How financial regulatory tools are used against law-abiding Americans — and how to fix it

Canadian officials have told banks to unfreeze the accounts of people involved in the recent COVID-19 protests. Cutting off access to financial infrastructure may be justified in certain serious situations (an extreme example is taking place today in Eastern Europe), but not in the case of citizens where standard law enforcement tools will suffice. Canada’s excessive use of power accomplished its immediate goal and is a wakeup call about how powerful, and how prone to abuse, the tools of financial regulation can be. And even though we in the United States have greater constitutional protections, financial regulation is regularly turned against Americans.

The bell cannot be unrung; it must be broken. To do so, we must take affirmative steps to prevent financial abuse in the future.

One way in which financial regulation provides subtle and insidious means of abuse without explicit congressional approval is the concept of “reputational risk.” This tool of bank supervision has regulators look at whether a bank’s actions might impair its future financial prospects, even if the bank is doing nothing illegal. While originally focused on threats like whether the bank could be unwittingly used for money laundering, it’s expanded to include the idea that a bank’s legal customers might pose a risk to its viability by being unpopular with other potential customers, bank employees, or, perversely, with regulators themselves. 

Reputational risk was the tool the Federal Deposit Insurance Corporation (FDIC) used in Operation Chokepoint, and it’s been used on other occasions when regulators sought to cut off legal businesses they considered controversial from the banking system. These efforts resulted in numerous legal businesses losing bank accounts and access to payments services because banks were more worried about offending their regulator than serving their client.

One reason this so insidious is that it’s very difficult to detect. Those with the most knowledge (financial services firms) are understandably hesitant to challenge their regulators. From a firm’s perspective, precious few accounts are worth drawing the ire of the regulator you’ll be stuck with even if you win in court. Meanwhile, the customer is left to guess what happened and try to find a new provider, who will likely be under similar regulatory pressure.

Reputational risk is also dangerous because it can empower the wealthy and powerful to exclude the poor and weak. Its logic is purely economic: There is no requirement for the customer to have violated the law, threatened the operational integrity of the bank, or that any allegation be true. Rather, if the customer is unpopular enough with some important group that keeping them may limit the bank’s future financial growth, even an honest regulator may need to take note.

This isn’t an idle threat. From pressure on banks to cut ties with gun companies, to private prisons, to “brown industries,” efforts to debank political opponents have become more common in recent years. The FDIC backed down from Choke Point after congressional inquiries and a lawsuit, but there have been no substantive legal changes to take similar conduct off the table. Meanwhile, regulators’ interest in using financial regulation to de facto legislate other issues has only increased.

If we are serious about protecting freedom, we need to eliminate, or at least significantly reduce, the ability of financial regulation to serve as a conduit of coercion. To be sure, there are legitimate concerns that the government must attend to. But these must not be allowed to justify circumventing the legal and constitutional protections Americans enjoy. 

One step to consider is explicitly outlawing the use of reputational risk in supervision. As University of Alabama Professor Julie Hill points out, the value of reputation risk is dubious at best, while its vagueness invites abuse.

A bolder and more controversial step, and one that should nonetheless be considered, would use the logic of antidiscrimination law to prohibit banks from refusing to do business with customers due to political or social pressure.

There is precedent for this. In 1974, the Department of Justice supported making religion and national origin protected classes under the Equal Credit Opportunity Act, in part because it would protect not only customers but the banks themselves. At the time, banks were being pressured by Arab governments and business clients to cut ties with Jewish-owned and Israeli businesses. Changing the law affirmatively prevented the U.S. financial system from becoming a tool of coercion and allowed banks to do what they should be doing — allocating capital to its most productive use.

There is wisdom to this, especially as we navigate a period of high political polarization and low trust. For freedom to be meaningful, its exercise must be possible, and that requires access to financial services. We have seen, both domestically and abroad, how the financial system and its regulation can be abused. We should not allow it to happen again.

Brian Knight is the director of innovation and governance and a senior research fellow at the Mercatus Center at George Mason University.