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State vs. Federal Banking Regulators in Our Imperfect World

Yesterday, in Cuomo v. Clearing House Association, the Supreme Court ruled that states could sue financial institutions for failing to comply with state laws, even if they were in compliance with federal regulations. Like many Supreme Court opinions, this one was probably influenced in part by its historical and political context -- in this case, the financial crisis and resulting recession.

As Neil Irwin put it in this newspaper, "During the lending boom earlier this decade, many state officials sought to clamp down on what they viewed as abusive or discriminatory practices by banks, but were rebuffed by long-standing legal principles that only federal authorities can regulate nationally chartered banks." In fact, the Office of the Comptroller of the Currency went to bat for the banks, arguing that federal regulations preempt state law.

Preemption is a relatively obscure but very important doctrine that determines whether companies must be in compliance with both state and federal regulations or only with federal regulations. In theory, the question is whether federal regulations constitute a minimum "floor" that all companies must conform to, while states are free to impose additional conditions, or whether federal regulations constitute the "optimal" level of regulation. (As you can imagine, the field of law and economics has given rise to the proposition that there is an economically optimal level of regulation, where the costs and benefits of regulation are equal; it works nicely in theory.) In practice, it often comes down to reading legislative history and trying to figure out what powers Congress intended to give a regulatory agency.

Preemption comes up in all sorts of areas, such as the recent suit by states to impose environmental regulations that are more strict than those set by the Environmental Protection Agency. In general, large companies like preemption because it means they don't have to conform to 50 sets of state regulations; however, some companies don't like it because they have a cozy relationship with specific state regulators, who should be easier to influence than the federal ones, since the latter have more firms clamoring for their attention.

When I was younger, I thought the whole idea of state regulation was silly; why not just do it once at the federal level, and do it right? If nothing else, the transaction costs of having 51 regulatory regimes seem like a deadweight loss. But now that I am older and somewhat wiser, I realize that this idea suffers from an obvious fallacy -- it assumes that "it" will be done right at the federal level. In other words, it posits a perfect regulator. When you have a federal regulator that has been captured by the banks it is charged with overseeing, even to the point of helping the industry fight off state regulatory efforts, then you clearly don't have a perfect regulator.

So at this point it should be evident that you have to balance the inefficiency of multiple regulatory regimes against the benefit that with multiple regimes you will be more likely to deter risky or criminal activity. And I think the theory of optimal regulation needs to be jettisoned, since even with perfect rules it relies on a perfect enforcer. Instead we have to recognize that we live in an imperfect world, and we have to protect ourselves against the possibility -- or likelihood -- that federal regulators will become advocates for the industries they "regulate."

By James Kwak  |  June 30, 2009; 2:34 PM ET
Categories:  Banking , Regulation  
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