A cautionary note for the CFPA

While I think that the CFPA should aggressively protect individual borrowers from unsuitable contracts (by for example defining ‘plain vanilla’ contracts etc.), I also think that  investor protection needs to be addressed with great care and balance — even when we’re talking about retail investors.  My concerns about investor protection derive from the fact that I think that one of the systemic problems that we faced in 2008 was a consequence of the over-regulation of money funds.

It’s very important to recognize that regulation that protects the public from investment losses may well have the consequence of making financial innovation more dangerous by creating the illusion that investment can be “safe”.  Thus, in my view the investor protection aspects of the CFPA should focus on the quality and ease of comprehension of disclosures as well as clarity and truth in advertising.  It should not dictate the content of investment products — especially with reference to ratings issued by rating agencies.

For example, in my view money market funds should be allowed to invest in any short-term assets — as long as the composition of the portfolio is fully disclosed.  Investors should be allowed to choose between low yield government money funds, mediocre yield AA money funds and high yield, high risk money funds.  Money fund failures are the discipline that will force investors to be careful.  Investors must face losses — even, rarely, on “safe” assets, because these losses train investors to be careful with their money.

While regulators should take aggressive measures to prevent fraud and deliberate misselling of investment products, care needs to be taken to avoid protecting investors from the risks of investing.  I think it is important to emphasize that it can not be considered the regulators’ job to make sure any investment product is “safe”.  When it comes to investor protection the regulators job is only to establish a strong framework for prosecuting those who engage in misleading marketing of investment products or who match investors with unsuitable products.

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