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September 18, 2018

Banks and Nonbanks: The Great Divide

The U.S. Treasury Department recently released a report with recommendations for regulating a rapidly growing sector of the financial services industry, known as FinTech.

Financial technology, often shortened to FinTech, is a thriving industry comprised of nonbanks, like PayPal and Venmo, that compete with traditional banks by innovating new methods of delivery for financial services. Funding for FinTech startups has increased at an annual growth rate of 41% over the last four years and much of that can be attributed to the fact that FinTech companies are geared toward a younger, more progressive, socially diverse customer base. Financial technology firms are capturing a substantial share of the consumer base by offering relatively simple product lines and a streamlined user experience through digital channels, easily accessible to a wider breadth of people.

FinTech emerged as a powerhouse in the aftermath of the 2008 financial crisis, when Congress passed regulations designed to protect consumers by enforcing stricter supervision over traditional financial institutions.  Many argue that these regulations have held back the innovation in the industry, leaving a banking gap that traditional banks weren’t allowed to fill. Consequentially, FinTech emerged to fill that demand.

As this emerging sector of financial services is new and up and coming, it is mostly without regulation, unlike its traditional banking counterpart. While the lack of regulation can present benefits for nonbanks, this can also be a drawback as traditional banks have easier access to security options like FDIC insurance to protect themselves and consumers. Overtime, this has caused a divide between the two sides: traditional banks are so heavily regulated that it strains innovation and financial technology companies are so loosely regulated that they aren’t considered banks, despite filling the banking gap with innovation and a diverse consumer base.

However, this divide might soon be bridged.

Over the eighteen months since President Trump signed an executive order outlining the core principles for financial regulation under his watch, the Treasury has tackled financial regulatory policy in a series of reports. Recently, the department investigated regulatory asymmetries – distinctions in either federal and state expectations or regulation between newer institutions and older, more regulated institutions – between nonbanks and banks. While the effort is noble, “one of the challenges will be to navigate a regulatory system that was designed in and for a different era,” according to Craig Phillips, Counselor to the Secretary of the Treasury.

Despite the steep undertaking, the Treasury has forged ahead with its endeavor to modernize regulation to promote innovation in financial serves at the state and federal level. In the report, published on August 1, the Treasury made more than 80 recommendations to regulators and Congress, fully addressing the burgeoning regulatory gap between existing bank regulations and modern institutions in the financial sector. Treasury Secretary Steven Mnuchin even prefaced recommendations with a statement saying, “We must keep pace with industry changes and encourage financial ingenuity to foster the nation’s vibrant financial services and technology sectors.”

The 222-page report is extensive and grapples with a number of pressing issues facing the financial services industry. Of those recommendations, here are three that may change the face of financial technology, if enacted:

  1. Financial Communication

The Treasury report provides clarity on communication between financial providers and consumers, specifically when using technology. The rules currently governing communication stem from the Fair Debt Collection Practices Act (FDCPA) and the Telephone Consumer Protection Act (TCPA) and both laws fail to consider the increasing reliance on text and email. The Treasury report finds that the reach of current regulations is overly broad and recommends changes to the FDCPA and TCPA to make it easier for consumers to revoke consent to be contacted. It also calls for greater clarity about the ways in which providers can reach consumers and the information they can disclose over email and voicemail services.

  1. Data Sharing

The report also calls for integrated data access between FinTech firms and traditional banks. Enabling FinTech applications to gain access to one’s financial data can improve consumer welfare by making it easier and cheaper to partake in banking practices, but banks are reluctant to give access to customer data due to liability issues and the fact that FinTech firms are a competitive threat. However, traditional banks may soon be without a choice, as the report recommends increased efforts to improve data aggregation, favoring standardization of applications to make data-sharing easier and more secure without ruling out federal standards.

  1. Fin Tech Charter

Another recommendation within the report, is a FinTech charter to allow FinTech firms to do business nationwide. Such a charter will put FinTech companies one step closer to being banks, and also place them under some of the same regulatory scrutiny faced by existing traditional banks. In April, Comptroller of the Currency Joseph Otting hinted at the regulator publishing its position on the charter within the next 60 to 90 days, a timeframe that may cross paths with the publication of the final report from the Treasury. In fact, only a few hours after the report’s release, the Office of the Comptroller of Currency announced that it will start taking applications for a special purpose charter for “FinTech companies engaged in the business of banking.”

While the above is not a comprehensive dissection of the report, it does examine the key changes that will affect the relationship between banks and nonbanks. Many look forward to these changes, believing that less red tape will allow banks to take advantage of new innovation and grow, while FinTech firms will be steps closer to becoming banks. FinTech companies are already tapping the global movement toward mobile wallets and focusing on social inclusion to close the banking gap for disadvantaged communities who currently have no access to banking services. If FinTech companies have a viable path to become banks, then banking overall becomes a more diverse and accessible institution.

According to a report released by PWC earlier this year, Fintech companies are now applying more technology innovations in the financial service industry than ever before. With PWC’s report findings and the Treasury’s recommendations, it is clear that the system has failed to keep pace with innovation in the sector and now, that innovation is happening outside of traditional banking boundaries. Going forward, financial institutions may have no choice but to catch up to FinTech firms and collaborate, thanks to the Treasury’s recommendations.

Hopefully, financial institutions can forego its reluctance – because if they won’t leverage emergent technologies, then FinTech startups will.