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Tearsheet Briefing: Fintech changed consumer finance — how are regulators thinking about this?

  • Welcome to the first Tearsheet Briefing, featuring weekly insights from our reporters on the intersection of finance and technology – exclusively for Tearsheet PRO members.
  • In our first briefing, we're exploring how the entry of fintech and non-bank firms has added complexity to the financial system, and its implications from a regulatory standpoint.

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Tearsheet Briefing: Fintech changed consumer finance — how are regulators thinking about this?

Welcome to the first Tearsheet Briefing, featuring weekly insights from our reporters on the intersection of finance and technology – exclusively for Tearsheet PRO members. In our first briefing, we're exploring how the entry of fintech and non-bank firms has added complexity to the financial system, and its implications from a regulatory standpoint.

Classified as ‘TradFi disruptors’, fintechs are the new entrants that threaten incumbent banks in core financial services. But for consumers, this means more choice, convenience, and wider access to better services.

Most Americans depend on secure and economical financial services to steer clear of financial adversity, build wealth, and achieve financial security over time. Fintechs have gained traction in segments where the traditional financial system had been lagging by delivering innovative digital solutions, transforming the core consumer finance markets – namely deposits, payments, and credit. 

In the US alone, there were just over 10,000 fintech startups at the end of 2021 – making the Americas the region with the most fintech startups globally. The sector is scaling up rapidly thanks to evolving technology, but this has raised concerns among US policymakers, who are looking at the sector from a regulatory lens.

In November 2022, the Secretary of the US Treasury submitted a report to the Chair of the White House Competition Council, assessing how the entry of large technology firms and other non-bank companies into consumer finance affects competition. 

The report focuses on the role of new non-bank firms (including fintech, big tech, and retail firms), how they interact with insured depository institutions (IDIs), their impact on the markets hinging on core functions of traditional banking, and the risk and regulatory compliance aspect.

Fintechs add complexity to the financial system

Regulators noted that among other developments, fintechs provide improved delivery of financial services by offering: 

  • expanded access to credit through alternative approaches to underwriting 
  • greater access to payments solutions through more user-friendly and accessible payment tools
  • increased access to low-cost transaction accounts through digital banks

Fintechs are offering services similar to those by traditional institutions, but outside the bank regulatory perimeter – blurring the lines between commerce and banking. This focus on speed and ease of access to financial services could become harmful to consumers, according to the report. 

Source: Silicon Valley Bank

The detriment can be broadly attributed to the loss of privacy, compromised data security, fraud, scams, and discriminatory use of data and data analytics.

Therefore, new regulations and rules are approaching to monitor fintechs on the same level of scrutiny and regulation as banks.

Outside of all the positive contributions that non-bank firms and fintechs have brought to the industry, they have also added a layer of complexity to the number of parties that can be involved in the financial equation. 

“Non-bank firms and fintechs are more efficient, and often perform tasks better than banks – hence, they have become key players in the transactional and/or information flow of a financial transaction,” said Luis Trujillo, Chief Compliance Officer at Alviere.

Traditionally, in a typical bank-fintech relationship, both sides act as competitors and collaborators at the same time – however, there are as many differences as similarities between the two. 

The fintech sector is highly reliant on traditional banks, and still has to plug into core banking technology to work. When forging partnerships or embedding services, banks should ensure fintechs remain compliant with existing regulations by having a strong third-party risk management program, according to Trujillo.

An Insured Depository Institution (IDI) – a bank or savings association whose deposits are insured by the federal deposit insurance corporation – serves as a de facto regulator and enforcer for fintech partners. Therefore, it is imperative for the IDI to ensure that internal controls are in place to minimize the risk of consumer harm. 

Banks are subject to other obligations as well, which include requirements for minimum capital and liquidity, constraints on large exposures, specific rules on governance arrangements, and compensation schemes for decision-makers. In addition, they are scrutinized with detailed regulations around consumer protection, anti-money laundering (AML), or combating the financing of terrorism (CFT), which apply across all the different services they offer – deposit-taking, credit underwriting, payment services, and wealth management. 

Particularly, capital requirements are based on an overall assessment of the credit, market, and operational risk of the institution. These requirements are centralized around a consolidated balance sheet, sometimes encircling specific constraints for individual legal entities within banking groups. As a consequence, regardless of the nature of the business, all subsidiaries of banking groups are directly or indirectly subject to heavy regulation.

Incumbents have to follow these service obligations and strict compliance standards that fintechs and big tech players are not mandated to follow to such an extent. As a result, banks’ competitiveness can be hampered if steps are not taken by regulators to establish a more balanced regulatory framework to promote fair competition among traditional banks, fintechs, and big tech players.

Greater risks of fraud and bias

The fintech space has moved at an unprecedented pace, making it increasingly difficult to effectively track and identify where each player (new entrants, and those exiting) stands within the space. As many of these non-bank firms and fintechs are not regulated, it becomes challenging to track at scale what they do.

Moreover, the continued growth of the fintech sector has been a big driver of the surge in fraudulent activities, which remain a pressing concern in the financial services industry – leading to declining consumer trust in digital payments. 

While this evolution is vital for the financial services industry at large, fraudsters are exploiting digital transitions and attempting to use evolving technology to their advantage. On the back of a challenging economic climate and the transition to digital banking, online fraud saw a rise of 285% in 2021 compared to the previous year.

Another rising concern in need of regulatory supervision is around artificial intelligence-based lending. Despite fintechs seeking the Consumer Financial Protection Bureau’s guidance on making AI-based lending fair, it is seen that AI can drive racial inequity in subtle ways.

While AI adoption is considered a smart economic investment for the future, AI bias is also becoming prevalent. A Federal study found that people of color are more likely to be misidentified by AI-based facial recognition technology.

But how can a machine discriminate?

If a credit assessment methodology is programmed to evaluate safe lending opportunities, it may only consider applicants with rich credit histories, resulting in inequalities for minority communities. Screening algorithms often deem them ineligible, leading to large segments of the population having limited options for financing solutions.

Error-prone data collection methods can add to the paradigm of financial exclusion and bias for the underserved. Moreover, the predictive ability of machine learning models can increase potential risks due to the design’s complexity – resurfacing historical discrepancies and flaws in underlying data.

In the last couple of years, the Biden administration and federal lawmakers were criticized for their lack of regulatory efforts to protect people from diverse backgrounds from mistreatment by today’s technologies. 

This pushed the US Department of Commerce and the National Institute on Standards (NIST) to form the inaugural National Artificial Intelligence Advisory Committee (NAIAC) in April 2022, which was tasked with advising the Biden administration on how to proceed with national AI governance efforts. 

There is a need to develop and execute a more well-rounded governance approach in this regard, and regulators need to pilot it, as directed by the report.

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