January 30, 2018

Modernizing Regulation to Encourage FinTech Innovation

Testimony before the House Committee on Financial Services, Subcommittee on Financial Institutions and Consumer Credit Examining Opportunities and Challenges in the Financial Technology (“Fintech”) Marketplace
  • Brian Knight

    Director of the Program on Financial Regulation
Key materials

Good morning, Chairman Luetkemeyer, Ranking Member Clay, and members of the subcommittee. Thank you for inviting me to testify.

My name is Brian Knight, and I am the director of the Program on Financial Regulation and a senior research fellow at the Mercatus Center at George Mason University. My research primarily focuses on the role of technological innovation in financial services. Any opinions I express today are my own and do not necessarily reflect the views of my employer.

First, let me thank Chairman Luetkemeyer and Ranking Member Clay for your leadership in holding a hearing on the promise and challenges of financial technology, or “fintech,” and how the legal and regulatory environment should adapt in response. I also appreciate your efforts to have representatives from a broad array of positions and viewpoints engage in a collegial and respectful discussion. It is an honor to be asked to testify.

Defined most broadly, fintech is simply the application of technology to the provision of financial services, and it is therefore ubiquitous and constant. However, we are seeing a unique period of innovation in financial services marked by the use of the internet (as a borderless delivery mechanism), lower barriers to entry, new competitors from outside the traditional financial services industry, and increasingly rapid innovation by firms and adoption of innovative technologies by customers. These characteristics are placing pressure on the existing regulatory environment.

Given the potential breadth of the topic and the limited time available, I would like to focus my testimony on some of the issues facing nonbank financial firms and the role that Congress should play in supporting innovation, though I am happy to try to answer any questions you may have to the best of my ability.

Specifically, there are three ways Congress could help:

  1. Clarifying existing regulation, including but not limited to issues around the validity of a loan made by a depository institution in conjunction with a fintech lender partner so that consumers can benefit from more efficient and competitive credit markets.
  2. Modernizing regulation to eliminate unnecessary or unjustified barriers to competition from new firms, including but not limited to fintech lenders and money transmitters being subject to state-by-state licensing and limitations while their bank competitors enjoy broad uniformity granted by federal law.
  3. Enabling regulators to provide the necessary and appropriate regulatory environment where companies can experiment with innovative services while ensuring appropriate consumer protection.

The Potential Promise of FinTech

Innovations in financial technology have the potential to significantly improve the quality of financial services available to Americans. For example, there is evidence that nonbank fintech lenders are able to fill in holes left by banks that have left communities and to offer some consumers credit at lower rates than would otherwise be available using traditional funding and credit scoring metrics or to consumers who otherwise would have trouble accessing credit. This would explain why a significant portion of loans offered by fintech lenders are used by borrowers to consolidate existing debt. There is also evidence that the use of algorithmic scoring may result in less discrimination than traditional underwriting. For example, researchers at the University of California, Berkeley, have found mortgage data indicating that fintech lenders who use algorithmic underwriting were significantly less likely to discriminate against African American and Hispanic borrowers than were traditional lenders.

Likewise, in money transmission, nonbank technology-enabled firms are providing alternatives to traditional checks and wires, offering real-time and peer-to-peer payments. This competition has prodded banks to improve their products, including the introduction of same-day ACH payments and the introduction of bank-sponsored peer-to-peer payments apps. Fintech firms are also helping facilitate payments by employers, allowing employees to be paid on a daily basis rather than being paid every week or every two weeks.

Virtual currencies, the largest and most famous being Bitcoin, are also providing consumers with new means to conduct financial transactions. Virtual currencies are means to an end, rather than an end in themselves. For example, Bitcoin was designed to compete with government-backed currencies. However, the underlying technology of a distributed, modification-resistant ledger has been considered for a wide range of transactions outside of currency where the ability to maintain a common record of transactions is important. Other virtual currencies have also developed seeking to more effectively facilitate actions ranging from international money transfer to corporate capital formation.

The Challenges Posed

While fintech presents significant promise, it also presents certain challenges. For example, while Initial Coin Offerings (ICOs) may enable firms to access capital more effectively than traditional methods, there are significant concerns that they are being used by both outright frauds and well-meaning but ignorant firms to obtain capital in contravention of existing laws governing the sales of securities, commodities futures contracts, and products and services.

The considerable increase in value for numerous virtual currencies in the past year has given rise to fears that the prices reflect an asset bubble rather than the assets’ true value and that the eye-popping prices attract scammers preying on the vulnerable. Virtual currencies may also potentially present risks to both law enforcement and national security by allowing bad actors to move money illegally or avoid sanctions. This risk, however, is not unique to virtual currencies—it exists with every means of value transmission, including cash.

In the lending context, there is a concern that fraudulent and unlicensed lenders, brokers, or lead generators will defraud borrowers. This concern is particularly acute in the online payday loan space and in small-business lending, where concerns about broker business practices have led to industry initiatives like the Small Business Borrowers’ Bill of Rights.

The firms providing fintech services also face challenges. For example, online lenders face a significant risk of being defrauded by borrowers because of the arms-length nature of and limits in knowledge inherent in the online model. Borrowers may use false identities to obtain credit they have no intent to repay, or they may apply for multiple loans from different lenders over a short period of time. This “stacking” prevents the lender from knowing about the borrower’s other lines of credit until it is too late. While not every “loan stacker” intends to defraud lenders, the practice can prevent lenders from making fully informed lending decisions and increase the risk of default, leading to increased prices for other borrowers.

The Challenges Posed by the Current Regulatory Environment 

Every example of fintech is highly regulated from the moment it is conceived of. In some cases, the existing regulatory environment harms innovation by forcing firms to comply with multiple, often inconsistent sets of rules, pay the costs of having to constantly monitor numerous state and federal regulators, and face the uncertainty of not knowing whether an activity is subject to regulation.

The ability of new fintech competitors who are able, from the very beginning, to serve customers nationwide, is hampered by state-by-state regulation that their bank competitors do not face. If this discrepancy were justified, there would be no concern, but all too often it isn’t. One clear example is the difference in treatment around lending licenses and the laws governing interest.

Under federal law, nationally chartered banks and federally insured state-chartered banks are able to lend nationwide on the basis of their charter and under their home state’s laws governing interest. This uniformity allows for legal certainty and product uniformity nationwide, as banks are able to lend to similarly situated borrowers at the same terms. Conversely, fintech lenders are primarily regulated at the state level and are required to obtain licenses from each state they wish to lend in, and they are subject to the laws governing interest of the borrower’s home state.

This difference in regulatory treatment makes it very hard for fintech lenders to compete directly with banks, since banks are simply able to operate in a more consistent and streamlined manner. This has encouraged fintech lenders to partner with banks. Partnering with a bank allows fintech lenders to offer a consistent product nationwide. It also allows the banks to access additional borrowers and make more loans than they would otherwise be able to. While the bank often sells off at least a significant portion of the loan to either an institutional buyer or the fintech lender, the bank frequently receives a fee tied to the performance of the loans and ultimately retains regulatory responsibility for the loans. The fintech lender is also regulated under the Bank Service Company Act and is subject to examination by the bank’s federal regulator for the lender’s actions conducted pursuant to the partnership. While partnerships driven by regulation can benefit fintech lenders, their bank partners, and the public, they are also a second-best solution.

Yet even this second-best solution of bank partnerships is under threat from recent litigation and regulatory actions. The most notable of these actions are the decision in Madden v. Midland Funding in the United States Court of Appeals for Second Circuit and Colorado’s lawsuits against two marketplace lenders. The result in Madden has called into question whether a bank could sell a loan that was valid when made by the bank to a nonbank, and have the loan remain valid if it was usurious under the borrower’s state’s law. While this case does not directly implicate fintech lenders, its seeming refutation of the principle that a loan valid when made remains valid even if sold implicates the bank partnership model.

More directly relevant are the recent enforcement actions by Colorado against two marketplace lenders who made loans in Colorado in conjunction with bank partners. Colorado is seeking to hold that the marketplace lenders are the “true lender,” and that therefore the loans are governed by Colorado state law, despite the loans actually being made by two FDIC-insured state-chartered banks. Colorado does not dispute that if the loans are made by the banks, they are valid—rather, they argue that the banks lack a sufficient economic interest in the loans to qualify as the true lender. The banks have in turn sued Colorado, arguing that the state’s efforts impede their ability under federal law to make and sell loans.

The uncertainty surrounding the bank partnership model has reduced credit availability. For example, recent research has found that credit availability for borrowers with FICO scores below 700 from three large fintech lenders decreased significantly in New York and Connecticut compared to states outside the Second Circuit after the Madden decision. Further, the uncertainty risks creating an absurd situation where the legality of a loan is not determined by the loan’s characteristics but by who ends up owning the loan, even though the borrower’s obligations do not change. It also privileges banks over competitors because banks are allowed to make and hold loans that nonbanks may not be allowed to.

Another area where state-by-state regulation risks impeding innovation is money transmission, both for firms that operate in dollars and those that use virtual currencies. While, generally speaking, banks are not required to obtain state money transmitter licenses, nonbanks—including innovative fintech firms—are required to obtain a license in every state where they offer services. While almost all states require licenses, the criteria of who is covered by the licensing regime and what is required for compliance vary among states, and obtaining licenses can be an expensive and time-consuming activity.

This problem is even more acute with firms that provide payments services via virtual currencies. Some states have held that virtual currency exchanges are covered under their existing money transmission laws; others have modified their laws or remained silent about the extent to which their existing rules govern virtual currency transactions. New York is unique in creating a virtual-currency-specific regulatory regime with its BitLicense. While the Uniform Law Commission has proposed a uniform law to regulate virtual currency transmitter businesses at the state level, this law has not yet been adopted by any state.

Beyond questions of federalism, there are broader problems with the fragmentation of the current regulatory system. While this problem is not new, the pace of innovation and adoption and the cross-cutting nature of fintech offerings exacerbate the problems created.

For example, outside of the money-transmission context there is confusion as to which regulators have authority over transactions involving virtual currencies. The use of digital tokens by firms to raise money may be considered a sale of securities, commodities, or the presale of a product, or some combination thereof. This confusion is the result of the law privileging substance over form in that the economic reality of the transaction, rather than the method, governs. While this approach is understandable, it can also create gray areas that Congress could clarify.

Overlapping regulatory jurisdictions may hamper any efforts by regulators to provide regulatory relief via a “regulatory sandbox” or other means. Even if one regulator enters into an agreement with a company to allow the company to experiment in exchange for limited liability, this would not be binding on other regulators (potentially including state regulators), severely limiting the usefulness of the regulatory relief program. This problem would also apply in cases where a state wished to offer a regulatory sandbox because the company would still face potential federal enforcement and private liability.

Possible Improvements

The current regulatory environment is not ideal, and Congress could improve it in several ways. First, while the power of a bank to make a loan and have it remain valid after it is sold exists under current law, clarification would be helpful to provide certainty. Congress could amend the relevant statutes to make explicit the right of a bank to make and sell a loan, and have the loan remain valid on its original terms.

Second, fintech firms should be able to operate on a nationwide basis without unduly burdensome state-by-state regulation. One option currently being considered by the Office of the Comptroller of the Currency (OCC) is to offer national-bank charters to nondepository lenders and money transmitters. This would allow those firms to tap into the existing powers of national banks. While this is a worthy idea, it is not and should not be the only solution. Instead, in addition to the OCC’s efforts, the states should be allowed to play a more active role in forwarding innovation.

States are currently at a disadvantage in that, while it is arguably possible for national banks to be nondepositories and still be able to export their home state’s law governing interest, under federal law that power is limited to FDIC-insured state banks. Congress could change this requirement to allow states to offer new nondepository bank charters comparable to those considered by the OCC.

Congress could also allow nonbank, state-licensed lenders and money transmitters to operate on the basis of their home state license and law in a way comparable to the privileges banks enjoy under federal law. This would allow innovative nondepository firms to be able to compete on a national basis without forcing them into the banking system, and it would allow for state experimentation and competition.

Third, Congress should explore allowing state and federal regulators to establish regulatory sandboxes or other comparable regulatory relief programs for limited trials of innovative products. Congress could allow a firm that participates in such a program and complies with the program’s requirements to avoid liability beyond that established by the program, subject to minimum requirements including the firm making its customers whole if the firm causes harm owing to a violation of the law.

Fintech presents significant potential to improve the quality and inclusiveness of financial services. The current regulatory environment risks hampering this development, but intelligent changes can be made to make regulation friendlier to innovation and competition while still protecting consumers.

Thank you again for the opportunity to testify. I look forward to your questions.