Regulatory Turf Wars

During times of economic duress it is standard practice for the states and the federal government to try and grab power from each other. But the ever evolving concept of federalism in the United States sometimes creates unusual situations when it undergoes rapid mutation.

Today’s WSJ featured an article highlighting one such example. Against the backdrop of rapidly expanding federal authority in everything from industrial planning to health care, the states are flexing their muscles over the issue of bank regulation.

At issue is the legal concept of “pre-emption”, which asserts that in areas where the federal government has clear constitutional authority it can pre-empt/overturn any attempts by states to regulate an industry, in this case the banking industry.

New York Attorney General Andrew Cuomo is appealing the Supreme Court to overturn a lower court decision that ruled in favor of the Office of Comptroller of the Currency (OCC). The OCC is the bureau of the Treasury Department that charters, regulates, and supervises all national banks. It also supervises the federal branches and agencies of foreign banks.

The case was originally brought against the OCC by disgraced Gov. Eliot Spitzer. In 2005, then-Attorney General Spitzer began investigating whether banks were issuing high-interest (predatory) loans to minorities at significantly higher rate than to white borrowers. His office began issuing subpoenas to national banks, which formed a group (dba “Clearing House Association”) and filed for an injunction in Federal Court. The court ruled in favor of the banks, a decision later upheld by the 2nd Court of Appeals.

So what’s going with this appeal? On the one hand, we have state governors exhorting the government to take greater control of the financial system, while at the same time state attorney generals are suing the federal government for having too much interference in the banking industry. We’ve actually stumbled into a regulatory turf war that is spilling over from the 1990’s.

Less than a month before Spitzer’s prostitution scandal, he penned an editorial indictment of the Bush Administration in a Washington Post op-ed, blaming the administration for standing blindly by while minorities borrowers were being exploited:

"Predatory lending was widely understood to present a looming national crisis. This threat was so clear that as New York attorney general, I joined with colleagues in the other 49 states in attempting to fill the void left by the federal government…Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye.

Let me explain: The administration accomplished this feat through an obscure federal agency called the Office of the Comptroller of the Currency (OCC). The OCC has been in existence since the Civil War. Its mission is to ensure the fiscal soundness of national banks. For 140 years, the OCC examined the books of national banks to make sure they were balanced, an important but uncontroversial function. But a few years ago, for the first time in its history, the OCC was used as a tool against consumers.

In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks."

Spitzer is right in that the Bush administration sought to block states from regulating national banks, but his actions largely followed the example set by previous administrations, which have sought to preserve the federal government’s autonomy in the realm of national bank regulation. In 1996, the OCC adopted a regulation clarifying that, under federal code “the exercise of visitorial powers over national banks is vested solely in the OCC.” Visitorial powers include:

(i) Examination of a bank

(ii) Inspection of a bank's books and records

(iii) Regulation and supervision of activities authorized or permitted pursuant to federal banking law; and

(iv) Enforcing compliance with any applicable federal or state laws concerning those activities

In 2004, John Hawke Jr., head of the OCC and a Clinton appointee (1998-2004), issued a ruling in further support of that interpretation, as

“not grant[ing] state or other governmental authorities any right to inspect, superintend, direct, regulate or compel compliance by a national bank with respect to any law, regarding the content or conduct of activities authorized for national banks under Federal law”

The federal courts agreed with that interpretation. In the appellate court’s ruling against the states, they upheld federal pre-emption of state regulation, arguing that

“the purpose of the visitorial powers restriction is to “prevent inconsistent or intrusive state regulation from impairing the national system.”

The near unanimous support of pre-emption has been echoed by the federal courts in similar cases in Michigan and Georgia. Yet the debate still rages on. Last fall, BusinessWeek did a great piece that described the battle between the OCC and state regulators over the issue of pre-emption. The debate has been heightened as both sides attempt to saddle each other with blame for the regulatory failures that helped lead to the sub-prime meltdown.

The states blame the OCC (whose charter is to oversee the financial stability and ongoing legal adherence of national banks) for a failure to properly regulate the issuance of sub-prime mortgages. They accuse the OCC of catering to the financial services lobby, allowing banks to hide behind pre-emption so they could avoid state investigation of their activities. The OCC argues that the states did nothing to regulate sub-prime the mortgage brokers who were originating these risky loans and engaging in high-pressure sales tactics with no thought of the consequences. Both arguments have merits.

The real issue is who will own regulation of the banks, the states or the federal government? Once again, both options have merits:

1) State regulators are closer to their constituents and are more likely to be held accountable for regulatory oversights than would the federal government. At the same time, a centralized federal agency would certainly be more coordinated and effective in prosecuting oversights. Compare any state AG’s office with the U.S. Attorney’s office. The NY Attorney general certainly didn’t bring down the mafia.

2) State regulatory laws are easier to adapt to changing circumstances and would provide fewer loopholes, but that leaves the unpalatable scenario of the banking system having to accommodate fifty separate regulatory regimes. For an example of how well that works, look at the insurance system in this country.

3) State elected officials have every incentive to rule against out-of-state banks and in favor of their constituents, which could quickly devolve into a state-by-state race to the bottom. Yet at the same time, the OCC has its own conflict of interest. It is not funded by congressional appropriations, but rather by fees it collects from the very banks it is supposed to regulate. Remind anyone of the ratings agencies?

Realistically what will happen is that the Supreme Court will uphold pre-emption and the federal government will retain regulatory control of the banking industry. But in response to the outcry sure to follow from the states, the OCC’s focus will be shifted and the agency will be charged with taking a much more aggressive stand against predatory lending.

The next head of the OCC- they serve five year terms, with the current term ending in October 2010- will undoubtedly have a more activist, prosecutorial background. The previous two appointees were solidly grounded in the banking deregulatory mindset of the 1980’s and 1990’s. This appointee will be forced to take a much more collaborative role with state AG offices looking to investigate potential lending abuses, and the OCC will become a dramatically different organization.