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The Consumer Financial Protection Agency and the Coming Paradigm Shift in Financial Services

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Once Congress closes the door on health care reform, the next legislative fight on deck is how to reform the financial sector that led us to the precipice of economic catastrophe. I'm sorry but business as usual is not really an acceptable option. We have the right to expect a major overhaul of the regulatory regime under which banks, mortgage lenders, and financial service providers operate. Much work is already underway. In fact, the House of Representatives just passed a sweeping reform plan based on the general framework which the Obama Administration articulated in the spring. The White House is now expecting the Senate to take up the issue and push comprehensive reform over the finish line.

But it is important to keep in mind that battle has yet to be joined and we shouldn't expect the bankers (or "fat cats" as the President described them during a recent interview on 60 Minutes) to go down quietly. These titans of finance should be alarmed. If this is done right, the new regulatory regime will be designed with the consumer and not the banks in mind.

Certainly, we will need rules that more effectively manage systemic risk. We obviously learned the hard way that we should prioritize the safety and soundness of the entire interconnected system above that of any particular institution. This means stronger oversight, higher capital requirements, and other rules to increase transparency and accountability. But perhaps more significantly, a new array of consumer protections is required. These protections have to take into account how consumer behave and make decisions about their finances. They have to be at the heart of the system and not an afterthought.

The proposal to create a new Consumer Financial Protection Agency does just that. It identifies a set of principles that will drive future product regulations, such as transparency, simplicity, and fairness. Making the transition from a rule-based regulatory regime to a principles-based framework will be a significant paradigm shift in the provision of financial services.

What would it mean? Of course this will depend on the outcome of the legislative process. But we should expect that a new agency ends the proliferation of abusive financial practices that were justified by "disclosures" appearing in the fine print of statements and contracts written in unintelligible legalese. We also have a right to expect that it can transform portions of the financial sector into a low margin business, with limited profit opportunities. Fortunes should not be made by tricking people into products they don't need or understand. This became common practice in corners of the mortgage industry where "yield spread premiums" (better called side payments) were made when borrowers were steered into higher-priced loans than they otherwise could have obtained. Not to mention the recent boon for banks when overdraft fees become a $26 billion profit center almost overnight.

In the future, we should expect this new agency helps get us back to basics. There can still be opportunities for great wealth but these should be limited to cases when risk is assumed. If people want to play their hand at casino finance, they should be allowed to do so. But they can't put the rest of us at risk. Instead, basic financial services should be treated like a highly-regulated utility (I have heard others call this a "profit regulation" model). Whatever it is called, this is consistent with President Obama's view of the essential role of credit in our economy. In his first address to a joint session of Congress, he argued that "the flow of credit is the lifeblood of our economy." This makes finance a public good that has large benefits for society as a whole. There are countless positive externalities created when people have access to responsible credit. It is what creates access to home ownership, educational experiences, and entrepreneurial opportunities. If finance is a public good, we will need to take steps to protect it, just like we protect the air we breathe and the food we eat.

That is where the new Consumer Financial Protection Agency comes in. Creating this new entity has the potential to significantly remake the regulatory landscape for financial services. With strong enough teeth (and they are pretty sharp in Barney Frank's recently passed House bill and Chris Dodd's initial version), it creates the conditions for better matching consumers with appropriate products in a fair and transparent manner. This could be a foundation for an entirely new consumer banking system.

More consequentially, the creation of this new body could represent a necessary step to restoring integrity and trust back into our financial system. These are basic human values that we have allowed to be driven from the marketplace. We should demand a new set of rules that help usher them back in.

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