I spoke this month at the annual Symposium of Women in Housing & Finance in Washington, DC. This year’s topic was fintech and was well-timed, since the OCC had just issued its White Paper on Responsible Innovation. In my session, I talked with OCC Chief Counsel Amy Friend, who has chaired the innovation task force, about their plans.
Before the conference, WHF asked me to help them create a Q&A document for the program. I’d agreed, thinking I could dash off a few quick sentences on each item. As I worked on them, though, I found the questions (prepared by the OCC) to be exceptionally thought-provoking. The more I wrote, the more they clarified my own thinking -- even though I’m speaking and writing on these subjects every day.
So, I’m sharing them with you.
Meanwhile, if you’re in the DC area, join WHF for great events and networking!
"A Q&A with FinTech Expert Jo Ann Barefoot"
Ahead of the 2016 Symposium, WHF interviewed Jo Ann Barefoot, CEO of the Jo Ann Barefoot Group, LLC which advises on financial technology and regulation. Jo Ann previously served as Deputy Comptroller of the Currency and served for three years on the Consumer Advisory Board of the Consumer Financial Protection Bureau.
WHF: How would you define FinTech and what are some emerging products/services in the FinTech industry?
Barefoot: FinTech is innovation that applies new technologies to financial services and channels with the goal of making them faster, cheaper, clearer, more manageable and/or more user-friendly. In my view, they are more “tech” than “fin.” For that reason, the financial world is tending to underestimate the scale and speed of the coming change, because most of the change is happening in the technology world rather than in finance. It’s developing outside the field of vision of most financial people.
Emerging products and services take many forms. They include online lending; “marketplace” or peer-to-peer lending that matches borrowers and lenders online; payments innovations like digital currency and the “blockchain” and efforts to “uberize” payments by making them disappear into the consumer experience; “robo-investing” that automates investment management; and a vast array of mobile solutions that aim to solve a spectrum of consumer problems, from providing short-term cash, to making savings easy, to helping people manage their finances in new, engaging ways through personal financial managementtools, or “PFM.”
The five main technologies being leveraged are big data; artificial intelligence and “machine learning;” natural voice technology; digital currency and the blockchain; and online and especially mobile. Importantly, most FinTech innovators are applying more than one of these. Just as Uber disrupted both the taxi industry and traditional payment processes, FinTech companies are trying to break category walls by combining, say, sophisticated new data analytics with mobile delivery channels.
WHF: Why are regulators turning their attention to the FinTech industry now?
Barefoot: The regulators are recognizing that these technologies are rapidly disrupting financial services and call for updated regulatory thinking. Financial services are by far the most pervasively regulated sector to undergo disruption, which inevitably means that the changes ahead will disrupt the regulatory framework too. The agencies face a range of challenges. One is the sheer speed of change, which is dramatically mismatched with the normal pace of regulatory action. A related issue is that traditional regulatory processes don’t easily lend themselves to ongoing collaborative dialogue, which will probably be needed to foster the “rapid learning” regulators will need to keep up with new developments. These forces are likely to push the regulators toward more use of principles-based, rather than rules-based strategies, because the market will change too fast for rules to stay current.
In terms of consumer impacts, the agencies are increasingly recognizing that regulatory actions could inadvertently undermine desirable innovation. For instance, Federal Reserve research has shown that lower-income and minority consumers are disproportionately high users of smart phones. Mobile fintech creates an unprecedented opportunity to reach millions of consumers with more affordable products than has ever been possible before. Similarly, alternative Big Data and analytics are making it possible to make finance more inclusive by reaching more customers with “thin” or no credit files or complex credit histories. Robo-investing, too, expands the affordability of investment advice. Digital currency, meanwhile, is speeding up payments, which can reduce the difficulty of paying bills for consumers who have no financial cushion and currently rely heavily on cash to be sure their payments are credited on time.
On the other hand, the agencies also see fast-emerging new consumer risks from FinTech. These range from loss of privacy and cybersecurity, to likely increases in branch closings, to fairness and discrimination questions arising from use of alternative big data to evaluate credit worthiness.
Beyond these issues, regulators are concerned about the impacts of FinTech on the overall financial system. They are looking at risks to banks from adopting new technologies that have not been tested by time and the business cycle. They are working on how best to allow banks to partner with innovators, while assuring protection of the bank and its customers. They need to worry about whether regulatory burdens on banks will cause them to lose ground to nonbanks. They are also grappling with how to regulate a fast-growing and diverse nonbank industry that will include players ranging from “big tech” firms like Facebook and Amazon to legions of small startups. At the federal level, we have a bank-centric financial regulatory system, confronting an increasingly diverse nonbank marketplace. At the state level, regulators are working on equipping themselves to evaluate license applications and to oversee novel kinds of companies and to consider the challenges involved in enabling nonbank innovators to reach scale.
Regulators are also exploring how best to work together. These issues impact our five federal agencies that directly supervise financial institutions, as well as agencies ranging from the FTC (which generally leads in privacy matters) to FINRA to the SEC. Coordination will be important.
WHF: You have used the term “Regulation Innovation” in the past. What does this mean and don’t the two words oppose each other?
Barefoot: I use the phrase “Regulation Innovation” partly because, as you say, it seems incongruent – it startles people! I think the most important thing for banks to recognize is that they are facing two overwhelming strategic challenges. One is regulation. The other is innovation. Today, banks manage these as separate issues, with different people and tools. In reality, though, the two are deeply intertwined, because the same weakness cause vulnerability in both realms.
A critical point is that consumer protection regulators and disruptive innovators are targeting the same aspects of traditional consumer finance. They are both identifying places where the provider benefits – knowingly or not -- from the customer’s confusion, inertia, or lack of financial education, or where pricing is high due to legacy structures and compensation arrangements. It’s like a pincer attack, from two directions at once. Examples include overdraft protection by banks and payday lending. The industry knows that regulators are reviewing these, but may not realize that innovators are attacking them too. The more profitable a product or practice is, the more likely it is that innovators are aiming to compete with it.
Regulation and innovation are also connected in that both have entered a stage of permanent uncertainty. This may be obvious regarding innovation, but it’s also true of regulation. Change is coming so fast the regulatory clarity will lag behind. The traditional compliance model of waiting for regulators to provide rules and then implementing them will need to be remade. We’ll still have many rules, of course, but increasingly banks will have to use their own judgment about regulatory risk, in the absence of clear prescriptive regulations. The solution to this will be to build ever-improving consumer benefit and pricing into every product. Doing this will, simultaneously, defend against FinTech competition.
Another trait linking the two areas is that they both are, increasingly, all about data, and especially understanding the overall patterns that data reveal. Most banks’ IT systems have evolved over decades and are weak in connecting data to gain a holistic picture. Today, regulators are analyzing data, such as CFPB complaint numbers, and finding patterns that raise concerns about unfair and deceptive practices (UDAAP) or discrimination. Most banks are blind to these because their compliance systems look mainly at technical regulations, while greater risks are arising “in the cracks” where compliance never looks, such as in unintended impacts of operating systems or in disconnects between what is marketed and what some customers receive. Principles-based regulation, especially UDAAP, has become the top risk in consumer protection, and it is often detected initially by looking at data.
The good news is that the interconnection of regulation and innovation means that fixing one, helps fix the other. The more banks assure that products and practices are transparent and well-priced, the more they will be well-positioned to prevent both regulatory and FinTech competitive risk.
Finally, banks (and policymakers) should focus on burgeoning innovation in “Reg-Tech” – new technologies that can make regulation simpler and more automatic, leveraging the same strengths that are driving FinTech solutions.
WHF: What are some of the biggest changes that have taken place within the financial services industry as a result of FinTech?
Barefoot: The industry is in the early stages of responding. Most large banks have created innovation teams or labs and are actively inventing, buying, and/or investing in new ideas. Some of this is explicitly designed to be a learning experience, while other efforts aim at practical problem-solving for customers or operations issues. Large banks are also exploring how to use the blockchain – the “distributed ledger” invented by Bitcoin – as a new approach to managing complex internal operations that involve chains of activity or transactions. (The blockchain is a transparent way of tracking a chain of transactions or records, such as payments or, say, legal titles, on the internet. This makes the information move instantly, at very low cost, and in ways that can be viewed and verified by all interested parties and therefore, cannot be duplicated or faked).
For smaller banks and credit unions, most have taken steps to create more mobile apps. Some have begun partnering with innovators in areas like online lending – for instance, Lending Club has a partnership with BancAlliance for working with community banks. Most small banks will not be able to invent their own innovation. They will need to get good at working with innovators while still satisfying regulatory standards about third-party risk management. It’s a tough challenge.
One thing most banks are not doing is upgrading their IT and data systems enough to compete well in this fast-changing market. I believe it will be necessary to do so. Banks underestimate the degree to which innovators have an advantage, simply because they are working with clean, powerful data.
WHF: You were a financial regulator and now you advise financial institutions. What regulatory challenges does the FinTech industry face? What are some of the compliance concerns?
Barefoot: The FinTech industry faces enormous regulatory challenges. One is the sheer cost of compliance – most startups can’t afford the expertise and systems needed to be sure to get everything right, although the smart ones are finding ways to do so and are building a compliance focus into their businesses early. A related challenge is the difficulty of assuring cybersecurity and getting anti-money laundering compliance right, on a small budget.
Another issue is that regulators often don’t understand these enterprises. For instance, digital currency companies need state money transfer licenses, and some states today are not yet familiar with these new technologies. Also FinTech tools are usually mobile – often mobile-only. This makes it complicated to manage disclosures even electronically, not to mention the ones requiring paper mailings.
Some innovations are breaking regulatory molds. Is digital currency a currency, an investment, or a payment system? Marketplace lending is being affected by a court case invoking usury laws written long before this form of lending existed, and also faces the question of whether its investors, including individuals, could be subject to fair lending laws if they select loans to fund using criteria that could create disparate impact.
Another challenge is that innovators often use alternative data to evaluate creditworthiness.
Again, this can help drive toward more inclusive but sound lending, but raises many unresolved issues about fair lending disparate impact. It is not clear what data standards and algorithms will survive regulatory scrutiny over time.
WHF: Are traditional banks and FinTech firms’ natural competitors or can they co-exist?
Barefoot: They can definitely co-exist! However, both face big challenges and a great deal of change. I believe traditional banks will have to embrace innovation fully and will not survive if they don’t. Similarly, many FinTech firms will fail. Over time, I think some FinTech firms will probably emerge as top-tier financial providers. I think many will be bought by banks. Many will become banking vendors and partners.
I also believe large nonbank technology firms will become major financial players – candidates would include Facebook, Google, Amazon and Apple. All of these already offer some form of consumer financial services, have huge customer bases and data, and are liked and even loved by many customers. They are also young companies with strong innovation cultures. Telecom and internet providers will increasingly enter the market as well (and already dominate in some parts of the world), although they have less natural strength in innovation and customer popularity.
Ultimately, the new technologies will permeate the whole market, creating business and market models that are cheaper, faster, more inclusive, and much more transparent to customers (including through Yelp-type customer reviews). We’ll still have banks, and nonbanks, both serving customers directly and working in partnership with others to provide financial solutions.
WHF: What, if any, traditional consumer financial services are at risk of becoming obsolete because of technological innovations?
Barefoot: As noted above, the most vulnerable areas are the ones being targeted simultaneously by innovators and regulators based on a perception that customers don’t really understand the product and pricing. Examples include deposit overdrafts, payday lending, and compensation models that may incent higher rather than lower pricing. Also vulnerable are any products and processes that are lengthy and burdensome for customers and anything that has high built-in costs due to high personnel or infrastructure needs.
The more profitable a product or channel is, the more likely it is that innovators will target it to remove costs, delays, and customer frustrations.
Beyond specific products, banks have broad vulnerability due to their “full-service” strategies and the fact that they often bundle services together with cross-subsidized pricing. Innovators are trying to pick off each product one by one, with simple solutions and minimized pricing.
While many customers do want the convenience of one banking relationship, the smart phone is increasingly making it easy to manage one’s finances with tools other than a consolidated banking arrangement.
Branches are also very vulnerable. Branches will not disappear overall, but many will close and others will be repurposed. Most banking transactions are already done online and as online and mobile services grow, banks will face challenges with how best to manage and streamline costly branch systems. (These will include Community Reinvestment Act issues.)
A vulnerability that banks tend to underestimate is that many innovations offer a better “user experience,” or UX. This is mainly because innovators are designing them from scratch and are fully integrating all elements – human-centered design, the latest technology, and compliance – in a seamless whole. This is different from taking an existing bank product and putting it into a new channel, like mobile. Banks are well-advised to hire people from technology backgrounds outside of banking, and also to listen to their own younger employees, who tend to be users of innovative solutions.
Finally, all bank products are vulnerable to the potential of disappointing millennials. This is the largest generation in world history and the first to be “digital natives.” Already their tastes and habits are reshaping the larger culture, just as the huge Baby Boomer generation did. Their preferred technologies are rapidly spreading to older customers, in the same way email and cell phones started with young people and expanded to everyone. Millennials expect technology to get constantly better, faster and cheaper, and they think of financial services in terms of technology tools.
Also, millennials expect high engagement, and innovators are giving it to them. Many FinTech companies have strong personalities and are funny. This raises the customer’s active interest and builds lasting relationships. Banks are, sad to say, vulnerable of seeming boring by comparison.
WHF: What advice can you give to someone interested in starting a FinTech startup company?
Barefoot: My top recommendation, other than generic advice for any entrepreneur, is to focus from the start both on “compliance” and, more deeply, on consumer benefit.
On compliance, build or buy clean new compliance tools that use technology to assure and document compliance, rather than doing it the traditional ways.
On consumer benefit, be ready to make the case for why the product will be good for consumers. Think through how it might be harmful, and design those vulnerabilities out of it. Strive for very high transparency. Strive for simplicity. Strive to be trustworthy, as trust is the factor that will make or break most of these companies over time. Also invest in strong data protection, AML compliance, and in winning the confidence of banks, as a customer or partner.
Finally, commit to continuous innovation. Even high-tech companies lose their edge today if they stagnate. The technology is changing constantly. The products should keep getting better and better.