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Strong State Controls Critical to Strengthening the U.S. Financial System

Systemic risk can be considered the fifth horseman of the financial industry apocalypse.

At the extreme, it is the threat posed by the potential failure of one or more institutions to the entire U.S. economy. President Bush acknowledged that much at the onset of the current crisis when he said that what was at stake was the future of democratic capitalism.

The Senate Banking Committee passed a proposal put forth by Chairman Christopher Dodd to reform the financial system. The full Senate is expected to vote on the bill after the spring recess. Republicans are expected to introduce numerous amendments to attempt to weaken or kill key provisions of the reform bill. Among its many provisions is the creation of a systemic regulator in the form of a nine-member Financial Stability Oversight Council to monitor the financial markets for potential threats to the system.

We welcome the creation of a systemic regulator. However, findings from two recent studies by a research team led by the UNC Center for Community Capital indicates that bill should be strengthened, not weakened, as it goes through the Senate. To strengthen the bill, states should be allowed to enact and enforce strong consumer protection laws, and federal regulators should not be able to override or pre-empt them.

Housing markets are local in nature and, to a large extent, so are mortgage originations. As such, states are better able to tailor regulation to the dynamics of local markets than their federal counterpart.

Nowhere is this more obvious than when examining the impacts of state-enacted anti-predatory lending laws on the current foreclosure crisis. States with strong anti-predatory lending laws exhibit lower foreclosure risk than other states, even when taking other explanations into account. A typical state law reduces risks by as much as 18%. The strength of the state law also matters.

States with laws that go beyond the federal coverage or restrict more mortgage terms have lower default risks. Simply put, this means that in states that enacted better laws, fewer homeowners are losing their homes to foreclosures than they otherwise would have.

Of course, the effectiveness of any regulation depends on the political will to enforce it. This is painfully clear in the action of federal regulators, who used their powers to pre-empt state anti-predatory lending laws.

Our research estimates that the 2004 pre-emption order by the Office of the Comptroller of the Currency that exempted national banks and their affiliates from provisions of state laws led to deterioration in the quality of mortgages originated and an increase in default risks, by as much as 41% in some cases, among exempt lenders.

The fact that all the members of the proposed systemic regulatory council are political appointees and heads of the same agencies charged with overseeing some of the financial institutions at the center of the financial meltdown suggests that more protection is needed.

Our findings clearly indicate that financial reform aimed at lessening systemic risk must include the ability for states to enact tougher consumer protections for their markets beyond those provided by any federal regulatory floor. Sen. Dodd's bill includes such a proposal but needs to be strengthened to extremely limit, if not ban, the use of pre-emption.

Based on evidence from the recent past, stronger state regulatory controls are our best means of preventing future financial system collapse by ensuring that if one regulatory institution fails, the entire system will not fall with it. Roberto Quercia is director of the UNC Center for Community Capital, based in the College of Arts and Sciences at the University of North Carolina at Chapel Hill. The centerís research on the effect of federal preemption and state anti-predatory lending laws is available at www.ccc.unc.edu/preemptioneffect.