Hydraulic Regulation: Regulating Credit Markets Upstream

Abstract

Consumer protection in financial services has failed. A crisis is now playing itself out in the mortgage, credit card, auto loan, title loan, refund anticipation loan, and payday loan markets. Consumer protection was a traditional element states' regulatory power until federal preemption ousted states from almost all direct regulation of federally-chartered banks without substituting equivalent protections and enforcement.

This Article argues that one avenue may remain to permit states to engage in consumer protection regulation of federally-chartered banks. Recent changes in financial markets have placed the majority of consumer debt in the hands of secondary market entities, such as securitization trusts and debt collectors, which are not protected by federal preemption. States' ability to directly regulate the secondary consumer debt market also gives them the ability to indirectly regulate the primary market, even when direct regulation would be preempted. States can impose targeted regulatory costs on the secondary market tied to the presence or absence of particular terms in consumer debts, regardless of what type of institution initiated the debt. By tying regulation to the terms of the debt, states can channel the hydraulic force of the market, which will pass these costs on to the originators of the debts - including federally-chartered banks. This would create an incentive for originating lenders to adjust the terms under which they originate consumer debts so as to avoid state regulatory costs. This Article contends that such regulation would not run afoul of preemption doctrine because it does not directly regulate federally-chartered banks; it affects them only indirectly, through the market.

Keywords: banks, thrifts, preemption, consumer protection, regulation, securitization, secondary markets, OCC, OTS, chartering, refund anticipation loans, payday loans

JEL Classification: K20