Creating Pro-Innovation Fintech Regulation

Contributors

Brian Knight

The views expressed are those of the author in his personal capacity and not in his official/professional capacity.
To cite this paper: Brian Knight, “Creating Pro-Innovation Fintech Regulation”, released by the Regulatory Transparency Project of the Federalist Society, January 30, 2018 (https://regproject.org/wp-content/uploads/RTP-Financial-Services-Corporate-Governance-Working-Group-Paper-Fintech.pdf).

Executive Summary

Innovations in financial technology (“fintech”) are changing the landscape of financial services. These changes include the use of the internet as a means of connecting borrowers and lenders through innovative non-bank “fintech” lending (including peer-to-peer and marketplace), crowdfunding, mobile payments, the use of algorithms and unique data sets to help underwrite people poorly served by traditional methods, automated investment advice that seeks to provide investors with the benefits of investment advice at a fraction of the cost, and the use of distributed ledger technology (DLT) to facilitate transfers of value and the memorialization of contracts and property ownership. These innovations have the potential to make the financial system more efficient, and inclusive, and safe.

Unfortunately, misregulation of these innovations risks hampering their progress. As regulators and lawmakers come to grips with the dramatic and rapid changes to financial services they all too often seek to apply existing rules that do not fit the new reality. Regulators sometimes also chill innovation by placing undue risk on companies seeking to innovate. While regulation to protect consumers may be warranted, applying regulations that do not take account of just what makes these new products and services innovative, or which discourage both start-ups and established companies from trying new things risk depriving the public of the benefits these new methods could provide. This chapter will briefly discuss how fintech, discussed through the example of fintech lending, can improve our lives and how poor regulation risks harming the very people it seeks to help.

I. The Benefits of Fintech

A.  Efficiency

Fintech can allow firms to provide services more efficiently than traditional methods. In the context of lending, a lender’s fixed costs affect the rates they are able to charge borrowers.1 There is evidence that the use of technology can allow fintech lenders to have lower overhead costs.2 This in turn can allow them to offer borrowers better terms than they would have otherwise received from a traditional lender.3 There is also evidence that fintech lenders’ use of innovative underwriting metrics may allow them to offer some borrowers better prices than they are able to obtain from more traditional lenders.4 This evidence indicates that a fintech lender can use an underwriting method with relatively low correlation with traditional FICO scores5 with the loan grading providing relatively accurate predictions as to loan risk.6

While price is an important attribute for a loan, speed and convenience are also important. Here, again, fintech appears to show promise. The approval process for innovative firms can often be easier to complete and quicker than for traditional lenders.7 This can be especially important for borrowers who need capital quickly and cannot devote significant time to the application process, such as small business owners.8

B.  Inclusion

Innovations in non-bank lending also have the potential to make lending more inclusive, providing credit to borrowers who might otherwise be excluded.9 A challenge facing traditional lenders is that making small loans is frequently almost as expensive as making large loans, just less profitable.10 This risks excluding customers, such as small businesses, that are looking for relatively small loans.11 Thanks to their greater efficiency and lower cost structure, innovative lenders are able to service the small loan market.12 Fintech lenders are also helping to replace bank lending in areas that have seen significant bank closures.13 Finally, online lending may lead to more equitable outcomes among borrowers. For example, while women own approximately a third of small businesses, they receive under 20% of small business loans from banks.14 Online loans made to women-owned small businesses approximates their market-share.15 Whether this is because online lending is a better fit than applying through a bank or that the process is somehow fairer is unclear,16 but online lending does appear to be a more attractive option for many women entrepreneurs.

C.  Safety

Innovative lending is also potentially safer than traditional bank lending. This is driven by two factors. First, the loans are not backed by a customer’s bank deposits that the lender is obliged to make available on demand.17 This means that in the event of a crisis, the people who fund the loans cannot pull their money out on demand. It also means that in the event an innovative lender fails, the federal government’s depository insurance fund is not threatened. Second, fintech lenders may also make banks safer, especially small banks with limited geographic reach, by allowing them to diversify their loan portfolio with loans outside their traditional service area.18

Innovations in non-bank lending also have the potential to make lending more inclusive, providing credit to borrowers who might otherwise be excluded.9

II. The Risks of Misregulation

While the benefits of innovative lenders are significant, they are threatened by misregulation. These services were created subject to regulations that were designed without them in mind. These regulations, while well-meaning, can make it harder for companies to innovate and decrease access to high quality credit.

Lending is highly regulated, and fintech lending is no exception. Fintech lenders are subject to the same consumer protection laws as banks.19 However, unlike banks, fintech lenders are subject to state-by-state regulation. This often requires the lender to become licensed in every state they extend credit in and prevents them from offering consistent products nationwide because of differences in what constitutes “interest” and what rate of interest they can charge.20 Conversely, under federal law, banks are able to extend credit nationwide under the laws governing interest of their home state.21 This places fintech lenders at a disadvantage that many seek to redress by partnering with banks and having the bank initiate the loan which the fintech lender then purchases and services.22

While the bank partnership model provides a work-around, it raises costs and increases complexity. It is also hard to justify given that fintech lenders are subject to the same consumer protection laws as banks. Why should a bank, but not a fintech lender, be able to extend credit nationwide on consistent terms, without the need to be licensed in every state?

Unfortunately, even the second-best option of bank partnerships is under attack. This attack is most direct in courts. A federal court of appeals in New York recently ruled that a loan that was valid when the bank made it can become invalid under state law if it is sold to a non-bank.23 Courts are also conflicted as to whether the “true lender” is determined by the loan contract,24 or by the court looking beyond the contract to determine the “economic reality of the transaction,”25 creating a confusing morass of conflicting opinions and potentially undercutting the bank-partnership model further.

These court challenges are impacting the ability of fintech lenders to extend credit to the most in need. For example, research shows that in the wake of the Second Circuit’s decision, the number of loans extended by certain fintech lenders to borrowers with poor credit (FICO scores under 625) in 2015 decreased in New York and Connecticut (two states covered by the ruling) by 52 percent compared to 2014, while it increased by 124 percent in states not covered by the ruling.26 This represents a real harm to the borrowers least able to access credit.

The risks created by litigation would be bad enough, unfortunately regulators, whether intentionally or not, are also discouraging banks from partnering with fintech lenders. For example, the Federal Deposit Insurance Corporation’s (FDIC) proposed guidance for banks that partner with third-party lenders tells banks that they will be held responsible for everything their partners do as if it was the bank who acted. 27 This guidance ignores that the fintech lender is an independent entity that should be held responsible for its own actions, not the bank. The prospect of liability for actions the bank has no knowledge or control over will discourage banks from working with fintech lenders, which will discourage innovation and limit people’s access to credit.

More generally, there is a risk that regulators are going to needlessly prevent innovation in a misguided effort to protect the legacy banking system. President and CEO of the St. Louis Federal Reserve James Bullard has said that there is a risk that regulators could “wake up one day and most of the big banks have been eviscerated and most of the activity has moved elsewhere” and that the banks could be “eviscerated” by fintech.28 While a reasonable level of concern about the impact of non-bank fintech firms on the economy could be warranted, there is a risk that regulators tasked with preventing banks from failing view non-bank competition as a threat to banks and therefore dangerous, rather than as pro-consumer and a possible evolution of financial services.

While the benefits of innovative lenders are significant, they are threatened by misregulation. These services were created subject to regulations that were designed without them in mind. These regulations, while well-meaning, can make it harder for companies to innovate and decrease access to high quality credit.

III. Efforts at Regulatory Innovation

Regulators have at least rhetorically acknowledged the importance of modernizing regulation to allow for innovation. For example, the Office of the Comptroller of the Currency (OCC) has established an Office of Innovation that is tasked with helping to encourage “responsible innovation” within the national banking system.29 Likewise, the Commodity Futures Trading Commission (CFTC) has established an innovation program called LabCFTC to “promote responsible innovation and fair competition for the benefit of the American Public.”30 One of the earliest programs of this most recent, nominally pro-innovation, regulatory trend is the Consumer Financial Protection Bureau’s (CFPB) Project Catalyst, a program designed to allow the CFPB to engage with innovators and provide guidance, and in some cases regulatory relief, to firms.31

While these efforts sound appealing, there is a very real question whether they represent a meaningful change in a regulatory dynamic that is often seen as hostile to innovation. For example, the CFPB has only granted one no-action letter to a firm32 and that letter33 provides almost no actual limitation to the CFPB’s enforcement power. Likewise, it fails to provide meaningful guidance or information to the public that would allow other firms to assess how the CFPB views the law. This risks creating an environment where regulatory favor provides a significant advantage to some competitors over others.

A more concrete step to modernize regulation has been taken by the OCC with the proposed non-depository “fintech” special purpose national bank charter.34 This charter would allow fintech firms that lend or provide money-transmission services, but do not accept deposits, to become national banks.35 This would allow fintech firms to tap into the existing laws that govern national banks, including the ability to export the laws governing interest of the bank’s home state, and to remove the need to obtain state licenses for lending and money transmission.36

The OCC’s fintech charter offers some potential to help fintech firms rationalize their regulation and compete more fairly with incumbents. However, it also presents significant questions as to whether it will actually be a meaningful option for all but a few firms. First, the exact scope of requirements to obtain a charter, and the OCC’s wiliness to issue one, are not yet determined.37 Second, some of the requirements, whether imposed by statute or contemplated by the OCC itself, may place an unnecessary burden on fintech firms. For example, national banks are not permitted to go through bankruptcy.38 This means that even though a firm could utilize bankruptcy as a non-bank, it must be wound down by the OCC in a receivership as a bank. As a result, the OCC has indicated that they will expect fintech firms obtaining bank charters to meet certain capital and liquidity requirements39 that may exceed what would be necessary to allow a firm to close out its business and be liquidated in bankruptcy. Additionally, the OCC has announced its intention to require firms that obtain charters to implement a “Financial Inclusion Plan”40 that might approximate, or even exceed, the requirements imposed on depository institutions by the Community Reinvestment Act.41 These requirements, and others like them, create a significant risk that the OCC’s charter will only be viable for the largest and most established fintech firms, preventing new competitors from taking advantage of the regulatory improvement.

The OCC’s proposed charter is flawed, but it would at least represent some effort at making regulation more innovation friendly. It is unfortunate then that the OCC is being sued by the Conference of State Bank Supervisors (CSBS),42 the trade group for state bank regulators, and the New York Department of Financial Services43 to stop the OCC from issuing any fintech charters. The CSBS and NYDFS argue that the OCC is exceeding its authority to issue charters to non-depository firms absent an explicit statutory grant of authority, has failed to follow the appropriate procedure to promulgate the charter, and that the charter would prevent the states from protecting their citizens from predatory behavior.

While the states’ use of litigation to try and impede regulatory innovation is unfortunate, they do have at least one legitimate complaint. Under federal law a state-chartered bank must be an FDIC-insured depository to be able to export the law of their home state governing interest.44 This is one of the key advantages of being a bank, and while the OCC arguably has the authority to charter non-depository national banks that could take advantage of interest rate export,45 the states do not. This makes it hard for states to compete with the federal government on innovation.

While the states have sought to impede innovation on some fronts, they have embraced it on others. State banking regulators have embarked on a program called “Vision 2020”46 that is designed to help make it easier for state-licensed financial services firms to operate in a multi-state environment. While the project seeks to make multi-state licensure and examination more streamlined it remains to be seen whether these innovations will be sufficient.

Other state initiatives may hold more promise. For example, states are beginning to contemplate establishing their own “regulatory sandboxes” as a way to encourage innovative financial services companies to pilot programs within a particular state. The Attorney General of Arizona has called for Arizona to establish a sandbox47 that would provide a path for firms lacking a license or charter to engage in a limited trial of a product before they have to obtain full licenses. This effort follows the successful deployment of regulatory sandboxes in other countries, with the United Kingdom’s Financial Conduct Authority (FCA) regulatory sandbox48 being the first and most developed. As Arizona Attorney General Mark Brnovich notes, states could establish different sandboxes with different rules or focuses, allowing for more innovation and experimentation that could be translated from states to the national market.49

While these efforts sound appealing, there is a very real question whether they represent a meaningful change in a regulatory dynamic that is often seen as hostile to innovation.

IV. How Should Regulators Approach Fintech?

Regulators fill an important role, but if they aren’t careful their policies can hurt the people they are supposed to help. Rules that are unclear, outdated, or needlessly discourage companies from experimenting deny the public the benefits that new products and services can provide. For example, the borrowers denied access to fintech loans they would otherwise view as their best opportunity are not being protected, they are being forced to go to the next worse option.

Further, to the extent that regulators are tempted to conflate the fate of particular firms or ways of providing services (such as banks) with the national interest, they risk harming customers to benefit incumbents.

Fortunately, regulations can fulfill their legitimate and important role of protecting the public while being more innovation friendly. However, this will require regulators to be willing to change rules and processes that are outdated or a poor-fit to the reality of new transactions.

First, regulators must realize that there is nothing per se sacred about any specific method of providing financial services, and that what matters is the ability of the public to meet their financial needs while being protected from fraudulent or unfair bad-acts. As such they should accept that innovation may threaten traditional services and service providers and that that can be ok. For example, if banks become threatened by non-bank fintech firms because customers prefer the new firms regulators should not seek to protect incumbents. Instead, regulators and policy-makers should work to ensure that public policy is not too entwined with the fate of any type of service provider so that market innovations can proceed and help customers obtain the services they need as effectively as possible.

Second, regulators should accept that facilitating innovation will also require regulators to be willing to change how they do business, even if it means forgoing authority or jurisdiction. For example, establishing “regulatory sandboxes” can provide a space where companies can try new things under regulatory supervision. However, a fragmented and overlapping regulatory environment can negate a regulator’s efforts to provide such a space. To work, regulators must be willing to defer to their colleagues in other agencies, whether within the federal government or at the state level, and let one regulator operate their sandbox and take lead in any enforcement decisions. Processes exist to enable this but regulators need to be willing to use those processes.

Likewise, state regulators should stop opposing regulatory innovation at the federal level. Instead, state regulators should pursue federal enabling legislation to allow state licensed or chartered fintech firms to compete with federally chartered firms in the national market. The states may try to accomplish this via harmonization of state requirements, and such efforts should be encouraged, but it is likely that changes in federal law will be required for truly durable change. This could take the form of changing the law to allow state chartered non-depository banks or state licensed financial service providers like lenders and money transmitters to export their license and at least some of their home state law similarly to the exportation enjoyed by federally insured depositories.

Finally, regulators should revise existing policies to better facilitate innovation. For example, the CFPB should change its No Action Letter process to provide greater transparency to the public and the market on its view of what the law requires and how the firm seeking the letter plans to meet those requirements (without divulging trade secrets). This enhanced transparency will allow competitors to develop their products to achieve compliance, making it easier for market participants to comply with the law and seek their own letters. Enhanced transparency will also allow interested parties, whether market participants, consumers, or policymakers to assess the CFPB’s position and, if necessary, take action in the form of litigation or legislation to correct any errors the CFPB has committed.

Done properly, regulation helps create an environment where innovation and consumers can thrive. However, when regulation stifles innovation and prevents people from accessing better products and services, it is failing in its mission. Regulators can become more innovation friendly without jeopardizing legitimate consumer protection; it is time they do so.

Done properly, regulation helps create an environment where innovation and consumers can thrive. However, when regulation stifles innovation and prevents people from accessing better products and services, it is failing in its mission. Regulators can become more innovation friendly without jeopardizing legitimate consumer protection; it is time they do so.

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