State and federal authorities have been engaged in a regulatory tug-of-war since Congress levied a tax on currencies issued by state banks in 1865. Today, the application of interest rate caps is a prominent battle ground where state and federal interests play out against one another. The recent settlement of two cases in Colorado has created a temporary truce in the battle over the applicability and preemption of state usury laws. But the growing impact of technology suggests that such cease fires won’t last long unless policymakers redefine the respective roles of federal and state regulation so that they correlate to the world we live in.
In the Colorado cases, two out-of-state banks offered a variety of small loans at rates in excess of Colorado state limits under the protection of federal law. Colorado had chosen not to opt out of that framework as Congress had permitted it to do, but it took issue when the banks subsequently sold those loans to non-bank fintech lenders, filing the two lawsuits in question for violation of state usury laws.
These cases represented a form of proxy war between state and federal regulators. Both the comptroller of the currency and the FDIC indirectly weighed in, effectively lending support to the arguments presented by the banks. While the cases were pending, they issued statements clarifying that the terms of a loan validly made by a bank under federal law continue to be its terms no matter who it is sold to.
Subsequently, the OCC issued a proposed rule clarifying that federal law views a bank as the “true lender” for purposes of determining the applicability of federal law when it is named as the lender in a loan agreement or funds the loan. Not long thereafter, the cases settled.
While at the OCC in the late 1970s, I worked on the creation of these modern-day battle lines when the Supreme Court’s sided with the comptroller in Marquette National Bank of Minneapolis v. First of Omaha Service Corp. That case ratified the exportation of interest rates by national banks from their home state so that they could be applied to lending transactions in other states notwithstanding local usury laws.
In 2015, the states got some revenge when the U.S. Second Circuit decided Madden v. Midland Funding, LLC. That decision threw gas on this smoldering fire, but created the specter of massive economic market distortions. It concluded that when a national bank sold a loan to a party that could not claim the benefit of federal preemption, the loan became unenforceable to the extent that it charged an interest rate that the new owner of the loan could not have charged. This decision is poorly reasoned and ignores a century of precedent.
Stepping back from this long-standing battle over the application of usury rates, which has prompted politicians such as Sen. Bernie SandersBernie SandersFranken targets senators from both parties in new comedy tour Pelosi says House members would not vote on spending bill top line higher than Senate's Groups push lawmakers to use defense bill to end support for Saudis in Yemen civil war MORE (I-Vt.) and Rep. Alexandria Ocasio-CortezAlexandria Ocasio-CortezFeehery: The confidence game Democrats face full legislative plate and rising tensions McCarthy on Dems' spending bill: 'The amount of money we spent to win World War II' MORE (D-N.Y.) to offer legislation creating arbitrary federal interest caps, we can see a much more fundamental issue at stake that is being exacerbated by new products and services driven by technology. When the parties to a transaction can be anywhere and have access to financial services offerings around the world from wherever they are seated, location-based regulation may not only lose its effectiveness, it begins to add unnecessary costs and credit restrictions which are not offset by the consumer protections that it can provide.
Given today’s new world of borderless digital commerce, no one would create the current system of oversight that subjects the offering of financial services to redundant and duplicative oversight. A bank that engages in a national mortgage lending business, for example, must not only comply with a blizzard of federal laws, rules and interpretations promulgated by more than a half-dozen federal agencies. It must also deal with those of 50 state banking departments, state consumer protection agencies and state attorneys general. That is 100 or more regulators and their rules that must be satisfied each and every day it turns on the lights to do business.
The effectiveness of this dual system of financial oversight may be reflected to some degree in the history of bank failures in the country. Approximately 80 percent of the 493 financial institutions that failed between 2008 and 2013 were state chartered.
The relative number of state and federal bank failures in the S&L and banking crises of the 1980s were similarly skewed toward a preponderance of state bank failures. Indeed, since the establishment of the FDIC in 1934, those ratios are fairly consistent.
While there have always been more state banks than national banks in the country, and large national banks may be less likely to be allowed to fail, these numbers at least suggest that the dual system of regulation may need revisions, particularly as technology changes the rules of engagement. If Congress doesn’t consider and decide these issues, rapidly changing markets and others will.
More than 1600 cryptocurrencies have been launched, and blockchain applications are remaking the way money moves as well as who moves it. The OCC is approving the organization of fintech and payments banks and fostering the entrance of banks into the crypto assets business, which is likely to eventually lead to crypto companies entering the banking business. The OCC’s efforts to provide a platform for financial innovation is increasingly being challenged in court by states that freely admit that they want to be the promoters and regulators of such fintech innovations. This ongoing intramural battle provides little benefit to the public, and the specter of 50 different state standards facilitating fintech innovation seems contradictory.
Compromises like that reached in Colorado are part of the solution. But to be effective and satisfactorily address the many conflicts between state and federal regulation, they will have to be achieved on a national basis and cover a wide range of activities. The allocation and application of state and federal laws and rules and the primary responsibility for their examination and enforcement must be reconfigured in a way that is economically efficient.
Congress must come to grips with the economic benefits and detriments of usury laws and protect consumers while allowing them to use technology to access the broadest spectrum of available credit sources. They must agree on who takes the lead and when; there is no benefit to multiple federal and state agencies handling every aspect of every case as they all then rush for credit and jockey for press release preeminence. All of this creates enormous costs that are eventually passed on to consumers, offsetting the usefulness of usury laws for not much incremental benefit.
Technology is telling us in no uncertain terms that financial regulation must become smarter and more efficient. Let’s hope that the Colorado settlements are a first step toward the creation of more rational and less costly systems of financial regulation that can lower costs for American consumers. I have my doubts.
Thomas P. Vartanian, formerly a bank regulator at two different federal agencies and then a private practitioner for four decades, is the executive director and professor of law of The Antonin Scalia Law School's Program on Financial Regulation & Technology. He was an expert witness in the recent Colorado cases referenced in the article and is the author of “200 Years of American Financial Panics,” which will be published in early 2021.