Money and Federalism

The United States is the only country in the world in which both federal and state governments possess independent and yet overlapping authority for bank chartering, regulation, and supervision. The roots of this unique ‘dual’ banking system can be traced back to the Constitution: written almost a century before banks rose to the apex of the financial system and became the dominant source of money. Beginning with the landmark Supreme Court decision in Maryland v McCulloch, this system has been a wellspring of jurisdictional conflict. Yet over time it has also produced strong federal oversight and a financial safety net that protects bank depositors, prevents destabilizing runs, and promotes monetary stability.

This system is now under stress. The source of this stress is a new breed of technology-driven financial institutions, licensed and regulated almost entirely at the state level, that provide money and payments outside the perimeter of both conventional bank regulation and the financial safety net. These institutions include popular payment platforms like PayPal, Venmo and Cash App. They also include a wide range of institutions and platforms within the rapidly expanding and evolving fintech and crypto ecosystems.

In my new working paper Money and Federalism, I chronicle the rise of these new monetary institutions, describe the state-level regulatory frameworks that govern them, and identify the threats they may one day pose to monetary stability. I also examine the legal and policy cases for federal supremacy over the regulation of these new institutions and advance two potential models: one based on complete federal preemption, the other more tailored to reflect the narrow yet critical objective of promoting public confidence and trust in our monetary system.

The starting point for this paper is the fundamental tension created by the separation of state-level responsibility for licensing, regulation, and supervision from federal responsibility for monetary stability and the administration of the financial safety net. While states have long been laboratories of regulatory and monetary innovation, it is the federal government that ultimately controls the legal and institutional machinery necessary to make these innovations safe and ensure that they do not pose a threat to monetary stability. This tension foregrounds three central questions in the context of the complex and evolving relationship between money and federalism.

The first question is whether the Constitution gives Congress the power to charter and regulate this new breed of monetary institutions. This question is more complicated than it might first appear. One of the peculiar byproducts of a monetary system that has for so long been dominated by a single species of financial institutions is that the constitutional debates around the power of Congress to regulate money have almost exclusively been projected through the narrow and fractured prism of banks. And even where courts have reluctantly weighed into these debates, they have typically grounded their reasoning in the fiscal—as opposed to regulatory—dimensions of monetary design. In many cases, they have also eschewed in-depth substantive, historical, or economic analysis in favor of a more pragmatic approach. As a result, Maryland v McCulloch and its progeny offer only limited guidance in answering this all-important question.

The second question is whether there are strong policy grounds for federal intervention. The answer here is a clear and resounding yes. Despite their valiant efforts, the states have collectively failed to provide strong and consistent legal protections for the customers of these new monetary institutions. The significant divergence in legal protections across states and frameworks is responsible for growing monetary heterogeneity. This heterogeneity generates significant information costs: forcing customers to either conduct costly due diligence or take a leap of monetary faith. During periods of institutional or wider systemic instability, these information costs can become a catalyst for destabilizing runs as customers rationally decide to withdraw first and ask questions later. Under certain conditions, these runs could potentially metastasize into wider panics that threaten the stability of the entire monetary system. Preventing these destructive dynamics requires strong and fully harmonized legal protections, the disapplication of federal bankruptcy law, and a bespoke resolution framework that ensures that the customers of failed institutions are repaid rapidly and in full. The federal government—and only the federal government—can provide these key ingredients of monetary stability.

The third and final question is how Congress should design and implement any policy intervention. This includes complex and thorny questions about how to fit a new regulatory framework within the existing federalist structure. In theory, the options range from competing federal and state frameworks to exclusive federal chartering, regulation, and supervision. In between, there is also the possibility of shared federal and state responsibility within a single overarching framework. In practice, both Congress and federal bank regulators have already put forward several proposals that have run aground on federalism’s rocky shores. These proposals include the Responsible Financial Innovation Act released by Senators Cynthia Lummis and Kirsten Gillibrand in June 2022 and the Clarity for Payment Stablecoins Act voted out of the House Financial Services Committee in July 2023. While these bills were not without merit, neither would have successfully navigated the complex challenges posed by the emergence of new monetary institutions.

This Article explores these three important questions and offers two blueprints for regulatory reform. The stakes are extremely high. During the late 19th and early 20th centuries, the US financial system and economy were routinely disrupted by periods of paralyzing monetary instability. Monetary instability was also at the root of the Great Depression: with widespread bank failures leading to a broad contraction in the money supply that undercut investment, destroyed jobs, and stifled economic growth. The modern financial safety net for banks was created to prevent this type of monetary instability, along with the economic devastation that inevitably follows in its wake. Yet given the recent emergence of new monetary institutions, preventing future crises demands that we rethink our approach toward the sources of money, the potential vectors of monetary instability, and how to effectively regulate them.

The author’s full article can be found here.

Dan Awrey is a Professor of Law at Cornell Law School.