March 8 (Bloomberg) — Republicans and Democrats in Congress have been squabbling about whether the new financial consumer-protection agency should be housed within the Federal Reserve or as part of an independent body.

The new watchdog, wherever it goes, is the linchpin of the emerging financial-reform bill, and its premise is that greedy bankers exploiting dumb consumers essentially caused the credit crisis. Stop bankers from selling toxic mortgages and other harmful loans and we won’t have any more meltdowns.

Even though bankers were greedy, and many borrowers were naive, this is a simplistic way of viewing the financial crisis and one that misses its underlying cause. Since mortgage bankers make money from loans, it’s tempting to think of them as parasites that prey on customers. But there is no such thing as a smart bank with a dumb customer; if the loan turns sour, the banker was dumb, too. And in the mid-2000s, scads of them were.

Foreclosures by consumers heavily weighed on the economy, but what triggered the credit crunch was the failure (or near- failure) of the banks that issued (or acquired) the mortgages. In short, the root cause of the meltdown wasn’t that customers borrowed too much; it’s that banks lent too much.

This isn’t to deny that many subprime loans were exploitative, and that customers often didn’t understand repayment terms. Nor is it a bad idea to police banks, preventing them, for instance, from charging unreasonable fees.

Bank Self-Harm

Yet a sound economy needs healthy financial institutions. Rather than stop lenders from hurting consumers, the first priority should be to keep the banks from harming themselves. In the short run, solvency is often at odds with what consumers want (or with what they think they want). We should remember that for every mortgage customer that was hosed, others were willingly grabbing all the unsound mortgages they could get.

Before the bust, champions of the new consumer agency, such as Representative Barney Frank, were consistent advocates of more loans to subprime borrowers. That’s hardly surprising; it’s in the nature of folks to want more credit. As Warren Buffett once reminded a person in his employ, it’s the job of the banker to screen out loans with a low probability of repayment.

The aim of regulators should be to force banks to do what is in their own and society’s interests: to practice sound banking. No consumer watchdog can do this because systemic risk aggregates at the level of the lender. The surest solution is to limit the leverage of financial institutions. Regulators have already moved against dicey products such as no-documentation mortgages (“liar loans”), and ones in which borrowers get 100 percent financing. And well they should.

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