“Paradigm shift” is a post-modern cliché, but it works for us when we think through the Dodd-Frank Act. Pundits have of course raced to pronounce the law either wholly good or totally bad, based on their sometimes theological predilections about banking reform. We won’t join this rush to judgment – we’re too busy reading the damn bill – but we know one thing for sure: Dodd-Frank will redefine retail banking in ways that will come at a shock to higher-risk consumers and, after them, to the policy-makers who love them.  Who are these higher-risk consumers? Loosely defined, they are what Victorians would have called the “deserving poor.” To them, we’ll also add the deserving first-time homebuyer, workforce entrant or senior citizen dependent on a fixed income. These consumers are higher-risk than others because of discretionary-income restrictions and little resilience to even modest changes in their economic circumstance. They are also not just higher-risk – most of them are also higher-cost because they are high-transaction customers even when they don’t take out credit.  How have these customers been served to date? In part, through high-fee products that, at the worst, have steered customers from suitable products — where available – to higher-cost or even predatory ones. The new Bureau of Consumer Financial Protection will make short work of any dubious product and pronto, judging by our read of Dodd- rank. Good riddance, to be sure, but that’s not the end of the story on how higher-risk and higher-cost consumers have been getting the banking products they want and will still need.

The other vital factor in serving these consumers is cross-subsidization. That is, lowerrisk borrowers or transaction-account users pay the direct or indirect costs of more problematic ones. The best example of this is in the GSEs’ guarantee fees (g-fees). As a study of them released last week by the Federal Housing Finance Agency demonstrated, Fannie and Freddie charge higher g-fees to lower-risk borrowers to subsidize borrowers on mortgages with high loan-to-value (LTV) ratios – a key risk criterion. Some of this cross-subsidization may be mission-driven due to the GSEs’ need to promote affordable housing. But, the bulk of it was due to the GSEs’ desire for large marketshare across the mortgage spectrum. The lowest g-fees for the highest-risk borrowers were put in place by the GSEs as mortgage markets went wild so Fannie and Freddie could compete against private securitizations. Now, in the sorry aftermath, the GSEs have reversed their fees so dramatically that they are doing very little high-LTV business (except HARP refis). Thus, most of the high-LTV business is going to FHA.

Now, high-risk mortgage borrowers with a prayer for a sustainable mortgage can only get one from the FHA. Everyone else is out in the cold. As a result, some high-risk borrowers who should never have been home-buyers will stay the renters they always should have been. But, many others will either be forced to rely on a nationalized mortgage-finance system or abandon their hope of a home.

Private capital can compete with public funds for these borrowers, but not as long as the government dominates mortgage finance. Thus, we may not see for years if the end of cross-subsidization in mortgage finance rights a once-wrong market or tilts it permanently in favor of only the lowest-risk borrowers served by whatever private capital is left to meet their needs.  In mortgages, public capital may pick up the pieces, albeit at long-term risk to already cranky taxpayers. In other consumer-finance segments, though, there’s no such backstop.  Thus, as cross-subsidization goes, so will lots of products – think free checking – long beloved by consumers who didn’t understand that the overdraft fees they and their friends paid subsidized free transaction accounts with negligible opening-balance requirements.  Same for no-fee credit cards, where fees paid by high-flyers or those who didn’t read their account statements with a green eye-shade subsidized costs for those who paid their balance each month on time and in full.

Will these checking-account customers keep funds under the mattress? Can they move funds from high-cost branched-banking networks to the myriad of new, on-line funding networks sprouting around the web? And, when they do so – as we think they will – will the new Bureau’s authority over non-traditional deposit-gathering be put in place quickly and firmly enough to protect consumers from these non-banks?

We’ve written a lot in the past about “shadow” banks from a systemic risk point of view.  But, there’s also a tremendous risk that the new consumer framework will, by ending cross-subsidization, force higher-risk, higher-cost consumers back to the shadows of the banking system. Banks – even those who pushed way too far in recent years – might start to look a lot better a lot quicker than consumer advocates might think unless the new Bureau gets it right on the shadow retail banks – and fast.

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