Neil H. Buchanan

The Proposed Consumer Financial Protection Agency: Enhancing, Not Restricting, Free Markets

By NEIL H. BUCHANAN


Thursday, October 22, 2009

One of the major battles currently brewing in Congress concerns the Obama administration's proposal to create a new agency to change the regulatory rules governing credit cards, mortgages, and other consumer financial transactions. The Consumer Financial Protection Agency (CFPA) would shift the balance of power slightly away from the current stranglehold enjoyed by banks and lending companies, and toward households and individuals.

Not surprisingly, the financial industry is fighting tooth and nail to prevent this agency from coming into being -- or, failing that, to so weaken the agency that it would be little more than window dressing.

Also unsurprisingly, the financial industry is trotting out its tried-and-true arguments against "more regulation," arguing that Americans should automatically be opposed to regulation as an impingement on liberty; that this new set of "bureaucrats" (the all-purpose term intended to defame someone you dislike) will meddle in private affairs; and that free markets are everyone's best protection from abusive practices.

But there is a serious problem with the anti-regulation argument. As I have argued in my two most recent columns here on FindLaw -- which can be found here and here -- the suggestion that there is a way to have a modern economy without government regulation is simply incorrect. As applied to the financial sector, such a suggestion is especially incredible. The lending side of the financial sector -- that is, banks and other lenders – currently benefits from some of the most effective regulation that the government can offer.

If the government decided not to regulate the financial sector, there would soon be no financial sector. Shortly thereafter, there would be no economy. We should not, therefore, be arguing about whether the CFPA would impose "regulation," but about whether it would improve the operation of an industry that exists only because a government exists to force borrowers to honor their contracts.

The Regulatory State as Collection Agent for Lenders

A loan is a contract. As such, it involves an exchange of promises that will be enforced by the government. Indeed, it is the very enforceability of contracts that makes them worth entering into in the first place. The existence of a government is thus presumed in any modern -- that is, non-Hobbesian -- system of lending.

Indeed, even when the government does not itself send out the bill collectors to enforce a contract, it is the government that decrees how private agents may attempt to collect on valid debts (garnishing wages, seizing property, sending people to the almshouse, and so on). Moreover, it is the government that must put in place a system to determine which debts are valid and collectible in the first place. That is the purpose of rules determining, for example, whether contracts have to be written and signed in order to be valid.

In the case of the financial sector, as I explained in my most recent column, the whole point of the industry is to set up enforceable contracts, with one side of the contract (repayment of the loan) to be performed in the future. For banks to say that they do not want the government intervening in financial markets, therefore, is more than a bit disingenuous. Their very existence as lenders is premised on the government's willingness to intervene when a consumer fails to pay off her loans as scheduled.

Moreover, the government's support for lenders in the instance of default – for instance, its decision to provide, free of charge, a public court system that hears cases regarding private contracts – is greatly subsidized by taxpayers. That fact makes it very ironic, and false, for lenders to claim to oppose government intervention in lending; in reality, they benefit from such intervention every time they go to court or simply benefit from the fact that it is well-known to all that the courts are there to enforce contracts.

The market for loans, therefore, is currently regulated and must continue to be regulated in order for the market to continue to exist and function. The question is simply whether the current form of regulation should be changed.

Current Rules Governing Financial Transactions

Because loans are contracts, the default set of rules governing loans is drawn from the common law of contract, as modified by state legislatures and the federal government. The odd thing about this set of rules is that it was developed in a context in which the typical transaction was the result of a one-on-one negotiation between relatively equal, informed, and well-advised parties.

The standard "meeting of the minds" notion in contract law imagines a negotiating table over which two parties hammer out an agreement. When that assumption is violated, contract law has developed an elaborate but completely inadequate set of exceptions to the normal rules.

In particular, first-year law students learn about notions of "duress," "misrepresentation," and especially "unconscionability" as equitable limits on the law of contract. The fact is, however, that those defenses against a claim of breach of contract are rarely successful in court. The typical approach taken by courts is: "You're a grown-up. If you didn't want to fulfill your side of the deal, you shouldn't have agreed to the deal."

The intuitive appeal of this default position, however, ignores many realities that have been built into the law of contract. For example, if I were to sign a contract that included several pages of fine print, and in a section labeled "Effective Date" there appeared a sentence that reads: "The signer agrees that, notwithstanding anything written above, the signer will pay interest at a rate of 100% per day," that provision would not be enforceable in court.

Even the most hard-core believers in "You signed it, you must live by it" have long since conceded that some basic rules must be enforced to protect against sharp dealing. This might be surprising, because the very term "sharp dealing" is arguably just another term for "self-interested negotiating." Yet we have grown (appropriately) comfortable with the idea that contract language may not cross the blurry line between driving a hard bargain and perpetrating deception.

Moreover, the background presumption in classical contract law is based on the idea that the parties to a contract are not merely adults, but also are able to comprehend the agreement and to anticipate their ability to fulfill their duties when the time comes. In a country where large numbers of adults are functionally illiterate, however, it becomes especially difficult to blame people for signing unwise contracts. Often, consumers have been told that they can have money now in return for promises that they do not really understand -- and that they have not been equipped by our educational system to be able to comprehend.

Business Not only Accepts, But Needs, the Rule that Some Promises Are Non-Enforceable

Even people who are well-educated and are able to understand contracts, however, generally do not read contracts before they agree to them. They are busy, or they assume that the contract contains no surprises, or they simply take their chances. Ultimately, they are relying on the government to guarantee that they cannot inadvertently, say, sign away the life of their first-born child or sell themselves into slavery. In short, they expect that some contracts will not be enforced, which means that they believe that there is a regulatory structure in place that goes beyond "You sign, you pay."

What if people could not rely on that presumptive guarantee? I often see the surprise in people's eyes when I actually start to read a contract in my day-to-day life. The first time I rented a car (long before I became a law professor), for example, I not only read the contract at the rental counter but asked questions about various provisions. After a few minutes of this, the rental agent impatiently said: "You don't understand anything, do you?"

Similarly, when I signed a residential lease in New York City a few years ago, the rental agent put the twenty-page contract in front of me and showed me where to sign and initial. I started to read the contract. She asked me why, and I said, "Because I want to make sure that there is nothing in here to which I wouldn't want to agree." She replied: "Well, even if there is, there's nothing you can do about it. The contract can't be changed."

Both of these examples point to a little-appreciated aspect of contract rules: Consumer protections lubricate commerce. Car rental agents, leasing agents, and countless other business representatives need people not to read contracts. Why? It is not that these businesspeople are counting on fooling the customer; it is simply because they do not have time to negotiate with each one separately. When they must deal with someone who knows that those background protections are highly imperfect, their ability to do business slows down markedly.

This assumption by consumers that contracts will be non-abusive is especially important to the financial industry, because the last thing loan officers need is to spend their time justifying every line of a complicated contract to a skeptical counter-party.

Added Protections for Borrowers

All of this brings us back to the proposed CFPA, which would change the laws of financial contracts in what would, generally, be a consumer-friendly direction. It is important to remember that the recent financial crisis began in large part because of the peddling of loans to parties who could not live up to their future obligations. The crisis should have taught us that we need better rules -- and that we need those rules not just to protect consumers, but also to protect business and, in the final analysis, the entire economy.

The CFPA's duties (summarized nicely on the Wall Street Journal's blog here) would include the creation and enforcement of rules changing the way contract law is enforced in financial transactions: "The agency's objectives would be to make sure consumers can make informed decisions about financial products and services, protect them from abuse, make sure markets operate fairly and efficiently, and ensure that all consumers have access to financial services."

There is a reasonable debate to be had over what the precise duties of such an agency should be, and what limits should be placed on it. There is, however, no reasonable argument that such an agency restricts our current freedom to form contracts, or causes the government to intrude in "free market" transactions that should be left to the will of the parties. Contracts are already regulated, and such regulation is not only timeworn but vital. The only question on the table now is: What should such regulation look like?

Government currently regulates the financial sector in ways that strongly favor financial institutions. The Consumer Financial Protection Agency would change those rules in ways that the financial industry reflexively resists – rendering the law a bit more pro-consumer, and in so doing, leveling the playing field somewhat. The ultimate purpose of such rules, however, is to allow borrowers and lenders to enter into transactions that are truly advantageous to the parties involved, and to our system of free enterprise itself.


Neil H. Buchanan, J.D. Ph. D. (economics), is a Visiting Scholar at Cornell Law School, an Associate Professor at The George Washington University Law School, and a former economics professor.

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