John S. Barry*
The financial services industry has changed significantly over
the past 60 years, but federal and state laws have not. Now that
Congress is seriously considering changing how commercial banks,
investment banks, and insurance companies interact, it is important
to recognize that the industry no longer can be defined as it once
was. The current regulatory approach is based on clearly defined
institutions that provide specific and easily identifiable products.
Today, however, the distinction between financial services and other
commercial activities is less clear than it once was. A new paradigm
for overseeing and deregulating this changing industry is needed.
The first step Congress should take in defining this new paradigm
is to distinguish between the limited and expressed responsibilities
of the federal government and the residual responsibilities of the
statesan issue that has been debated since the United States
was founded. The U.S. Constitution was written and adopted precisely
because the proper balance between the state and federal governments
had not been clearly established by the Articles of Confederation.
In the current realm of financial services, the debate centers on
two key questions:
- What is the proper balance between state sovereignty
and the federal governments constitutional duty to ensure
free interstate commerce?
- How can the delicate balance between these two
levels of government be maintained to protect individual liberty
while promoting economic prosperity through a free and open financial
Financial services firms depend on sophisticated networks of transactions
and deposits that cross state lines and even extend outside the
United States. Defining the proper role for the states and the federal
government in overseeing such a diverse economic sector will not
be easy, but it is necessary if Congress is to facilitate the integration
and modernization of financial services.
Constitutional and other legal tests can help Members of Congress
uncover protectionist intent, discriminatory effects, or extraterritorial
overreach in a financial activity; determine the proper responsibilities
of state and federal regulators; and offer a sound course of action.
Specifically, these tests should include:
The Constitutional Test: The Constitution is the ultimate source
to determine proper jurisdiction. Thus, lawmakersbefore moving
on to other public policy tests must determine whether the Constitution
and statutes passed pursuant to it, or established and tested judicial
precedents, prohibit state action in a given field.
The Public Policy Tests:
- Historical pattern of regulation. This test provides a principled
and practical guideline for handling jurisdictional questions.
However, improper past regulation may need to be overcome.
- Technological complexity and "network externalities"
(costs and benefits that accrue to groups not directly responsible
for deregulation). Many industries today rely on an intricate
network of wires, communication lines, and satellites to deliver
their products to consumers and to conduct business. These networks
are national, international, or even global. Wherever oversight
or deregulation of such industries is considered, such technological
considerations require at least some minimal federal guidance.
- Interstate scope. The mere fact that a state or local activity
may involve anti-competitive consequences does not justify federal
intervention. The key question is whether the particular activity
or industry is truly interstate in scope.
- Level of interstate spillover. This test is closely related
to the interstate scope test in that it concerns the nature of
the interstate activity but asks whether the states policies
have a discriminatory impact on interstate commerce by effectively
prohibiting firms in one state from doing business in another
- National need. If an issue cannot pass the hurdles set out in
the other five tests, it is doubtful that any genuine national
need for federal intervention can be argued. If these hurdles
are cleared, however, and Congress can claim a justifiable "national
need," then it should exercise at least some limited jurisdiction.
State and federal policymakers should use these constitutional
and public policy tests to help strike the proper balance between
state sovereignty and federal oversight of interstate commerce.
As these tests are applied to the financial services industry,
it should become clear that, in general:
- The federal government has the constitutional
responsibility to oversee the commerce of financial services.
The commercial aspect of financial services firms involves activities
that are necessary to ensure that they function as safe, sound
institutions. Commercial activities of financial services firms
necessitate intricate interstate networks, create extensive interstate
spillovers, and are the backbone of the nations monetary
- The states should retain the right to regulate
the business aspects of the financial services industry. The business
or industry of financial services involves the actual products
sold to the public. These may be annuities, insurance policies,
checking or savings accounts, or securities. In any case, the
sale of the actual product and the actual delivery of that product
can be pinned to specific geographic locations. Therefore, it
is appropriate that states regulate the business or industrial
activity of financial service firms within their borders.
- The federal government has the constitutional
responsibility to ensure interstate commerce. Specifically, the
federal government should retain the right to preempt state regulations
proscriptively when they interfere with interstate commerce. This
does not mean, however, that the federal government has the right
or responsibility to promulgate such regulations prescriptively.
Although the business and commerce of financial services cannot
be separated entirely from each other in practice, such a distinction
is necessary if Congress is to define the proper roles for the federal
and state governments in overseeing these activities. Given the
current division of entrenched regulatory power, this will not be
easy. But if Members of Congress follow the principle and process
of federalism, the American financial services industry can enter
the 21st century renewed, reinvigorated, and unburdened by outmoded
*John S. Barry is President of Americas Future Foundation,
a Washington, D.C.-based non-profit public policy research institution
focused on issues of importance to young professionals. This article
was drawn from John S. Barry, "Federalism and Financial Services"
Backgrounder No. 1160, published by The Heritage Foundation on May
1, 1998. That paper may be found at http://www.heritage.org/library/