What is the dual banking system?

Unpacking the United States’ approach to banking

The United States’ banking system is unusual in the world in that, unlike European banks, which are supervised by a single regulator, we rely on a so-called “dual banking system.” This means we have two types of banks: nationally chartered and state-chartered. This dual banking system has existed since a national bank and national currency were established in the 1850s, and has continued to provide consumers with banking options and improvements in financial services.

How the dual banking system operates

A bank can be chartered, or legally established, by either the federal government (specifically, the Office of the Comptroller of the Currency) or any individual state. Both types of banks perform the same services: namely, accepting and safeguarding individuals’ and organizations’ deposits and providing loans.

Federally chartered banks are usually larger and have to follow federal laws. These banks, such as Bank of America, Chase, and Goldman Sachs, are regulated by the OCC and are members of the Federal Reserve. (Last year, the OCC announced that fintech companies would also begin to be granted federal bank charters, which would make it easier for them to provide financial services—but would also hold them to higher federal standards.)

State-chartered banks tend to be regional or community banks, and even though they are organized under state laws, they also generally have a federal regulator. State banks like SunTrust and Fifth Third Bank, for example, choose to be members of the Federal Reserve and are regulated by it. Other state banks like Bank of the West aren’t members of the Federal Reserve but are regulated by the FDIC. A bank can opt to become a member of the Federal Reserve if it meets certain requirements (and, generally, larger banks choose this option) to gain certain advantages such as greater access to capital and stock. However, the Federal Reserve also has tighter regulations than the FDIC.

Any newly established bank is part of the dual banking system and may choose whether it wants a federal or state charter. According to the FDIC, only 14 banks have been established since 2010, and of these, all have chosen state charters but one, Florida Community Bank, which is federally chartered. State banks often have the advantage of being closely attuned to the community and enabling supervision that matches the needs of the local economy. On the other hand, state laws can significantly restrict in-state branching, for example, which can lead a bank to choose a national charter instead.

What the choice comes down to most often, however, is regulation. Even though they’re overseen by the FDIC or the Federal Reserve, state-chartered banks primarily report to state supervisors, who generally have less stringent regulations. In fact, after the financial crisis, community banks sought en masse to change their charters from national to state because of a federal regulatory crackdown that, while meant to rein in big banks’ risky lending behaviors, put small banks at a disadvantage—and caused many to fail—by drastically regulating their loan-loss reserves.

Following regulations that are perhaps more tailored to a community’s financial needs is not the only consideration for smaller banks; state inspections are also cheaper.

An interesting situation is emerging with the marijuana industry being denied access to banks in states where it has become legal. Because the drug is still considered illegal under federal law, bank regulators have cracked down on banks’ abilities to grant these businesses capital or conduct business with them at all. This is true even for state-chartered banks, because they rely on deposit insurance, which is granted by the FDIC and thus overseen by that agency along with a state regulator. Though credit unions have stepped in to fill this unexpected niche, and California—where revenue from medical marijuana could exceed $6 billion in the next few years—is poised to be a driving force of legal change, it remains to be seen what role banks at either the state or federal level will be able to play in the industry in the coming years.

History of the dual banking system

Early banking in the United States relied either on a single national bank or only on state banks. By the time Alexander Hamilton’s First and Second National Banks were liquidated in the early 1800s, banking became a state-run service. There was no federal oversight, and each state banked in its own way. In Wisconsin, for instance, banking was totally banned, while other states could have a single state bank or many. Each state could also print its own currency. Not surprisingly, it was chaos.

The United States first attempted to establish a national currency to finance the Civil War, with the passage of a series of Legal Tender Acts in 1862, ultimately leading to the passage of the National Bank Act of 1865, which strengthened regulations on national banks and extended federal charters. Moreover, the Act established a 10-percent tax on any state-issued banknotes, encouraging consumers to use the national currency. This also led to a dramatic decrease in the popularity and number of state-chartered banks, though they never ceased to exist. In fact, they experienced a resurgence by the 1880s when they began offering customers demand deposit, or checking, accounts. As interest in demand deposits soared—and people used state banks to open their accounts—state banks bounced back, outnumbering national banks once again by the turn of the century.

Deposit accounts changed how banks did business, providing them with a new source of revenue. This new dichotomy led to the dual banking system. At the time, federally chartered banks dealt largely in banknotes, and state banks largely in deposit accounts.

Over time, the two types of banks’ responsibilities began to increasingly overlap. Even so, the dual banking system continues to exist and has become a stalwart of our financial system, providing banks with choices about their regulators and priorities.

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