The Regulatory War on Fintech

Innovation is a hallmark of the modern U.S. and global banking system. Credit and debit cards, automated teller machines, online and mobile banking — each of these products and services, now commonplace, were novel technologies of their day. To bring each of these products and services to market, banks, innovators, investors and regulators had to work together to identify and address the new risks each technological development posed.

Unfortunately, the experience of most novel technologists and banks today is that regulators — both the leadership in Washington and the front-line examiners — are skeptical of anything new or disruptive. This skepticism and fear of the unknown regarding technology comes at a cost for U.S. households, businesses and the competitiveness of the overall economy.

In the U.S., banks have several significant advantages to nonbanks, including cheap funding (via deposits) and access to liquidity (through the Federal Reserve’s discount window). In return, banks are subject to a variety of federal and state oversight. Often, banks face challenges innovating because they rely upon legacy technologies and older core operating systems.

Enter fintechs. Unencumbered by old technology and energized by fresh thinking, fintechs can act nimbly to develop new solutions to old problems. In addition, the operations of fintechs are frequently free from scrutiny by federal and state regulators (at least during their development phase). Fintechs often need banks for access to the payment system and only banks can provide certain services such as deposit products. However, the potential benefits of these symbiotic relationships cannot be recognized without the regulators.

Regulators are by their nature risk averse to, among other things, avoid losses to the Federal Deposit Insurance Corp.’s insurance fund. Recent events show that regulators’ hesitancy about bank-fintech partnership are not unfounded; however, in our view, regulators too often fail to appreciate that there are real costs to the roadblocks they put up. Such costs include the growth of activity outside the “regulatory perimeter” — so-called shadow banking — that bank regulators often do not have the authority to supervise. As the shadow banking market continues to grow, questions arise as to whether an event in that market could result in a systemic event with broader implications for financial stability.

In addition, fintechs let smaller banks compete with bigger banks. Smaller banks often have fewer resources than their larger peers to innovate internally and partnering with fintechs allows smaller banks to offer competitive products and services. If regulators limit the ability of smaller banks to partner with fintechs, it should come as no surprise that larger banks that are investing in innovation will increase their already out-sized market share (both on the lending and deposit side). The resulting increase in concentration in certain of the largest banks would have the “unintended” consequence of increasing financial stability risks and competitive concerns.

In recent years, the pendulum has swung rather aggressively between regulators open to innovation and those who are highly skeptical of it. The financial system and the public would benefit from a more honest debate about the costs and benefits of innovation. The regulators, the regulated and the fintechs would be wise to recognize that there are three parties in this partnership, and all of them would be better off if each maintained an open mind and an open door.

This is the first article in a four-part series. In part two, we will discuss recent regulatory developments that highlight regulators’ resistance to innovation. Part three will address guidance for banks and fintechs that seek to continue to innovate, and part four will review the post-election changes in Washington and the likely implications for the future of innovation in banking.

Copyright 2024 Bank Director www.bankdirector.com. Reproduced with permission.