This week, the Administration submitted to Congress draft legislative language that would create a new, powerful regulator to promote transparency, simplicity, and fairness in consumer financial products.  The new regulator, dubbed the Consumer Financial Protection Agency (the “CFPA”), would integrate the existing, fragmented approach to federal consumer protection efforts, and be armed with reasonably expansive rule-making, supervisory, and enforcement powers.

Given the manifest failings of the existing regulatory architecture, it is difficult to muster credible arguments against a substantial change.  Perhaps understandably, then, the usually powerful bank lobby has mustered only formulaic policy arguments against the CFPA -- the old standby’s of any regulated industry seeking less regulation:  assertions that better regulation would reduce innovation; that adhering to regulation would raise consumer costs; that a focus on fairness would reduce access to consumers that the legislation is intended to benefit.  These are arguments so routinized in our broader policy discourse that one could have written them well before the Administration’s proposal was unveiled.  Indeed, perhaps that is the case:  mid-summers in our nation’s capital are notoriously unpleasant, and one cannot much fault bank executives and lobbyists for wanting to be at their beach homes, and not fighting a Beltway battle that is almost certainly doomed in any case.

So, barring some odd twist of fate, the CFPA, in some form, will likely be a part of the financial regulatory landscape going forward.  Given that, it is best to turn our collective attention to how to structure the new agency to best avoid the problem that seems to have beset its predecessors in consumer financial protection -- the problem of agency capture.

WWGSD?  Agency Capture in Financial Services

Agency capture is a well known problem, and one not confined to financial services.  The phenomenon takes various forms, but its central problem is simple:  over time, regulatory agencies tend to become more philosophically aligned with the powerful firms they are meant to regulate, and tend to exhibit a persistent bias against the more atomized constituent interests they are meant to protect.

The impact of this phenomenon should be painfully obvious to anyone who has invested in the U.S. financial services sector over the past two years.  Investor returns in banks, sadly, have been less driven by fundamental strategic and financial strength, and more driven by the nature and magnitude of federal intervention and subsidies.  Success in investing, then, has mostly been driven by success in predicting federal regulatory responses.  And the best way to predict federal regulatory responses, right up until the Obama Administration’s regulatory reform proposals in June, has been to determine what policy decisions would most benefit the largest, most powerful regulated firms.  (Back when I counseled clients on financial sector investments, during the last Administration, I occasionally urged them to ask “WWGSD?” -- or “What would Goldman Sachs do?” -- to be able to divine how a Paulson-led Treasury Department would dole out taxpayer subsidies.  This was, in retrospect, depressingly good advice).

The influence of large private firms on their regulators should come as no surprise.  The firms themselves, of course, are merely seeking their own self interest; we should expect nothing less.  And regulators, alas, are human beings; we should expect nothing more.

Gauging the CFPA’s Vulnerability

Although specific personnel decisions are premature, it is a reasonably safe bet that the CFPA’s staff will also consist of human beings.  Indeed, many of that staff are, presumably, currently in the employ of agencies that have failed mightily in their consumer protection responsibilities.  Given that, it is prudent to gauge the CFPA’s own future vulnerability to agency capture. 

To do so, we can evaluate each of four risk factors that have helped enable agency capture among financial services regulators in the past:  regulator shopping; funding dependency; “revolving door” employment; and over-reliance on industry expertise.  While the CFPA, as contemplated by the Administration, appears reasonably well inoculated versus the first two, it risks capture, over time, through the third and fourth.

Regulator Shopping, and Funding Dependency

First, let’s consider the problems of “regulator shopping”, and “funding dependency”, for which the OTS provides a useful and recent example.

The Administration’s overall reform proposal contemplates, in effect, shuttering the OTS and folding its responsibilities into a re-named OCC.  Virtually no one is objecting. 

Indeed, by any objective standard, the failure of the OTS to safeguard the safety and soundness of thrifts is nothing short of astonishing in its scale.  The list of the largest OTS charges just a few years ago looks, now, like the ’27 Yankees -- quite frightening, and quite dead:  Washington Mutual, Countrywide, AIG, IndyMac, and BankUnited among them, plus the likes of Sovereign, now a headache for a large Spanish bank, and Golden West, which was acquired by Wachovia and became the proximate cause of that bank’s collapse.

The federal savings bank (“FSB”) charter, which the OTS stewards, and which the Administration would abolish, had been on the slow road to irrelevance for quite some time.  Between that slow attrition, and the natural market consolidation among large firms, the OTS’s universe of regulated thrifts had by 2006 become highly concentrated in a handful of relatively large thrifts.  Those large firms had the ability to convert from an FSB to a different charter (and a different regulator); and if they did, the OTS would become irrelevant faster. 

Moreover, because the OTS was dependent on assessments upon FSBs for much of its operating budget, the threat of losing large thrifts to another regulator was a near-term existential threat, not just a long-term threat to its stature.

As a bureaucracy that was concerned, as they all are, with its own institutional relevance and survival, the OTS had a strong incentive to stay in the good graces of those firms it was supposed to be regulating.  Not surprisingly, then, the OTS took a systematically permissive approach to thrifts’ risk-taking in the build-up to the crisis.  This is how, at precisely the time that home values seemed most hyper-inflated, Washington Mutual began retaining (as opposed to selling) its subprime credit risk.  This is why, as Angelo Mozilo’s Countrywide faced the scrutiny of an increasingly skeptical Fed and OCC, the firm sought refuge in the comforting arms of the OTS.

Thankfully, the Administration’s proposal for the CFPA steers clear of these potential mishaps.  One of the many attractive features of the CFPA is that it would supervise virtually any institution that participates in consumer financial services.  A regulated firm cannot simply opt out of CFPA coverage, and opt into supervision by a more permissive regulator.  This inability to escape CFPA regulation also takes pressure off of funding dependency issues, and the Administration’s approach to funding the agency through a combination both Congressional appropriations and user assessments -- though still quite high-level -- seems reasonable to mitigate agency capture risk as well.

Revolving Door

A third driver of agency capture is the “revolving door” between regulatory agencies and their charges.  In theory, if a regulator’s staff members are recent alumni of private regulated firms, or are looking to eventual employment with private regulated firms, their supervisory zeal is likely to be tempered.

This is as much a problem with the proposed CFPA as it is with other financial regulators.  The desire to serve the public does not necessarily insulate professional staff from all-too-human, conscious and sub-conscious biases in this regard.  The SEC’s numerous failures in the run-up to the crisis (e.g. letting broker-dealers’ leverage run wild; letting the Madoff scheme go on for years) can likely be attributed in part to this issue.  Indeed, agency capture is perhaps the only systematic way to reconcile such broad-based SEC failings with its seemingly talented, credentialed, and driven staff.

A relatively straightforward restriction on departing CFPA employees’ ability to work with the CFPA on behalf of a new employer, within some window of time, would likely remedy this agency capture threat.  By contrast, it would seem a poor choice to refuse to hire staff from regulated private firms, particularly at the CFPA’s outset.  This is a new agency, with an expansive and important scope; it should not cripple its hiring efforts.

Over-Reliance on Industry Expertise

The final risk factor is the most problematic for the CFPA, and warrants the most significant change to the Administration’s proposal.

Regulators risk being captured when, in order to discharge their basic supervisory and rule-making duties, they rely on special insight or institutional capabilities that are uniquely within the control of their charges.  Take, for example, the Clinton-era decision to, in effect, minimize capital and liquidity requirements with respect to OTC derivatives, including credit default swaps.  In retrospect, that seems nothing short of insane.  But at the time, the magnitude of the cost and administrative friction associated with incremental regulation was best estimated (and, as it turns out, probably exaggerated) by industry participants, and not at all by regulators.  And because regulators, just like the rest of us, don’t like to appear naive, they systematically toed the broker-dealers’ line -- that is, their agencies were captured by industry interests. 

There are two ways to remedy this problem.  The first is to build agencies’ independent research capabilities.  The Administration proposal succeeds in this regard; it certainly contemplates a robust research function for the CFPA, and one that (at long last) focuses on how actual consumers, in real life, interact with financial products and their marketing.  This is long overdue.

The second approach is more nuanced:  policy-makers should tailor regulators’ scope to duties that are both necessary, and reasonably manageable given their own independent capabilities.  After all, if we force a regulator to accomplish some lofty goal, and that lofty goal simply cannot be accomplished without a close and symbiotic relationship with private firms, then we should not be especially disappointed if those private firms steadily co-opt the regulator’s staff.  Such mandates, in effect, set a regulator up for failure.

The Administration’s proposal is deeply problematic on this score, in one specific dimension:  the CFPA’s responsibility to set standards for “plain-vanilla” products. 

It could be that the existence of Fannie Mae and Freddie Mac have deeply confused policy-makers about the ease with which viable product structures can be formulated in a vacuum.  It’s easy to develop a Fannie or Freddie product -- they’re artificially under-priced with respect to both credit and rate risk, and senior funding comes guaranteed courtesy of the eternal generosity of the American taxpayer. 

Developing products in the real world, without unending taxpayer subsidies, is hard:  it requires an iterative, disciplined approach that combines marketing, credit, and capital markets analytics.  The Administration is essentially asking a brand new agency to take on that responsibility, despite having no day-one access to high-priced talent, historical loan-level data, proprietary marketing channels, customer base, brand, or profit motive.  It cannot be done, at least not without essentially relying entirely on private market partners.  And that kind of hand-in-glove partnership invites the kind of agency capture that has already doomed existing regulators’ efforts.

Given the obvious institutional hazards of asking a regulator to get into the product development business, it’s useful to ask what, precisely, the Administration was trying to accomplish with its “plain-vanilla” mandate.  Presumably, the answer is that we are trying to create a choice architecture that pushes consumers to choose simpler products, which they are more likely to understand. 

But if that is the goal, there is no need for the CFPA to be the one developing the plain-vanilla products.  Instead, the CFPA should impartially gauge products structures according to published set of criteria. 

The criteria are subject to debate; here is how that debate should resolve itself.  The CFPA should use a three-part test:  (1) transparency (based on how this product is marketed, does a consumer know what he’s getting?); (2) fairness (in a normative sense, is this an arguably fair deal for the utility received?); and (3) suitability (is this product at least arguably a good idea for the kinds of customers who will actually acquire it?).  Truly egregious products will get an “F”, and should not be permitted.  All other products will be awarded a letter grade of “A”, “B”, and “C”.  That creates an incentive for private firms to compete to innovate and create customer-friendly products (that is, the “A” graded products). 

With this calibration scheme in place, then, there is no need for the CFPA itself to get into the business of product design.  A taxpayer-funded regulatory agency should not be forced to do bank managements’ jobs for them.  The CFPA can accomplish its desired ends through more pragmatic, less intrusive means.

So eliminating the CFPA product development duties would have at least two direct benefits:  mitigate the risk of agency capture; and spur private party innovation of customer-friendly products. 

There is a third, indirect benefit as well.  To the extent that the CFPA actually succeeded in developing spectacular financial products, the relative ease of offering them would iron out differences and local customization in product structures across the market.  (This, in practical terms, has already happened in the mortgage market today, courtesy of Fannie and Freddie).  But if product development and customization is not a differentiator among private players, then operating scale, massive brand spending, and funding cost advantages will necessarily determine winners and losers.  And that will further accelerate the dominance of the largest, too-big-to-fail banks over the steadily shrinking population of community banks. 

We have already lived through the hazards of a highly consolidated banking market; we shouldn’t be actively making those hazards worse.

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The CFPA is a major step in the right direction.  Let’s not set it up to fail.

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.