It’s almost become a distant memory, the near collapse of the financial system. Regulators were overwhelmed by increasing technical complexity, competitive product innovation run amok and global financial institutions that leap-frogged sovereign regulatory boundaries.
Regulators, with no global framework to conduct oversight and decades of laissez faire regulation, had neither the tools nor the manpower to see the contagion of systemic risk growing in a globally connected, automated and digitized financial system.
{mosads}Even today, a yet to be completed new risk regime is facing setbacks from the everyday reality of discovering unintended complex interactions in its implementation. Now looming over this “work-in-progress” comes a dramatic new set of technologies that is again both capable of revolutionizing global finance and again overwhelming its regulators.
“FinTech” (financial technology) has been embraced by existing financial institutions as well as spawned a next generation of yet unregulated FinTech companies.
FinTech companies are using or planning to use advanced technologies to offer financial services. These technologies encompass:
- fifth generation (5G) networks that operate at 1000 times the speed of current networks;
- networked computers that operate at ever-accelerating speeds and lowered costs;
- artificially intelligent (AI) programs that mimic human thought;
- cloud computing that can store unlimited amounts of data;
- distributed networks and distributed ledgers (collectively referred to as blockchains) that offer secure communication and trusted recordkeeping; and
- globally interconnected networks that promise to make everything available in real-time.
Now into this mix of advanced technologies comes the game changing “GiantTech” companies — globe-spanning commercial technology platforms and systemically important financial institutions joining up to embrace FinTech and drive even more dramatic change. The result, again, may be the risk of unintended consequences.
GiantTech is represented by:
- the global financial behemoth J.P. Morgan offering their version of cryptocurrencies (JPM Coin) pegged to the dollar for use in commercial payments and securities transactions;
- Facebook engaging with cryptocurrency exchanges to support their version of a multi-currency based cryptocurrency for use in consumer payments; and
- Apple, marrying up with Goldman Sachs new online bank, Marcus, to closely couple its credit card with Apple pay for new consumer services.
In July 2018, the Treasury Department released a report identifying improvements to the regulatory landscape that the agency believes will better support nonbank financial institutions, embrace financial technology and foster innovation.
That report stated that from 2010 to the third quarter of 2017, more than 3,330 new FinTech companies were founded, 40 percent of which are focused on banking and capital markets. In total, global investments in FinTech companies reached $22 billion in 2017, 13 times what they were in 2010.
According to TransUnion, one of three major credit reporting agencies, U.S. retail customers are increasingly using Fintech firms instead of traditional financial institutions for their credit needs.
TransUnion reported that the unsecured personal loan market hit an all-time high in 2018, increasing 17 percent year over year to $138 billion. FinTech companies were largely responsible for that increase.
Further, FinTech companies issued 38 percent of all U.S. personal loans for debt consolidation, home improvement financing and retail purchases due to increased e-commerce and online shopping. That’s up from 35 percent a year earlier and just 5 percent as recently as 2013.
Traditional banks’ share of those loans is down to 28 percent from 40 percent five years ago. Credit unions are down to 21 percent from 31 percent in the same time period.
FinTechs reach further down the credit curve, raising questions about how many of its customers would fare in their encounter with an economic downturn. In 2018, most of the growth was at the subprime tier, which grew the fastest at 4.3 percent year over year.
Any inherent risk in those subprime loans is tied closely to financial stress in the economy. Subprime borrowers are more prone to loss of jobs or lower hourly wages.
What this means for financial services is radical revisions to our way of interacting with and regulating the financial system and its financial supply chain of originators, receivers and intermediaries, both at the consumer level and at the institutional level.
Think about regulating a financial entity with a billion globally dispersed retail customers (the Apple/Goldman venture); or regulating Facebook’s multi-billion member platforms using its own currency and payment network; or regulating a blockchain network supporting all the world’s major corporate and institutional payments (the JPMorgan venture); or regulating self-activating “smart contracts,” artificially intelligent trading systems or new cryptocurrencies.
The design of each innovative product or service needs to be explained in detail to already under-budgeted and technology deficient regulators. Legacy regulatory best-practices, such as time-limited or “no action letter” approvals might prove wanting as was the case with earlier era risk model or trading system approvals.
{mossecondads}Taken together with many creative FinTech products, processing approaches, distribution techniques and financing and payment innovations, GiantTech initiatives may unwittingly force our financial system back to “lazier-fair” regulations.
Worse yet, our financial regulators may fail to regulate or just slow down innovation in regulated financial institutions and thus accelerate the growth of unregulated FinTechs and, more ominously, lightly supervised GiantTechs.
We may spin out of control again if regulators don’t receive the funding needed to build the sophisticated tools necessary to oversee an ever more complex digital financial system.
While the financial system is resting on a platform of regulations crafted by lawyers, it is increasingly operating on a technology ecosystem built and understood by data scientists, technologists and communication experts.
Regulators have to add such expertise quickly to their staff’s lest they again become overwhelmed by increasing technical complexity and competitive product innovation run amok.
Allan D. Grody is president of Financial InterGroup Advisors, a strategy, research and acquisition consultancy.