The fintech industry needs to transform to help underserved communities

Alternative credit options can mean the difference between financial well-being and financial hardship for many borrowers. Fintech advances such as buy-now-pay-later, plus the combination of credit models powered by artificial intelligence and machine learning, could pave the way for a fairer and more inclusive future for credit.

But the lesson from the financial crisis is clear: When only one part of the market is required to follow the regulations, the other will compete by offering disadvantageous and risky products.

Regulators are now faced with how to promote a regulatory framework that encourages innovation while protecting consumers.

Balance access with growth

Buy now/pay later options spurred marked industry growth, as well as advances in artificial intelligence and machine learning during the pandemic, with implications and improved assistance for underserved communities.

More generally, bank partnerships with fintech companies have increased. Everyone wants to bank digitally and quickly, despite the data security risks.

Algorithmic underwriting and process automation have recalibrated how credit risk is measured by reducing the role of humans in such decisions.

A 2012 study shows that more than 50% of loans to black-owned businesses under the pandemic’s Paycheck Protection Program came from fintech lenders—double such lending made by manual small banks.

The improvement is easy to understand. Automation can empower smaller lenders, increase financial inclusion and reduce reliance on payday lenders.

AI tools can tap into a cache of data not used in traditional credit reports to make more accurate risk assessments that are critical to obtaining credit and other financial services.

By expanding credit availability, AI can enable historically underserved communities to gain credit and build wealth.

Other benefits of incorporating AI/ML tools into financial services include reducing fixed costs where lenders can afford to make smaller loans, expanding service to communities with fewer bank branches, and generally keeping incumbent financial players honest.

But machine economy is no panacea. The fintech industry is facing new challenges and regulatory scrutiny to combat the growing risk of abuse and fraud.

Regulatory considerations

This dynamic contradicts a common misconception that fintech is unregulated. Sharp questions must be asked as the likelihood of further regulatory measures in 2023 becomes clearer:

• How can strict consumer reinvestment laws and fair lending standards be applied?
• How can protection against data-driven bias be strengthened?
• How can all parties be better inoculated against unauthorized data and privacy disclosures?
• How can the effectiveness of such protections be signaled to cautious borrowers?

Bridging the small lender gap helps protect consumers and enable transformation and innovation. Status quo credit scores are typically calculated using 25 to 30 data points, while ML/AI can integrate perhaps 300, countering the privileging of legacy asset metrics over a potential borrower’s emerging performance.

Other advances can be realized through revisions to the regulations for electronic money transfers to banks that transfer unauthorized fees to consumers.

What to expect

The CRA encourages financial institutions to address credit needs in communities where they operate, including low- and moderate-income neighborhoods.

Applying CRA requirements to fintechs can help curb abusive lending while incentivizing them to offer more loans, investments and services in LMI communities.

When applying for licenses or charters, fintechs must expect strict CRA and financial inclusion plans with measurable performance targets. Periodic CRA examinations and fair lending reviews should be rigorous to provide incentives for fintechs to meet and/or exceed their performance targets.

The creation of lending assessment areas can ensure that fintechs make a significant effort to serve LMI borrowers and communities. Given the novelty of fintech underwriting and marketing, fair lending reviews must be comprehensive and confirm that fintechs do not overtly or inadvertently discriminate in their lending.

Last October, the Consumer Financial Protection Bureau outlined options to strengthen consumers’ access to and control over their financial data. This includes the freedom to safely walk away from companies that offer poor products and service and move towards lenders with alternative or innovative products and services.

A recent financial report calls for collaboration and partnership between traditional banks and fintech, provided it is done safely and with guidelines. This can be achieved by using existing regulatory powers, but guided by developed principles.

Bank-fintech partnerships providing services of an insured depository institution should operate within the IDI rules.

Regulators should balance the needs for innovative guarantees with increased credit visibility, reduced bias and cautious expansion to provide credit to the underserved.

Consumers should be able to change lenders to improve and/or escape bad services.

Regulators must address threats from legacy lenders that can monopolize personal data and block competitors’ access to such consumers.

The CFPB is considering several regulations worth watching, including looking at requiring firms to make consumer financial information available to them or a third party at the consumer’s direction, so consumers can transfer their account histories so they don’t have to start from scratch with a new supplier, and limit any party’s ability to resell authorized data.

The CFPB will receive written feedback until January 25.

A regulatory balancing act is integrated. Improving the economic inclusion and health of underserved communities will benefit everyone, but if it comes at the expense of industrial innovation, progress will be undermined.

If executed thoughtfully, fintech can help close the racial divide by providing underserved populations and communities with increased virtual access to banking services.

Continued encouragement of industry transformation and dry-eyed assessments of results on the ground will help ensure fairer lending.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Robin Nunn is a partner and co-leader of the Banking Industry Team at Morgan, Lewis & Bockius. She advises national and international banks, investment advisors, broker-dealers, mortgage servicers and emerging financial services providers.