The Administration’s white paper on financial services regulatory reform includes a much needed re-think on consumer protection, in the form of a Consumer Financial Protection Agency (“CFPA”).  And not a moment too soon.

The CFPA proposal generally echoes a bill introduced by Senators Durbin, Schumer, and Kennedy in March, which in turn was built on a years-old proposal from Harvard’s Elizabeth Warren.  The CFPA, as contemplated in the Administration’s white paper, would be charged with establishing minimum standards for the safety of financial products like credit cards and mortgages, and would be focused especially on identifying and stamping out deceptive and fraudulent practices.  In most ways, the institution’s mandate would be analogous to the Consumer Product Safety Commission.  As the three Senators argued in a letter to Secretary Geithner, “there is no reason for us to have regulations that prevent toasters from exploding into flames, but no protections to prevent mortgages and credit cards from doing the same.”

The proposal is generally a good one.  But it is not ambitious enough, especially in two respects:  (1) the CFPA should preempt other regulators on consumer protection issues; and (2) the CFPA should be concerned with minimum standards, but also should rank acceptable financial products into broad tiers of relative safety. 

Innovation and Preemption

Opponents, thus far, have mustered what seems a half-hearted and formulaic argument against the proposal:  that by introducing a new bureaucracy that is the ultimate arbiter of product safety, we would effectively iron out differences in product structures and pricing, and thereby dampen innovation.

Almost precisely the opposite is true.

First, and most obviously, the existence of minimum standards does not make innovation impossible.  We have minimum standards on practically every consumer product -- from automobiles to the aforementioned toasters -- but innovation appears to proceed apace.  You would be surprised what toasters can do these days.

Indeed, the difficulty for principled innovators in consumer financial services, especially in recent times, has been that it has been difficult to engineer new, improved product structures or features that can economically match the value captured through questionable, customer-unfriendly practices engaged in by competitors.  Take the prime credit card business, for example.  If all the large incumbents (JPM Chase, Bank of America, Citi) were willing and able to use 0% teaser rates, coupled with hair-trigger universal default re-pricing, it was, practically speaking, impossible to compete with them on the basis of other product innovations.  The economic value of that customer-unfriendly practice was a killer advantage; it stifled the need or potential for innovation.

Minimum product standards, then, don’t necessarily crowd out innovation.  By contrast, by providing a clear set of boundaries, they can prevent a race to the bottom in customer practices, and thereby clear the field for value-added innovation.

A more reasonable objection to the CFPA is that it would be merely additive to the existing thicket of state and federal financial regulators, rather than replacing them. 

The Administration has tried to steer a moderate course here; it should have been immoderate.

The white paper expressly points out that, while the CFPA would assume consumer protection responsibilities from federal agencies, it would not reduce any existing state regulators’ authority in consumer protection issues.  As a result, it creates further administrative hoop-jumping, and thereby does create some destructive friction on innovation.

The fact is that most regulators are, recent experience would suggest, dreadful when it comes to consumer protection.  It was not by accident that Countrywide decided to re-charter its depository away from the OCC, towards the OTS, when the Fed and OCC began raising real consumer protection concerns about non-traditional mortgage structures.  It was not by accident that as the Fed and OCC were raising those concerns, the SEC-regulated Merrill Lynch was, amazingly, buying the subprime and Alt-A lender First Franklin at an eye-popping valuation.  In a similar vein, it was state regulators’ profound failure to monitor mortgage brokers that helped propagate toxic product structures across the nation.

The simple reality is that the industry suffers not from too much regulation, but from too many regulators.  And, when it comes to consumer protection, many of those regulators are demonstrably not institutionally competent.  The CFPA should preempt them all.  The result would be more clarity, less regulatory arbitrage, and less administrative burden.

Los Angeles Restaurants

The CFPA proposal could also be improved with a more fundamental shift in its mission.  The agency should certainly be concerned with minimum standards, but it should also develop and promulgate a perspective on the relative safety of various financial products.

It is in this way that the analogy of the Consumer Product Safety Commission fails us; let me suggest a different one.

Since 1998, restaurants in Los Angeles County have been required to post a large placard in their front windows, showing an “A”, “B”, or “C”.  Those letter grades correspond to the establishment’s scoring in routine health department inspections.  Unlike the historical practice of merely publishing minimum standards (that is, if a restaurant was below the minimum, it was shut down -- else, from the restaurant-going public’s point of view, nothing happened), the Los Angeles approach made more transparent the fact that while lots of restaurants meet some minimum threshold of hygiene, some are more hygienic than others.

The same approach should be applied to financial products.

There should, of course, be minimum standards (like with ones that prevent toasters from bursting into flames).  But that is not enough.

To explain why, it’s worthwhile exploring why the notion of minimum standards so captures the imagination of policy-makers.  The reason is a largely mythical narrative -- the myth of the hoodwinked consumer.  In this narrative, consumers are fundamentally logical economic decision-makers, who, if they had full disclosure of contractual terms, would unerringly choose prudent product structures at attractive economic terms.  If one chooses to embrace this narrative, then the fact that consumers quite frequently embrace objectively dreadful products (payday loans, option-ARMs, NSF-laden “free” checking), suggests that they must have been misled.  Thus, by merely stamping out misleading and deceptive practices by adopting minimum standards, consumers will make better choices.

It is certainly true that deceptive sales practices are a major problem in consumer financial services.  But they aren’t the main problem.  The main problem is that consumers -- who, as it turns out, are human beings -- are, in general and on average, incapable of adequately weighing abstract financial risks and rewards.  Perhaps the most telling example is banks’ “free checking” offerings, which, in an Orwellian twist, aren’t free at all, because they tend to generate significant fees through non-sufficient funds (“NSF”) penalties on overdrafts.  Consumers are aware of NSF fees; they just systematically underestimate how often they will incur them.

This is where the proposed CFPA could help.  By virtue of its access to industry data and its institutional competence, it could assign financial products a simple letter grade (I rather like the Los Angeles County approach for restaurants, but there are presumably others).  That would, at minimum, cause consumers to pause and more deeply examine products that, for most, tend to lead to trouble, even if they are fully disclosed and fairly marketed. 

At the same time, the availability of a hierarchy of passing grades would allow the CFPA to encourage and reward especially consumer-friendly product structures, while not ironing out innovative product wrinkles. 

It is precisely that outcome that we should desire.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.