Federal preemption of state bank regulation: A conference panel summary

Chicago Fed Letter, Sep 2006 by Davis, Erin, Rice, Tara

Benefits and costs of preemption

National banks typically favor preemption because it lowers their operating costs and eases the administrative burden of complying with multiple regulations. As Roselle explained, multiple sets of regulations are costly for banks not only because of the technology and training costs but also the increased likelihood of making costly administrative errors. As an illustration, he discussed the difficulty of complying with the state of Alabama's regulations. If a bank inadvertently made a mortgage-backed real estate loan in Alabama without meeting the local business registration requirements, Roselle said, the loan could be declared void and uncollectible. Preemption helps banks avoid such risks by creating a single set of regulations for national banks operating across state lines. Those benefits should eventually be passed on to consumers in the form of lower prices.

Preemption, Strahan argued, is part of a larger trend toward financial openness in banking, which in turn benefits both banks and consumers. For example, the increased openness allows firms to expand geographically and achieve greater economies of scale and scope. In fact, recent research has examined the effect of geographical deregulation on efficiency and pricing in the banking sector.8 These studies find that bank performance improves after geographical restrictions on bank expansion are lifted; operating costs are reduced and reductions are passed along to bank borrowers in the form of lower loan rates. Financial openness also allows banks to create more geographically diverse portfolios and become less vulnerable to local risks. Finally, Strahan noted, it increases market oversight of financial institutions and improves the nation's overall economic performance.

Preemption, however, could result in banks abandoning one regulatory system in favor of the other. If banks do so in large numbers, it could upset the balance of the dual banking system and alter its costs and benefits.

To some extent, such a shift has begun to occur. Preemption has intensified regulatory competition by making national charters more attractive, relative to state charters, to banks operating in multiple states. Increased competition, Strahan explained, could have one of two negative outcomes. First, it could result in a "race to the bottom," in which banks play competing regulators off against one another, making the regulators unwilling to impose appropriate standards on the banks they regulate. Alternatively, it could result in a "single winner," in which banks all migrate to a single regulator because that regulator relaxes its rules in some way to reduce the regulatory burden to banks. Strahan pointed out that in some markets this has already happened; most credit card banks are now located in Delaware or South Dakota because of those states' lenient usury laws.

Some level of regulatory competition, on the other hand, may be desirable. Strahan explained that competition is helpful because it limits regulators' ability to tax an industry excessively. The dual banking system in the U.S., argued Wilmarth, has been successful largely because competition between regulators provides important checks and balances for oversight standards. These checks and balances are in danger of being lost, he suggested, because of the substantial threat to the dual banking system that OCC preemption raises.