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Blog Post | February 21, 2023

An Overview Of The History Of American Financial Regulation

Congressional OversightEconomic PolicyExecutive BranchFinancial RegulationIndependent Agencies
An Overview Of The History Of American Financial Regulation

The Supreme Court is expected to announce soon whether it will hear Consumer Financial Protection Bureau v. Community Financial Services Association of America, a case about whether the Consumer Financial Protection Bureau’s funding mechanism is unconstitutional. The plaintiff, Community Financial Services Association of America, argues that the CFPB circumvents Congress’s budgetary authority by not being subject to the same annual appropriations process as most other executive agencies. That’s because the CFPB is funded via the Federal Reserve. This could undermine other financial regulators, particularly as the plaintiff is prima facie taking issue with how revenues of the Fed are being used.

The government asked the Supreme Court to intervene to overturn a ruling from the 5th Circuit Court of Appeals that invalidated CFPB operations in Texas, Louisiana, and Mississippi. The 5th Circuit decision agreed with the plaintiff that it was unconstitutional for the CFPB to be funded outside of Congress’s annual appropriations.

In reality, the CFPB’s funding structure is the norm among American financial regulators – and largely identical to the Fed itself. Declaring its funding structure illegitimate would directly threaten most of the rest of our financial regulatory system. In turn, that could throw financial markets into extraordinary uncertainty — Wall Street types hoping to starve the CFPB once and for all might be the proverbial dog that catches the car.

One important thing to note is that the federal government has both financial instrument regulators and depository institution regulators, and the distinction is important. 

Financial instrument regulators regulate financial mechanisms, crimes, and instruments themselves while also protecting investors and regulating businesses who engage in investments, like hedge funds. In other words, they set the rules about what it means to buy or sell a stock, bond, or what-have-you — what these assets are in the legal sense, and what you can or can’t do with them. The most prominent examples are the Securities and Exchange Commission and the Commodity Futures Trading Commission. 

Depository institution regulators regulate banks and other depository institutions, ensuring they are adequately managing risk and maintaining capitalization. They oversee the institutions which take your deposits or cash out your withdrawals from the ATM. While there are several of these, the most well known are the Federal Reserve and the Federal Deposit Insurance Corporation. 

While the SEC and CFTC do operate on budgets funded by congressional appropriations, the Fed, the FDIC, and all other depository institution regulators do not. In fact, in American history, none of our depository institution regulators or their predecessors have been funded through the annual appropriations process. 

What Is A Depository Institution?

First, let’s hammer out what exactly it is we’re talking about. A depository institution is an entity that engages in the business of banking, usually by taking deposits in exchange for promising interest while also providing loans. While there are many varieties — including national banks, community banks, thrifts, savings and loans, and more — they boil down to a class of institutions that help people use money, and make money themselves by providing various types of loans at interest. They provide somewhere safe to keep deposits, offer interest and at least some basic investment tools, and service loans. For our purposes, we’ll clump them all under the term “bank.” Currently, there are five federal agencies that each oversee a portion of the banking industry:

  1. The Office of the Comptroller of the Currency (OCC) regulates national banks, whose charters have been granted by the federal government.
  2. The Federal Reserve (Fed) regulates Bank Holding Companies, the U.S. branches of foreign banks, and state member banks (banks chartered by a state government which are members of the Federal Reserve System).
  3. The Federal Deposit Insurance Corporation (FDIC) manages the Deposit Insurance Fund, which guarantees any bank that takes deposits. It is the primary regulator of non-member state banks, which are chartered by state governments and are not members of the Federal Reserve System.
  4. The National Credit Union Association (NCUA) regulates credit unions, which are basically banks owned by their depositors.
  5. The Consumer Financial Protection Bureau (CFPB) regulates all financial institutions with assets over $10 billion for compliance with federal consumer financial protection laws. That includes banks, but also non-bank lenders that have been specifically designated by CFPB.

America’s First Bank Regulators

During the American Revolution and the age of the Articles of Confederation, there was the Bank of North America, which operated as a pseudo-central bank. Following the adoption of the Constitution, the Federalists, led by Alexander Hamilton, established the Bank of the United States, which would act as the new country’s central bank under a 20-year charter. (That’s what Hamilton and Thomas Jefferson rap-battle about in Act 2 of Hamilton.) Congress let the Bank of the United States’ charter expire in 1811, and the federal government went without a dedicated banking authority for five years until the Second Bank of the United States was established in 1816.

Both Banks of the United States were established, first and foremost, as banks, meaning that they made money from lending and accepted deposits. They didn’t go through the Congressional appropriations process. They were structured much the same as the Bank of England was and is. 

In the early days of the US republic, the primary form of regulation was preventing other banks from extending too much credit, so that bubbles and speculative mania were kept to a minimum. 

The central banks’ solution to this functioned similarly to how the Fed conducts monetary policy now, with an extra step, since most money in circulation was bank notes and not actual federal currency at the time; the Banks of the United States collected all taxes and other government revenues, and regulated the money supply in the process by calling in the private bank notes those revenues were paid with — essentially, they forced private banks to cough up the gold and silver that actually made their notes valuable. This kept the money supply tight to lower the risk of financial bubbles, but the Banks of the United States could also loosen it when the economy needed to be stimulated. Basically, both banks were beta versions of the Fed.

The Second Bank of the United States, however, ran into a major problem called President Andrew Jackson. Famous for hating paper money, Jackson opposed the idea of a central bank in its entirety and withdrew the government’s deposits from the bank, ushering in its death a few years later. After the Second Bank’s end, there was a period of virtually no substantial federal bank regulation. This time, called the free banking era, had no one to restrict rampant credit. As a result, from 1837 to 1864, a plethora of regional banks all printed notes that could often vary wildly from their printed face value. It was up to every individual to somehow judge how much each bank’s note was worth relative to a different bank’s note, which often came down to a matter of reputation and seriously complicated interstate commerce.

Where Today’s Agencies Came From

The free banking era ended with a boom. After Confederate militia fired on Fort Sumter in South Carolina in 1861, the United States found itself torn in half fighting a brutal Civil War. And that war was expensive. Hundreds of thousands of soldiers had to be paid, massive quantities of weapons and ammunition purchased, and infrastructure to enable efficient supply lines constructed. President Lincoln couldn’t fight a war while worrying if the different paper notes he was spending were all worth the same amount. To address this, Congress passed legislation that authorized the Treasury Department to issue a federal paper currency (prior to the 1900s, dollars were coins minted from silver) and established the Office of the Comptroller of the Currency to regulate banks and ensure soundness in the financial system. 

Like the Banks of the United States before it, the OCC wasn’t funded primarily through Congressional appropriations. It received fees and insurance premiums from the banks it regulated.

For decades, the OCC remained the sole significant federal regulator of the financial system. However, in 1913, following a series of financial panics (and after earlier efforts in 1907), the Federal Reserve was created to serve as a new central bank. (The Federal Reserve Act is also the origin of Federal Reserve Notes, the “greenback” type of dollar bills that most people are familiar with and the only legal paper tender currently issued in the United States.) The idea was to establish a permanent lender of last resort who could help banks maintain their liquidity in the event of a panic. As a central bank, the Fed could quite easily pay for itself without Congress — it regulated the money supply by lending with interest in the currency it printed. 

However, the Fed alone proved incapable of properly overseeing the financial sector, as evidenced by the Great Depression. As part of President Franklin Delano Roosevelt’s New Deal, new financial regulators were born. The Federal Deposit Insurance Corporation was created in 1933 to insure deposits, so that average people wouldn’t lose everything if a bank went under. This necessarily meant that banks paid it insurance premiums, providing its funding stream. The FDIC also regulated banks on a case-by-case basis and ensured adequate capitalization, liquidity, and management practices. The next year, the Securities and Exchange Commission was established to regulate financial products outside of traditional commercial banking — most notably, corporate stocks.

These regulatory schemes were further expanded in the 1970s with the creation of the National Credit Union Administration and the Commodities Futures Trading Commission. The NCUA was created as a parallel to the FDIC that specialized in depositor-owned institutions. Like its big cousin, the NCUA funded itself through premiums paid by the credit unions it regulated. 

The CFTC, meanwhile, was created to regulate commodity-based financial instruments, including futures and swaps — essentially forms of insurance against possible future disasters, such as bad weather destroying a farmer’s crop. A few particular types of derivatives, like Collateralized Debt Obligations (CDOs), would eventually play a big role in the 2007-2008 financial crisis.

That gets us to the CFPB, the youngest financial regulator. It was created in 2010 as part of the Dodd-Frank Act. A big part of the 2008 financial crisis involved sketchy lenders selling people bad deals by masking the terrible terms in many layers of complexity. The CFPB’s job was to keep that from happening by setting rules and intervening when lenders use cheap tricks to screw over the public. 

So Where Do They Get Their Funding?

Across all of these institutions, there is a surprisingly consistent theme: none of them are a drain on the federal budget. The financial instrument regulators like the SEC and CFTC receive Congressional appropriations, but usually fees and settlements more than offset those costs. (They spend all day catching multimillion-dollar fraudsters, after all.) As for the depository institution regulators, none of them even rely on the appropriations process. And none of their predecessors, going back to the days of the Founding Fathers, did either. 

Both Banks of the United States funded themselves through operating as a central bank, extending lines of credit, charging assessment fees to regulated banks, and performing open market operations. The Fed does the same thing today. Fed Vice Chair for Supervision Michael Barr testified in Congress that the Fed’s independent funding structure helps provide stability to the financial system, because no one has to worry that the central bank could be under-resourced. “That kind of certainty is quite important to doing our job effectively,” Barr said. Meanwhile, the FDIC, OCC, and NCUA are all funded primarily by fees and insurance premiums paid by banks. And the CFPB gets its revenue sub-granted to it by the Fed. Also of note, the Fed (even after paying its own costs and the CFPB’s) usually nets the US Treasury tens of billions of dollars a year.

Clearly this type of funding mechanism is very much the norm. So, what’s this lawsuit about? 

Well, it really boils down to banks not being able to take advantage of consumers as freely under the CFPB’s watch. Exploitative fees are an easy way of generating big profits on Wall Street. In reality, this is a rather transparent attempt to get rid of a regulator just because it is serving the public. As a result, there are a couple of deeply dangerous implications for this case.

The first, and most obvious, is that other regulators will be impacted. The case rests on the premise that it is unconstitutional for the CFPB to be funded outside of the appropriations process. Logically, there is no reason why the Fed funding itself would be fine but the Fed funding the CFPB wouldn’t. And the NCUA, FDIC, and OCC all seem to be funded in ways that also violate that same principle. In fact, the judges in the 5th Circuit seem to have outright said that this principle must be broadly applied. 

This case could create total chaos in the world of financial and economic regulation. Such a sweeping indictment of the way that the American government has helped stabilize markets for hundreds of years would also represent a sea change, with the conservative Supreme Court outright destroying federal agencies instead of trimming the powers those agencies are permitted to exercise.

There are three odd arguments that the 5th Circuit Court of Appeals used to rule against the CFPB last year. Several judges signed onto a concurrence that argued the CFPB violated the appropriations clause from Article I of the Constitution.  The clause reads “No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time.” The use of the appropriations clause is a strange decision, given that the phrasing very explicitly refers to funds “drawn from the Treasury,” which the CFPB’s funding is not. Another strange choice was to emphasize “double-insulation,” meaning an independent agency that is housed within another independent agency. But while that is technically the case, Dodd-Frank built in mechanisms to provide oversight of the CFPB and, despite being legally housed within the Fed, its operations are broadly the same as any other independent agency. Finally, one judge on the 5th Circuit argued that no funding can ever be constitutional unless it is “temporally bound.” As we’ve seen, that’s simply ahistorical nonsense.

Second, the case could establish some really weird precedent. The core thesis seems to be that the Constitution gives Congress the power to fund the government, ergo only funding from Congress is legitimate. This is, frankly, stupid. There is no Constitutional prohibition on alternative funding structures. Congress cedes its potential power over domains of American life all the time — indeed, the whole point of regulatory agencies is that Congress sets legal parameters around a complex and fast-moving topic, then lets full-time experts handle the specifics within those parameters. And Congress’s power is not being violated — it could still just make the CFPB subject to annual appropriations via legislation any time it likes, just as it can pass laws about a domain of life regulated by the agencies any time it likes. 

Rather, the fact that Congress itself established an alternative funding stream is the body exercising its authority to control how government money is allocated. Indeed, one might say that the division of labor is that Congress passes the laws, then the executive branch, well, executes them, and if Congress should have second thoughts… Congress changes the law. If anything, the court blocking such a measure is a usurpation of legislative discretion by the judiciary. The insistence on time-limited funding further decreases Congressional power to have any part of the government funded indefinitely.

But beyond the inanity of the case, the legal logic here threatens to bring down virtually every other financial regulator and do serious damage to the banking system. If the Supreme Court endorses the line of argumentation that funding must come from the Treasury directly and is time-limited, it also opens entitlement programs to constitutional challenges. Social Security, Medicare, and Medicaid are all funded via payroll taxes that go directly to those particular programs rather than the federal government’s general purpose money pot.

Despite the terrible plan advanced by Sen. Rick Scott to sunset all federal legislation every five years, neither Congress nor Republicans should want to see this line of argument reach its logical conclusion. Congress already has too much to do. Especially in an age of hyper-partisan gridlock, even routine measures like continuing resolutions to keep operating the government and getting Presidential appointees confirmed can drag on so long it undermines basic functions of the state. There’s a very clear revealed preference here; if Congress did want to determine the CFPB’s budget annually, they would amend Dodd-Frank and just do it. If the court overrides that preference, the legislative workload would balloon to something hardly imaginable.

Similarly, the only people who really want to see consumer protection regulation rolled back by a decade are payday lenders and the nuttiest radical jurists. After Dodd-Frank, many existing rules and regulations were moved from across a range of executive agencies into the CFPB. Defunding the CFPB would de facto invalidate all of those. And that would necessitate Congress to take up the mantle of reinstituting (or at least considering) many such measures. And legislators really shouldn’t want to handle every tiny piece of lending oversight. It’s highly technical, math-heavy, and, frankly, can get pretty boring. Not to mention, if conservative justices were to accidentally imperil Social Security and Medicare, they would be in for an electoral shellacking in 2024.

The 5th Circuit’s invalidation of the CFPB’s funding mechanism is dangerous, ill-considered, and counter to centuries of history and legal thought. It quite literally represents an affront to the entirety of American bank regulation and centuries of understanding of Congressional fiscal authority.

Image credit: “Supreme Court IMG_1062” by OZinOH is licensed under CC BY-NC-ND 2.0.

Congressional OversightEconomic PolicyExecutive BranchFinancial RegulationIndependent Agencies

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