Fed’s High Wire Inflation Fighting Effort Risks Triggering a Recessionary Fall

Imagine a high-wire act performed without a net.  That describes the Federal Reserve’s effort to curb inflation without crashing the economy.  Success will bring applause and relief; failure, a brief downturn, at best, with a prolonged recession the worst case outcome. 

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Delivering an expected but nonetheless unwelcome defeat to the financial services sector, the House Financial Services Committee has approved legislation establishing a new Consumer Financial Protection Agency (CFPA), with broad authority to enforce compliance with consumer protection laws.

A cornerstone of the Obama Administration’s planned overhaul of the bank regulatory structure, the legislation effectively strips consumer protection authority from federal regulators, which will retain responsibility for safety and soundness oversight of federally insured banks and savings institutions. The bifurcated structure – dividing consumer compliance and safety and soundness regulation – was one of the primary concerns cited by financial industry executives in opposing the plan. The legislation also shreds the hitherto impenetrable federal preemption shield for national banks, explicitly state regulators to enforce state laws against nationally chartered banks and their state-chartered subsidiaries.

Banks and credit unions, backed by Republican lawmakers, fought furiously to block the legislation or significantly dilute it, but Democrats and consumer advocates prevailed, securing a largely party-line 39-29 committee vote to approve the measure, with one Republican voting for it and two Democrats opposed.

Opponents did win a few significant concessions, however – primary among them, an amendment exempting credit unions with assets of $1.5 billion or less and banks with assets of $10 billion or less from consumer protection examinations by the CFPA.

Exempt institutions - a category that will include all but about 120 banks and all but an estimated 80 credit unions – will continue to be examined for both safety and soundness and consumer protection compliance by their primary regulators. However, these institutions will still have to comply with CFPA regulations.

Additionally, the CFPA can send an examiner to participate in the consumer protection reviews, must receive all information related to those examinations, and can remove prudential regulators, on a case-by-case basis, if agency officials determine that the regulator‘s consumer compliance supervision falls short.

Larger institutions subject to CFPA oversight will have separate safety and soundness and consumer compliance examinations, but those reviews will be conducted simultaneously, unless the institutions request otherwise. “The banking agencies and the CFPA will have to coordinate and consult one another on the timing, scope and results of exams to ensure a minimum regulatory burden,” a committee summary of the legislation notes.

Rep. Barney Frank (D-MA), chairman of the Financial Services Committee and the bill’s primary sponsor, hailed the committee’s approval of the CFPA as “a very significant event” and predicted that the measure “will only get better going forward.”

While approval by the full House is likely, the bill’s prospects are uncertain in the Senate, where it will continue to face stiff opposition from Republicans and from some moderate Democrats, along with continued efforts by the banking industry to scale back the CFPA’s authority.

As proposed in the pending House bill, the CFPA “would be more powerful than any other government agency,” Wayne Abernathy, executive vice president of the American Bankers Association, told the Wall Street Journal. “It can control every aspect of a financial institution’s relationships with its customers.”

Credit union trade groups viewed the exemption for all but the largest institutions as a significant victory, but only a partial one. Fred Becker, president of the National Association of Federal Credit Unions (NAFCU), said that trade group still hopes to persuade lawmakers to exempt all credit unions from CFPA oversight.

The Credit Union National Association (CUNA) similarly, wants more changes in the legislation, according to President and CEO Dan Mica, who said he has “significant concerns bout the impact element of this legislation will have on credit unions and their members.” CUNA and the Independent Community Bankers Association have suggested that while the CFPA should have authority to adopt rules and regulations for financial institutions, the existing federal regulators should retain responsibility for enforcing the rules and conducting compliance examinations.

Preemption Battle Continues

Financial institutions dislike many provisions of the legislation establishing the Consumer Financial Protection Agency (see above), but the provision they dislike most, and the one that is likely to be a primary target of opponents as the measure moves through the House and Senate, is the language undercutting the long-established authority of federal bank regulators to preempt the enforcement of state laws against nationally chartered institutions.

As originally proposed, the bill would have erased the broad preemption authority the Office of the Comptroller of the Currency (OCC) has carved out over the past decade. A compromise amendment, sponsored by Reps. Mel Watt (D-NC) and Dennis Moore (D-KS), softened the original language, giving the OCC the authority to preempt state laws on a case-by-case basis if those laws are deemed to “prevent or significantly interfere with” the exercise of federal banking powers or “discriminate unfairly” against national banks, compared with state-chartered institutions.

A Financial Services Committee summary makes clear the bill’s intent to overturn Waters v. Wachovia, (a Supreme Court decision affirming the Comptroller’s position that state-chartered subsidiaries of national banks are not subject to state laws) and to “codify” Cuomo v. Clearinghouse, a more recent Supreme Court decision, holding that state regulators have the authority to pursue enforcement actions against national banks as long as federal laws do not specifically prohibit them from doing so. The legislation also explicitly authorizes state regulators to enforce CFPA regulations “provided that they consult with [the new agency] prior to initiating such action.”

Financial industry lobbyists had fought fiercely to preserve the federal preemption authority, arguing that uniform standards are essential to prevent a “patchwork” of potentially conflicting state regulations that would complicate the compliance efforts of financial institutions and ultimately increase costs for consumers.

“Consumers benefit from an efficient financial services system, where you can operate under uniform rules wherever you go,” Comptroller of the Currency John Dugan told the Washington Post in a recent interview. “It is important to have strong rules to protect consumers,” Dugan agreed, “but what we don’t need is 50 different rules.”

Consumer advocates and state regulators, who persuaded the Supreme Court to narrow the scope of the OCC’s preemption authority, contend that federal law should establish minimum consumer protection standards that states should be allowed to exceed if they choose.

“Washington does not always know what’s best,” Michael Barr, assistant Treasury Secretary, told the Washington Post. “We need to restore the authority of states to protect their citizens with the rules they think make sense.”

As long as the federal standards are reasonable, Barr and others who oppose broad federal preemption authority contend, states will have no incentive to enact stronger protections. They cite as an example the 1999 Gramm-Leach-Bliley Act establishing federal privacy standards for financial institutions. Although the law gave states the authority to adopt stronger protections, only three states have done so.

But federal regulators question how much can be extrapolated from experience with that law. “GLBA is a very narrow example,” Julie Williams, Senior Deputy Controller in the OCC, told American Banker. “In [the] CFPA,” she noted, “the scope on which state regulators can act is virtually unlimited.”

That’s why bankers are so concerned about the preemption provision, Ron Glancz, a partner in Venable, LLP, added in that American Banker article. The subprime crisis and economic downturn have stimulated an aggressive response from state legislators and regulators. “Because [regulation of the banking industry] is such a hot political issue and is on everyone’s mind,” Glancz noted, if the federal preemption restraint is removed, “I think at this point you would have chaos.”

Response Time

The House Financial Services Committee may not have labeled its agenda, “stuff financial institutions won’t like,” but recent actions certainly fit that description. The same day the committee approved landmark legislation creating a Consumer Financial Protection Agency (CFPA) – see related item -- lawmakers advanced a measure accelerating by two months the effective date for new restrictions on credit card practices.

Anger over reports that card issuers have been boosting interest rates and fees, cutting credit lines, closing inactive accounts, and taking other steps that will be restricted or barred by the new law triggered the move to make the law effective in December rather than in February of next year, as originally planned.

Responding to pleas that the accelerated deadline would be, not just burdensome but almost impossible for smaller institutions to meet, the committee approved an amendment introduced by Representatives Shelley Moore Capito (R-WV) and Brad Sherman (D-CA), leaving the February date in effect for banks and credit unions with fewer than 2 million credit cards in circulation.

Dan Mica, president and CEO of the Credit Union National Association (CUNA), praised legislators for “recognizing the burden” the expedited implementation would have on smaller institutions. In a letter to the committee’s chairman and ranking member, Representatives Barney Frank (D-MA) and Spencer Bachus (R-AL), respectively, Mica noted that the additional time is short but “critical” for credit unions. “Many steps need to be taken before credit unions and others will be able to comply,” Mica noted. The new rules will require card issuers to revamp their billing practices, fee structures, and disclosure notices, among other practices.

The exemption will affect only about 10 percent of the 700 million cards in circulation, according to Sherman, who said those smaller issuers “barely have the staff to go in the right direction” by the February compliance date. Larger companies, on the other hand, “Have the capacity to quickly make changes in the wrong direction,” Sherman said. A study by the Pew Foundation, found that the lowest advertised rates on 400 credit cards have increased by an average of 2 percent since December, while more than half of those issuers have shifted from fixed to adjustable rates during that period.

On the Senate side, Christopher Dodd (D-CT), chairman of the Senate Banking Committee, has proposed, as an alternative to the accelerated compliance date for the new credit card rules, a measure that would freeze interest rates and fees on existing card balances until the new law takes effect. Financial institutions have complained that they need more time to comply with the new requirements; a rate freeze avoids those concerns, Kristin Brost, committee spokesman told the New York Times. Dodd’s legislation tells the banks, “Ok, we’re calling your bluff,” she added.

Banking industry executives say both Dodd’s bill and the House measure, accelerating the compliance deadline for the new credit card rules, are misguided, because they assume, incorrectly, that issuers are boosting rates and making other changes in advance of the new rules. In fact, industry officials contend, the changes are motivated by concerns about the credit risks created by a weak economy and rising delinquency and default rates.

Industry lobbyists don’t view Dodd’s bill as a serious legislative initiative; most think it is aimed more at altering the public perception that he is tied too closely to the financial industry to bolster his standing with constituents as he faces a tough re-election bid in Connecticut.

Lobbyists also expect both Democrats and Republicans on the Senate Banking Committee will be more sympathetic to their arguments against accelerating the compliance date for the new credit card rules. In testimony before the House Financial Services Committee ,the American Bankers Association warned that compliance with “800-plus pages” of proposed rules will be “an enormous undertaking,” confronting lenders with what amounts to a “Catch-22 -- move forward and provide a card product that may be subject to significant administrative problems, customer confusion, and potential litigation risk, or take drastic action to somehow mitigate that risk, which may include increased prices and reduced access. It is hard to see how the vast majority of American consumers, let alone our economy, can befit from such a result,” the ABA suggested.

The Federal Reserve meanwhile is still drafting the regulations implementing the credit card legislation and will finalize those rules without public input if Congress approves the accelerated effective date, Fed Chairman Ben Bernanke told lawmakers at a recent hearing. In response to questions, Bernanke declined to speculate about the impact speedier implementation will have on interest rates and credit availability for consumers, “but it would mean that consumers would receive important benefits and protections earlier,” he said.

OVERDRAFT IN OVERDRIVE

The growing list of “stuff bankers don’t like” includes legislation targeting perceived abuses in overdraft protection programs that have become a major source of fee income for financial institutions, and a major generator of complaints from consumers and consumer advocacy organizations. Citing those complaints, Sen. Christopher Dodd (D-CT) recently filed legislation targeting the way banks price and structure their overdraft programs.

Mirroring in key respects a measure already introduced in the House by Rep. Carolyn Maloney (D-NY), Dodd’s bill would require lenders to obtain permission from consumers before enrolling them in overdraft protection programs, prohibit them from manipulating the order in which transactions are posted in order to maximize the overdraft fees incurred, and requires “prompt notice” to consumers when an overdraft has occurred (although not at the point of sale, as Maloney’s bill would require). Dodd’s bill would require that customers be warned if an ATM or branch teller transaction will trigger and overdraft and be given the option of canceling the transaction without incurring an overdraft coverage charge.

In other areas, Dodd’s bill goes several steps beyond the House version, requiring that overdraft fees be “proportional” to lenders’ costs, prohibiting banks from charging insufficient funds fees for overdrafts on ATM and debit card transactions, and requiring banks to notify consumers on the day an overdraft charge is assessed the details of how the overdraft occurred and explain how they can correct their negative account balance. Dodd’s bill would also cap the maximum number of overdrafts consumers can incur at no more than six per year and one per month; the House bill sets the cap at three per year.

“At a time when many can afford it least, American consumers are being hit with hundreds of dollars in penalties for overdrawing their account by just a few dollars,” Dodd said in introducing his legislation. “Banks should not be trying to bolster their profits at the expense of their customers,” he added.

Industry executives say the proposed overdraft restrictions are both heavy-handed and now unnecessary, because many large banks have adopted voluntary policies addressing the major concerns the legislation targets.

The overdraft bills represent “a huge government intervention into the markets,” complained Scott Talbott, chief lobbyist for the Financial Services Roundtable, who told CNNMoney that the proposed restrictions “are largely redundant, because the industry has already made numerous changes to overdraft fees in response to consumer concerns.”

Consumer advocates counter that banks began changing their policies only when confronted with legislative proposals requiring them to do so. “They were hoping to head off new federal regulation of a business that is designed to ambush ordinary people and siphon off as much month as possible,” a New York Times editorial asserted. Recent studies have highlighted the outsized fees overdraft charges generate for banks, the editorial noted. “They clearly will not renounce [that fee income] unless the government forces them to do so.”

WILL PAIN BRING GAIN?

Widespread defaults on home mortgages and other consumer loans would be seriously bad news for lenders but could be beneficial for the economy. That seemingly counterintuitive conclusion comes from analysts who note that excessive consumer debt loads – representing nearly 125 percent of after-tax income – remain a serious drag on household spending. The sooner consumers manage to “de-leverage” and rebalance their finances, the sooner they will be able to resume the high-octane spending that will speed the economic recovery.

Considering mortgage debt alone, an estimated 26 percent of all homeowners owe more on their homes than they are currently worth; RealtyTrac, Inc. estimates that 4 percent of those underwater owners have walked away from loans they could afford to repay, representing a small but growing group of “strategic defaulters.” Overlay that trend on the 52.4 million borrowers who were 60 days or more behind on their mortgage payments in July, and analysts calculate that the combination of strategic and unavoidable defaults could produce $1.2 trillion in debt relief, which could significantly boost consumer buying power.

That kind of debt relief “isn’t ideal, it carries other costs,” Karen Dynan, a consumer finance specialist at the Brookings Institution, told the Wall Street Journal recently. “But it’s going to help get household balance sheets back to the right place.”

Even if debt loads are reduced dramatically, the Journal article noted, “there is no guarantee spending will take off…. Many people don’t have jobs, and they won’t have access to the kind of credit they did during the boom” the article pointed out. And even consumers who are feeling more secure about their finances are becoming more cautious about their spending, several studies and a slew of surveys have found. That’s hardly what retailers want to hear as the all-important holiday shopping season looms. But on balance, “a more carful U.S. consumer isn’t a bad thing,” the article suggested. “Combined with a radically reduced debt burden, it could be just what the economy needs in the long term.”