FIU Law Review Volume 5 Number 1 Article 8 Fall 2009 The Subprime Crisis and the Link between Consumer Financial Protection and Systemic Risk Erik F. Gerding University of New Mexico School of Law Follow this and additional works at: https://ecollections.law.fiu.edu/lawreview Part of the Other Law Commons Online ISSN: 2643-7759 Recommended Citation Erik F. Gerding, The Subprime Crisis and the Link between Consumer Financial Protection and Systemic Risk, 5 FIU L. Rev. 93 (2009). DOI: https://dx.doi.org/10.25148/lawrev.5.1.8 This Article is brought to you for free and open access by eCollections. It has been accepted for inclusion in FIU Law Review by an authorized editor of eCollections. For more information, please contact [email protected]. The Subprime Crisis and the Link between Consumer Financial Protection and Systemic Risk Erik F. Gerding This Article argues that the current global financial crisis, which was first called the “subprime crisis,” demonstrates the need to revisit the divi- sion between financial regulations designed to protect consumers from ex- cessively risky loans and safety-and-soundness regulations intended to pro- tect financial markets from the collapse of financial institutions. Consumer financial protection can, and must, serve a role not only in protecting indi- viduals from excessive risk, but also in protecting markets from systemic risk. Economic studies indicate it is not merely high rates of defaults on consumer loans, but also unpredictable and highly correlated defaults that create risks for both lenders and investors in asset-backed securities. Consumer financial regulations can mitigate these risks in three, non- exclusive ways: (1) by reducing the level of defaults on consumer loans, (2) by making defaults more predictable, and (3) by reducing the correlation of defaults. The Article argues that: “predatory lending” can constitute a collective action failure by lenders; consumer behavioral biases may frustrate predictions of consum- er defaults; but consumer financial rules that take into account these biases and address the “menu design” of consumer loan choices may not on- ly protect consumers, but make the risk of consumer defaults more predictable. The Article also draws tentative conclusions on the implications of the link between consumer protection and systemic risk for the institutional reform of financial regulation by: arguing against federal preemption of state consumer regulation; * Assistant Professor of Law, University of New Mexico School of Law. The author would like to thank Fred Hart, Max Minzner, and participants in the UNM Department of Economics Colloquium for their comments. Any errors are mine. 93 94 FIU Law Review [5:93 providing a rough analysis of regulatory reform proposals for creating either a single financial regulator or a “Twin Peaks” model of separate regulators for consumer protection and systemic risk regulation. I. INTRODUCTION There has been a historical division in financial regulation between regulations designed to protect consumers and regulations intended to pro- tect financial markets from the collapse of financial institutions. This Ar- ticle argues that the current global financial crisis, which was first called the “subprime crisis,” demonstrates the need to revisit this division. More par- ticularly, this Article argues that consumer financial protection can, and must, serve a role not only in protecting individuals from excessive risk, but also in protecting markets from systemic risk. This additional role for con- sumer financial protection provides novel support for promoting vigorous and diverse consumer regulations. This Article defines consumer financial protection laws and regula- tions as legal rules designed to prevent individual borrowers from taking on excessive risk.1 These rules address lending practices that are sometimes labeled as unfair, abusive, or predatory, and are often justified on efficiency grounds.2 For example, consumer financial protection laws may address information asymmetries that prevent consumers from understanding the risk of a particular loan3 or behavioral biases and cognitive limitations that 4 cause consumers to act against their long-term self interest. 1 See generally Oren Bar-Gill & Elizabeth Warren, Making Credit Safer, 157 U. PA. L. REV. 1, 8- 11 (2008) (proposing new financial regulator to protect consumers from risk posed by credit products). Consumer financial law covers a broad range of concerns, many of which lie beyond the scope of this Article. For example, this Article does not address financial laws or regulations intended to: ensure wide consumer access to credit (including regulations that combat racial discrimination by lenders in denying credit to consumers and regulations that address private credit reports on consumers); govern consumer banking and payment transactions; address debt collection or foreclosure practices; or regulate consumer bankruptcy. Nevertheless, lender practices in these areas might also contribute to the phenomenon that is the subject of this Article– excessive consumer defaults that threaten the solvency of financial institutions. More particularly, this Article focuses on consumer credit products and consumer lending practices that lead to a a high level of market-wide consumer defaults that are both unpredictable and highly corre- lated. See infra notes 14, 15, 19, 76-82, Part IV.A.2 and accompanying text. 2 See generally Kathleen C. Engel & Patricia A. McCoy, A Tale of Three Markets: The Law and Economics of Predatory Lending, 80 TEX. L. REV. 1255 (2002) (arguing that predatory lending represents a market failure). 3 E.g., Bar-Gill & Warren, supra note 1, at 4 (arguing that market for consumer credit fails when consumers are not optimally informed); Elizabeth Renuart & Diane E. Thompson, The Truth, the Whole 2009] Subprime Crisis - Consumer Fin. Protection & Systemic Risk 95 As Part II.B explains, a separate set of financial laws and regulations address systemic risk. Scholars have defined systemic risk as the risk of market-wide losses or the breakdown of financial markets.5 Because sys- temic risk threatens the entire market, diversification does not adequately protect investors.6 To address systemic risk, financial regulations focus on the “safety and soundness” of financial institutions.7 By ensuring the finan- cial health of institutions, systemic risk regulations attempt to protect finan- cial markets from the collapse of a significant institution.8 There is a tension between the objectives of protecting consumers and ensuring the financial health of individual financial institutions. As Profes- sor Adam Levitin notes, lending practices that extract additional value from consumers strengthen the balance sheets of lenders.9 This means that ef- forts to clamp down on lending practices to protect consumers could ad- versely impact the finances of financial institutions. However, there is little empirical evidence that consumer protection efforts have ever threatened the stability of a financial institution to a de- gree that increases systemic risk. In fact, this Article argues that consumer financial protection is not antithetical to, but, in fact, represents a critical tool in mitigating systemic risk. When widespread consumer credit prod- ucts or lending practices induce high levels of consumer default, the safety and soundness of financial institutions can be threatened.10 Systemic risk can thus arise when losses due to consumer defaults threaten either one Truth, and Nothing but the Truth: Fulfilling the Promise of Truth in Lending, 25 YALE J. ON REG. 181, 181-82 (2008) (noting that Truth in Lending Act was intended to address information asymmetries that prevented consumers from understanding loan terms). 4 E.g., Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, 65 MD. L. REV. 707, 754-89 (2006) (using theories from behavioral economics to ex- plain predatory lending). Many consumer financial protection laws are also grounded in paternalism. Cf. Joshua D. Wright, Behavioral Law and Economics, Paternalism, and Consumer Contracts: An Empirical Perspective, 2 N.Y.U. J.L. & LIBERTY 470 (2007) (challenging empirical foundations of behavioral critiques of con- sumer credit markets). 5 George G. Kaufman & Kenneth E. Scott, What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It, 7 INDEP. REV. 371, 371 (2003) (defining systemic risk as “the risk of a break- down in an entire system, as opposed to breakdowns in individual parts or components”). See also Steven L. Schwarcz, Systemic Risk, 97 GEO L.J. 193 (2008). 6 Schwarcz, supra note 5, at 200. 7 See Adam Feibelman, Commercial Lending and the Separation of Banking and Commerce, 75 U. CIN. L. REV. 943, 967 (2007) (equating concerns in banking law with the “safety and soundness” of banks with efforts to mitigate systemic risk). 8 Kaufman & Scott, supra note 5, at 372, 385 (discussing regulations designed to prevent domi- no chain failures of financial institutions). 9 Adam Levitin, Hydraulic Regulation: Regulating Credit Markets Upstream, 26 YALE J. REG. __ (forthcoming 2009). 10 Professor Levitin recognizes this potential confluence. Id. 96 FIU Law Review [5:93 important financial institution (and that failure, in turn, threatens other insti- tutions) or a number of institutions simultaneously.11 These two pathways to systemic risk point to a need for a refined un- derstanding of when consumer default can lead to market-wide