Evaluating “Veto” Powers on Consumer Financial Protection

On March 22, the Senate Banking Committee will begin debate over Chairman Dodd’s proposal to reform U.S. financial services regulation.  That proposal calls for the creation of a new Bureau of Consumer Financial Protection (“Consumer Bureau”) within the Federal Reserve System.  The Cambridge Winter Center has created briefing materials meant to help policy-makers evaluate that Consumer Bureau.

Mostly independent. Despite being housed within the Fed, the new Consumer Bureau would benefit from significant functional and financial independence from the Fed or other prudential regulators.  This is a substantial improvement.  As the OCC itself last week (unintentionally) demonstrated, bank regulators charged primarily with safety and soundness concerns cannot be expected to oversee consumer protection issues well. 

New “Council” has veto power, for no apparent reason.  Curiously, the Dodd proposal sacrifices a significant measure of Bureau independence by permitting the newly created Financial Stability Oversight Council (the “Council”) to override Consumer Bureau regulations, if the Council finds, by a two-thirds vote of its nine voting members, that those regulations would threaten the safety and soundness of the banking system, or the financial sector’s stability. 

As a threshold matter, it is not clear what problem this veto provision is meant to solve.  There is no empirical evidence that the over-protection of consumers ever has created systemic risks.  By contrast, there is considerable recent evidence that the under-enforcement of consumer protection can contribute to systemic risks.

Case example illustrates problem with Council “veto”.  To evaluate the potential impact of the “veto” provision, it is useful to consider what would have occurred during the credit bubble if the Dodd proposal had been in place at that time.

Most consumer protection problems do not create systemic risks.  But it can happen:  as illustrated by the proliferation of non-traditional mortgages (especially prime interest-only and Option-ARMs during 2003-2006), products with considerable non-transparent consumer risk can create massive distortions in the credit markets, and artificially inflate underlying asset values as well.

As contemporaneous evidence strongly suggests, at least six of the nine voting members of the Council, if it had existed at the time, would have been likely to vote against the regulation of non-traditional mortgages during the bubble.  As a result, Consumer Bureau attempts to better regulate non-traditional mortgages would have been overruled.

Veto provision should be re-evaluated.  The veto provision, then, would likely have led to precisely the wrong substantive outcome with respect to the most serious systemic risk created by abusive consumer products and practices during the run-up to the crisis.  Policy-makers would do well to re-evaluate that provision in the Dodd proposal.