OCC with support of Treasury moves forward with FinTech Charter
Following the release of the Treasury report, which encouraged the Office of the Comptroller of the Currency (OCC) to proceed with a special purpose national bank charter, the OCC released a formal policy statement and an updated licensing manual indicating that it will begin to accept applications. The OCC formally announced it would consider a special purpose charter for FinTechs and non-banks in December 2016, but this effort has been on hold through leadership changes and as the agency collected comments. Such a charter had been intended to reduce “regulatory fragmentation” and better facilitate growth for non-bank lenders and FinTechs in a regulated, and arguably streamlined, environment. To date, the proposed charter has seen various degrees of criticism from state and consumer groups, and that is likely to recur with the formal application process now in place.
The Treasury’s support of a special purpose charter is meaningful, as it shows a more unified regulatory mandate for the OCC to oversee these institutions. Further, Treasury support for a streamlined path for national licensing of non-banks and FinTechs, when compared to a state-by-state process, is a path for companies to more quickly and efficiently scale product distribution at a national level.
However, the special purpose charter is only one option for many non-banks and the appeal for some companies may be limited. For starters, the OCC will accept applications only for non-depository firms and this comes at a time when many non-bank financial technology companies are evolving to include deposit services. Further, many marketplace lending (MPL) organizations already have pursued state licensing with many now licensed as lenders in 40-plus states. As expected, the charter is not a watered-down version as the OCC will apply the same safety and soundness standards applied to all national banks. Within this context, the capital and liquidity requirements (which still have not been clearly defined) may be too onerous for many companies. It is important to note that technology and financial services companies have fundamentally different financial models in which the growth and return expectations of equity shareholders in technology firms may differ significantly from what is standard for many banks.
Interestingly, the special charter may be of interest to established financial services companies that are not bank holding companies, such as retail brokerages. All major retail brokerages already depend on sweep deposit net interest margin (NIM) for most of their overall profitability, and they have expanded their product and service offerings to include lending products and transactional payments functionality (e.g., debit cards, billpay). Many large brokerages, with a few prominent exceptions, are owned by bank holding companies, and these firms typically partner with third-party banks for FDIC insurance on sweep deposits. Such firms could gain additional strategic flexibility—and realize better economics—with their own banking charters. For example, a charter could enable a broker to capture full NIM from sweep deposits, rather than partial economics per many existing arrangements. There are of course trade-offs with the aforementioned capital and liquidity requirements.
The OCC and Treasury acknowledged the special purpose charter is just one option for non-banks. State harmonization is an area mentioned by the Treasury (and has received attention by several state groups) in an effort to reduce overlap. And for organizations that desire deposit-taking capabilities that require FDIC oversight, alternatives such as an industrial loan charter (ILC) or a full-fledged bank charter remain viable options.
Specific recommendations to address consumer access to financial data
In an effort to improve consumer access to financial data while addressing any related privacy and security considerations, the Treasury recommends removing barriers to the adoption and use of more secure methods for sharing personal data. The core components of this effort include recommendations that 1) data aggregators and FinTechs be defined as “consumers” rather than “financial institutions” for the purposes of Section 1033 and 1002(4) of the Dodd-Frank Act, essentially allowing them to avoid certain data privacy and security requirements, and 2) that “banking regulators remove ambiguity stemming from the third-party guidance that discourages banks from moving to more secure methods of data access such as APIs.”
By enabling direct connections to third parties, banks can aim to integrate faster, spur innovative ideas, and deliver a wider scope of products for customers. Limiting factors for this direct connection—or sharing consumer-authorized data in general—have been security, privacy, and sometimes competitive concerns.i This has given rise to workarounds including “screen scraping” and one-off data sharing arrangements, which have downsides in security risks and scale limitations, respectively.
Specific recommendations in the report favor data aggregators and FinTechs, many of which often leverage bank-housed data, but encourage the use of standard-based application programming interfaces (APIs) in lieu of screen-scraping and bilateral data sharing agreements. Standards in technology are more often industry-led and in support of APIs such as the Open Financial Exchange (OFX) or the durable data API (DDA). This could serve as a rallying point for industry coordination to credentialize certain “industry-approved” API standards, especially when combined with the prescriptive recommendations that data aggregators be defined as “consumers,” which is at odds with the view of many banks.
i For additional information on security and privacy concerns surrounding open APIs, see PwC’s Financial crimes observer, Open banking: US is next (April 2018).
Recommendation for US regulatory sandboxes would close the gap with other regions
The US has trailed many other countries with regulatory sandbox programs. Two examples: The UK’s Financial Conduct Authority (FCA) and the Monetary Authority of Singapore (MAS) both have mandates to foster innovation and new or improved services. The report’s recommendation to create a “unified solution that coordinates and expedites regulatory relief under applicable laws and regulations to permit meaningful experimentation for innovative products, service, and process” has a dual-purpose: To provide greater regulatory clarity and help educate regulators on alternative business models and technologies.
A formalized “innovation facilitator” system that is harmonized across states and federal regulators could help accelerate alternative models and the use of emerging technologies for financial services. To date, due to lack of a formal system or interest, there has been limited use of such programs, one being the CFPB’s no-action letter sent to Upstart with a focus on the use of alternative data and credit models based on artificial intelligence (AI) for credit decisioning.
The use cases within such a sandbox are wide open but could be geared toward new methods and technologies (e.g., AI) to utilize data. This is due to a focus on lending in the Treasury report and specific interest by regulators on alternative data and new credit models. Regulators have been primarily interested in two areas with respect to use of AI in lending: 1) adverse action if credit is denied (can the institution provide a reason, a new challenge based on an exponential increase in variables), and 2) disparate impact (the credit model must demonstrate that it does not exhibit racial, age, demographic, etc. bias). There is an enormous cross-industry effort on explainable AI, and that provides some tailwind for this use case within a financial services-based regulatory sandbox.
Treasury takes a stance on Madden vs Midland
The Treasury took a somewhat controversial step in recommending “that Congress codify the ‘valid when made’ doctrine” stemming from Madden vs. Midland. Initially filed in 2011, the case has seen various decisions, appeals, legislative actions, and industry workarounds with several MPLs adjusting their business models. The US Court of Appeals for the Second Circuit’s decision essentially put MPLs, and arguably broader aspects of the credit market, on more restrictive state-imposed rate limitations throughout the duration and ownership of the loan. The "valid when made" doctrine provides that a loan that is "valid when it was made cannot be invalidated by any subsequent transfer to a third party.”
Many MPLs have slowed loan issuance in a number of states including New York, Vermont, and Connecticut in response to the appellate court’s ruling. The passage of a House bill in February 2018, which essentially reversed the appellate ruling, was a victory for many lenders but is expected to face a tougher test in the Senate. With the Treasury now inserting its influence with support of the bill, the long-running drama may gain some clarity.
The adjustments many MPLs made in response to the ruling may have altered their business models to look a little more like a bank than a technology company, but in reality this was just one issue. Many MPLs now hold a slightly greater economic interest in originated loans, have grown their balance sheets, diversified their investor base, and begun to diversify revenue beyond a single source. Clarity on Madden is important for the industry, but management of the funding and credit model, especially in a rising-rate environment, will be more critical to longer term growth.