The Subprime Crisis and the Link between Consumer Financial Protection and Systemic Risk

This Article will appear in a May 2009 symposium issue of the Florida International University Law Review on the global financial crisis. This Article argues that the current global financial crisis, which was first called the “subprime crisis,” demonstrates the need to revisit the division between financial regulations designed to protect consumers from excessively risky loans and safety-and-soundness regulations intended to protect financial markets from the collapse of financial institutions. 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. 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 consumer defaults; but consumer financial rules that take into account these biases and address the “menu design” of consumer loan choices may not only 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; and 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