Why Pre-Emption Matters for Consumer Finances.

Victoria McGrane, Moderates win Wall St. bill changes:

“The New Dems had concerns [about] a number of the amendments that we wanted to see either made in order or some of the language included in the manager’s amendment. And we’re satisfied that we came to a good place on this,” Rep. Melissa Bean (D-Ill.), a leading member of the New Democrats group and a member of the House Financial Services Committee, said upon emerging from House Speaker Nancy Pelosi’s office Wednesday night.

Specifically, the moderates hammered out a compromise on the issue of whether national banks should be subject to tougher state consumer protection laws. House Financial Services Chairman Barney Frank (D-Mass.) had promised Bean a vote on her amendment to shield national banks from state rules – a situation known as pre-emption, since the federal rules set by the new consumer watchdog would pre-empt those made by the individual states.

Luckily, from what I am hearing, the new language that will be included from Bean is far less severe than she originally proposed. I’ll have more later, but though this new language is a step in the wrong direction, it isn’t a giant leap in the wrong direction as the original push for pre-emption was.

But let’s back up: What is pre-emption and why is it a big deal? The federal government provides an outline of financial regulation. State government add to that regulation. The question is, if they differ, should the federal government be able to override, or ‘pre-empt’, the state regulation for national banks? So if the state regulation has a stricter law on, say, home equity loans, but the federal government doesn’t, should the federal government be able to force its regulation onto the state level, removing the additional protections?

Melissa Bean says yes, the federal government should be able to do this. Consumer groups says no. What are reasons why the “no” answer is worth fighting for here?

Local Knowledge: Texas is not Wisconsin is not Vermont is not Florida. States themselves have both better knowledge of their local economies and the policy tools to address issues occurring locally. This should not be controversial.

I think there will be a fair amount of research over the next decade on this topic, but preliminarily evidence is that tougher consumer protection laws, particularly those centered around home equity loan restrictions and prepayment penalties, helped prevent a massive wave of foreclosures. The Dallas Federal Reserve found that: “Due to the state’s strong predatory lending laws and restrictions on mortgage equity withdrawals, a smaller share of Texas’ subprime loans involve cash-out refinancing, which reduces homeowner equity and makes default more likely when mortgage payments become unaffordable…”

We looked at Vermont’s consumer protection laws in a similar light here. Whatever the motivation for these practices – Texas’ laws date back to Homestead Act of 1839, an accident of history – they are by far our best first line of response to consumer protection.

Consumer Activism: In terms of making political changes, activists are far more effective at the state level than at the federal level. Here’s Kate Sheppard writing about anti-poverty, religious, and consumer advocacy groups partnering up to protest payday loan lenders in Virginia. It’s impossible to imagine such a group being as effective at the federal level, especially the more grassroots it was.

Game Theory: You have two regulators, the state and the federal government, they are in conflict. The federal government is easier to corrupt: you can bribe 1 federal regulator with 50x the money of 50 state regulators; and in so much as bad regulation may be felt more heavily at the state level, there’s even more of a incentive misalignment. If they are forced to compete, because the entity being regulated can choose, it’s even more favorable to that entity. One way to solve these nasty equilibria is to choose the stronger regulation proposed between the two parties, which is what happens when you exclude pre-emption.

Corruption: I will take it for granted that it is easier for there to be corruption at the federal level than at the state level. The elections are more expensive, the tenure is too strong. And if it is forced to be the law of the law through pre-emption, the more it will necessarily have to cover (since the states will be unlikely to try). And you don’t want states to be subject to the whims of banker captured beltway insiders.

So what’s the argument for? The best argument is that national banks don’t want to have 50 legal divisions to have offices in 50 different states. If Texas is not Wisconsin, then you need a Texas law team and a Wisconsin law team. This is excellent business logic for large banks, as it forces through law a return to scale on their legal infrastructure. However we don’t make laws to benefit how profitable being large is to national banks – we make laws to make sure contracts are valid and well-informed, that property rights that involve debt and uncertainty are maintained properly and that borrowing and lending market are as complete as they can be without being exploitive. In so much as this amendment hurts our ability to do those things and all we get in return is that shareholders of the largest national banks get a slightly better return, this approach is a terrible deal.