and as Chairmen of the relevant committees in the Senate and House, would be tasked with advancing financial reform proposals. Both policymakers saw merit in creating an independent agency whose primary objective is ensuring consumers have access to financial products and services that are safe, suitable, and sustainable.[6]

The new agency would be mandated to promote a set of far-reaching principles, including transparency, simplicity, fairness, accountability, and equal access. Rather than relying on the traditional practice of disclosing the terms of financial transactions—which increasingly has been performed in ways that obscure rather than clarify—the new agency would be on the lookout for unfair or deceptive practices in the financial services industry.

The next question would become what would happen when such practices were uncovered. Would the agency have the authority to change behavior, either through publicity or punishment?

Throughout 2009, a series of hearings were convened by Barney Frank (D-MA), chair of the House Financial Services Committee, on the diverse aspects of financial reform. This led to a legislative proposal designed to modernize the country’s financial rules. On December 11, 2009, the House of Representatives passed by a partisan vote of 223 to 202 the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173).

The bill was sweeping in a number of respects.

First, it called for the creation of a Financial Stability Council of regulators that would be tasked to identify firms that are so large and interconnected to others that their collapse would threaten the stability of the entire system. These firms would be subject to increased oversight.

Second, the bill would establish an orderly process for “resolution,” which is the shutting down of large and failing financial firms, such as AIG, in ways that limit public sector exposure and prevents contagion to other firms.

Third, firms would be required to disclose compensation structures in ways that are transparent to shareholders and regulators in an attempt to rein in executive pay.

Fourth, new rules would be proposed to govern the derivatives marketplace and the hedge fund industry in ways that would increase transparency and accountability. Derivatives would have to be cleared and traded on an exchange.

Hedge fund managers would have to register with the SEC and subject to a systemic risk evaluation. And Title IV of the bill would create the Consumer Financial Protection Agency (CFPA), a new and independent federal agency with a mission to protect consumers from unfair and abusive financial products and services.

Consumer groups, such as the Center for Responsible Lending and the Consumer Federation of America, have lined up to support the bill, while the large financial services firms opposed the bill and the U.S. Chamber of Commerce led an advertising campaign specifically against the creation of the CFPA.

As the policy debate shifts to the Senate, there is a need to focus greater attention on the policy issues in play. This paper will contribute to this process by presenting the case for creating a new agency with a mandate to protect consumers when they access financial services and products, describing key features of the legislation as passed by the House of Representatives, and reviewing some of the primary issues as stake in future policy deliberations.

[1] Letter from Federal Reserve Chair Ben Bernanke to Senators Chris Dodd (D-CT) and Richard Shelby (R-AL), January 13, 2010, on the Public Policy Case for a Role for the Federal Reserve in Bank Supervision and Regulation.

[2] The TARP was created by the Emergency Economic Stabilization Act of 2008 to buy up “troubled” or other assets whose purchase would promote financial stability. Accordingly, TARP funds have been used for a variety of activities, such as to purchase assets, inject capital into financial institutions, support foreclosure mitigation, purchase ownership shares of American Insurance Group (AIG), and lend capital to automakers General Motors and Chrysler.

[3] Bair (2010).

[4] U.S. Treasury (2009). Financial Regulatory Reform: A New Foundation. June 17, 2009.

[5] Warren (2007).

6] Dodd (2009).