Congress Must Protect Financial Consumers Without Stifling Innovation

Tuesday, June 30, 2009

BERNARD L. MADOFF has been sentenced to 150 years in prison for swindling hundreds of people out of billions of dollars. The equivalent of a life sentence, well deserved, comes too late to save Mr. Madoff's victims from financial ruin. An important lesson of this case has to do with the limits of business regulation. Mr. Madoff's activities were unambiguously illegal; a whistleblower repeatedly warned the Securities and Exchange Commission about them, in detail; the SEC had authority to stop the scheme. But the government did not act until Mr. Madoff's sons finally turned him in.

All of this is worth remembering as Congress debates President Obama's plan for financial regulatory reform. A key part of that plan is the creation of a Consumer Financial Protection Agency. That agency would replace the Federal Reserve and other banking regulators as the primary federal supervisor of home mortgages, credit cards, car loans and the like. The idea is to prevent a repeat of the past decade, in which unregulated mortgage brokers sold subprime, adjustable-rate mortgages to consumers who lacked the resources or the knowledge to use them wisely. To its advocates, the agency would protect people from "unsafe" mortgages the same way that the Consumer Product Safety Commission protects them from faulty toasters.

In principle, it could be wise to streamline the consumer protection function by taking it away from agencies whose other responsibilities may have conflicted with it. The Fed, which had both consumer protection and bank solvency duties, admits that it was too slow to rein in subprime loans. Another useful focus of such an agency would be simplifying the eye-glazing disclosure forms borrowers now face when they buy a house or sign up for a credit card. Still, even financial literacy is no guarantee: Many of Mr. Madoff's pigeons were sophisticated business people.

We're somewhat less persuaded by another mission being floated for the agency: identifying "plain vanilla" financial products, such as 30-year, fixed-rate mortgages with 20 percent down payments, for favored regulatory treatment. Unlike a badly wired toaster, an "exotic" mortgage is not necessarily unsafe for everyone all the time. The costs of additional consumer protection regulation will be paid by consumers, who may get greater safety at the cost of fewer choices and higher prices. To be sure, the now-busted boom gave financial innovation a bad name, lending appeal to a vanilla-

flavored financial sector. But in shaping the new agency's authorities and jurisdiction, Congress must be careful not to overcorrect.

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