The real problem with bank-fintech partnerships

Between the passage of the Dodd-Frank Act in 2010 and roughly the beginning of the Trump administration in 2017, there was one core meta-question floating around banking regulation: How much capital—and what type—do banks need to hold to prevent another 2008 from happening again?

I will spare us the tediousness of explaining why it is important for the global economy not to have another financial crisis and start from the assumption that the banking system was undercapitalized and needed both greater capitalization and to some extent more effective supervision. But how much more capital and how much more oversight was needed to pass the “no more 2008s” threshold without imposing duplicative or counterproductive levels of capital and oversight was—and remains—an unknown and subjective question to answer, particularly in the absence of a real-time crisis to see how Dodd-Frank holds up.

The economic fallout from COVID-19 was a pretty good example of the kind of stress test that regulators and banks didn’t want to see coming, and at least following former Federal Reserve Deputy Chairman for Supervision Randal Quarles, the banking industry emerged relatively unscathed. It is not exactly a consensus view, and certainly most economic shocks do not bring with them an abundance of bank deposits. But the pandemic seems to have discredited the extreme arguments that Dodd-Frank was unnecessary in its entirety or that banks are as vulnerable today as they were in 2008, at least for most bank customers.

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That is not to say that there are no further improvements that may be necessary, and new regulators probably will always be working around the edges to make post-crisis supervisory and macroprudential rules more effective. But as regulators and lawmakers seek and destroy new sources of financial stability risk, there is a lesson from Dodd-Frank that policymakers may be missing.

Last week, Acting Comptroller of the Currency Michael Hsu called out bank-fintech partnerships as a potential source of systemic risk, and his argument was compelling. Banking information technology concerns, Hsu said, make up a quarter of all the OCC’s supervisory concerns, and while they are “known unknowns,” he said, there are likely many more unknown unknowns lurking in the shadows.

“Technological advances can offer greater efficiency to banks and their customers,” Hsu said. “However, the benefit of these efficiencies is lost if a bank does not have an effective risk management framework in place, and the impact of significant deficiencies can be devastating.”

Fintechs make their money in countless ways, some of which may pose a risk to the financial system and others not. But to the extent that fintechs or other non-banks offer the same kind of services that banks do without the supervision that banks have been required to have for almost 100 years, presents an obvious disparity that sooner or later has to be reckoned with.

To illustrate, let’s take back the tape about the COVID crisis. The Federal Reserve used its § 13(3) authority to lend to non-banks on a large scale in 2020, and the financial entities that soaked up most of it of that liquidity were money market funds, broker-dealers and other large businesses — entities that do not have supervisory requirements at the federal level.

None of this is to say that fintech is unregulated – many are at the state level and most are required by their banking partners to comply with relevant rules. This is also not to say that fintech should be treated in the same way as banks as a matter of course. What I’m saying is that what’s good for the goose is good for the gander, and without doubt the banking industry has become far more stable since the introduction of stricter supervisory rules than it was before the financial crisis in 2008. So why not do the same in the fintech industry?

Of course, doing so is not as easy as writing a column about it. If Congress passed a law requiring, for example, all publicly traded companies to be subject to some sort of minimum capital and liquidity requirements, many companies would go private, the prices of things would likely go up, and lawmakers would likely not win re-election.

But policymakers don’t have to go to great lengths to get non-banks engaged in bank-like activities to cleanse themselves in the healing waters of capital, liquidity and supervision. And the sooner they articulate that sound regulation is the way to help non-banks deal with the unknown unknown, the better equipped they will be and the less risk taxpayers will have to take.