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Jo Ann Barefoot explores how to create fair and inclusive consumer financial services through innovative ideas for industry and regulators


First Teaser to my New Video Series

Jo Ann Barefoot

Welcome to my video briefing series, Regulation Innovation -- Thriving on disruption.

Each video comes with a fuller written briefing that includes background resources. The series is designed to build over time, as a journey. You can start anywhere, but watch them all. 

Please share the videos in meetings, and circulate the briefings throughout your organization. And I hope you enjoy the little bonus videos offering my light-hearted take on some of these issues.

Here is my briefing on the introduction to the series.

Why fintech matters:  What is it, and why is it so disruptive?

Before exploring precisely why regulation and innovation are two sides of the same challenge, let’s look quickly at what’s happening (later briefings will go in depth on these topics).

Fintech is innovation that applies new technologies to financial services and channels to make them faster, cheaper, clearer, more manageable, more user-friendly and/or more engaging and fun (yes, fun). It includes online and marketplace lendingdigital currencyand real-time payments; efforts to “uberbize” payments by making them disappear into the consumer experience; “robo-investing;” emerging “insure-tech;” and a vast array of personal financial management, or “PFM” solutions (usually mobile apps). The latter do things like smooth out financial volatility, make savings easy, organize bill-paying, and enable bill-sharing. The term sometimes also includes “reg-tech” that seeks to simplify compliance. 

They all leverage some combination of emerging technologies (usually several at once), including big data, powerful data analytics, natural voice technology, the blockchain, and the smart mobile phone, all of which we’ll explore in the series.

Broadly speaking, fintech innovators are trying to do these things:

  • Identify everything that bothers people about traditional finance, and fix it
  • Find additional things people don’t even realize bother them about today’s financial markets, and fix those too (just as Uber has solved problems we didn’t know we had until Uber removed them, like having to pay at the end of a taxi ride)
  • Wring every possible cost out of delivering financial services, through mobile channels, new uses of data, blockchain technology, and leveraging the newcomers’ clean-slate edge over banks’ old legacy IT systems.
  • Find broader markets and make financial services more inclusive, again, using mobile delivery and alternative data.
  • Usually, make products simpler and more transparent
  • Help consumers manage their own financial lives better, with easier and more powerful tools and by more actively engaging consumers through use of behavioral science and nontraditional methods like playfulness.

Their thinking reflects “blue ocean strategy” – growing not by competing with incumbents in a zero-sum “red ocean” game, but rather creating whole new markets through innovation that will simultaneously raise value to customers and cut costs for providers.

The new technologies, themselves, are neither “good” nor “bad.” They’re just powerful -- often mold-breaking. Similarly, innovators’ motives may or may not be “good” – they range from idealism to straightforward profit goals. In general, though, the innovators believe they can sharply improve on traditional financial offerings. Some hope to do so by replacing parts of today’s financial industries. Some hope to sell to today’s incumbents. Many hope to partner with them.

These changes are highly disruptive. The Financial Times reports the Bank of England’s Andrew Haldane as saying (“astonishingly”) that the unit cost of US financial intermediation seems to be unaltered over a century. Innovators plan to change that, and a great deal more, through technology, in the same pattern seen in so many other sectors.

More than any other sector, however, financial services are pervasively regulated. This means inevitably that the impacts will disrupt not only the industry, but its regulatory framework as well.

As a result, the technology changes ahead will create enormous regulatory shifts. The industry will have to create entirely new ways to manage both the innovation and the regulation, together.

How are regulation and innovation intertwined?

The top two existential challenges facing nearly every financial company today are, first, regulation, and second, disruptive innovation. Most people view regulation and innovation as very different topics – like oil and water – but they actually are intricately intertwined. Neither can be gotten right unless they are addressed together. Here’s why.

First, regulators and disruptive innovators are often attacking the same things about traditional consumer finance. They’re both finding every place where the industry’s current business models benefit (knowingly or not) from customer confusion or inertia about complex products and pricing, and where old delivery channels and legacy IT create high costs, errors, or lack of access. Obviously regulators and innovators have different motives and tools, but they have locked in on the same vulnerabilities. For traditional companies, it’s a pincer attack. 

An example is bank overdraft protection fees. Most banks know the CFPB plans to issue new rules on these.  Many don’t realize, though, that innovators are meanwhile inventing products to keep consumers from needing to overdraw. Attracted by the revenue potential in the estimated $30 billion consumers pay in annual overdraft fees, they are aiming to create affordable and convenient alternatives (watch for Briefing 2 in our series, Meet the Innovators.) Similar dual assaults target payday lending and many other areas.

Second, regulation and innovation have both pushed financial services into a state of permanent uncertainty, impossible to manage with traditional tools. 

For innovation, the permanent uncertainty arises from the fast pace of change and the mold-breaking nature of new technology (which we’ll explore extensively in the series).
For consumer protection regulation, the uncertainty is fueled by a huge shift from rules-based to principles-based oversight. Most financial companies sense this but have not grasped its profound ramifications, maybe because the regulators have not formally articulated it.

One driver for the regulatory transition is that the financial crisis revealed massive failures in our traditional federal policy of using prescriptive rules and disclosures to protect consumers. While detailed rules will still loom large, they are already a shrinking share of regulatory risk, overshadowed by a rapidly rising focus on broad principles. Regulators have massive discretionary powers to punish unfair, deceptive and abusive practices (UDAAP), and credit discrimination, including unintentional patterns of statistical “disparate impact.” These are the tools they will increasingly rely upon, as innovation undermines policymakers’ ability to keep technical rules up to date. 
Principles-based regulation is inherently subjective, and therefore uncertain. While the post-crisis industry has established compliance programs for UDAAP, few have infused all decision-making with robust thinking about the emerging principles dominating regulatory risk. Companies must move beyond compliance models geared to reactive implementation of rules, and create new ones that work proactively in the absence of clear regulatory guidance. 

This means financial companies must learn to think for themselves about these principles, in order to predict and plan for unknowable regulatory reactions as technology changes the industry. They must also learn to predict coming innovation trends, and build compliance systems able to accommodate them efficiently and effectively. 

Rapid change will make this difficult. Here are “9 Dangerous Words” reflecting the challenge.

Third, regulation and innovation continuously reshape each other. Innovators introduce new products and channels; regulators respond with rules and principles and with oversight and enforcement; then innovators respond to those; and the spiral goes on – ever-accelerating and permanently interlocked.

Fourth, the high costs of regulation and innovation can only be optimized together.Companies that don’t invest enough in either area face enormous risks. Banks are spending 70-80% of their IT budgets on compliance, leaving scant resources for technology innovation. Fortunately, though, approaching the two challenges holistically can cut their combined costs. Updating legacy IT systems will solve tremendous problems in both realms, as will using new and better data and data analytics. Similarly, “reg-tech” solutions are emerging to make regulation easier, but again, only for institutions that connect both sets of challenges. Future videos in the series will explore how to do so.

Fifth, the path to innovation will be easier for companies that win regulators’ “trust.”Again, disruption of the industry will disrupt the regulatory system too. Agencies will face rapid and unmanageable change and critical decisions about what innovations to permit, and by whom.

Those decisions will be difficult, since the innovation underway will inevitably create risks to both consumers and the financial system, even as it generates benefits. Regulatory challenges will include protecting privacy and data security, assuring “fairness” in new uses of data, and updating disclosures for mobile and voice-based services. Consumers will be exposed to harm from well-meant but unfamiliar technology. And while most innovators are trying to create pro-consumer options, some will channels these new technologies into manipulative or predatory uses. Our fractured and bank-centric regulatory framework will also be mismatched with the industry’s changing competitive structure, especially regarding nonbanks. 

All these issues will be discussed in Video 3: Meet the Regulators. Their combined impact will be to give an edge to companies that regulators can trust to have both compliance strength and committed innovation strategies aligned with the regulatory principles of customer fairness and business soundness. The banks that are best at this will have an advantage in pursuing new ways to both partner and compete with innovators. Banks with weak and rules-based compliance systems will discover these have become a strategic barrier to competitiveness.

Here’s the good news: the interconnectedness of regulation and innovation will enablecompanies to reduce risks in both realms together. For most banks, vulnerabilities on regulation and innovation are lodged in the very same places – in legacy IT systems, old ways of using data, and outdated profit and compensation models and cultures. This means that fixing one, can help fix the other -- equipping companies to thrive on disruption.

Exponential change

Tackling the twin challenges of regulation and innovation is urgent, because the industry is evolving so fast. Accenture reports that global investment in fintech increased 75% in 2015, reaching $22.3 billion. After a late-year lull, it surged 67% in the first quarter of 2016. The U.S. saw 667 fintech investment deals in 2015, up 16%, while North American investment rose 44%, to $14.8 billion. A McKinsey study finds over 12,000 fintech firms invading every aspect of bank activity and predicts that the innovators could win up to 60% of traditional bank revenues in the next decade.

The change underway is exponential, driven by the phenomenon that Gordon Moore accurately predicted in the 1970’s, called “Moore’s Law” --  that computing power will double every two years. 

By its nature, exponential change masks the magnitude of what’s ahead because the transformation will hit quickly. Imagine, for example, that someone has a pond on which lily pads start to spread at a rate that doubles every day. Suppose that, on day 30, the owner realizes the water is half covered and starts pondering how to respond. 

The next day, this owner will find the pond completely covered. What took 30 days to reach fifty percent, takes only one day to reach one hundred.

Moore’s Law means that in five years, computing power will be 32 times more advanced. In ten years, it will be a thousand times more advanced. In twenty years, a million times. In fifty years, a quadrillion times. As computing power grows, technology change will accelerate with it, transforming every aspect of life. Here’s just one example:  imagine a world in which computing capacity is not finite and costly, but rather limitless and cheap – for everyone. The possibilities are breathtaking.
We’re living now on the steep part of this curve, using brains and institutions wired for linear change. The challenges we feel today will only intensify.

I highly recommend reading this thought-provoking post by Niv Dror on exponential change.

Reading before the next video:

  • Here’s an article I wrote for Forbes on how fintech will disrupt finance and financial regulation.
  • Here is a Q&A discussion I developed for Women in Housing & Finance’s 2016 fintech symposium, which teases out many of the keys to understanding it. 

Suggested Action Steps:

  • Share this article with your team
  • Form an innovation task force that deeply integrates innovation and regulation (include & empower young employees as part of it)
  • Begin to educate the team on fintech innovation and assess the challenges likely to arise
  • Come back next time for Briefing 1: “The Five Tech Trends,” to understand the five huge, converging technologies that are driving disruption.

Which is not like the others? 
Legislation, litigation, regulation…innovation