Can Regulators Stop Bankers From Doing Stupid Things?

A few weeks ago I wrote about an excerpt from former Treasury Secretary Henry Paulson's book "On the Brink" that I found profoundly disturbing. It basically explained how banks sometimes knowingly acted irrationally, because they believed that competition gave them no choice. I was reminded of this excerpt when reading a new paper on the new Dodd bill by former investment banker and current Brookings Institution scholar Douglas Elliot. He too says competition makes banks do stupid things. He concludes that this is a reason why banks should support a consumer financial protection agency.

Elliot writes:

Ironically, banks themselves might be better off with a somewhat stronger consumer agency. Many of the worst practices leading up to the financial crisis came from non-banks that were significantly more weakly regulated than the banks were. An agency of adequate strength could create a more level playing field that should benefit the banks by shielding them from unfair competition coming from risky or shady operators.

So let me see if I understand. Non-banks were creating insane products that were bound to fail. As a result, banks felt pressured to do the same. Otherwise they would lose business. Yet, these bad products came back to haunt them.

But if a CFPA existed, then brilliant regulators would have reined in those misguided non-banks. Therefore, a CFPA would have prevented banks from feeling pressured to create these awful products, because it would have stopped the non-banks from making them too.

Right -- or the banks could have relied on a little business acumen.

If banks know that products are harmful, then why would they sell them? Why wouldn't they instead refrain from doing so, and then sit back and smile while they watch the rest of the industry burn?

Their profits will suffer in the short-term -- true. But surely they won't suddenly go bankrupt because they refuse to, say, originate option-adjustable rate mortgages for a few years while others do. In the meantime, the profits that the stupid firms are reaping are an illusion. In the long-run, those products will cause deep losses, even failure in some cases. At that time, the banks that relied on prudent risk management will look shrewd and their profits will ultimately be far greater than they would have if they bought into risky financial product fads.

I just find it so impossible to believe that we need a regulator to step in so that banks don't make decisions that they know to be stupid. If they're really that irrational, then they all deserve to fail. Eventually smarter people will start banks who understand that acting irrationally will lead to bad consequences.

Consequently, I don't think this argument works particularly well to support a CFPA. The potential losses a bank will ultimately face should be enough to compel banks from knowingly developing stupid products that will result in long-term losses. Banks that do so will fail. (And the system needs to be repaired to make sure they can.)

That's not to say there aren't arguments that are more compelling for a CFPA. But they contradict this one. In fact, banks find products like overdraft protection and credit cards with arbitrary interest rate changes very, very profitable. Any losses that eventually result will be easily overshadowed by the profits they reap -- otherwise they wouldn't be engaging in such tactics. If you think they're bad from a consumer perspective, then you can argue for a CFPA. But that's different from saying that a bank is better off not charging fees that it has found to be quite profitable.