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JBL Symposium examines implementation of Dodd-Frank, consumer financial protection

November 22, 2011

By Jenny Chung C’12

Professor Cary Coglianese
Penn Law Professor Cary Coglianese

An audience of students, faculty, and members of the public filled Penn Law’s Levy Conference Room November 19 for the 2011 Journal of Business Law Symposium, a full-day event comprised of three panels and five keynote lectures delivered by leading authorities in the fields of corporate law, financial regulation, and commerce, as well as other fields.

Organized by the Law School’s Journal of Business Law, this year’s Symposium addressed the implementation of the Dodd-Frank Act and the wider topic of consumer financial protection.

Professor Cary Coglianese’s opening remarks centered on the common ground between recent questions concerning relations between public authority and the ordering of private affairs as compared against those raised several centuries earlier at the nation’s founding.
 
“We’re considering today questions that have deep roots in American history and a core reflected in the movements of today,” he said. “The concerns underlying Occupy Wall Street’s efforts tap into a deep suspicion of power that underlies the American polity.”

He advised audience members to ask themselves how a conference organized around the issue of consumer protection five to ten years from now would assess whether the Dodd-Frank Act was successful at ending corporate abuses and, in turn, what criteria should be employed in evaluating the success of legislation intended to regulate relations between businesses and consumers.

“A gathering like [this Symposium] comes at a perfect time to look backward as well as forward and look forward to looking backward,” he added.

Professor Franklin Allen
Wharton School of Business Professor Franklin Allen

Prof. Allen keynote address: Dodd-Frank and systemic risk

Coglianese’s introduction was followed by the Symposium’s first keynote lecture, delivered by Wharton School of Business Professor Franklin Allen, who discussed systemic risk within the framework of the Dodd-Frank Act.

According to Allen, most regulators before the financial crisis were confident that controlling the risk assumed by individual banks was sufficient to prevent crises as it forestalled the buildup of risk in the financial system. He suggested that this view is “fundamentally flawed” given its inability to account for systemic risk, which can arise from “panics, banking crises due to asset price falls, contagion [and] foreign exchange mismatches in the banking system.”

Tracing the origins of financial panics to “multiple equilibria in the banking system” which compel people to withdraw their funds from banks when they sense others are likely to withdraw—even if there exists no other rational incentive to do so—Allen posited the guarantee of all short-term debt as a possible method of ruling out such “self-fulfilling equilibria” but cautioned that this approach may entail other types of systemic risk and itself prove costly.

Allen also identified the extensive involvement of banks in real estate and too-low interest rates coupled with large foreign exchange reserves—mostly held in dollars and accumulated by central banks in Asia—as contributing factors to the crisis.

He emphasized the need to reduce global imbalances and explained that self-insurance by Asian countries through large reserves is optimal for the countries in question but “inefficient” globally. To rectify this, he suggested, a stronger Asian presence in the governance structure of the International Monetary Fund is central.

Allen also proposed that ensuring the permanence of the IMF liquidity facility may provide the solution to foreign exchange mismatches, another source of systemic risk.

“Systemic risk is a complex phenomenon and we don’t understand it well enough,” he said. “Central banks are constructed to manage crises, but those who are dissidents are screened out from the get-go—it’s important not to do that so we don’t miss things as we did in the previous crisis.”

Prof. Jacoby keynote: Regulatory innovation and the Bureau of Consumer Financial Protection

UNC School of Law Professor Melissa B. Jacoby, authority on bankruptcy and commercial law, delivered the next keynote speech on regulatory innovation and the Bureau of Consumer Financial Protection.

Jacoby opened her talk with the observation that current discussion of the Bureau’s existence “has played out in extreme terms” and “moderate discussion” of the issues is necessary.

Professor Melissa B. Jacoby
UNC School of Law Professor Melissa B. Jacoby

While the principal objective of the bureau is to raise consumer confidence in financial markets and ensure individuals make “smart” decisions, she said, the Bureau also provides a basis for systematic assessment of the market in addition to venues for direct two-way communication with the public like online interactive forms and comment logs.

“This was a particular way to communicate with and get substantive comments back from a wide swath of the population—as confidence builds one can anticipate even more,” she said, adding that public commenting affects public perception of the Bureau “perhaps more so than voting” by providing a means of fostering a sense of inclusion.

Shifting her focus to the Dodd-Frank Act, Jacoby maintained that the passage of the bill was key to safeguarding the ability of states to protect their own citizens insofar as it enabled states to enforce their own consumer protection laws.

Citing the inability of government to “solve all problems” as justification for the Bureau, Jacoby criticized the “extreme” nature of the arguments frequently leveled against it.

“People opposed to the Bureau talk about the ‘right to be wrong,’ and it’s hard to disagree with that as a general proposition, but when people can’t internalize the consequences of their decisions we have to move beyond that,” she explained.

In her view, government has long played a role in encouraging debt, and while the state does and should be entitled to invest significant resources in subsidizing debt collection, it is imperative that “ground rules” be set.

“No one likes all aspects of the Bureau, but we need something to look across the entire market and provide a credible threat of enforcement somewhere within the system. There has to be an actor who can and will step in,” Jacoby said.

Consumer Protection and the Consumer Financial Protection Bureau panel
Professors David Skeel, David Reiss, Jason S. Johnston and Paul G. Mahoney

Feature panel: Consumer Protection and the Consumer Financial Protection Bureau

Moderated by Penn Law Professor David Skeel, the first panel addressed “The Project of Consumer Protection and the Consumer Financial Protection Bureau” and invoked the expertise of four distinguished legal scholars.

The panel commenced with a modern-day fable, recounted by Professor David Reiss of Brooklyn Law School, illustrating the “fundamentally irreconcilable worldviews” held by people evaluating the events leading to the subprime market crisis.

A reimagining of the age-old tale of the emperor’s new clothes, Reiss’ story involved an emperor swindled by scoundrels posing as lenders who claimed to have invented a mortgage “so insubstantial it looks burdensome to anyone too stupid to appreciate its quality.” While the entire kingdom perceived the mortgage as heavy, no one was willing to voice his opinion for fear of appearing incompetent.

The moral of the story, Reiss suggested, is that “disclosure can be insufficient to convey the complexity of certain transactions to many consumers” and that the persistence of “muddled and conflicting views about consumer protection” will result in inefficient regulation.

University of Virginia Law School Professor Jason S. Johnston then offered a preliminary critique and examination of the likely consequences of the Dodd-Frank Act’s consumer protection provisions, highlighting areas in which Dodd-Frank departs from existing law.

Prior to the subprime mortgage crisis, Johnston said, prudent consumers had adapted expectations and were reluctant to approach adjustable rate mortgages due to the risk of rates increasing. However, this changed when rates were artificially suppressed from 2001 to 2005 and the Federal Reserve actively encouraged consumers to take out adjustable rate mortgages and lauded the rise of the subprime segment.

Johnston contested the legitimacy of attributing consumer mortgage decisions to “irrational optimism,” contending that those “running national policy and the Federal Reserve especially” should be held accountable.

Jason S. Johnston
University of Virginia Law School Professor Jason S. Johnston

Johnston argued that Dodd-Frank fails to address the central issue of government officials and experts misrepresenting market conditions to rational consumers. “If they say low interest rates are now a permanent feature of the economy and you trust them, reading contract terms is irrational because what matters is haste,” he explained.

He added that fundamental reform is needed with regard to the role of the Federal Reserve. “Its discretion has to be limited and its powers restricted—not expanded,” he said.

Paul G. Mahoney, Dean of the University of Virginia Law School, spoke on the shift in regulatory philosophy from disclosure-based standards to restricting and shaping contracts between firms and consumers.

While the drafters of the first federal securities laws explicitly rejected the merit review approach in favor of more disclosure-based systems, enabling fully-informed investors to decide what is best for them, Mahoney explained, this strategy has eroded over time in favor of policing abusive deals.

The change in approach, he said, is reflective of a “current and powerful strand in academic thinking” which holds that individuals are subject to a range of cognitive biases that interferes with their ability to select the best financial product for them even if they are fully informed about the terms.

Mahoney criticized the idea that social welfare can be improved by suppressing consumer preferences and replacing them with those designated by technocrats, noting the “remarkable similarity between arguments that consumers are too dumb to make good decisions and those a century ago in favor of a centrally planned economy.”

While the proponents of the Consumer Financial Protection Bureau argue that the Bureau will not seek to manage financial markets but instead nudge consumers in right direction, Mahoney remains skeptical.

“Governments are not good at nudging, what they do is shove,” he said, adding that the current approach “ignores public choice theory.”

University of Virginia Law School Professor Edmund W. Kitch concluded the panel by examining the ways in which the Bureau could tackle consumer credit card debt.

According to Kitch, the simplest criterion by which to determine whether it is advisable for a consumer to borrow capital relates to whether or not the consumer has available projects which will yield a higher rate of return than the cost of capital.

“If we’re going to assume in terms of credit cards that the rate of return is 18 percent, it’s a very high rate,” Kitch said. “It’s hard to identify projects that return in excess of 18 percent a year, and if you use that standard I agree that Americans are drowning in debt.”

Given that the Bureau cannot impose an interest rate cap, the next viable alternative in Kitch’s view is extending credit only after the project for the use of the credit is evaluated and approved by an independent expert acting in the interest of the consumer to determine whether the proposed use of the credit has a reasonable return that exceeds the rate on the card.

Kitch explained that while the Bureau’s budget may be insufficient to provide this service, it could mandate that banks pay for it or outsource to firms specializing in evaluating credit extensions, which would then be evaluated and approved by the Bureau.

“This would raise the cost of providing credit cards but reduce the amount of outstanding debt,” he said, adding that “every means” of consumer credit must be covered to render this method effective. 

Founded in 1997, the Journal of Business Law publishes articles and comments on a broad range of business law topics including corporate governance, securities regulation, capital market regulation, employment law and the law of mergers and acquisitions.