Can Regulators Keep Up with Fintech?

Compared to the transformation of other sectors, financial services have been slow to take full advantage of technology. But that may be changing; PwC estimates that by 2020, 28% of traditional banking and payments business will go to fintech—the all-purpose category that covers almost any meshing of financial services with technology, including everything from banking apps to bitcoin to robo-advisors for investors.

In theory, regulators define a level playing field, businesses compete within those bounds, and consumers benefit from a system that encourages both innovation and stability. But theory doesn’t always match reality; it’s simply difficult to set a truly level playing field when all the players are seeking to tilt it their way, and especially when the lines between industries are blurring.

“Fintech companies have quickly moved on from their initially modest offerings in back office operations into areas such as trading, investment, retail banking, thus emerging as direct competitors in the industry,” notes Reuters. This was “partly due to a regulatory void in which [fintechs] have operated until recently, and the lackluster innovative adaptability by traditional banks.”

With change underway, regulators must decide what their goals are. According to Reuters, a mainline “evolutionary” approach would mean “fintech companies offering bank-like products and services [that] must comply with laws that apply to national banks as well as consumer protection regulations.” A “revolutionary” proposal, on the other hand, prioritizes innovation through a Financial Services Innovation Offices that would create a separate category for fintechs where “regulatory beta testing” would speed the flow of innovative financial technologies to market.

To understand the regulator’s perspective, Yale Insights talked with Gary Stern, former president and chief executive officer of the Federal Reserve Bank of Minneapolis. Stern was in New Haven to participate in the Fintech Transformation Conference hosted by Yale SOM’s International Center for Finance.

Q: What kind of challenges does fintech innovation pose to the Federal Reserve and other financial services regulators?

I think the place to start is with the public policy objectives for financial services regulators. I’ve always broken it down into two distinct objectives. First is to encourage a financial system that meets the needs of its customers—customers being households and consumers, small business, big business, municipalities, and so on. Second is to make sure the taxpayer is reasonably well protected. Or, turn that around, you want to encourage financial stability because, if you don’t, then sooner or later, the taxpayer winds up getting stuck with large bills, as we saw in the most recent financial crisis.

If you’re a policymaker and those are the objectives, how do you view fintech? Fintech’s biggest impacts are likely to be on customers of financial services. Over time, I can imagine that the implications turn out to be quite substantial. I’m sure there’ll be some disagreement with this, but I think right now, most customers of financial services firms are already reasonably well served in the sense that they can choose a wide range of products and services from a wide range of institutions. Pricing is reasonably competitive. But with the innovation and application of fintech, there’s a good reason to believe that costs might go down. The range of services probably will broaden even further. The speed of transactions will probably increase. Perhaps the safety and security of transactions will improve. There seems to be good upside. In and of itself, fintech probably doesn’t have profound implications for financial stability.

From a regulator’s point of view, you want to make sure, if you can, that the upside is achieved without unintentionally or inadvertently compromising something else. For instance, speed is desirable, but it isn’t an end in and of itself. You may have to weigh the cost and benefits of speed versus, say, security of the transaction. That’s the kind of thing that policymakers will have to think about.

Q: How do the people inside government keep up with the changing technology?

It’s not easy. I mean, you’re pointing to a real issue. There are various tactics, but at the end of the day, they all involve applying resources to it. They can be internal resources—for the Federal Reserve it might mean creating a committee tasked with staying up to date on developments in an area like payments. I’m sure the SEC is devoting resources to developments that affect the financial markets, how well they function, and making sure that the consumer is reasonably well protected as fintech evolves.

Another use of the resources would be to hire outside experts, individuals, or firms. I don’t think any institution has a monopoly on insight and expertise. Or you can attend events like this conference where in a single day you can pick up a fair amount of knowledge at relatively low cost.

Even so, regulators will often be a half-step behind. That can be good because you don’t want regulators to pre-judge or anticipate how things are going to go. The private sector is going to be much better at that. It could be bad because there could be an accident along the way, and the regulator has to go in and pick up the pieces. But in a market economy like ours, that shouldn’t be unduly distressing, because we’re used to success and failure. It’s what makes a market economy succeed at the end of the day. If you try to have the regulators constrain things at the outset, you would probably cut off some very important innovation.

Q: How do you find that line between defining the playing field and allowing freedom to innovate?

It involves judgment. Information is key, too. It’s necessary to assess in a timely way what’s developing, what’s new and different, its characteristics, and its implications. I don’t mean to suggest that assessing potential risks is easy, but I think you ask, if we go down this path, how serious might any unanticipated negative consequences be? And if you can answer that question within a reasonable approximation, and there’s no reason to think the worst case would be really destructive, I would err on the side of letting things flow and not trying to anticipate and therefore step in to prevent every bad outcome.

Q: What lessons, if there are any, from the financial crisis can be applied to fintech?

There are multiple stories that could be told about the financial crisis, why it occurred, what went wrong, and so forth. But one thing is sure—the incentives were bad. The incentives led to excessive risk taking. I don’t think you could have anticipated exactly what that risk taking would look like, but when the incentives are wrong, there’s a good chance that something is going to go wrong. And that’s what happened.

Will fintech help to improve incentives? I don’t think it’ll do any damage. Fintech may enable financial market participants, whether they’re investors or creditors or borrowers, to make better decisions by weighing more factors at less cost than might have otherwise been the case. But whether you’re a provider or a consumer of financial services, you’re going to make decisions based on what you perceive to be in your best interest, not in the best interest of your neighbor or the economy as a whole.

It’s up to the policymakers to think broadly. There, fintech may on the margins help regulators do their job if they get better data or can analyze it more quickly. That might help formulate better regulations over time. But again, it isn’t obvious that fintech in and of itself will improve incentives.

Q: Who should regulate the innovations coming out of fintech?

Right now, we have a very jumbled regulatory system. There are upwards of a dozen regulators in the financial services arena. Who ought to bear responsibility for thinking about fintech and regulation? Certainly the bank regulators, and perhaps the SEC and FINRA (Financial Industry Regulatory Authority) as well. The Consumer Financial Protection Bureau probably enters in some way. Given the current structure, the best thing would be to have the FSOC (Financial Stability Oversight Council), which is under the leadership of the Secretary of the Treasury, decide who’s got responsibility for what. But that’s a stretch because FSOC doesn’t function terribly well right now. I think everybody would agree that the system we have is flawed. But there doesn’t seem to be any real momentum or traction to try to fix it.

Maybe this is a solution looking for a problem in the sense that even if you can’t point to the Fed or the SEC as the key player, it’s not like the regulators aren’t already working on it. Ultimately, I think most if not all of the regulators want to make sure they understand what’s happening in the fintech world, because the implications may turn out to be very significant.