Perspectives on Fintech: A Conversation with Governor Lael Brainard
Welcome to the special fintech edition of Consumer Compliance Outlook. For the lead article, staff asked Governor Lael Brainard of the Federal Reserve Board of Governors to share her perspectives on recent developments in fintech and how regulators and bankers should approach financial innovation.
Why do you think fintech is generating so much interest from institutions, consumers, and regulators?
Fintech has the potential to transform the way that financial services are delivered and designed and change the underlying processes of payments, clearing, and settlement. The past few years have seen a proliferation of new digitally enabled financial products and services in addition to new processes and platforms. Just as smartphones revolutionized the way in which we interact with one another to communicate and share information, fintech may impact nearly every aspect of how we interact with each other financially, from payments and credit to savings and financial planning. In our continuously connected, on-demand world, consumers, businesses, and financial institutions are all eager to find new ways to engage in financial transactions that are more convenient, timely, secure, and efficient.
In many cases, fintech puts financial change at consumers’ fingertips — literally. Today’s consumers, particularly Millennials, are accustomed to having a wide range of applications, options, and information immediately accessible to them. Almost every type of consumer transaction — ordering groceries, downloading a movie, buying furniture, or arranging child care, to name a few — can be done on a mobile device, with many different applications from which consumers can choose for each of these tasks based on their preferences. It seems inevitable for this kind of convenience, immediacy, and customization to extend to financial services. Indeed, according to the Federal Reserve Board’s most recent survey of mobile financial services, fully two-thirds of consumers between the ages of 18 and 29 who have a mobile phone and a bank account use mobile banking.
While financial innovation holds promise, it is crucial that financial firms, customers, regulators, and other stakeholders understand and mitigate associated risks. There is a tension between the lightning pace of development of new products and services being brought to market — sometimes by firms that are new or have not historically specialized in consumer finance — and the duty to ensure that important risks around financial services and payments are addressed. Firms need to ensure that they are appropriately controlling and mitigating the risks that are unique to fintech as well as those that exist independently with new technologies.
What do you see as the greatest potential benefits and risks of financial technology?
New fintech platforms are giving consumers and small businesses more real-time control over their finances. Once broad adoption is achieved, it is technologically quite simple to conduct cashless person-to-person fund transfers, enabling, among other things, the splitting of a check after a meal out with friends or the sending of remittances quickly and cheaply to friends or family in other countries. Financial management tools are automating savings decisions based on what consumers can afford, and they are helping consumers set financial goals and providing feedback on expenditures that are inconsistent with those goals. In some cases, fintech applications are automatically transferring spare account balances into savings, based on monthly spending and income patterns, effectively making savings the default choice. Other applications are providing consumers with more real-time access to earnings as they are accrued rather than waiting for their regular payday. This service may be particularly valuable to the nearly 50 percent of adults with extremely limited liquid savings. It is too early to know what the overall impact of these innovations will be, but they offer the potential to empower consumers to better manage cash flow to reduce the need for more expensive credit products to cover short-term cash needs.
One particularly promising aspect of fintech is the potential to expand access to credit and other financial services for consumers and small businesses. By reducing loan processing and underwriting costs, online origination platforms may enable financial services providers to more cost effectively offer smaller-balance loans to households and small businesses than had previously been feasible. In addition, broader analysis of data may allow lenders to better assess the creditworthiness of potential borrowers, facilitating the responsible provision of loans to some individuals and firms that otherwise would not have access to such credit. In recent years, some innovative community development financial institutions have developed partnerships with online alternative lenders, with the goal of expanding credit access to underserved small businesses.
The challenge will be to foster socially beneficial innovation that responsibly expands access to credit for underserved consumers and small businesses and for those who otherwise would qualify only for high-cost alternatives. It would be a lost opportunity if, instead of expanding access in a socially beneficial way, some fintech products merely provided a vehicle to market high-cost loans to the underserved or resulted in the digital equivalent of redlining, exacerbating rather than ameliorating financial access inequities. For example, some fintech firms are exploring the use of nontraditional data in underwriting and pricing credit products. While nontraditional data may have the potential to help evaluate consumers who lack credit histories, some data may raise consumer protection concerns. Nontraditional data, such as the level of education and social media usage, may not necessarily have a broadly agreed upon or empirically established nexus with creditworthiness and may be correlated with characteristics protected by fair lending laws. To the extent that the use of this type of data could result in unfairly disadvantaging some groups of consumers, it requires careful review to ensure legal compliance. In addition, while consumers generally have some sense of how their financial behavior affects their traditional credit scores, alternative credit scoring methods present new challenges that could raise questions of fairness and transparency. It may not always be readily apparent to consumers, or even to regulators, what specific information is utilized by certain alternative credit scoring systems, how such use impacts a consumer’s ability to secure a loan or its pricing, and what behavioral changes consumers might take to improve their credit access and pricing.
In addition to addressing any new risks that may be specific to fintech firms, it is important that institutions establish and maintain the same kind of compliance management systems and controls that would be expected for any entity engaged in offering consumer financial products and services. Financial institutions partnering with fintech firms should also ensure that they control for the risks associated with new products, services, and third-party relationships.
How do you think regulators should approach potentially transformative and disruptive innovations like fintech?
With fintech, as with any other emerging financial product or service, the Federal Reserve is learning as much as we can to ensure that we have a robust understanding of the technologies and activities in which banks and other financial firms are engaging and to inform the development of our policy and supervisory approaches. To that end, the Federal Reserve Board has established a multidisciplinary working group that is engaged in a 360-degree analysis of fintech innovation. We are bringing together the best thinking across the Federal Reserve System, spanning key areas of responsibility — from supervision to community development, from financial stability to payments — to assess the impact of technological development on the Federal Reserve’s responsibilities. As part of this effort, Federal Reserve senior officials and staff have been closely watching developments in fintech, evaluating its impact on financial services delivery, and assessing the policy and supervisory implications in this arena.
The rapid pace of change and the large number of actors — both banks and nonbanks — in fintech raise questions about how to effectively conduct our regulatory and supervisory activities. As an ever-broadening array of choices become available to consumers, we have to think carefully about ensuring that consumers can meaningfully make informed choices among the options presented to them. In one sense, regulators’ approach to fintech should be no different than for conventional financial products or services. The same basic principles regarding fairness and transparency should apply regardless of whether a consumer obtains a product through a brick-and-mortar bank branch or an online portal using a smartphone. Indeed, the same consumer laws and regulations that apply to products offered by banks generally apply to nonbank fintech firms as well, even though their business models may differ. However, the application of laws and regulations that were designed based on traditional financial products and delivery channels may give rise to complex or novel issues when applied to new products or new delivery channels. As a result, we are committed to regularly engage with firms and the technology to develop a shared understanding of these issues as they evolve.
Fundamentally, financial institutions themselves are responsible for providing innovative financial services safely. Financial services firms must pair technological know-how and innovative services with a strong compliance culture and a thorough knowledge of the important legal and compliance guardrails. While “run fast and break things” may be a popular mantra in the technology space, it is ill-suited to an arena that depends on trust and confidence. New entrants need to understand that the financial arena is a carefully regulated space with a compelling rationale underlying the various rules at play, even if these rules are likely to evolve over time. More is at stake in the realm of financial services than in some other areas of technological innovation. The consequences are more serious and lasting for a consumer who obtains, for instance, an unsustainable loan on his or her smartphone than for a consumer who downloads the wrong movie or listens to a bad podcast. At the same time, regulators may need to revisit processes designed for a brick-and-mortar world when approaching digital finance. To ensure that fintech realizes its positive potential, regulators and firms alike should take a long view, with thoughtful engagement on both sides.
When we look back at times of financial crisis or missteps, we frequently find that a key cause was elevating short-term profitability over long-term sustainability and consumer welfare. It was not long ago that so-called exotic mortgages originally designed for niche borrowers became increasingly marketed to low- and moderate-income borrowers who could not sustain them, ultimately with disastrous results. In addition to the financial consequences for individual consumers, the drive for unsustainable profit can contribute to distrust in the financial system, which is detrimental to the broader economy. It is critical that firms providing financial services consider the long-term social benefit of the products and services they offer. Concerns regarding long-term sustainability are magnified in situations where banks may bear credit or other longer-term operational risks related to products delivered by a fintech firm. One useful question to ask is whether a product’s success depends on consumers making ill-informed choices; if so, or if the product otherwise fails to provide sufficient value to consumers, it is not going to be seen as responsible and may not prove sustainable over time.
The key challenge for regulatory agencies is to create the right balance. Ultimately, regulators should be prepared to appropriately tailor regulatory or supervisory expectations — to the extent possible within our respective authorities — to facilitate fintech innovations that produce benefits for consumers, businesses, and the financial system. At the same time, any contemplated adjustments must also appropriately manage corresponding risks. Financial products must be fair and transparent so that consumers can make informed choices and have confidence that the terms of their credit, savings, and investment accounts are as advertised and disclosed. It is important that consumers have this level of trust in financial products and services, regardless of the type of firm with which they do business.