Today, the Cambridge Winter Center participated in a conference on the future of consumer financial product regulation, hosted by the Federal Reserve Bank of New York. 

Cambridge Winter’s presentation argues that effective regulation of consumer finance will require mitigation of two persistent market distortions -- an information asymmetry that prejudices customers, and an information asymmetry that prejudices investors.  Together, those asymmetry problems enable bad products and practices to scale up quickly, driving good products and practices out of the marketplace.  The results are bizarre by free-market standards:  products like Option-ARMs can achieve devastating growth and prominence, despite being glaringly poor choices for customers and investors alike.

Mitigating those information asymmetries should be possible within the broad contours of the reform proposals in both the House and Senate -- but doing so well will require further refinement by regulatory agencies. 

First, the Consumer Financial Protection Agency, if created, should focus on helping consumers prioritize and focus their evaluation of financial products.  The CFPA can and should seek to highlight for consumers where they would be wise to dig deeply, and focus on the fine print -- and where, by contrast, close attention is likely less critical.  Importantly, the new agency should not simply repeat the mistake of assuming that mountains of disclosure documents can be rendered effective simply by making those mountains higher.  This mission is notably distinct from the notion of designing or mandating “plain-vanilla” products -- a notion that is problematic both in concept and in practice.

Second, regulatory agencies will have to further articulate “risk retention requirements” that are intended by Congress to rein in undisciplined capital markets-funding of dubious financial products.  Ideally, the most “skin in the game” required for asset originators or intermediaries should be where two different variables are present:  (1) where a firm has significant influence over an asset’s value; and (2) where the nature of the asset itself precludes efficient due diligence by market participants.  Taken together, this would mean that the “natural owners” of residual credit risk should not easily be able to slough off that risk onto definitionally ill-equipped buyers.