The financial services industry has changed significantly over the past 60 years, but federal and state laws have not. Now that Congress is seriously considering changing how commercial banks, investment banks, and insurance companies interact, it is important to recognize that the industry no longer can be defined as it once was. The current regulatory approach is based on clearly defined institutions that provide specific and easily identifiable products. Today, however, the distinction between financial services and other commercial activities is less clear than it once was. A new paradigm for overseeing and deregulating this changing industry is needed.

The first step Congress should take in defining this new paradigm is to distinguish between the limited and expressed responsibilities of the federal government and the residual responsibilities of the states--an issue that has been debated since the United States was founded. The U.S. Constitution was written and adopted precisely because the proper balance between the state and federal governments had not been clearly established by the Articles of Confederation. In the current realm of financial services, the debate centers on two key questions:

• What is the proper balance between state sovereignty and the federal government's constitutional duty to ensure free interstate commerce?

• How can the delicate balance between these two levels of government be maintained to protect individual liberty while promoting economic prosperity through a free and open financial services market?

Financial services firms depend on sophisticated networks of transactions and deposits that cross state lines and even extend outside the United States. Defining the proper role for the states and the federal government in overseeing such a diverse economic sector will not be easy, but it is necessary if Congress is to facilitate the integration and modernization of financial services.

Legal tests can help Members of Congress uncover protectionist intent, discriminatory effects, or extraterritorial overreach in a financial activity; determine the proper responsibilities of state and federal regulators; and offer a sound course of action. Specifically, these tests should examine:

1. Legal precedent. Do the Constitution or statutes passed pursuant to it serve as legal precedent for prohibiting state action in a given field?

2. Historical pattern of regulation. Has the industry or activity historically been regulated at the federal, state, or local level?

3. Technological complexity and "network externalities" (costs and benefits that accrue to groups not directly responsible for deregulation). In sophisticated modern markets (especially complex, interlocking national networks), are there negative effects associated with state-by-state regulation?

4. Interstate scope. Is the industry or activity clearly interstate in nature and scope?

5. Level of interstate spillover. Will state actions result in "substantial spillover effects" that adversely affect interstate commerce?

6. National need. Is there a clear and overriding national need for congressional action?

State and federal policymakers should use these legal tests to help strike the proper balance between state sovereignty and federal oversight of interstate commerce. As these tests are applied to the financial services industry, it should become clear that, in general:

• The federal government has the constitutional responsibility to oversee the commerce of financial services. The commercial aspect of financial services firms involves activities that are necessary to ensure that they function as safe, sound institutions. Commercial activities of financial services firms necessitate intricate interstate networks, create extensive interstate spillovers, and are the backbone of the nation's monetary system.

• The states should retain the right to regulate the business aspects of the financial services industry. The business or industry of financial services involves the actual products sold to the public. These may be annuities, insurance policies, checking or savings accounts, or securities. In any case, the sale of the actual product and the actual delivery of that product can be pinned to specific geographic locations. Therefore, it is appropriate that states regulate the business or industrial activity of financial service firms within their borders.

• The federal government has the constitutional responsibility to ensure interstate commerce. Specifically, the federal government should retain the right to preempt state regulations proscriptively when they interfere with interstate commerce. This does not mean, however, that the federal government has the right or responsibility to promulgate such regulations prescriptively.

Although the business and commerce of financial services cannot be separated entirely from each other in practice, such a distinction is necessary if Congress is to define the proper roles for the federal and state governments in overseeing these activities. Given the current division of entrenched regulatory power, this will not be easy. But if Members of Congress follow the principle and process of federalism, the American financial services industry can enter the 21st century renewed, reinvigorated, and unburdened by outmoded constraints.

John S. Barry is a former Economic Policy Analyst at The Heritage Foundation.