By William K. Black

July 11, 2017 Bloomington, MN

Politico has just published a column with a title and analytics that drive white-collar criminologists nuts: “In a major setback for businesses, CFPB opens door to consumer class actions.” Logically, the title should have read: “In an important step forward for consumers, investors, and honest bankers and lenders, CFPB begins to restore the rule of law to banking.”

The CFPB is the acronym for the Consumer Financial Protection Bureau. The problem that led to CFPB to issue its new rule has six parts. First, it is often profitable for lenders to abuse and defraud borrowers. Second, lenders are able to do this because financial understanding is highly asymmetric. Third, even if the borrower eventually spots the fraud or abuse it is rare that the typical borrower could profitably prove the fraud and recover enough funds in a lawsuit to (net of legal expenses) recover effectively and could never recover enough to deter future misconduct. Fourth, the only potential legal remedy for the typical victim to recover and deter is the class action suit.

Fifth, lenders routinely eliminate this potential remedy by requiring in their form contracts that the borrower give up any right to bring a class action suit against the lender. Indeed, they typically forbid the victims of their frauds and abuses to bring any civil suit. They permit only arbitrations in a rigged system that ensures that the typical borrower will rarely find it cost-effective to arbitrate and deterrence is impossible. The Supreme Court, to its shame, has allowed this abusive use of form contracts.

Sixth, the environment I have just described is highly criminogenic. It creates powerful perverse incentives not simply for individual bankers to defraud and abuse their customers, but for such frauds and abuses to become dominant. Elite bankers will gain a competitive advantage by causing the firms they control to abuse and defraud the borrowers. Economists and criminologists refer to this as a “Gresham’s” dynamic. George Akerlof gave it this name in his famous 1970 article on a market for “lemons” that led to the award of the Nobel Prize in Economics in 2001. Akerlof explained that the dynamic is so perverse that it not simply the individual customer who is a victim of the fraud, but also the honest CEO who cannot compete with the cheater. Akerlof further explained that this meant that all of us would suffer as customers in such an industry as it became corrupted.

[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.

Economists and criminologists have a common sense definition of a Gresham’s dynamic – bad ethics drives good ethics out of the markets unless the rule of law prevents it.

Kartik Athreya, an exceptionally conservative economist who is the Richmond Fed’s research director, admitted that Akerlof had demonstrated that asymmetric information could create “spectacular pathologies” and that they were most severe in the lending context. (Economists like Athreya focus almost exclusively on the hypothetical case in which the borrower has superior information compared to the lender, but that is the product of his ideological blinders). As the recent financial crisis demonstrated, it is the CEOs that control our largest and most elite lenders that create and exploit those loans that seem to the unobservant to create an informational advantage for the borrower, i.e., “liar’s” loans. It was overwhelmingly lenders and their agents that put the lies in “liar’s” loans and appraisals as I have demonstrated in many articles.

The Supreme Court and the lending industry have destroyed the rule of law in lending for the typical borrower. The result, as economics and criminology predicts, has been an orgy of fraud and abuse of borrowers. This adds to the profit of firms led by dishonest and abusive CEOs and tends to drive honest competitors out of the business. The way to block the dynamic is to take the profit out of fraud and abuse by lenders by restoring the rule of law. The four strategies that are essential to defeat a Gresham’s dynamic are (1) prosecutions of the elite fraudsters, (2) regulations banning the industry’s odious form contracts requiring borrowers to give up their legal rights to bring class action suits, (3) adopting laws and rules that encourage and protect whistleblowers to come forward and disclose the lenders’ frauds and abuses, and (4) a campaign by honest CEOs to denounce publicly their fraudulent competitors and embrace and require the highest standards of integrity in hiring senior officers and in rejecting compensation systems that create perverse incentives to cheat and abuse the customer. Steps three and four should be combined. The way for lenders to signal their adherence to the highest moral standards is to hire as leaders whistleblowers who have been through the crucible and demonstrated their exceptional integrity.

The CFPB cannot prosecute. The Trump administration has made clear that it intends to withdraw resources from the already inadequate FBI agents and prosecutors dealing with elite white=collar criminals. This makes the CFPB rule restoring the civil rule of law to borrowers all the more essential. The dishonest lenders are baying for the Republican-controlled Congress to block the CFPB’s restoration of your civil law rights. This gives each of us two invaluable opportunities. First, we can push our representatives to refuse to destroy our civil law rights. Second, we have a priceless opportunity to observe how many honest bank and credit card CEOs come forward to defend the CFPB rule to begin restoring the rule of law to lenders and breaking the Gresham’s dynamic that favors the most dishonest CEOs. I am skeptical that we will observe many honest CEOs come forward, but I would be delighted to praise in print any who do so. I make this invitation to all CEOs of lenders; please contact me with your public statement of support for the CFPB rule. I will write to praise your membership in our legion of honor. It will take courage to take on your industry trade associations, which are uniformly opposed to restoring the rule of law to finance.