Why Burying the CFPA Inside the Fed is a Lousy Idea

Last Updated Mar 17, 2010 11:41 AM EDT

A major point of contention regarding Sen. Chris Dodd's latest financial reform bill is whether the Federal Reserve should have anything to do with the proposed Consumer Financial Protection Agency.

Absolutely not, say a host of prominent economists. Indeed, a 2009 paper by the Squam Working Group, a nonpartisan group of 15 academics who offer prescriptions on financial regulation, suggests that embedding the CFPA within the Fed could harm both agencies.

  • First, the Fed is already in line to become the nation's chief regulator of "systemically important" financial firms. The institutional skills and mindset involved in gazing over the entire financial landscape to spot threats is "fundamentally different" than what's required to, say, shield consumers from predatory lending, according to a 2009 paper from the group, whose members include econ all-stars as Columbia's Frederic Mishkin, the University of Chicago's Raghuram Rajan and Yale's Robert Shiller. Specifically, systemic crises are rare by nature, while combating financial fraud and abuse is an everyday affair. As a result, regulators charged with doing both are likely to gravitate toward the latter, in part because that's how such enforcers advance in their careers. That means less time is spent scanning the horizon for the next AIG.
  • Second, consumer protection often involves politically controversial decisions. Regulating products that affect lots of people naturally draws politicians into the fray. And when votes are on the line, lawmakers are often inclined to lean on a regulatory agency to ensure a favorable outcome for their constituents. That could cause problems if the Fed is responsible both for overseeing "too big to fail" financial institutions and for guarding consumers, since politicians will be apt to focus on the latter while ignoring the more abstract dangers of the former. "Political pressure on a systemic regulator due to politicians' unhappiness with its role as a consumer regulator may interfere with the regulator's independence and ability to perform systemic regulation," write the economists.
Dodd contends that the CFPA would merely be housed within the Fed, noting that the new agency would have its own budget. Nonsense. Living within the Federal Reserve, the director of the CFPA will be hard-pressed to override the authority of the Fed chairman. Such an arrangement must be seen as a political compromise with lawmakers, who -- acting on behalf of financial firms -- fear that an independent consumer watchdog would rain on their parade.

Putting the Fed and the CFPA together may be good politics, but it's lousy policy.

Image courtesy of SEIU

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    Alain Sherter covers business and economic affairs for CBSNews.com.