How Specter of Regulatory Capture Shaped CFPB's First Year

First of two parts

WASHINGTON — While all camps praise the Consumer Financial Protection Bureau's efforts to get off the ground in its inaugural year, there is one sore point: exams.

Bankers complain that some of the CFPB's examiners are too green and the agency's practice of sending enforcement lawyers on exams has made the process too confrontational.

Agency officials dispute both claims, but all sides agree the concerns stem from a conscious effort by top CFPB leaders to avoid the criticism that has long dogged traditional bank regulators — that they sometimes go soft on the banks they oversee because they become too close to them.

"People talk to me from time to time and ask an important question: how do you build a culture and a DNA that is enduring over time?" CFPB Director Richard Cordray said in a wide-ranging interview to discuss the agency's first year. "How do you prevent yourself from becoming one of the captured regulatory agencies?"

After the financial crisis, many critics accused the banking agencies — fairly or not — of regulatory capture. As the newest banking regulator — one tasked with a fundamentally different mission than the others — the CFPB has taken pains to avoid that label since it opened its doors on July 21, 2011.

For starters, although it has hundreds of jobs to fill, the CFPB has sought to limit its hiring of existing federal bank regulators.

As of June 2, 28% of the CFPB's 920-person staff had come from the Federal Reserve Board, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency, Department of Housing and Urban Development or the former Office of Thrift Supervision.

In interviews with both Cordray and Steve Antonakes, the CFPB's enforcement chief, it is clear they have sought to keep that percentage relatively low. Part of it, Cordray said, is because the agency has a different job than the banking agencies, which are focused on safety and soundness issues.

"We have a somewhat different approach here," Cordray said. "We are now examining institutions for how they treat consumers. It's not about the institution itself. It's about the impact on consumers."

But one of the motivations is more philosophical: the desire to create a new culture for the CFPB.

"We hired a significant number of examiners from federal agencies, but by the same token, we didn't want to fill our entire allotment with those," said Antonakes. "We weren't trying to replicate another agency's culture — we wanted to create our own."

The situation has given rise to one of the few complaints leveled at the CFPB in its first year: that some on its exam teams are inexperienced.

"It's very mixed," said Jo Ann Barefoot, co-chair of Treliant Risk Advisors. "I know some banks that have had very good experiences and some that have been concerned and frustrated."

Barefoot, in addition to others who did not want to speak on the record, point to the agency's hiring practices as the cause.

"They made a decision — a conscious choice — to avoid importing large chunks of the other agencies, because they didn't want to import their cultures," Barefoot said. "Therefore, they've had more start-up challenges than they would if they brought in existing examiners."

Alan Kaplinsky, a partner at Ballard Spahr, said it's clear the agency has brought in some very experienced personnel — both from state regulators and the federal supervisors — but some on its staff have a lot to learn.

"A lot of people are described as very inexperienced," Kaplinsky said. "They are trained on the job while they are doing an exam — it is frustrating."

CFPB officials say they have hired a range of examiners, from the highly experienced to others who are relative novices. But Antonakes emphasized that experienced personnel lead the exams.

"There will be instances with us — as with all other agencies — in which there are variances in experience on the exam team," he said. "The examiner-in-charge is likely to be deeply experienced. There will be other folks with more experience, but there may be folks that are junior."

Overall, however, Antonakes said he is "really pleased with the blend of examiner experience."

"We have a number of people with deep experience and some 20 to 30 years of regulatory experience, both on consumer protection and safety and soundness," he said.

Antonakes estimates that roughly 50% of his supervision staff comes from the former banking regulators, while the other half is drawn from the states and private sector. Many state examiners also have experience regulating nonbanks such as mortgage lenders — a sector the CFPB now oversees but that federal banking regulators did not.

Still, many in the industry say experience at the CFPB isn't the only issue. They argue that the agency has changed the tone of exams by bringing in enforcement lawyers early into the exam process — spurring fears that the CFPB intends to resolve matters primarily with enforcement actions.

This, in turn, has caused many bankers to bring their lawyers into the process earlier, industry representatives said.

"Sending out enforcement lawyers along with examiners is unnerving to banks, since they aren't used to it," said Tom Vartanian, a partner at the law firm of Dechert. "Banks will have to decide whether to bring their own lawyer into the room."

The presence of enforcement lawyers in the exam is a significant shift from the banking regulators, which do not typically bring attorneys into the process until an enforcement order is in the offing.

The situation sparked an angry demand to stop from the U.S. Chamber of Commerce last week, which accused the agency of making exams too confrontational.

"This fundamentally alters the supervisory relationship, transforming it into an adversarial proceeding," wrote David Hirschmann, the president and chief executive of the Chamber's Center for Capital Markets Competitiveness. "If the goal of the supervision process is an open exchange of information between the bureau and the companies it supervises, this practice is counterproductive."

That is not the CFPB's intent, Cordray says. The agency is trying to manage its exams differently than other regulators, he says.

"I feel like that has been much misunderstood," Cordray said. "From the beginning, this bureau integrated enforcement and supervision. We want supervision examiners to understand the role of enforcement. But we also — and this is important and the banks miss this — we want the enforcement attorneys to understand the role of examination and supervision."

Both he and Antonakes emphasized that the lawyers are only present at the beginning of the exam, mostly just to meet with bank personnel. They are not intended as a threat, Cordray says.

"We are not trying to send a message," Cordray said. "We are just trying to train our work force and also we want people to be in communication with one another and this facilitates that."

Enforcement lawyers "join the exam team during the entrance meeting in an effort to meet the leadership of the institution," Antonakes said.

"They are not engaged on site in the normal course of the exam," he said. "The examiners are communicating with enforcement lawyers during the course of the exam, but their presence is not meant to signal an enforcement approach versus supervision approach …The enforcement lawyers are not rolling up their sleeves with the exam team day in and day out — that's not the model at all."

But many industry observers said the practice has made banks more distrustful of the CFPB's motivations.

"None of the other federal banking agencies have ever done it," Kaplinsky said. "I don't think it's a good thing. It puts a chilling effect on the exam process."

Barefoot agrees.

"There are definitely banks lawyering up in the exam process," she said. "If banks start hiding their problem, the system isn't going to function."

The tension speaks to a larger concern the banking industry has over what type of agency the CFPB will be. So far, it has been squarely focused on meeting statutory deadlines, including issuing proposals on mortgage disclosures and student loans, as well as studying issues like arbitration and overdraft fees.

In other words, it's been primarily working on the regulation side of its mandate. But — particularly since Cordray is a former Ohio attorney general — the industry fears the CFPB will become an agency that regulates by enforcement orders.

"As the agency finds its footing, there will be a struggle with whether it should be an enforcement agency or a regulatory agency," said Vartanian. "There are two ways to effectively create the law as a regulator — one is to write regulations and enforce them. The other is to just bring the enforcement actions you want to bring — and that will make the law."

So far, industry observers praise Cordray for avoiding the latter approach.

"He did not meet the assumption that he would approach the role as an enforcement attorney and former state AG," said Barefoot. "Clearly he's taken a broad approach; they haven't brought any enforcement actions."

But those actions are coming — and likely soon.

"There will be enforcement at this agency," said Cordray. "Timing is not easy to calibrate. Things ripen on their own. But once we start, it will be a steady stream of things."

Still, Cordray said it's just one tool the agency will use. He said the agency is not out to get banks on small issues, but instead focused on products and practices that truly harm consumers.

"One of the things I've tried to stress both to our folks and externally: we are not going to go out and try and nickel and dime people on things that are in the gray area," he said. "We have many, many institutions that we need to clean up their practices. So we are not going to be out there playing gotcha with people on technical issues."

The industry is anxiously awaiting to see which the CFPB will hit first: banks or nonbanks. There are likely more bank actions in the pipeline already, given that the agency inherited some from the other federal agencies.

Some predict the agency will act before the election, in part because President Obama has made the creation of the CFPB a critical part of his accomplishments during his first term.

"We still expect enforcement actions against banks and nonbanks before the election," said Richard Hunt, the president of the Consumer Bankers Association. "I hope I'm proven wrong."

But Cordray is quick to dismiss political motivations.

"Election cycles are going to come and go. They are always going to come and go every 2 years, not just every 4 years," he said. "That can't really affect our work."

To him, the driving force is ensuring that the CFPB stays true to its mission — protecting consumers.

"One of the things that we've been working very hard to do — and I do think we are doing well on it, but it's not a job that is never done — is trying to attack that problem [of regulatory capture] by building into this agency a direct relationship with consumers across the country," he said. "What they tell us, what they bring to us, really informs the work that we do."

This is the first part in a series on the CFPB's first year. Part two, featuring a Q&A with CFPB Director Richard Cordray, will be published tomorrow.