RESTORING THE RULE OF LAW IN FINANCIAL REGULATION.

• Author: Calomiris, Charles W.
• Position: Report

The financial crisis of 2007-08 ushered in the most sweeping changes in financial regulations since the Great Depression. Unlike the reforms wrought in 1932-35, which remained in place for decades, much of the post-2008 legislation is already a likely target for repeal or at least significant modification.

Critics point to many shortcomings. Some focus on the costs of regulation, arguing that regulatory reform has benefited large Wall Street banks by codifying their status--as "too big to fail"--and by creating new regulatory costs that big banks can bear more easily than competitors. Small banks face a morass of new rules and compliance burdens. Lux and Greene (2015) find that the "increasingly complex and uncoordinated regulatory system has created an uneven regulatory playing field that is accelerating consolidation for the wrong reasons," producing a declining market share for community banks. These various costs are being passed on to bank customers. Many Americans are finding it increasingly difficult to access banking services on favorable terms. For example, the share of banks offering free checking accounts fell from 75 percent prior to Dodd-Frank to 37 percent in 2015. Monthly service fees charged by banks have grown 111 percent over the same time, while the number of "unbanked" Americans has grown. Credit card interest rates are 2 percent higher, and the number of credit card accounts has fallen by 15 percent. A Goldman Sachs Global Markets Institute (2015) study on the consequences of financial regulation for small businesses also found major costs: "The tax from increased bank regulation falls disproportionately on the smaller businesses that have few alternative sources of finance. We see this in the muted recovery in bank lending to small businesses: outstanding commercial and industrial (C&I) loans for less than $1 million are still well below the peak 2008 level and are only 10 percent above the trough seen in 2012."

Other critics have focused on the current or prospective failings of regulation to achieve its desired prudential objectives. The continued reliance by capital regulation on book values of tangible net worth as a measure of loss absorbing capacity is one obvious weakness. That approach is not likely to work better in the future to prevent too-big-to-fail banks from failing because it does not reliably track the true economic value of bank equity. Risk measurement under the Basel approach employed in the United States and many other countries notoriously creates opportunities for circumvention through the understatement of risk. New bank liquidity requirements are extremely complex, easy to circumvent, and lacking in any fundamental grounding in economic theory. Title II of Dodd-Frank is viewed by many academic critics as unworkable and unlikely to produce orderly resolution of nonbank institutions or large bank holding companies (1)

In this article, I focus on another, even more fundamental, problem. Increasingly, our regulatory structure has been adopting processes that are inconsistent with adherence to the rule of law. (2) These process concerns are rarely voiced by academics, but that is a strange omission. Appropriate regulatory process is fundamental to the ability of regulation to succeed because process defines the incentives of regulators, which are crucial to ensure that regulators act diligently in pursuit of bona fide objectives. Relying on regulatory processes that avoid transparency, accountability, and predictability increases regulatory risk and is likely to lead to poor execution of regulatory responsibilities, as well as create unnecessary regulatory costs and opportunities for politicized mischief. This is not merely a theoretical concern. As I will show, because recent regulation has increased regulators' discretionary authority, and has reduced the predictability and transparency of regulatory standards, it has reduced the accountability of regulators. This has already resulted in abuses that not only deform our democracy but also impose unwarranted costs on the financial system and distract from legitimate problems that should be the focus of prudential and consumer protection regulation.

The Demise of the Rule of Law in Financial Regulation

CFPB Structure, Process, and Policies

Barney Frank has said that he regards the creation of the Consumer Financial Protection Bureau (CFPB) as the greatest achievement of the Dodd-Frank Act. (3) But the CFPB has been a lightning rod for controversy, both about its policies and with respect to its structure and process. With respect to its structure and process, the CFPB was given a unique position within the government. Its budget is determined without the possibility of congressional limitation (its expenses are assessed against the Federal Reserve System, prior to the Fed rebating its surplus to the Treasury), its mandate is extremely broad, and unlike similar regulatory authorities (such as the Securities and Exchange Commission [SEC]), it is run by an individual director rather than a bipartisan panel. In October 2016, a three judge panel of the U.S. Court of Appeals for the District of Columbia found not only that the CFPB was incorrect in its interpretation of a law that it used to justify the imposition of a $109 million penalty, but also that the CFPB "violated bedrock due process principles" and that its structure was unconstitutional because Congress gave the CFPB "more unilateral authority than any other officer in any of the three branches of the U.S. government, other than the president" and that consequently the CFPB "possesses enormous power over American business, American consumers and the overall U.S. economy" (U.S. Circuit Court for the District of Columbia 2016). The full appellate court overturned that ruling in January 2018, but the conflict over the CFPB's structure continues.

With respect to its policies, the CFPB has been aggressive in promoting unprecedented interpretations of consumer protection regulation. Perhaps its most controversial decision was the use of "disparate impact" theory to gauge discrimination against minorities. According to this theory, if one group of people (identified on the basis of racial or ethnic identity) receives different average outcomes (different approval/denial rates or different terms for lending), even in the absence of any evidence of differences in treatment by a lender on the basis of race or ethnicity, then that disparate impact constitutes evidence of illegal discrimination. Furthermore, the CFPB's (2014) information about race and ethnicity was derived not from actual knowledge of individuals' race and ethnicity, but rather from "a Bayesian Improved Surname Geocoding (BISG) proxy method, which combines geography- and surname-based information into a single proxy probability for race and ethnicity." In other words, discrimination was punished based on forecasted probabilistic racial or ethnic identities, not actual ones.

The report of a congressional investigation into CFPB's practices by the U.S. House Committee on Financial Services (2015) found that the CFPB had knowingly failed to control for influences other than discrimination that cause differences in outcomes, and that its actions were inconsistent with congressional intent in creating the CFPB, with the law (which specifically exempted certain automobile financing from CFPB authority), and with Supreme Court definitions of what constitutes discrimination. Racial and ethnic forecasting was also unreliable. The Executive Summary of the report is a scathing indictment of CFPB practices:

Since at least February 2012, the Bureau of Consumer Financial Protection (Bureau), and in particular its Office of Fair Lending and Equal Opportunity, has engaged in an aggressive effort to enforce the Equal Credit Opportunity Act (ECOA) against vehicle finance companies using a controversial theory of liability known as disparate impact. In doing so, it has attempted to implement a "global solution" that enlists these companies in an effort to alter the compensation of automobile dealers, over which the Bureau has no legal authority. As internal documents obtained by the Financial Services Committee and accompanying this report reveal, the Bureau's ECOA enforcement actions have been misguided and deceptive. The Bureau ignores, for instance, the lack of congressional intent to provide for disparate impact liability under ECOA, just as it ignores the fact that indirect auto finance companies are not always subject to ECOA and have a strong business justification defense. In addition, memoranda reveal that senior Bureau officials understood and advised Director Richard Cordray on the weakness of their legal theory, including: (1) that the practice the Bureau publicly maintained caused discrimination--allowing auto dealers to charge retail interest rates to customers--may not even be recognized as actionable by the Supreme Court; (2) that it knew that the controversial statistical method the Bureau employed to measure racial disparities is less accurate than other available methods and prone to significant error, including that for every 100 African-American applicants in a data set for which race was...