Financial Reform & Risk Management (2)
An AP summary of the negotiated consolidated Financial Reform act of 2010, there are 9 major provisions. These posts will feature commentary on the Risk Management implications of each.
2. CONSUMER PROTECTION A Consumer Financial Protection Bureau within the Federal Reserve would police lending, taking powers now exercised by various bank regulators.
The current financial crisis is not unique in the financial history in that the major banks took it on the chin.
But while there are many troubling stories of consumers who are suffering hardships as a result of transactions that they entered into during the run up to the crisis, Roger Lowenstein admitted in a recent Sunday New York Times magazine article that try as they might, journalists have not been able to find a story of a truly innocent consumer who was taken advantage of. In fact, if you look at most situations where folks seem to have been hurt, they either went into the situation with their own greedy motives to get something for nothing (house flippers) or were able to live in much better housing often at a lower price than before the crisis. As the crisis hit and housing prices fell and refinancing opportunities evaporated, many consumers lost the houses that they could not afford in the first place. But in fact if you look at the details of what happened, they usually got more than their money’s worth in terms of housing during the time they had a house. What they lost were their unrealistic expectations.
To be brutally honest, the consumers did ok not well, but ok, and the bankers got hosed.
So as a result, Congress has decided to protect the consumers from any such future abuse.
And to again be brutally honest, the motives of this “consumer” protection seems to be to protect banks from themselves.
But motives and consequences will doubtless be different. The consequences of this part of the financial reform act will likely be the erosion of the margins of banks and other financial organizations that deal with consumers.
The margins that banks and others were getting from the sub prime mortgage business were so great that they generated their own myth of the actual viability of that business. That self justifying myth can be thought of as the actual driver of the crisis. To anyone who was not caught up in the wave of activity of the housing market, the myth may have seemed as somewhat unrealistic and benign. But belief in the myth of unending appreciation of real estate enabled people at all levels to justify the behavior that now can be seen to be clearly outrageous.
But getting back to consumer protection, the new Consumer Protection Bureau will clamp down on abuses large and small that have helped to drive the bloated profitability of banks over the past 10 years.
The Risk Management consequences of this are that banks will not stand still and watch their earnings get savaged. If they did that, then their stock values would either stay low or erode further. So their reaction will be to seek other sources of revenue to replace the loss of the various fees and charges to consumers that are now found to be abusive.
And why is that a Risk Management concern? It is because the new activity that will be undertaken to replace the lost revenues adds uncertainty to the system. Some of that activity will fall inbetween the cracks of the regulatory system. It will create risks that are not recognized in Basel III. Some banks will act as if they believe Basel III and run these new activities as if there is no need for capital and end up adding significantly to their actual leverage.
So beware the unintended consequences of this new regulation. The danger will only pass when banks have accepted the fact that they are fundamentally only 5% to 10% ROE businesses. As long as they believe that they are 20% to 25% ROE businesses, they will end up finding the risks that will allow them to post those ROEs.
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