In his book Stress Test, former Treasury Secretary Tim Geithner vividly describes the difficulty he encountered in trying to get the various federal financial regulators to go along with the Obama administration’s post-crisis regulatory reform agenda. In the summer of 2009, after the Treasury Department released the details of their proposal, regulators swarmed Capitol Hill to lobby Congress on behalf of their agencies. Frustrated by this obstructionism, Geithner called the heads of these agencies to Treasury, where in no uncertain terms he told them: “You’re having a lot of fun right now, fucking with us, trying to protect your own turf. You’re going to screw up the chances for meaningful reform. And you should know that at some point at the end of this process, we’re going to be in the room and you’re not.”
If financial regulators were unwilling to cooperate in the aftermath of the worst financial crisis since the Great Depression, what are the odds they will work together in times of relative stability? This is the question that companies in the emerging financial technology (fintech) sector have been asking themselves, as they begin to grapple with a regulatory apparatus that appears ill-equipped to incorporate innovation that challenges the traditional definition of what it means to be a bank. By failing to provide needed clarity to fintech firms, the U.S. risks losing out on hosting the next wave of innovative companies that could drive economic growth going forward.
The potential impact of fintech on jobs and economic growth is very much uncertain. What is not uncertain is the amount of investment flowing into the fintech sector and the sector’s disruptive potential. According to PWC, funding of fintech start-ups went from $5.6 billion in 2014 to $12.2 billion in 2015, and Goldman Sachs estimates that up to $660 billion in revenue could migrate over time from traditional financial services firms to fintech companies operating in the payments, crowdfunding, wealth management and lending space. The jobs associated with this migration will be better paying than your traditional financial services jobs. In 2014, the median annual wage for computer and information technology occupations was $79,390, compared to $35,540 for financial occupations.
The U.K.’s Sandbox
The U.K. was quick to recognize the potential of the fintech industry to help consumers, create well-paying jobs, and serve as an engine of growth. This is why, in 2015, the U.K.’s Financial Conduct Authority (FCA) launched a regulatory sandbox in order to provide businesses a ‘safe space’ to test “innovative products, services, business models and delivery mechanisms in a live environment without immediately incurring all the normal regulatory consequences of engaging in the activity in question.”
Applicants to the sandbox must demonstrate that their product/business is a genuine innovation; helps consumers; could benefit from being in the sandbox; and is ready for testing. If these criteria are met and the applicant is admitted into the sandbox, they will receive individual guidance from the FCA, a waiver or modification to existing rules if the applicant demonstrates they are unduly burdensome, and possibly a no enforcement action letter that protects the firm from disciplinary action provided they deal truthfully and fairly with the FCA. The FCA received 69 applications for its initial sandbox cohort and admitted 24 firms who met the eligibility requirements. They are currently accepting applications for the second cohort.
The U.K. government’s proactive approach to fintech has begun to pay off. Earlier this year, Ernst & Young looked at several different metrics and found the U.K. to have the “strongest FinTech ecosystem” in the world. This is in large part due to the U.K. fintech sector generating £6.6 billion in revenue in 2015 and employing 61,000 people. Policymakers and regulators around the world have taken note of the U.K.’s approach, and many have adopted, or are exploring, similar sandbox structures.[1]
The OCC’s Approach
In the U.S., regulators have only recently begun to take action on the fintech front. Last month, the OCC released its Responsible Innovation Framework, which, among other things, establishes an Office of Innovation to serve as a central point of contact for fintech companies seeking guidance on regulatory matters. The framework also calls for the creation of a Chief Innovation Officer (CINO) and for increased hiring of employees with technical expertise. In order to facilitate the flow of communication between the OCC and fintech firms, Innovation Officers will be located in the “financial technology hubs” of New York and San Francisco, in addition to the head office in Washington D.C. The Framework also opens the door for the creation of a pilot program that would “facilitate adoption of new solutions and enhancement of risk management by permitting testing and discovery before full-scale commitment and rollout.” Such a program would only be available to OCC-supervised banks or fintech companies in partnership with an OCC-supervised bank. The OCC also makes clear that participants in such a program would still have to comply with all the relevant consumer protection requirements.
Impediments in the U.S.
The OCC’s Innovation Framework is a step in the right direction, and is expected to be followed in the coming weeks by the unveiling of a new fintech bank charter. However, both these measures fall short of the sandbox approach adopted by the U.K. and other countries. Part of the problem is that U.S. regulators are primarily focused on preventing ‘bad things’ from happening. As the OCC’s general counsel, Amy Friend, recently said: “We are risk-averse by nature.” The U.K.’s FCA was able to overcome this mental hurdle due to the fact that in addition to protecting consumers and promoting market integrity, they are also mandated to promote effective competition.
Perhaps a greater impediment to fostering financial sector innovation in the U.S. is our alphabet soup of federal financial regulators and their historical reluctance to cooperate with one another – as someone who worked for five years at the Federal Reserve Bank of New York I can attest to this. Even if the OCC creates a fintech charter, a whole host of other questions must be answered before we see a wave of new fintech products hit the marketplace. For instance, the Federal Reserve Act requires all national banks to be members of the Fed; which raises the question of whether the Fed would require a fintech national bank to become a Federal Reserve member. And because the Fed regulates all bank holding companies, would a firm that receives an OCC fintech charter be required to register their parent company as a bank holding company? And of course, any fintech company that aims to hold customer deposits must get deposit insurance from the FDIC, and they have remained largely silent on fintech matters.
The uncertainty is just as great at the state level. Any fintech firm that seeks to transmit customer funds must get licensed on a state-by-state basis. Each state also has their own interest and usury laws, as well as licensing requirements, that new peer-to-peer and marketplace lenders must contend with. This is why so many of these new online non-bank lenders are partnering with traditional banks, who have long enjoyed the ability to export their home state’s interest rate limits across state lines.[2]
A New Bill to Foster Financial Innovation
Congressman Patrick McHenry (R-NC), recently introduced a bill designed to remove the many impediments currently faced by innovators in the financial services industry. It is a sensible piece of legislation that can achieve bipartisan support. The bill requires each financial regulatory agency to establish a financial services innovation office (FSIO) that will facilitate the development of financial innovations and work with fintech companies to help them understand and comply with the relevant regulatory requirements. The Director of each agency’s FSIO office will also serve on the FSIO Liaison Committee which will help ensure that agencies are working together to foster innovation and are developing uniform principles and standards. Combined, these efforts will help ensure a level of inter-agency coordination that is unlikely to occur otherwise.
But the real meat of McHenry’s bill is the adoption of something that looks similar to the U.K.’s sandbox approach, albeit with a few variations that give U.S. regulators less discretion. The bill allows any fintech company to petition one or more federal financial regulators for a waiver or modification to an existing agency rule or regulation provided the innovation:[3]
- would serve the public interest;
- improves access to financial products or services; and
- does not present systemic risk to the United States financial system and promotes consumer protection.
If these conditions are met, the company would enter into an enforceable compliance agreement with the relevant agency that would specify the waiver or modification and the company’s plan for complying with other applicable rules and regulations. Once the enforcement agreement is in effect, no federal or state agency can initiate an enforcement action against the company “with respect to the financial innovation that is the subject of the enforceable compliance agreement.”
What makes McHenry’s bill unique, compared to the U.K.’s sandbox, is that it gives the benefit of the doubt to fintech companies and places the onus on federal regulators to come up with credible reasons for why a waiver or modification should not be granted. Within 30 days of receiving a petition, the agency must publish the petition in the Federal Register and allow 60 days for public comments. Within 30 days after the end of the comment period, the agency must provide an answer to the petitioner in writing. If the petition is denied, the agency must describe why, as well as list any companies likely to benefit from rejecting the petition. This last part is critical, as it is likely that large banks, in many instances, would prefer not to have some aspect of their business challenged by a new tech startup. By publicly identifying incumbent firms that benefit from a banking agency rejecting a fintech company’s petition, it brings transparency to the process and ensures that regulation does more than simply protect firms already under the regulatory umbrella.
Legislative Outlook
The McHenry bill hasn’t seen much movement since it was introduced in September. Nor does the bill appear to rank highly on the incoming administration’s list of priorities. But President-elect Trump has said his number one priority is jobs, and the McHenry bill would go a long way towards ensuring that the next generation of financial services jobs stay in this country.
[1] Australia, Malaysia, Singapore, Hong Kong and Abu Dhabi all have, or are considering, a sandbox approach
[2] Traditional banks have relied upon the ability to export interest and fees pursuant to 12 U.S.C. § 85 (2015) and 12 U.S.C. § 1831d(a) (2015). Non-bank lenders do not enjoy this privilege.
[3] Agencies in scope include: the Board of Governors of the Federal Reserve System, the Bureau of Consumer Financial Protection, the Commodity Futures Trading Commission, the Department of Housing and Urban Development, the Department of the Treasury, the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Federal Trade Commission, the National Credit Union Administration Board, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission.
All the Agencies in scope should try improve in the way of delivering services to their client.