Last month marked the one-year anniversary of the Consumer Financial Protection Bureau (CFPB). At the time the Bureau was created I predicted that it would be a bureaucratic train wreck: an institution that is almost perfectly designed to manifest all of the worst pathologies that scholars of regulation have identified over the past several decades. Unfortunately, its operations to date have confirmed those fears.
The institutional structure of the CFPB is novel in American history—not merely an independent agency, it is an independent agency tucked inside another independent agency (the Federal Reserve). Its decision-making is not only independent of any review by the President or Congress, but also from the Federal Reserve itself. Its budget is independent from the congressional appropriations process and is instead drawn directly from the operating revenues of the Federal Reserve, a sum that will rise to 12% of the Federal Reserve’s operating expenses by 2013 (an estimated budget of $448 million). The only check on CFPB’s power is the power of the Financial Stability Oversight Council (FSOC) to veto actions by the CFPB but even then the veto can be exercised only by a 2/3 vote of the Council and only if the proposed action would seriously threaten the safety and soundness of the American financial services system.
Unlike most independent agencies the CFPB is not headed by a multi-member commission: even the Federal Reserve has a multi-member commission structure. Instead, it is headed by a single director appointed for a fixed term of 5 years and removable only for cause, such as corruption or complete dereliction of duty. Its powers are vast and vaguely defined: the power to regulate or even ban any product or loan term that it considers to be “unfair, deceptive, or abusive,” to engage in rule-making, or to bring litigation, including seeking penalties of up to $1 million per day for violations.
As currently structured, CFPB had only one meaningful democratic control—the power of the Senate to confirm the Bureau Director. Yet even this tiny shred of democratic control was thrown out the window by President Obama’s decision to end-run this check and illegally appoint Richard Cordray as the acting director, even though Congress was not in recess.
What may be most striking about the CFPB is not just its extraordinary combination of power and unaccountability—although it may be the single most extreme combination of power and unaccountability in American history (except for those that have been struck down as unconstitutional). It is the way in which CFPB ignores virtually all of the lessons of sound regulatory design that has been learned over the past century. In fact, the CFPB resembles some sort of creature from Jurassic Park frozen in amber during the Nixon Administration and thawed out by President Obama to run the American economy.
Beginning during the Progressive Era and accelerating during the New Deal it was believed that all that was necessary was to cede power to independent “experts” who would bring technical expertise to bear on regulatory problems. During the 1970s, however, America learned the damage that insulated, uncontrolled regulatory agencies can inflict on the economy—a period of economic stagnation, declining international competitiveness, and rising inflation, caused in large part by unresponsive regulation. Beginning with Jimmy Carter and accelerating under Ronald Reagan, a bipartisan consensus came to recognize that unaccountable regulatory dinosaurs were strangling the American economy. This bipartisan awareness prompted a wave of reform and, in some cases, even abolition of numerous dysfunctional and counterproductive regulatory agencies.
An agency headed by one person, completely insulated from democratic control and budgetary oversight, guarantees an agency that is vulnerable to all of the excesses that strangled the American economy in the 1970s—regulation that chokes innovation and cripples economic growth. And, indeed, even in its short time in existence the CFPB is already manifesting the problems of cost externalization, undue risk aversion, and other regulatory costs.
To date, the CFPB has issued one final rule, governing cash remittances. The CFPB’s own estimate is that compliance with the rule will impose 7,684,000 hours of compliance time for providers of cash remittance services. The rule turned out to be so onerous for smaller banks that the CFPB eventually raised the threshold for requiring compliance with the rule from 25 transfers annually to 100.
And its long-awaited rule to simplify mortgage disclosures landed with a 1,099 pages thud last month—a rule so convoluted and confused that Jonathan Macey noted that it even drew criticism from Habitat for Humanity, which expressed concern that it would impede its “ability to enable low-income families to become homeowners” because of the barriers it erects to extending home-ownership to low income households. Rather than merely simplifying disclosures, the proposed rule would impose a multiplicity of new substantive limits on high-cost loans—all of which will continue to strangle mortgage markets, constrict access to credit, and result in forcing lower-risk borrowers to subsidize higher risk. For example, in the name of consumer protection the payments in exchange for a large payment at the end of the loan—even though recent research shows that these sorts of “complex” mortgages were used by the most sophisticated, high-income borrowers during the housing boom, and who have acted rationally and strategically in defaulting on them, not victims of predatory lending. Similarly, the proposed rules cap late payment fees, forcing good risks to subsidize bad by making all consumers pay the additional costs that late payments create.
The proposed rule also prohibits prepayment penalties in high-cost mortgages, which reduce the interest rate that borrowers would otherwise have to pay—and even though there is no evidence that prepayment penalties increase foreclosure risk (in part because loans with prepayment penalties have lower interest rates and thus are more affordable than those without). But even more important is that the CFPB’s proposal fails to appreciate the reality that consumers respond to incentives and well-intentioned paternalistic rules can be exploited by rational consumers. Thus, while there is no evidence that the presence of prepayment penalties increase foreclosures, their absence can: by permitting borrowers to prepay and refinance their mortgages many borrowers were able to strip out their equity at the top of the market, increasing the number of underwater homeowners when housing prices later fell, and thus contributing to the foreclosure crisis.
In addition, the CFPB recently released a study on student loans that illustrates the politically-motivated nature of the CFPB’s decision-making and its failure to appreciate the problem of moral hazard by consumers. It compares student loans made during the past decade to subprime mortgage lending in terms of its excess. Moreover, it goes on to recommend easier dischargeability of student loans in bankruptcy—a proposal that would have disastrous consequences for the operation of the student loan market. By their very nature student loans present a uniquely powerful problem of moral hazard and opportunism with respect to bankruptcy. The standard bankruptcy proceeding enables a borrower to discharge all of her debt and shield her future income from creditors while surrendering her non-exempt assets to pay creditors. But a college graduate, and especially a graduate of graduate school, will often have a large amount of debt but few assets—and the promise of high future income. And while recent reforms to the bankruptcy code have reduced the incentives for high-income individuals to file bankruptcy, the problem still remains. Yet the CFPB seems oblivious to the real problems of moral hazard implicit in their proposal.
But this political motivation behind the student loan study hardly is unique. As House Government Reform and Oversight Committee Chairman Patrick McHenry has recently observed, there appears to be a remarkably high degree of political coordination between the White House and the ostensibly-independent CFPB. Although the agency was touted as a non-political expertise-based agency, the CFPB, of course, was politicized from the beginning. Rather than nominating an independent director in a timely manner, the White House instead decided to name the highly-partisan and ideological Elizabeth Warren to found the agency and oversee its initial actions. Warren, of course, later used this position as a springboard to run as the Democratic nominee for the United States Senate from Massachusetts.
A final likely consequence of CFPB’s operations will be to promote consolidation of the banking industry. Much of CFPB’s regulatory burden is compliance-related, such as paperwork obligations and the like. Economists have long-noted that these burdens generally do not scale with output as other burdens do: Citibank’s forms may be longer than First Bank of Smallsville but the number of forms and the like are comparable. This means that larger banks can swallow regulatory costs more easily as a percentage of their business than can smaller banks. Moreover, larger institutions can better-afford the lobbyists and lawyers to find and exploit loopholes in CFPB’s operations than smaller banks. Thus while regulatory capture is often a problem with Washington, the threat from CFPB is more dangerous: the imposition of new seemingly neutral regulations will give a comparative advantage to large banks over smaller banks. Community banks and credit unions, for example, have expressed concern over the groaning cost of CFPB regulation already. As Michael Martin, CEO of Lordsburg’s Western Bank put it, “We’re small business people. We have to understand and comply with the regulations just like Wells Fargo. We don’t have 70 attorneys on staff to figure it out.”
CFPB’s behavior to date unfortunately has vindicated the worst fears of its critics. It has imposed rules with massive regulatory compliance burdens (such as its remittance rules) with minimal benefits. Its study on student loans is a virtual invitation to moral hazard for borrowers by recommending expanded discharge in bankruptcy. And its proposed rules on mortgages are hugely complicated and impose new substantive limits on high-cost mortgages that are going to increase costs and reduce choice to consumers. Regrettably this sort of decision-making was entirely predictable for this agency with inadequate checks and balances. And the lessons of regulatory design will have to be re-learned yet again.