5 Ironies of Financial Reform

It protects consumers from themselves—and might make us dumber about money.

By SHARE

It will change the way banks do business and eventually touch most Americans. Yet the sweeping financial reforms that have finally emerged from the Great Recession, known as the Dodd-Frank bill, may not change as much as the breathless headlines suggest. It won't have much immediate impact on consumers. Some of the reforms have already occurred on their own. And consumers could ultimately end up frustrated with changes they thought were supposed to benefit them. Here are five reasons that financial reform isn't quite what it seems:

Banks have already cut back on risky loans. The new law will curtail some of the worst lending practices, such as "liar loans" that require no documentation of income and incentives for lenders to steer borrowers into high-rate loans or other abusive products. That's good, since millions of dubious loans were one source of the massive bank losses that helped cause the 2008 financial meltdown. But banks have already stopped making loans like that, since they've realized—duh—that bad loans are bad for business. The problem now, in fact, is the opposite: Banks aren't making enough loans, which is particularly onerous on small businesses that need credit lines to keep their businesses running. So the reforms will prevent another crisis like the one we just had, even though the painful lessons already learned by banks, regulators, and consumers will effectively do the same thing.

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Loans will become harder to get. This happened without reform, since banks became risk-averse and decided to sit on their money instead of risking losses on loans that consumers might not be able to repay. This credit crunch will ease once the economy gets better, but higher lending standards required by the reforms will make it harder for a lot of consumers to get mortgages and car loans and run up debt on their credit cards. This should produce a more stable financial system, but consumers who can't get loans won't feel that way. Instead, they'll feel discriminated against. The ongoing crunch could actually intensify and depress economic growth, since credit scores in general are falling at the same time that lending standards are rising. More people will simply have to do without borrowed money.

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Reform puts new limits on consumers. Politicians won't say it, but one of the biggest threats consumers need to be protected from is … themselves. The premise behind the new Consumer Financial Protection Bureau is that consumers need stronger safeguards against usurious lenders eager to steer them into loans with exploding interest rates, balloon payments, and other booby traps. There's truth to that. But a lot of consumers are vulnerable because they're uninformed, gullible, and greedy. By raising lending standards, the new law actually protects the overall economy from consumers who don't know how much debt is too much. We should be thankful for that. Right?

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It won't make us smarter about money. The law establishes an Office of Financial Literacy with the job of educating Americans about their personal finances. As if nobody thought of this before. There are reams of Web sites, TV shows, books, and other resources for people who want to learn more about money. You practically have to try if you want to avoid them all. Maybe the government effort will have a special allure that CNBC, Investopedia, Dave Ramsey, and the spectacular U.S. News Money site haven't yet stumbled upon. But the national drug czar hasn't convinced people to stop smoking pot, the Centers for Disease Control can't stop the spread of obesity, and the Minerals Management Service can't stop drilling disasters. So it would be foolish to think a new government agency will help cure the epidemic of financial illiteracy. Some consumers might even feel they don't need to bother learning about money, since the government is there to do it for them.

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It could breed a false sense of security. Government reformers are famous for fighting the last war, while devious minds plot something never seen before. Congress has actually done a serviceable job of closing major loopholes that banks and bona-fide crooks exploited for years, eventually bringing the nation to its knees. But it is wise to keep in mind that the huge rewards for "financial innovation"—finding new ways to make billions, without going to jail—remain firmly in place. That means that geniuses seeking fast money will continue to flock to Wall Street—and outsmart the regulators. The new law gives the government more power and flexibility to deal with them, but government agencies are always slowed down by bureaucracy and political interference. Somewhere on Wall Street, supercomputers are already cranking out algorithms that will seed the next financial crisis. If newly empowered regulators are going to stop it, they better start looking now.