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Highlights and Recommendations from the Treasury’s Report on Fintech

Tuesday, July 31, 2018 may go down in history as Fintech Day in the US. On that day, the US Treasury Department released a 222-page report titled A Financial System That Creates Economic Opportunities: Nonbank Financials, Fintech, and Innovation, and the OCC announced it would consider charter applications from fintech companies.

Below are highlights and recommendations from the Treasury report, with our So What? analysis.

Consumer Financial Data

One of the first sections in the report--and one of the most important in my opinion--was a discussion of the need for better regulation and policies concerning the sharing and use of consumers' financial data. According to the report:

"Data aggregators, consumer fintech application providers, and financial services companies generally agree that consumers should have secure and reliable access to their financial account and transaction data, and that, in principle, consumers, if they opt-in, should be able to utilize fintech applications and other innovations that make use of their data. However, there is a lack of consensus on what secure and reliable access entails. As described by one observer, 'the U.S. debate seems stuck at the yet-to-be resolved issue of migrating account aggregators from screen scraping-based to more secure and efficient API-based data-sharing methodologies.'

Consumers’ ability to realize the benefits of data aggregation is limited, in part due to the lack of agreement between data aggregators and financial services companies over access to consumer financial account and transaction data. As information and data technology advances, and with sustained commitment to the principle that consumers should be able to freely access and use their financial account and transaction data, Treasury believes that improved approaches to data aggregation that will benefit consumers and financial institutions alike are surely attainable."

The Treasury recommended that:

  • The Bureau work with the private sector to develop best practices on disclosures and terms and conditions regarding consumers’ use of products and services powered by consumer financial account and transaction data provided by data aggregators and financial services companies.
  • Consumers should have the ability to revoke their prior authorization that permits data aggregators and fintech applications to access their financial account and transaction data. If necessary, banking regulators and the SEC should consider issuing rules that require financial services companies to comply with a consumer request to limit, suspend, or terminate access to the consumer’s financial account and transaction data.
  • Barriers to data sharing agreements should be eliminated. Legal and regulatory uncertainties currently holding back financial services companies and data aggregators from establishing data sharing agreements that effectively move firms away from screen-scraping to more secure and efficient methods of data access should be removed.
  • Data elements should be standardized. Any potential solution [to data sharing and access] address the standardization of data elements as part of improving consumers’ access to their data.

The Treasury's report and recommendations go nowhere deep enough in addressing the complexities of how the data is used, and how to deal with the issues of what data is stored and where it's stored. The report's consistent reference to "data aggregators and fintech applications" ignores the role of non-fintech players like the big tech behemoths (Amazon, Google, Apple, e.g.) and even retailers (Starbucks, Walmart, etc.) who are increasingly offering funds storage and payment (i.e., financial) capabilities. Lastly, financial institutions should be concerned about the future costs of complying with any regulations concerning the standardization of consumers' financial data elements. How those standards will even come about should be of some concern.

Lending

According to the report:

"The share of non-bank lending in the US residential mortgage market has been significant in recent decades due in part to their e availability of warehouse financing and access to federally supported securitization programs. Non-banks enjoy access to securitization channels on largely equal footing to banks, which supports their ability to accommodate a large share of the origination market.

Non-bank digital lenders have gained out-sized attention [due to] their employment of technology-intensive approaches to lending. These firms, such as marketplace lenders active in consumer and small business lending, have digitized the customer acquisition, origination, underwriting, and servicing processes. Moreover, these lenders are designing these digital services to provide customer experiences that are seamless and more timely than the techniques generally employed by traditional lenders. These changes also appear to reduce expenses, which lowers the cost of credit as well as providing greater access to credit.

In contrast, many financial institutions have yet to digitize their lending at a similar level. Less than half of banks  have digitized some aspects of their loan origination channels. Moreover, the degree of digitization is much less comprehensive than new digital lenders. Even for banks that offer a digital origination channel, online features  vary, as 90% or more have digitized the application processes, less than half provide for electronic signatures and document uploads, a third provide online customer service, and less than 20% provide instant credit decisions."

Among a slew of recommendation in this area, the Treasury recommended that:

  • Congress codify the “valid when made” doctrine to preserve the functioning of U.S. credit markets and the longstanding ability of banks and other financial institutions, including marketplace lenders, to buy and sell validly made loans without the risk of coming into conflict with state interest rate limits. Additionally, the federal banking regulators should use their available authorities to address challenges posed by Madden.
  • Congress codify that the existence of a service or economic relationship between a bank and a third party (including financial technology companies) does not affect the role of the bank as the true lender of loans it makes. Further, federal banking regulators should also reaffirm that the bank remains the true lender under such partnership arrangements.
  • State regulation should not occur in a manner that hinders bank partnership models already operating in a safe and sound manner with appropriate consumer protections.
  • A risk-sharing program for institutions participating in the federal student loan program based on the amount of principal repaid following five years of payments should be implemented. Schools whose students have systematically low loan repayment rates should be required to repay small amounts of federal dollars in order to protect taxpayers’ growing investment in the federal student loan program.
  • The CFPB rescind its Payday Rule. In addition, the Treasury recommended that federal and state regulators to encourage short-term, small-dollar installment lending by banks, and that the FDIC reconsider its guidance on direct deposit advance services and issue new guidance similar to the OCC’s core lending principles for short-term, small-dollar installment lending.
  • Federal and state regulators enable the testing of newer credit models and data sources. Regulators should be willing to recognize and value innovation in credit modelling approaches, and recommended that regulators should provide regulatory clarity for the use of new data and modeling approaches that are generally recognized as providing predictive value consistent with applicable law for use in credit decisions.

Overall, the Treasury's recommendations are very bank-friendly. It's suggestions that universities have some skin in the student lending game are spot-on and intriguing, but will be met with a lot of political resistance. Speaking of political resistance, the CFPB's Payday Rule plans has already been met with a lot of criticism. But the Treasury's recommendation to encourage banks to do short-term, small-dollar installment lending could open the door to new business opportunities.

The recommendations with the potentially biggest long-term impact were those relating to the testing of new credit models and data sources. While the Treasury's recommendations on this topic were couched in terms of "expanding financial inclusion," the use of new credit model and data sources is what is enabling fintech startups and big tech firms to encroach on traditional banks' lending business. The Treasury's recommendations should be looked on as less regulatory permission, and more wake-up call.

Payments

Despite a lengthy discussion of payment-related topics including money transmitters, P2P payments, digital wallets, and faster payments, the report was conspicuously light on recommendations. One key passage on faster payments:

"While Treasury believes that a payment system led by the private sector has the potential to be at the forefront of innovation and allow for the most advanced payments system in the world, back-end Federal Reserve payment services must also be appropriately enhanced to enable innovations. Treasury agrees with the Federal Reserve’s policy criteria for introducing a new payment service – namely, that the Fed must: (1) expect to achieve full cost recovery in the long run; (2) expect the service to provide a clear public benefit, including improving the effectiveness of markets, reducing the risk in payments, or improving efficiency of the payments system; and (3) conclude that the service should be one that other providers alone cannot expect to provide with reasonable effectiveness, scope, and equity."

The Treasury punted. The Fed's policy criteria for introducing a new payment service is undoable. How much will it cost to launch a new "faster" payment service, and who is going to pay for it in order to meet the "full cost recovery" criteria? And how will anyone determine if other providers could provide that  service with "reasonable effectiveness, scope, and equity"?

Regulatory Sandboxes

The section on regulatory sandboxes wasn't a particularly big section, but the Treasury had this to say on the topic:

"The regulatory environment should be flexible so that firms can experiment without the threat of enforcement actions that would imperil the existence of a firm. Innovating is an iterative process, and regulator feedback can play a helpful role while upholding safeguards and standards. The fragmented nature of the U.S. financial regulatory system undercuts efforts by regulators to support innovation.

Treasury recommends that federal and state financial regulators establish a unified solution that coordinates and expedites regulatory relief under applicable laws and regulations to permit meaningful experimentation for innovative products, services, and processes. Such efforts would form, in essence, a “regulatory sandbox” that can enhance and promote innovation."

This recommendation was met with unfair criticism from a number of parties who misunderstand the intent of a financial "sandbox." The critique was that fintech startups were getting a "free pass" to experiment outside the regulatory guidelines. The reality is just the opposite--the sandboxes create an environment in which the impact of fintech innovations can be monitored and measure for regulatory compliance. According to Jason Henrichs, Managing Director at Fintech Forge:

"The purpose of the sandbox is to bring risk, compliance and security teams in early. With this grounding, efforts can be scaled and risk management industrialized at the appropriate time."

The appointment of Paul Watkins--formerly a lawyer in the Arizona attorney general’s office who set up an initiative to attract fintech firms with the nation’s first state-level sandbox program--to head up the CFPB's newly announced sandbox initiative is a major step to realizing the Treasury's recommendation.

For more details and discussion on the Treasury report and the OCC announcement, check out the Breaking Banks podcast episode from August 2, 2018. 

Ron Shevlin
Director of Research
Cornerstone Advisors

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