Federal Preemption Under Threat: Implications for National Banks and Lenders

The U.S. banking system is at a crossroads. For decades, federal preemption under the National Bank Act (NBA) shielded national banks from state-level regulations, creating a unified framework for lending and compliance. However, recent judicial rulings and legislative actions are eroding this foundation, creating a patchwork of state laws that threaten to fragment the regulatory landscape. This shift has profound implications for national banks and lenders, compressing margins, inflating operational costs, and forcing institutions to navigate a labyrinth of conflicting rules.

The Erosion of Federal Preemption

The NBA's preemption doctrine has long allowed national banks to operate under a consistent federal framework, free from state-level constraints. But this certainty is unraveling. In Conti v. Citizens Bank, N.A., the First Circuit Court of Appeals ruled that Rhode Island's law requiring banks to pay interest on mortgage escrow accounts is not preempted by the NBA according to the ruling. Similarly, the Ninth Circuit upheld California's equivalent law in Kivett v. Flagstar Bank, rejecting the Office of the Comptroller of the Currency's (OCC) argument for federal preemption as per the decision. These decisions signal a judicial trend: courts now demand a detailed showing of conflict or encroachment before recognizing federal preemption, making it harder for national banks to avoid state consumer protection laws.

California's aggressive stance exemplifies this trend. Governor Gavin Newsom's signing of Assembly Bill 493 in 2025 mandates that homeowners receive interest on insurance payouts held in escrow after disasters-a rule aligned with the state's existing interest-on-escrow law. The Ninth Circuit's affirmation of this law, despite the OCC's proposed federal preemption rule, underscores the jurisdictional tug-of-war between states and federal regulators.

Regulatory Fragmentation and Margin Compression

The erosion of federal preemption is not merely a legal abstraction-it directly impacts lending margins. National banks now face a mosaic of state laws governing everything from escrow interest to credit underwriting. For example, California's restrictions on using medical debt in credit scoring force banks to abandon alternative data points that could enhance risk assessment and loan yields. Meanwhile, states like New York and Illinois are introducing their own consumer protection mandates, creating compliance overhead that eats into profitability.

Quantitative data from 2025 highlights the toll. The Conference of State Bank Supervisors (CSBS) reports that smaller banks allocate 11% to 15.5% of payroll to compliance tasks, compared to 6% to 10% at larger institutions. This disparity reflects the fixed-cost nature of compliance, which disproportionately burdens community banks. Additionally, the Federal Reserve's July 2025 Senior Loan Officer Opinion Survey (SLOOS) notes tighter lending standards for commercial and industrial (C&I) and commercial real estate (CRE) loans, attributed to regulatory uncertainty and shifting state mandates.

Operational Efficiency Under Pressure

Regulatory fragmentation also strains operational efficiency. National banks must now allocate resources to comply with divergent state requirements, often duplicating efforts across jurisdictions. For instance, the CFPB's Section 1071 litigation over small business lending compliance has created a compliance quagmire, forcing banks to adjust loan structures and data-sharing protocols.

Cost-to-income ratios, a key metric for operational efficiency, reveal the strain. While national banks improved their ratios from 66% in 2020 to 54% in 2025, this progress is offset by rising compliance costs. Smaller banks, in particular, struggle: their compliance expenses account for 2.9% to 8.7% of non-interest expenses, with some spending up to 15.5% of payroll on regulatory tasks. These costs are exacerbated by the need to invest in AI and digital tools to automate compliance, as highlighted by BCG's analysis of innovative strategies to mitigate fragmentation.

The Path Forward

The regulatory landscape is unlikely to stabilize soon. With states increasingly asserting authority over banking practices and courts adopting a stricter preemption test, national banks must adapt. This means:
1. Investing in compliance infrastructure: Automating regulatory tracking and leveraging AI to manage state-specific requirements.
2. Lobbying for federal clarity: Advocating for Congress to resolve ambiguities in the NBA's preemption doctrine.
3. Strategic lending adjustments: Refocusing on markets with aligned regulatory frameworks to minimize compliance drag.

For investors, the implications are clear. Banks with robust compliance systems and diversified geographic footprints will outperform peers. Conversely, institutions reliant on a uniform federal framework face margin compression and operational inefficiencies. As the 2025 regulatory environment evolves, agility-not just capital-will determine winners and losers in the banking sector.