Regulatory Reform and the Timeless Value of Federalism

In the wake of the recent economic crisis, renewed calls for financial regulatory reform offer new opportunities for the federal government to assert its authority to define the engine of commerce: our financial system. The need for some form of financial regulatory restructuring is obvious, with far-reaching implications for the financial services industry. What is less obvious, however, is the impact this regulatory reform could or should have upon our American system of federalism. And what is little understood is the defining role that the state/federal relationship has played, and will play, in the structure of the banking industry and the accountability of financial institutions to our citizens.

In short, proximity matters. The proximity of state legislatures and governors to consumers, small businesses, and local community needs is why the U.S. has a community banking system of more than 8,000 banks and why most consumer protections are developed at the state level. Recognizing the importance of this principle, the Treasury Department, House Financial Services Committee Chairman Barney Frank, and Senate Banking Committee Chairman Chris Dodd have proposed, to varying degrees, to preserve and enhance the states’ role in financial regulation, consumer protection, and enforcement. If our current crisis teaches us anything, it is not that our banking and financial system is too important to be subject to the checks and balances of our state/federal system, but that it is too important to the lives of our citizens to be exempted from those checks and balances. A strong, dual banking system must allow states to both charter and regulate institutions and be able to craft applicable law to facilitate credit needs and protect consumers.

Federalism – The Founding Principles

Federalism has always been the organizing principle of the United States’ government. Children of the enlightenment, our nation’s founders sought a system of self-rule that distributed power across the broadest possible base, with checks and balances that would prevent any individual person or governmental entity from exercising too much power. After much debate, the system they settled on was federalism, which divided power between a central authority (in our case, the federal government) and constituent political units (the states).

Every aspect of this system is designed to insure accountability and prevent autocracy. The Constitution and our entire system of laws encourage citizens to hold leaders accountable, dismissing them and even dismantling the government if it does not serve the public’s best interests. It is a tense and careful balance that has proven both resilient and responsive since the ratification of the Constitution in 1787, and has made the United States one of the most successful, longest-lasting systems of government in the world. The structure of granting enumerated powers to the federal government while maintaining the states’ sovereignty through reserved powers allows our government to act as a unified body while protecting the rights of individuals. State sovereignty prevents the tyrannical abuse of power by serving as a natural check on federal authority.

Beyond this, the federalist system provides for fair representation of an incredibly diverse population distributed across a large and varied geographic area. A unitary state that consolidated power in a single central authority could not serve such a diverse, scattered population fairly; influence would inevitably favor certain populations, either by age or by wealth or by density, and our nation’s founding ideals — liberty and justice for all — would suffer. The United States Constitution declares that all of this country’s citizens, regardless of race, class, gender or creed, have the right to “life, liberty, and the pursuit of happiness”: what we call the American dream. Our society is based on the idea that everyone starts with the same opportunities to achieve success through ambition and hard work. The federalist system of government ensures that everyone has a voice, whether they live in a rich state or a poor one, an urban area or a rural one.

The American system of financial supervision has evolved in a way that reflects this federal system of representation and laws. Our so-called dual banking system, unique in the world, dates back to 1863, when Congress passed the National Bank Act. Before this date, states alone issued bank charters; in enacting the National Bank Act, Congress did not rescind the states’ authority to issue these charters, but allowed banks to choose between state and federal chartering and supervision. Subsequent rounds of financial system restructuring have granted new powers to the federal government and created new federal regulatory structures, but Congress has always been careful to respect the states’ authority to issue bank charters or supervise state-chartered financial institutions. During each round of major reform over the past 150 years Congress has recognized that the more localized accountability provided by a strong state role in financial regulation was not historic or a legacy but serves a timeless need.

The current system of financial regulation is undeniably complex. The creation of the Federal Reserve System (Fed) in 1913 and the introduction of federal deposit insurance in 1933 added new layers of federal supervision to the state-chartered banking system; today, state-chartered insured depository institutions are regulated by both the appropriate state department and either the Federal Deposit Insurance Corporation (FDIC) or the Fed. The Office of the Comptroller of the Currency (OCC), created in 1863, charters and supervises national banks, and federal savings associations are supervised by the Office of Thrift Supervision (OTS). Federal credit unions are regulated by the National Credit Union Administration (NCUA). Other federal regulatory agencies, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission, supervise the securities industry and the trading of futures. Other state authorities oversee additional financial services providers, such as insurance companies, state credit unions and savings associations, and mortgage originators.

While some simplification could undoubtedly occur, the participation of both state and federal agencies in financial services regulation has been a source of strength rather than weakness for the system because it draws on two levels of resources and expertise. State and federal financial regulators have different goals and different strengths. Because states are closer to the institutions they supervise and have more intimate local knowledge of the areas these institutions serve, state regulators can often identify potentially troublesome trends or practices before these issues bubble up to the federal level. These issues may be isolated to a specific state or region; in these cases, the federalist system of financial services supervision allows state authorities to implement laws, rules or regulations to handle the issue quickly. In other cases, the emergence of an issue in one state may be the first wave of a systemic problem that will affect the entire country. When problems become systemic, the federal government is best poised to act in a manner that protects the economy on a national level. This is not a lofty principle but a day-to-day reality of state government. A current example is the in the area of reverse mortgages. State regulators and legislators responding to constituent concerns identified practices and emerging products that posed consumer protection issues. States responded independently and then in a coordinated fashion through the Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR) to develop best regulatory practices and guidelines. It was only through the state participation in the Federal Financial Institutions Examination Council that federal banking regulators became aware of reverse mortgage issues and worked with the states to develop regulatory guidelines that will be applicable to all lending institutions.

The ability of states to act individually, testing innovative solutions before they affect the whole country, is one of the most powerful features of our federalist system. States are traditionally known as laboratories for innovation because of state legislatures’ ability to tailor solutions to regionally specific problems. In recent years, for example, the states have moved to fundamentally rethink mortgage supervision, first locally and then on a coordinated basis on a national level. What initially started as a grass-roots effort to protect consumers in the absence of federal legislation or regulation evolved into a national state/federal regulatory framework conceived by the states and then adopted by Congress. The creation of this regulatory system is a case study in the value of our federalist system for consumers of financial services.

In the early part of the decade, state regulators recognized a growing problem in the residential mortgage market. New players, new products and securitization were rapidly increasing the risks of the market. In an effort to enhance supervision of this market, state regulators, through CSBS and AARMR, developed and launched the Nationwide Mortgage Licensing System (NMLS) to establish a state-based nationwide regulatory infrastructure that would license and track mortgage companies and brokers and allow for coordinated supervision and a central repository for enforcement action. As the U.S. economy began to falter, Congress recognized the need for major mortgage market reforms and passed the Housing and Economic Recovery Act in June 2008 to try to stabilize the market. That law included the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (“SAFE Act”), which required all residential mortgage loan originators to be licensed or registered through NMLS and established a framework clarifying state and federal roles and a mechanism for state and federal coordination and information sharing.

Noteworthy is that the SAFE Act was not preemptive. It provided a “floor” not “ceiling” for state law. But despite industry predictions to the contrary, as all 50 states enacted laws in the past year to implement the SAFE Act, states converged on the high standards of the SAFE Act and around a state-developed model for mortgage regulation to create a vastly more uniform state system of mortgage regulation. The industry “patchwork quilt” arguments in this case were entirely wrong. And the differences between and among the states are often overblown. We in the states have embraced cooperative efforts, interstate agreements and model standards while recognizing the need to be able to respond quickly and decisively when we see issues in our own jurisdictions that must be addressed.

The lesson here is of the timeless value of federalism in banking. The states, with their specialized knowledge of local markets and hands-on relationships with their supervised entities and consumers, identified a problem and moved forward to find a solution. The federal government, seeing the crisis emerge on a national scope, implemented the states’ efforts on a nationwide basis to level the playing field for all industry participants. This is exactly the way federalism is supposed to work. Supporting the OCC’s vision of banking will end this state innovation.

The Obama administration’s recent proposal for financial regulatory reform would declare federal consumer protection laws a “floor,” allowing for the states to enact more stringent laws if necessary. Further, a state’s consumer protection laws would apply to any bank operating within its borders, regardless of the bank’s charter. Comptroller of the Currency John Dugan and the industry’s largest banks strongly oppose this provision, asserting that rolling back preemption would undo 150 years of banking law and create a patchwork quilt of widely varying state laws. Further, they fear the ruling this summer by the U.S. Supreme Court in Cuomo v. Clearing House, LLC will somehow unleash the attorneys general and create “50 Eliot Spitzers” who will attack national banks unfairly and indiscriminately. In light of the record rates of foreclosures and credit defaults across the country, it is hard to see the merits of an argument that values the convenience of giant financial institutions above the needs of homeowners and consumers.

Consolidation: Simplest Isn’t Best

The convenience of giant financial institutions would be best served by the creation of a monolithic supervisory agency. A single regulator would undoubtedly ease the burden of regulatory compliance for the nation’s largest banks and would facilitate their growth in both size and complexity. But at what cost? The United States has more than 8,000 federally insured banks and thrifts, a diverse community that allows for a great deal of competition, consumer choice and financial innovation. A regulatory system that seeks to accommodate the business model of our country’s largest banks while also attempting to regulate their risks could well lead to a financial services industry dominated by five or six super-banks, which may rule the international marketplace but have no need to be responsive to small businesses or consumers at the local level. The structure of the federal regulatory system will determine how the industry looks and whom it serves.

Over the past year, the federal government has been forced to take extraordinary measures to rescue our financial system. These initiatives have already led to consolidation within the industry as the government has effectively chosen winners and losers. The largest banks — or the “winners” — were saved because their failure would represent a systemic risk to the financial system or the economy as a whole. Meanwhile, community and regional banks — the “losers” in this scenario — have been allowed to fail even though they are largely suffering from poor economic conditions wrought, to some degree, by the “too big to fail” banks.

Consolidating supervisory authority would lead to even more dramatic consolidation within the financial industry. A single monolithic regulator would, naturally, focus most of its resources and expertise on the largest institutions it supervised. This would make sense because the nation’s biggest banks are the most complex, pose the most risk to the financial system and are the most politically influential. Rules and regulations adopted by the monolithic agency might be suitable for the biggest firms, but could place community and regional banks at a disadvantage. Eventually, the smaller banks would be pushed to the margins or simply gobbled up.

If past is indeed prologue, we need only look to the United Kingdom to see how a monolithic regulator leads to a consolidated industry. Before the economic collapse, advocates such as U.S. Senator Charles Schumer (D-NY) and New York City Major Michael Bloomberg were calling for a regulatory system modeled after the United Kingdom’s Financial Services Authority (FSA) to encourage the international competitiveness of our banks. [2] I believe the FSA model would never be appropriate within the United States. Our country is more than 40 times bigger than the United Kingdom and our population is approximately five times larger.[3] Supporters of the FSA model did not sufficiently consider the multiple differences between the United Kingdom and the United States, and why an FSA-type system may be inappropriate for our country.

What is truly baffling is that even in the wake of the current crisis, which exposed the weaknesses of the FSA just as it highlighted flaws in the American system, some advocates still support a monolithic regulator. Its size and power did not protect the FSA; the FSA has proven just as susceptible to market fluctuations and is not a superior model for financial supervision. Indeed, British authorities are now calling for breaking up financial firms in an effort to regain some of the industry diversity and competitiveness lost under the FSA regime. [4]

Despite its challenges, the American financial services industry is still the world’s most dynamic and democratic. It must be preserved. As of June 30, 8,204 insured depository institutions operated within the United States. The majority of these institutions — 5,958 institutions, accounting for 73% of the industry — are state chartered. The OCC supervises 1,508 (18% of the total) institutions and the OTS charters and regulates 728 (9% of the total) savings associations.[5] As the current recession should have taught us, the diversity of the financial industry is at the very core of our economy’s strength. This was most evident late last year, when the nation’s largest institutions all but ceased lending to preserve much-needed capital as they struggled to survive the market collapse. As the availability of credit declined drastically and the entire economy threatened to come to a halt, community and regional banks kept much-needed credit flowing to individuals and small businesses, preventing a complete economic shut-down. In short, the federalist system that encourages such a diverse industry worked.

Consolidating authority will not eliminate gaps or loopholes in supervision. In fact, the exact opposite is far more likely. Regulators are human and therefore fallible. Having more than one regulator with authority over a financial institution helps prevent costly errors and allows for detection of troubling practices or trends.

Finally, allowing financial firms the option of choosing a state chartering authority has not inevitably encouraged regulators to engage in a race to the bottom to attract charters in the past, and there is no reason to believe that preserving this choice will create such a race in the future given the checks and balances that exist in our state/federal system of bank supervision. Instead of fixing a problem that doesn’t exist — this imagined epidemic of charter flipping — consolidating supervisors and eliminating choice will exacerbate a problem that definitely has existed in the past: regulatory capture. If, in the words of Lord Acton, “absolute power corrupts absolutely,”[6] a single regulatory agency with absolute power over the financial system will be uniquely susceptible to capture. Eliminating the checks and balances inherent in our federalist system of supervision will create a system where no one watches the watchmen.

Roll Preemption Back

Rather than using the current round of regulatory reform to stake out new areas for federal preemption, Congress can and should take this unique and valuable opportunity to roll back existing regulatory interpretations of preemption and restore federalist checks and balances to our financial system.

Over the past decade, preemption of state consumer protection laws has dramatically undermined state regulators’ efforts to protect our citizens from predatory or fraudulent financial service providers or products. Recognizing this, President Obama, Chairman Barney Frank and Chairman Dodd have all proposed measures that would preserve, restore and enhance the role of state authorities in financial supervision.

The industry’s experience with the SAFE Act and NMLS should be enough to contradict arguments that restoring state authority will burden financial institutions unnecessarily or inhibit their ability to serve customers across state lines. The SAFE Act required states to enact their own enabling statutes within one year of the SAFE Act’s effective date. Within that one year, 49 states had effectively met the significant requirements put forth by the SAFE Act. These states have not gone beyond the SAFE Act requirements, even though federal law permits them to do so. Traditionally, however, state authorities have enacted more stringent laws and regulations to protect our citizens only when we have found the federal standards insufficient. If the federal government promulgates effective laws, the states will see no need to act further. States, too, understand the value of a unified, coordinated approach that offers seamless, comprehensive financial supervision for both institutions and consumers.

It is this dynamic, not preemption, that underlies the “150 years of banking law” preemption advocates keep referring to. The state banking system predates our Constitution, as the states were chartering banks even before the United States declared its independence. While the National Bank Act of 1863 presumed that banks would want to hold national charters, these institutions were also presumed to be subject to state laws. The latest round of unbridled preemption dates back only to 2004 and is authorized not by an act of Congress but by regulations promulgated by the OCC and the OTS. Congress now has the opportunity to reassert its authority over the checks and balances that govern financial regulatory compliance, and should restore the states’ longstanding authority to protect our citizens.

As for the argument that rolling back preemption would spur state attorneys general to declare open season on federal banks, this ignores the fact that most state attorneys general are elected officials. If they waste taxpayer dollars by going on fishing expeditions in search of fruitless litigation against financial institutions, the public will vote them out of office. It is in the AGs’ best interest to conduct legitimate investigations at all times.

A Reform of Checks and Balances

The recent economic crisis has certainly identified deficiencies in our financial regulatory system, and Congress must address and repair these flaws. Each cycle of regulatory reform is a response to the last cycle as well as a reaction to the latest cycle of economic boom and bust. Thus the danger is that hasty action may overcorrect, with unintended consequences that could prove much more damaging than the status quo. It is crucial that Congress identify the true causes of the systemic problems in our financial services industry; in doing so, they will see the need to preserve and enhance the unique characteristics and strengths of our federalist system and financial industry.

The 68 square miles of Washington, DC, are not the source of the entire nation’s wisdom, nor the font of all of the nation’s economic growth. While Congress must and will play a key role in restructuring our financial regulatory system for economic health in years to come, it is critical that policymakers look outside the Beltway for the information they need to make decisions on some of the more critical aspects of the reform proposals.

The simple, knee-jerk desire to put a single person — or a single agency — in charge will not serve the nation well. Financial services regulation is complicated for reasons that remain valid; the discussion of reform must consider the history of our system, the reasons behind it, and the continuing value of those reasons. Congress must preserve industry diversity and federalism, with its system of checks and balances and its scope for innovative problem-solving. A healthy, vibrant financial services system is one that recognizes the voices of the individual and the small business as well as those of the giant international competitors, and a cooperative state and federal system is the only one equipped to reach all levels of our economy and all citizens.

[1] Commissioner, Connecticut Department of Banking

[2] Michael R. Bloomberg and Charles E. Schumer, “Sustaining New York’s and the US’ Global Financial Services Leadership.” January 22, 2007, http://www.fr.com/practice/McKinsey.pdf.

[3] Source: National Geographic, available at http://travel.nationalgeographic.com/places/countries/index.html .

[4] Anthony Faiola, “British Break Up Several Bailed-Out Banks,” The Washington Post, November 3, 2009. NEED PAGE

[5] Source: FDIC.

[6] Letter by John Dalberg-Acton to Mandell Creighton, April 1887.