Regulators Should Foster Financial Innovation


This post is the eighth in a 10-part series on reform proposals for the Consumer Financial Protection Bureau. See below for previous posts.

It is becoming increasingly apparent that financial technology, or “fintech,” like other forms of technology, can drastically improve consumers’ lives. Yet one of the most glaring failures of the Consumer Financial Protection Bureau has been its neglect of the role of financial innovation.

Fintech has the potential to provide consumers with cheaper, easier, and diverse financial products that are more closely tailored to an individual’s needs. Indeed, fintech, in one form or another, has been doing this for centuries. In his treatise, “Money Changes Everything,” the economic historian William Goetzmann writes, “financial technology allowed for more complex political institutions, enhanced social mobility, and greater economic growth—in short, all the major indicators of complex society we call civilization.”

Importantly for the bureau, innovation can solve many of the consumer protection problems that regulators have historically been concerned with. Take the example of small dollar lending and a new fintech product called “Dave.” Dave is a mobile application that synchronizes with customers’ financial accounts and analyzes their spending habits. Dave then builds the customer a budget in order to better predict when they are at risk of overdrawing their account. If a customer is indeed going to overdraw their account, Dave will advance up to $75, interest-free, to cover the shortfall—a small dollar loan to be paid back from the consumers’ next paycheck. Rather than charging relatively high interest rates, as done by a typical payday lender, Dave is a subscription-based service charging merely $1 per month. Dave is an example of many fintech firms that are replacing loan officers with algorithms and brick and mortar stores with smartphone applications.

Where regulation merely takes away choices, as in the case of the bureau’s payday loan rule, fintech actually provides consumers with more and better choices. No matter how many lawsuits the CFPB brings or regulations it writes, it could never create a better product, at a better price, delivered in a more convenient manner. Innovation is a crucial aspect of improving consumers’ lives, and it deserves an equal place amongst the bureau’s consumer protection priorities.

Another example is alternative credit scoring. These non-traditional underwriting methods empowered by machine learning allow consumers and businesses to better price risk and expand the market for credit. Those consumers who were previously considered “credit invisible” or “unscoreable” due to a lack of credit history or other factors, can now be “scored” by lenders.

Many fintech lenders are increasingly moving toward nontraditional underwriting criteria can involve utility payments, electronic transaction records, medical and insurance claims, mobile phones or Internet usage data, consumer’s occupation and education attainment, or even their social network history and Amazon purchases. As the former director of the Bureau of Consumer Financial Protection, Richard Cordray, promoted:

By filling in more details of people’s financial lives, this information may paint a fuller and more accurate picture of their creditworthiness… adding alternative data into the mix may make it possible to open up more affordable credit for millions of additional consumers.

Unfortunately, antiquated regulation is too often getting in the way. One example, as highlighted in a previous post, is the threat of disparate impact liability under the Equal Credit Opportunity Act. For example, credit scores derived from alternative data containing no records based on prohibited characteristics may be shown to have a similar statistically divergent outcome in certain instances, regardless of whether actual discrimination has occurred. This would only be made worse with a broad section 1071 rulemaking. A small startup firm cannot weather the kind of regulatory risk this entails. Where such risk is high, lenders will resort to more standardized services that play it safe—in other words, they fail to innovate and serve new markets.

Under former Director Cordray, the CFPB provided wholly inadequate relief from such threats. The bureau had issued only one no-action letter, to Upstart, a fintech company that uses artificial intelligence to make credit decisions. However, the letter was “subject to modification or revocation at any time at the discretion” of the bureau. Even further, the bureau’s letter was explicitly non-binding, stating that they may initiate a retroactive enforcement or supervisory action against the company if deemed appropriate. Upstart was therefore required to hand over propriety data on its currently unapproved underwriting operations, to which the bureau had the authority to retroactively bring enforcement actions against. This is no assurance at all. 

Fortunately, new leadership is looking to turn this around. Under acting Director Mick Mulvaney, the bureau established a new Office of Innovation, which will seek to ensure that their policies are more considerate of their impact upon innovation, as well as looking at measures to encourage financial innovation.

Even further, under Director Kathy Kraninger, the bureau is now seeking to rewrite its no-action letter policy and create a “regulatory sandbox.” Sandboxes are a set of regulatory tools that enable innovative firms to test their business models without having to comply with the whole swath of financial regulations. They are a flexible method of regulation that seeks to relax certain requirements for a period, while also maintaining the overarching regulatory framework. The benefit of a regulatory sandbox is in lowering administrative barriers and costs to innovative business models, allowing them to scale faster and easier.

The bureau’s newly developed innovation policy has a number of benefits. First, one innovative feature is to allow trade associations to apply for no-action letters on behalf of one or more of their members and allowing service providers to apply for a letter covering business relationships with third parties.

Another much-improved aspect is the change to retroactive liability. The proposal assures firms that even if a no-action letter is withdrawn by the bureau, it will not pursue a penalty as long as the no-action letter is revoked for a reason other than a failure to comply with the terms and conditions of the letter.

Further, a major detriment of the previous policy was its exclusion of no-action letter relief for Unfair, Deceptive, or Abusive Acts or Practices (UDAAP). This exclusion severely limited the usefulness of the policy, as the bureau has relied upon UDAAP as its primary enforcement tool over the years in part because there are a broad range of penalties for violating UDAAP.

The bureau should also help states that share the common goal of simplifying red tape for fintech firms. It should support states that are building regulatory sandboxes by self-limiting its enforcement actions against those that it deems are appropriately protecting consumers, potentially through memoranda of understanding (MOUs) with various state regulators.

The bureau’s recent embrace of innovation is encouraging and it should work diligently to finalize current proposals. Innovation is a crucial aspect of improving consumers’ lives, and it deserves an equal place amongst the bureau’s consumer protection priorities.

Previous posts on reform proposals for the Consumer Financial Protection Bureau: