As we discussed in Chapter 8, the future will likely still involve relationships. The second hurdle is that the role of loan officers, those who interact with customers, can and should evolve, which means change for this key group of employees. Bankers will need to be trained to integrate their advice with the next generation of financial technology, in which small businesses will have more information to begin the conversation, and the loan officer’s role will be to provide expertise and advice that supplements that information. In medicine, patients now have online access to their test results and WebMD, but only doctors have the expertise and training to interpret the data effectively and recommend a course of action. Likewise, loan officers of the future will need to serve as experts—working with small businesses who have more access to financial data on their business, but are unsure of how to interpret and use the information.
Finally, banks are not to be counted out of the ranks of the winners in the future world of small business lending, but to be successful, they will need to make clear decisions about what small business customers they wish to serve, and invest in new technology and tools to serve that segment’s needs. The new world of technological solutions has increased small businesses’ expectations from their banks, and that trend will only continue. Those banks that concentrate on small businesses and prioritize their needs will likely be the most successful in the new small business lending environment.
Part III
The Role of Regulation
© The Author(s) 2018
Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_10
10. Regulatory Obstacles: Confusion, Omission, and Overlap
Karen G. Mills1
(1)Harvard Business School, Harvard University, Boston, MA, USA
Karen G. Mills
Email: [email protected]
In the mid-1960s, banks began to realize that a relatively recent innovation—credit cards—could become the next big contributor to their bottom lines. The first card that was usable at multiple merchants, Diners Club, was issued in 1950. This spurred financial firms to work out how to make offering them profitable and attractive enough to be adopted en masse by consumers and merchants. Among other improvements, they developed cards that could be used at any merchant—not just restaurants—anywhere in the country, and experimented with how to sign up more customers.1
By 1966, a group of Chicago banks thought they were ready to jump into the market with both feet. Just before that year’s holiday season, these banks began to mail millions of unsolicited credit cards to Chicago residents, especially targeting affluent suburbanites. The effort turned out to be a disaster.
The banks’ mailing lists were full of errors. Cards were sent to children, pets, and dead people. And since the banks publicized their effort, criminals were enticed to steal the cards, which did not require customers to activate them, from mailboxes and post offices. Some merchants even conspired with thieves to put banks on the hook to pay for fraudulent charges. In all, the Chicago Debacle led to an estimated $6 million to $12 million in losses.2
The scandal also produced scrutiny from legislators and reformers who realized that the financial regulatory system had not been adapted to handle the new cards. Some called for credit cards to be banned, but lawmakers took a more measured approach. During the late 1960s and 1970s, Congress passed several major consumer protection laws that banned a variety of abusive and predatory practices, and empowered consumers to dispute billing errors. In 1978, a Supreme Court ruling allowed banks to set credit card interest rates based on the home state of the bank, rather than having to abide by different interest rate caps in each state, which made broad credit card issuance more attractive to banks. Updated banking rules and regulations better protected consumers while creating more regulatory certainty for banks. As a result, the groundwork was laid for credit cards to become nearly ubiquitous in America.
In recent years, financial innovation has brought new lenders and loan products to the small business market that could have enormous potential. New actors, from fintech entrepreneurs, to nonbanks like Amazon and PayPal, are already operating under a legal and regulatory system that never anticipated their presence.
A hands-off approach to regulating online lending may result in more innovation, but innovations are not inherently good; they can be used by less scrupulous or predatory lenders to maximize their own profits at the expense of borrowers or the financial system. On the other hand, heavy-handed regulation may protect borrowers at the cost of a well-functioning market and the widespread development of affordable financial products and services for small businesses.
We need a balanced regulatory system that encourages innovation and helps small businesses find the best financing options for them, while simultaneously identifying and stopping the bad actors that can threaten the market. Unfortunately, the current financial regulatory system is flawed in ways that prevent the market from reaching this optimal state. Small businesses are paying for those flaws in the form of high costs, hidden charges, and confusing payment terms. And new innovation may be getting lost under the burden of overlapping, and sometimes overwhelming, rules and requirements.
Fintech Oversight Falls Through the Cracks of the Fragmented Regulatory System
No one would design the current U.S. financial regulatory system if they were to start from scratch. The existing structure was cobbled together piecemeal over more than 150 years, with Congress often responding to financial crises by creating at least one new federal financial regulatory agency. For example, in 1863, Congress created the Office of the Comptroller of the Currency (OCC) to help finance the Civil War and address inconsistencies in banking regulations among the states. The legislation that created the Federal Reserve (Fed) grew from the Panic of 1907, while the Great Depression led Congress to establish the Federal Deposit Insurance Corporation (FDIC) to prevent runs on bank deposits and the Securities and Exchange Commission (SEC) to provide oversight of securities markets. The creation of the Office of Thrift Supervision (OTS) was a response to the savings and loan crisis of the 1980s.
Following the 2008 financial crisis, Congress eliminated the OTS, which had failed to adequately supervise several large financial firms that were at the heart of the crisis, including American International Group, Inc. (AIG), Countrywide, and Washington Mutual. However, through the Dodd-Frank Act of 2010, Congress also created three new entities: the Consumer Financial Protection Bureau (CFPB), the Office of Financial Research (OFR), and the Financial Stability Oversight Council (FSOC). The result is not a model of efficiency or effectiveness. The U.S. financial regulatory system is fragmented, featuring multiple agencies—both state and federal—with overlapping jurisdictions engaged at times in duplicative, and even conflicting, activities.
Banks, thrifts (also known as savings and loans), and credit unions can all take customer deposits, but they are governed by different rules, and each can be chartered at the state or federal level. Each state has different rules for the depository institutions that it charters, while four different agencies—the Fed, the FDIC, the OCC, and the National Credit Union Administration (NCUA)—oversee federally chartered depositories and also have some authority to oversee state-chartered depositories. Collectively, these agencies are sometimes called “prudential” regulators, because their primary mission is to ensure the safety and soundness of the individual financial firms they oversee. Other financial regulatory agencies focus on oversight of certain activities rather than on individual firms. For example, the CFPB writes and enforces rules aimed at protecting consumers from predatory financial products. The SEC regulates securities activities with rules for trading, broker licensing, and transparency.
Few disagree that the financial regulatory structure is problematic. According to a recent report by the Government Accountability Office (GAO), the current regulatory structure, despite some strengths, “has created challenges to effective oversight. Fragmentat
ion and overlap have created inefficiencies in regulatory processes, inconsistencies in how regulators oversee similar types of institutions, and differences in the levels of protection afforded to consumers. GAO has long reported on these effects in multiple areas of the regulatory system.”3 Figure 10.1 depicts the current U.S. regulatory structure which resembles a “spaghetti soup”—a tangle of interconnected entities, relationships, and rules.
Figure 10.1 Small Business Online Lending Falls Through the Regulatory Cracks
Source: Adapted from GAO-16-175, “Financial Regulation: Complex and Fragmented Structure Could Be Streamlined to Improve Effectiveness,” February 2016.
The problems of fragmentation, overlap, and duplication never seem to get solved, but not for lack of ideas. Researchers from the Volcker Alliance catalogued no fewer than 45 legislative and official proposals to restructure the financial regulatory system between 1915 and 2013.4 This does not include many of the proposals made by think tanks and other policymakers during the same period.
There are several reasons for the lack of reform. Opponents of reform have, over the years, argued that competition among regulatory agencies improves the overall quality of regulation and avoids overregulation, that reform will create uncertainty, or that the system works fine as it is. Regulators themselves may lobby to protect their jurisdictional “turf,” and so too might members of congressional committees who would lose oversight authority over an agency within their jurisdiction if it were merged into another. Financial firms may also resist change because reform could mean extra costs of adjusting to a new supervisor and new rules.
Recent innovations in financial services have challenged regulators because new fintech firms are different entities than banks and other traditional financial institutions. Fintechs are subject to some of the same rules as other financial firms, to the extent that their activities are similar. But some of the regulatory regime either applies differently to fintechs, or does not apply to them at all. In fact, in its current state, small business lending has, in several important ways, fallen through the cracks of the current regulatory system. Specifically, until recently, there was no federal nonbank charter, and of even more concern, many of the protections consumers enjoy do not apply to small business borrowers.
Federal Agencies Did Not Charter Nonbank Lenders
There are at least seven federal agencies—not to mention states, each of which conducts its own banking and securities oversight—that have some regulatory authority over the banks and credit unions that lend to small businesses. But until 2018, none of these federal entities would grant charters to nonbank lenders, such as the new fintech competitors or nonbank platforms.The Federal Reserve (Fed). The Fed oversees state-chartered banks and thrifts that are members of the Federal Reserve System, foreign bank organizations operating in the United States, and all holding companies that include banks or thrifts. The Fed has additional duties, including promoting the stability of the financial system, promoting consumer protection, and fostering a safe and efficient payment and settlement system.5 The Fed also has a mandate to understand and monitor market conditions, including the small business lending market.
The Federal Deposit Insurance Corporation (FDIC). The FDIC provides deposit insurance and is the primary federal regulator for state-chartered banks that are not members of the Federal Reserve System.6
The Office of the Comptroller of the Currency (OCC). As an independent bureau of the U.S. Department of the Treasury, the OCC oversees all national banks, federal thrifts, and federal branches and agencies of foreign banks.7 The OCC announced in 2018 that it would allow nonbanks to apply for a limited purpose bank charter, though some have challenged that the OCC has the authority to do so.
National Credit Union Administration (NCUA). The NCUA regulates and supervises federal credit unions, and insures the deposits of all federal and most state credit unions.
The Federal Trade Commission (FTC). The FTC was created in 1913 to prevent unfair competition and business practices that affect commerce generally, including lending to consumers and small businesses. The FTC adopted the Credit Practices Rule to protect consumers against abusive terms and conditions in credit contracts. In 2016, the FTC indicated that it intended to extend the same protections that consumers have in traditional lending to marketplace lending.8
The Consumer Financial Protection Bureau (CFPB). In the Dodd-Frank Act, Congress created the CFPB and gave it the mission to monitor consumer financial markets, including industries such as student loans, retail mortgages, and consumer credit cards. The CFPB has jurisdiction over a wide range of financial products and activities to ensure that the marketplace works for both lenders and borrowers, but only consumer borrowers.9
The Securities and Exchange Commission (SEC). The SEC protects investors in public markets, including publicly traded small business loan securities. The agency also supervises securitization markets and new securities, such as funds that invest in peer-to-peer loans.
Despite some of the gaps in direct authority, several federal agencies kept an eye on a portion of early fintech activities. Regional Federal Reserve banks included fintech questions in their coordinated credit surveys on small business lending. The SEC monitored the activities of online lenders that were raising capital in securities markets, paying special attention to protecting investors in those markets and ensuring that appropriate disclosures were made. State-level regulators granted charters and licenses to fintechs in their states. Yet, until the OCC stepped up to the task, the federal regulatory system did not have a central mechanism to oversee nonbank small business lenders.
Benefits of a Federal Charter Overseeing Nonbank Lenders
Most early online small business lenders were governed by a patchwork of state-by-state oversight that made compliance expensive, complicated, and time-consuming. Nonbank lenders essentially had two options: (1) lending directly to borrowers by acquiring licenses and being supervised in each state in which they operated, or (2) originating loans through a partnership with a national or state bank. Some new entrants specifically designed their products so they did not qualify as loans, to avoid regulation and regulatory uncertainties.
The tangle of multi-state oversight raises compliance costs, especially for new and small firms. Large companies are better able than small or start-up firms to absorb these costs, which could cause start-ups to wait until regulation becomes more certain, thus stifling innovation.10 To their credit, state regulators recognized these issues, and the Conference of State Bank Supervisors (CSBS) began efforts to coordinate and align regulation across states. In 2018, they issued an ambitious plan to adopt an “integrated, 50-state licensing and supervisory system, leveraging technology and smart regulatory policy” by 2020.11 The initiative is admirable, but will probably take more time than projected and will likely encounter resistance, so it may not be the ultimate answer.
In 2016, the OCC announced that it would allow nonbanks to apply for a special purpose federal bank charter. Under the category of “no good deed goes unpunished,” this proposal was met with objections from multiple parties, including existing fintechs that had already gone through the pain of registering in every state and did not want to see new competitors find an easier path. Banks thought the charter would be “banking light” and disadvantage them. The state bank supervisors went so far as to file a complaint against the OCC proposal in U.S. District Court.
In July 2018, the OCC went forward with a charter that would allow nonbank lenders to become special purpose national banks. In its announcement of the move, the OCC affirmed support for federal regulation of innovative fintech firms saying, “The federal banking system must continue to evolve and embrace innovation to meet the changing customer needs and serve as a source of strength for the nation’s economy. The decision to consider applications for special purpose national bank charters from innovative companies helps provide more choices to consumers and businesses, and creates greater opportunity for co
mpanies that want to provide banking services in America. Companies that provide banking services in innovative ways deserve the opportunity to pursue that business on a national scale as a federally chartered, regulated bank.”12
This was a good step forward. With a national charter, online and other nonbank small business lenders will be able to operate nationwide, subject to a consistent set of federal standards that will increase transparency and benefit small businesses. The lenders will have a single supervisor and examination process, which should reduce barriers to entry and lower costs. Small business borrowers should benefit from these lower costs and additional innovation in new products and services from new nonbank providers.
Lack of Coordinated Third-Party Regulation Discourages Innovation
There are also regulatory frictions facing banks that want to partner with fintechs to bring innovative lending options to their small business customers. These partnerships fall under the category of “third-party arrangements” and are subject to oversight from a number of entities.
In 2013, the OCC issued guidance for banks on how to manage risks that may arise from their relationships with third parties, such as brokers, payments processors, and IT vendors. The OCC said that it would expect banks to use “more comprehensive and rigorous oversight” of third-party relationships that involved “critical activities.” The OCC set out an eight-phase process for managing risk with third parties, including due diligence, ongoing monitoring, documentation and reporting, and independent reviews.13 In 2017, in response to questions from banks, the OCC clarified that fintech firms are also subject to the 2013 guidance.14
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