The president-elect’s transition team has already vowed to dismantle the Dodd-Frank Act, the main financial regulation enacted in the wake of the 2008 crisis. A major part of that would be reducing the authority of the Consumer Financial Protection Bureau, created mainly to shield the public from exploitative lending practices. The Department of Labor’s fiduciary rule, which would require financial advisers to put customer interests ahead of their own, is also under threat. This has all been very good news for financial companies, especially the big banks that were the main target of the reforms. Already, financial stocks have soared, powering U.S. stock indexes to record highs:
There's this old idea that what’s good for American companies is good for Americans. But that’s not necessarily true, and it's certainly not true in the case of financial companies.
One well-known reason is moral hazard. Big banks, with their implicit guarantees of future bailouts, have an incentive to take more risk than is good for society. So far, thankfully, Trump’s team isn’t suggesting reducing capital requirements, which are the main regulatory barrier to excessive risk-taking.
Another reason is that sometimes banks and other finance companies use business models that hurt their customers. Anyone who has studied behavioral finance knows that there are many ways in which the average borrower and the average investor predictably make bad decisions. Taking advantage of these lapses in rationality is the dark side of behavioral finance, and in general it’s perfectly legal.
The 2000s housing bubble provides a fairly clear example. Many mortgage lenders made loans to customers who couldn’t pay them back. The borrowers, not realizing that they couldn’t pay back the loans, suffered negative consequences such as foreclosure, repossession and bankruptcy. The mortgage lenders sold the loans to banks, thus washing their hands of any of the risks they had created.
Rational, well-informed borrowers, of the kind that exist in many economists’ models, would probably not have taken out loans they couldn’t pay back. But in real life, people jumped at the chance to borrow in the expectation that they could quickly sell their home as prices rose. One of the most notorious products in vogue during the housing bubble was the interest-only loan, in which payments start off modestly and then balloon later on. These were one kind of exploding mortgage (other kinds existed as well). Millions of Americans took out such loans before the 2008 crash, often to their distinct regret.
A recent study by economists Marco Di Maggio, Amir Kermani, and Sanket Korgaonkar shows how loose regulation fed this sort of practice. In 2004, the Office of the Comptroller of the Currency carried out a sweeping deregulation of lending laws at the federal level. Before the change, lending was regulated differently in various states. So Di Maggio et al. compare states with strict laws against predatory lending to those with lax controls. The former saw a big change in what was allowed, while the latter didn’t.
Their first finding is that, rather predictably, interest-only loans and adjustable-rate mortgages increased substantially in the states that were now forced to allow them. But they also found that lenders who weren’t prohibited from offering exploding mortgages before now started doing so. Many laws against predatory lending affected only big, national banks. But when those banks were allowed to offer interest-only and adjustable-rate loans, the smaller, local banks started getting in on the game.
In other words, deregulation prompted a race to the bottom. Most banks didn’t engage in this sort of lending because they were unethical -- they did it because they felt like they had to, for the sake of competition. Regulation kept banks honest by assuring them that their competitors would also be forced to stay honest. Once that barrier was gone, it was a free-for-all, and poorly-informed or short-sighted borrowers -- not to mention the nation’s economy -- paid the price.
So financial deregulation can have dangerous consequences for the average person. It may displease some economists to hear this, but a great many people really do benefit from legal protection from business models that exploit their own irrationality and lack of information. Those are exactly the kind of protections that I’m afraid the Trump administration is looking to put on the chopping block.
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