FinTech and Regulators Partner on Innovation
The early days of financial technology (FinTech) go back to 2008. The well-known industry names and unicorns we see today were just starting out — competing against traditional banks and disrupting financial services. Fast forward to 2021 and these companies are industry giants partnered with financial institutions and helping the US stay competitive in the global financial ecosystem.
A large blocker in overall progress and competition is regulatory authority and oversight. In the US, there are numerous federal entities (SEC, OCC, IRS, FDIC, FINRA, CFPB) and state authorities that influence what products, services, and experiences fintech platforms can offer. Regulators are not transparent or upfront with policies or positions — opting to respond with guidance on an “after-the-fact” basis (typically after a company made its new product available). For fintechs choosing to connect with regulators for early guidance, there’s a lengthy waiting period for a response.
As fintech continues to grow in volume and demand, the industry’s market leaders are coming together to provide a united front: promoting a collaborative effort with regulators for improved policies governing payments, lending, data access, and licensing approvals. No more “wait-and-see” approach in financial services, the time has come for change that benefits all parties (consumers, fintechs, financial institutions, and regulators).
The FinTech Trade Association (FTA) was recently announced (including companies such as Plaid, Brex, Betterment, Marqeta, and Carta). In a 35+ page report (“Shaping the Future of Finance”), the FTA explains its mission, objectives, and policy focus areas towards ensuring long-term innovation and keeping the US competitive against other countries. Key takeaways we will expand on include:
How FinTech is addressing current issues with financial access and health;
What’s under the umbrella of FinTech;
How FinTech can collaborate with regulators;
Desired outcomes with policy through joint efforts;
In the 12 years since the Financial Crisis of 2008-2009, it’s time to reflect how far the industry has come and look ahead on a recommended path forward.
TACKLING FINANCIAL ISSUES WITH FINTECH
There’s a gap in financial services access both in the US and worldwide. Due to existing infrastructure and out-of-reach prerequisites, millions are without a bank account (unbanked). When FinTech gained momentum about a decade ago, startups targeted this major issue directly with digital banking options (as an alternative to traditional banks).
The impact from COVID-19 only accelerated the shift towards digital — mobile apps, ecommerce, receiving government payments electronically, and transferring funds. The demand for innovative solutions improving our existing financial system has only increased, despite legacy infrastructure still remaining. FinTech offers a way to quickly enhance dated processes and solve for the gap of unbanked and underbanked.
Assisting the Largest Need
Due to stringent requirements at time of application OR monthly fees, many individuals and families lack a basic bank account to deposit their income and pay bills. This has ripple effects in lack of savings and lack of credit to cover emergency expenses. The availability of neobanks and challenger banks provides a path for these consumers to start a banking relationship affordably and securely — most platforms require no fees or balance minimums. There’s also educational content and resources available for users to understand and improve their financial health.
For those in parts of the US without local banks or credit unions, mobile banking access reduces geographic barriers — no need to drive far in search of a physical branch or check cashing location. FinTech offers the best path for managing their finances. Most individuals have a mobile phone with capability for apps. Leveraging this widespread mobile access, FinTech has bridged the gap of access for the underserved in banking.
Financial inclusion can lead to greater economic growth and individual wealth building at the household level — both welcomed, long-term benefits in the US.
Data is also utilized by fintechs to provide credit to individuals with poor or no credit profiles. These customers are known as “credit invisibles”, who struggle in obtaining credit cards, loans, or approvals to lease an apartment. FinTech has created machine learning models to review billing transaction data and income history, in order to create alternative underwriting criteria and scoring. Approved customers are now able to build or improve their credit history and qualify for standard lending products.
tailoring to customers through specialization
Most fintech platforms target a core need and user group with their offering, before expanding their suite of services. This level of specialization drives efficiency over existing processes in banking and financial services. This is where an agile, tech-focused approach can deliver success at faster pace — through iteration based on data, tailored products are available at a lower cost.
As the trend of digital-only transactions increases, customer preferences will continue to shift accordingly. In-person banking requests have declined, especially in the last year due to the pandemic. The legacy models of banks and branch networks no longer meet the current needs of consumers and businesses. FinTech built mobile-only platforms, which are best equipped to provide the modern user experience.
Financial institutions have taken notice of customer experience enhancements from fintechs. No longer seen as competitors, many top banks and credit unions have partnered with startups to meet the needs of their existing clients. The growth of bank-fintech partnerships is expected to only increase in the next decade.
TOP SECTORS LEADING FINTECH DEMAND
The scope of FinTech continues to expand with more innovation and increased demand for embedded financial services. Most concepts stem from core banking needs (e.g. payments, storing funds) not properly addressed by industry incumbents. The new generation of products captures the latest trends from users and tech available, benefiting individuals, groups, and the overall economy.
Payments: The financial system runs on payments. Security, speed, cost, and increased efficiency are the main priorities behind innovation in this sector. The banking infrastructure of payment settlement and clearance lacks upgrades towards what’s currently available. The proliferation of e-wallets, peer-to-peer (P2P) transfers, cardless transactions, early wage access, overdraft protection, and crowdfunding all funnel under payments innovation.
The best application comes from stimulus relief payments. The most efficient method is disbursing through electronic transfers via the ACH network (aka direct deposit). Funds are available right away and can be easily tracked. Twenty years ago, the likely path would have been through physical checks being mailed; however, there’s a risk of lost mail, delay in receiving the check, and then waiting for the check to clear at the local bank.
The latest form of payments innovation comes from blockchain. This technology provides a secure, expedited, and clear path for financial transactions between two parties, without an intermediary. The most notable examples of blockchain in financial services come from real-time remittances (cross-border) and foreign currency exchange.
Lending: From marketplace to alternative lending, FinTech continues to provide access and options to consumers who don’t qualify under bank underwriting models. Streamlined application process, dynamic risk models, and user-specific reviews deliver solutions with higher acceptance rates and lower defaults. Artificial intelligence (AI) generates insights in updating credit scoring models and establishing creditworthiness. For low-credit users who need to build credit by getting approved and using loan products, declines in bank credit applications lead to a negative customer experience. FinTech lending solutions are a huge win for underbanked and credit invisibles.
The benefits carry over to capital partners providing the capital for unsecured credit products. They have access to a new portfolio of customers with lower defaults and higher rates of return, backed by data sets on risk levels. More funding is available to consumers and businesses being overlooked by legacy credit models.
The latest product propelled by new consumer demand is Buy-Now-Pay-Later (BNPL). Fintechs offer a new twist on the layaway model — equal monthly installment payments (interest and fee-free) without credit checks on small dollar products. These are new payment options at checkout and available at the majority of online retailers, such as Walmart, GameStop, and Footlocker. With many Gen Z and millennials choosing to avoid credit cards and only using debit cards, the BNPL method is a welcomed, flexible option.
Wealth Management: Investment options and advisory services were traditionally available to individuals with large balances or assets. FinTech removed these barriers through robo-advising platforms, which provide access to multiple portfolios and exchange-traded funds (ETFs) at no monthly or minimum cost. Consumers can keep long-term savings in accounts with higher rates of return than traditional savings. Recurring transfers and round-ups (taking card transactions and rounding up to the nearest dollar) help boost balances automatically.
As robo-advisors saturated the market, improvements were made to lower transaction costs, increase investing options, and provide custom guidance from licensed professionals. Fintech platforms also partnered with employers to offer incentives for retirement savings and company stock options.
Personal Finance: Living paycheck-to-paycheck, lack of savings for emergency expenses, or no credit — these are all indicators of poor financial health. The lack of education or parents struggling with finances makes it difficult for the next generation to improve their spending and savings habits, and feel secure about their financial future.
FinTech apps offer help with budgeting, savings towards specific goals, and overall money management. Customers can see all their balances and loan obligations on one dashboard. Spending patterns and insights are shared with users to reduce unnecessary purchases. There’s ease in tracking fees or unused subscriptions easily. Notifications can be sent about low balances or suspicious transaction activity. Credit monitoring is also an option to increase credit scores and report fraudulent accounts immediately.
New apps provide a gamification experience in which savings behaviors improve as part of a mobile game or sweepstakes model (e.g. prize-linked savings). Bonuses can be earned based on meeting certain conditions or carrying higher balances.
The list can go on detailing all the other sectors that FinTech is innovating (such as home lending, compliance, and insurance). The benefits are not just for the end-user or fintech platform, but also banks, vendors, and greater economy.
THE COLLABORATION BETWEEN FINTECHS and REGULATORS
With all the innovation and change taking place throughout the industry, sustainable growth needs to directly align with regulators who govern the financial ecosystem and protect consumers. Poor monitoring of financial products and platforms can lead to increased fraud and money laundering. Current policies in place focus on anti-money laundering efforts as the top priority, and not industry growth.
There needs to be an improved balance in policy that prevents criminal activity and also supports responsible innovation. Maintaining the status quo of poor transparency in regulatory frameworks prohibits the improved outcomes from FinTech. Modernization from regulators needs to includes the innovation of an online, tech-enabled ecosystem. A forward-looking model must accommodate and validate new business models.
NORTH STAR FOR THE FINTECH TRADE ASSOCIATION:
Safeguarding, empowering, and advancing consumer and end-user interests should drive policy formulation.
With this context, the FTA has mapped out five areas of focus with updated policies that include proper safeguards for consumers (i.e. data privacy, disclosures, multiple options) AND allow the innovation of financial services.
Improving Regulatory Processes for Charters and Licenses
Summary: Before 2020, bank license approvals for fintechs were rare. Most companies decided not to take this path due to the lengthy process, high cost, and uncertainty in outcome. The tide changed last year with Varo (neobank in the US) receiving its license to become an independent bank. Updating the overall application and approval process would increase interest from fintechs. Regulators would be able to provide direct oversight on companies with bank charters, especially on business models and products. Critical consumer protection can still be in place, but through an enhanced charter process there’s room to welcome innovative new companies.
Recommendations:
Update regulatory frameworks and processes towards charter and license approvals;
Utilize existing innovation from FinTech to enhance current payments infrastructure and networks;
Encourage new models that increase competition and maintain consumer safeguards;
Promoting collaboration between Federal and State Regulators
Summary: In the US, there is overlap and contradiction between federal policies and state-by-state guidelines. This complexity results in fintechs lacking accurate legal opinions on what’s allowed in open markets versus what would be penalized. The numerous regulating entities that exist at both federal and state levels should unite on what’s most important and how this can best be monitored to support innovation, competition, and end-users. Changes that minimize ambiguity with clear guidance would be immediately impactful.
Recommendations:
Clarify federal and state obligations for fintechs, and how they play out in launching a new platform or product;
Implement best practices towards efficiency in reviews and monitoring at the state level;
Encourage both federal and state regulators to work together in solving common issues;
Establishing Bank and Fintech Partnership Frameworks
Summary: The bank-fintech partnership model is now a common framework in the industry. New policies can show increased support of how beneficial these partnerships are towards increasing financial access, product options, and overall financial health. Standardizing certain partnership models would accelerate new platforms and models coming to market, and ensure proper compliance and monitoring from the start.
Recommendations:
Establish approved models and frameworks for partnerships between fintechs and banks;
Support new developments in partnership structures that spur innovation while balancing risk controls;
Provide guidance on best practices for technology and compliance standards between financial institutions and fintechs;
Expanding Financial Education and Long-term Investment Opportunities (for businesses and consumers)
Summary: In addition to beneficial short-term outcomes of financial access, changes in policy should also target long-term financial health in the US. A critical component is the accumulation of capital by businesses and wealth by consumers. New capital helps businesses launch and gain traction in the marketplace. Investing in these businesses at an early stage can increase household asset value and reduce financial inequality. The combination of financial education and opportunities can build new wealth.
Recommendations:
Encourage organizations and platforms to include financial education as part of their programs;
Stay up-to-date with objective info on the latest products and business models that generate wealth;
Support and validate marketplaces with new investment opportunities;
Upgrading Regulatory Oversight and Compliance
Summary: The broad scope at federal and state levels funnels into the risk and operations practices of fintechs and banks. Updating the path for companies to become (and stay) compliant is a critical component of long-term growth. FinTech has created regulatory technology (or RegTech) to solve for these complexities. The learnings and processes from RegTech firms can minimize findings and complaints for both fintechs and banks.
Recommendations:
Create government-sponsored testing programs and regulatory sandbox environments to test new models;
Include dialogue from fintechs at regulatory agencies and committees deciding on policy;
Digitize required compliance and government reporting to improve evaluation of new programs and approvals;
Adopt RegTech principles and practices to modernize oversight on money laundering, identity theft, and other criminal activity in the financial system;
DESIRED OUTLOOK FOR FINTECH policy IN THE US
The ask from the FTA is overarching and broad, but it essentially puts all the cards on the table for government regulators to take action. The first formal step in collaborating has been made and the beneficial outcomes not only for the FinTech industry (but also the country as a whole) are clear: to maintain a leadership position in the global economy, innovation must be encouraged and not deterred.
There are other countries with open banking support, regulatory sandboxes, and government-sponsored innovation programs. The US would be left behind if the current regulatory conditions persist. The ball is now in the hands of the various government agencies, some (such as the OCC) which have shown recent signs of fintech inclusion.
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