09/20/2010 06:13 pm ET Updated May 25, 2011

The Challenge Elizabeth Faces

The appointment of Elizabeth Warren has raised the hopes of many and the ire of some.  According to Simon Johnson, she is the perfect person for the job.

The president finally has an adviser who understands the financial sector and who has healthy skepticism about its intentions and actions.  As we documented at length in 13 Bankers, too many top policy people -- both in this administration and all its recent predecessors -- have been overly inclined to accommodate the interests of finance, particularly the big banks.  In this regard, putting Ms. Warren directly into the White House with the highest possible level of access is exactly the right thing to do -- much better, for example, than making her purely a Treasury appointment.

So now the question is, what will she actually be doing? Some Senators don't know.  A lot of folks though, like HuffPost blogger Richard Eskow, seem to know how she will be doing it:

Warren herself also became enormously popular, thanks to her own directness, intellect, ability to communicate, and most of all because of her apparent passion for protecting consumers. People are hungry for that kind of voice.

So let's move into the meat of this. Over the last 24 hours I perused the actual Dodd-Frank bill, skimming through 1,300 pages, and found this helpful White Paper by Vincent DiLorenzo of St. John's University School of Law, a mere 115 pages. I will return to that in a minute.

Dodd-Frank establishes that the purpose of the Bureau is to implement and enforce federal consumer financial law to ensure that markets for consumer financial products are fair, transparent, and competitive. Which raises the question, if all it is to do is enforce existing law, what has been going on all this time?  DiLorenzo addresses that in great depth. A lot of the problem is that the enforcement of the existing law was not a priority of the various regulators that are currently extant. Consumer protections were always secondary. In many cases, consumer protection was viewed as being in conflict with the primary legislative purposes. Two of those legislative purposes have been to keep financial institutions safe and sound and to make home ownership cheap and easy. To accomplish these purposes, a regulator may have determined that banks should have nice fat profits and that credit should be liberal and easily obtained. Well, for a long time the regulators accomplished both of those purposes. However, it was at great expense. DiLorenzo identifies in his paper what some of that expense was. It can be summed up as lasting harm to vulnerable populations who have had their wealth and credit ravaged, predatory profits by many unscrupulous lenders, and of course the damage to financial institution safety and soundness that required the bailout of the entire system, at great taxpayer expense. Then you can add to those the large numbers of unemployed and the damage to general business conditions and the security of all citizens.

So that should be easy to fix, no?

Well, the jury is still out on that. You see, there is a little complication written into the bill. From Dilorenzo:

As discussed in Part One of this article [DiLorenzo's], Congress has embraced three goals for the mortgage markets: safety and soundness, access to credit, and fairness. In the past Congress consistently sought to harmonize these goals and allowed regulatory bodies discretion to act in a manner that served, as nearly as possible, all three of these goals. As consequence, when Congress debated the imposition of statutory protections for consumers in the past, costs and benefits of prohibiting particular practices that unfairly disadvantaged consumers were considered but decisions were not determined by the net societal benefits standard. As result, consumer protections were enacted even when they might impair access to credit or might adversely affect banking industry profits, as fairness was at times accepted as the paramount goal. Title 10 of the Dodd-Frank Act changes this legislative landscape. Congress has, for the first time in recent memory, subordinated the goal of fairness in consumer credit transactions to a new goal of economic efficiency. Congress has embraced what Arrow, Sunstein and others have cautioned against. As a result, if the Bureau does not enact a detailed rule prohibiting particular "unfair" conduct, the industry is faced only with a principles-based prohibition against "unfair" products and practices. The legislative signal that no product or practice is intended to be prohibited if it serves the goal of economic efficiency then serves as a further justification for the industry to continue such activity unrestrained by the legislative principle.

So let me explain that a bit more. In the past, Congress put consumer protection on an equal footing in the legislation. It was implementation of the legislation that allowed consumer protection to be secondary to safety and soundness and liberal credit. Now, the rule-making powers of the Bureau are limited (prohibited) if the proposed rules conflict with the goal of economic efficiency. In other words, if the people in power determine that the consumer protections will restrict the flow of credit, jobs in construction, or whatever their priorities are, they may restrict the ability of the CFPB to make rules.

So there is an element of subjectivity. The door to political influence is wide open. In a Bush administration, there is little doubt that the error would be on the side of the banking lobby and the rules would be prohibited unless it could be proven that they will not interfere with economic efficiency. In an Obama administration, the subjective judgments will likely fall more to the protection of the individual consumer. This is why the qualities that Simon Johnson and Richard Eskow describe are so critical. The director must be articulate and persuasive in order to win these debates.

Now that is not to say there are no teeth in this bill. There is another section that provides greater power to the CFPB in the event an act or practice is considered "abusive."  An act can be considered abusive if it takes "unreasonable advantage" of:
  1. Lack of understanding
  2. Inability of the consumer to protect their interest, or
  3. The reasonable reliance by the consumer on a covered person (employee) to act in the interests of the consumer.
Elizabeth needs to drive a truck through door number three. Banks have taken an adversarial posture relative to their customers in many instances. Number three provides an opportunity to change that.

Finally, there are additional enforcement measures that, if they are used, can change the cost-benefit scenarios the banks and other firms operate under. Often in the past, the downside to an aggressive interpretation of the rules by a business was that their hands would be slapped and they would be required to cease predatory practices. In the meantime they may have made huge amounts of profit and the employees and executives may have personally banked big incentives. Dodd-Frank does provide new forms of relief including disgorgement (the giving back) of compensation for unjust enrichment, public notifications of violations, banning persons from the functions they abused, and civil money penalties. The imposition of such remedies will require a strong hand. The prosecutor, so to speak, will need to ask for a tough sentence.

So welcome, Elizabeth, and godspeed.