The Delicate Balance Between Government Financial Reform and Unintended Consequences

In last Saturday’s edition of the New York Times, Joe Nocera wrote an interesting piece outlining some of the major obstacles currently facing the House Financial Services Committee.  The agency, which considers measures ranging from the banking industry to economic issues to insurance, is responsible for drafting a new financial reform package on behalf of the Obama Administration.  At the heart of such a proposal lies the creation of a new Consumer Financial Protection Agency (CFPA), one which would regulate mortgages, credit cards, debit cards, installment loans and other financial products issued by financial institutions.

On the surface, such an agency would serve as a boon for US consumers.  For example, the agency could potentially reign in on some of the banking industry’s most questionable practices, such charging consumers egregiously high overdraft fees when they overspend on their debit cards.  In the past, banks were more apt to simply reject purchases by consumers who overspent with their debit cards.  Now, banks reap billions of dollars annually off such charges.  Other proposed regulations range from forcing brokers to spend more time explaining mortgage products to consumers to curtailing unannounced hikes in credit card fees.

Why is such legislation justified?  Well, after the near-collapse of our financial system in the past year, it has grown abundantly clear that the financial services industry must change its practices.  After all, we, the taxpayers opened our wallets for the Troubled Asset Relief Program to the tune of $700 billion.  A message must be sent, loud and clear, that the risky, irresponsible practices of the past are not to be repeated.  Part of the government’s role as chief rescuer is to hold these institutions accountable for their actions by 1). collecting on their TARP loans to the banks, while 2.) instituting new regulations preventing  the risk of moral hazard.  However, these two responsibilities are not one and the same…

As an example, take Citigroup and Bank of America.  Citigroup received $50 billion in TARP funds last year, in addition to receiving $306 billion in US Government guarantees on troubled assets.  Likewise, Bank of America received $45 billion in TARP funds, to go along with $118 billion in troubled asset guarantees.  The two, amongst the largest consumer banks in the world, are hugely indebted to the US Government.  Yet to the surprise of few, neither has repaid a cent of TARP money to date.

If the new House Financial Services Committee places more stringent controls on the banks, such as limiting overdraft fees, these banks could miss out on billions of dollars in revenues.  Placing caps or limits on credit card interest rate hikes could have the same effect.  This lost revenue, while protecting consumers (mainly, the minority with the weakest credit histories), would effectively hurt the US taxpayer, and further dampen the chances that the US Government fully collects on its loans to the banks.

Coupled with this, many of the more traditional revenue streams for these banks earlier in the decade have since dried up.  For example, with the housing industry’s continued struggles, banks cannot rely upon the heavy fees previously generated through the bundling and selling of mortgage-backed investment products.  Likewise, after being caught with over-levered balance sheets over the past few years, banks have considerably cut back lending to businesses and consumers.  Instead, many are shoring up their balance sheets to meet appropriate reserve levels.

So, what does this proposed legislation ultimately mean for the big banks, consumers, and taxpayers?  For the banks, such rules will force them to abandon formerly profitable practices and seek out new revenue streams.  This could be accomplished through several means.  First, they could sell company assets, as Citi did by selling Phibro, its profitable energy trading (albeit, controversial) business, just last weekend.  However, the selling of assets is not a sustainable activity over the long run.  Rather, the banks are much more likely to cut costs (lay off workers, close branches) or hike up consumer fees in other areas (think higher ATM fees and account charge hikes).

For consumers, the new CFPA will look out for their interests, serving as a watchdog for banking practices it finds unscrupulous, irresponsible, or even predatory.  That’s great, especially for the 10% of consumers with the poorest credit histories-those largely responsible for paying hightened fees for services like debit card overdrafts.  However, in forcing the banks to abandon practices it finds unacceptable, the agency indirectly forces these banks to seek revenues in other areas.  For example, by protecting the consumer who overdraws on her debit card account each month, the agency’s actions could simply force the banks to raise standard fees on all customer ATM withdrawals.  In other words, in return for protecting the interests of a minority of consumers, legislation could simply force banks to raise fees for ALL customers.

Lastly, we have the taxpayer.  Ultimately, you benefit when the banks repay their TARP funds.  As such, you need the banks to continue to increase revenues, grow, and flourish.  However, from the taxpayer’s point of view, the CFPA could inhibit this from occurring.  By placing more controls on the industry and limiting its ability to generate the necessary income, the agency could serve as an obstacle to these banks’ attempts at recovery.

When it was launched last October, the Troubled Asset Relief Program was widely lauded as a means of preventing additional bank failures.  Thus far, few can argue that the program has positively affected the financial landscape and reassured investors.  However, while it appears necessary for agencies such as the CFPA to prevent future abuses by ramping up regulations, those same regulations will undoubtedly inhibit some banks’ abilities to repay TARP funds.

For the Obama team, encouraging a more traditional, “bread and butter” model for the big banks is necessary to appease the needs of an industry, consumers, and his taxpaying constituents alike.   Yet, as you can see, introducing new regulations is a sensitive issue which can produce a variety of consequences to multiple parties.  Perhaps above all else, he must promote a sustainable industry model which ensures the banks’ ability to repay TARP funds without resorting to the same sort of wreckless behavior which brought about this crisis in the first place.  After all, as novelist George Santanaya once wrote, “Those who cannot learn from history are doomed to repeat it.”

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