Self-regulation can be effective. For example, the American Bar Association (ABA) developed Model Rules of Professional Conduct to set minimum standards for attorneys to follow. Many states adopted all or part of these standards into their own legally binding rules for ethics and conduct. Although the online lending industry came up with some strong proposals, they have not been widely adopted even among those who suggested them. The self-regulation effort would benefit from greater coordination, more commitment among lenders to participate, and a way to raise the consequences for lenders that do not comply.
Unfortunately, it is likely the case that self-policing and voluntary disclosures alone will not stop predatory lenders, since principles and best practices do not have the force of law. Only regulation can compel every lender and broker to treat borrowers fairly. Without universal standards, it is more difficult for lenders and brokers to abide by high standards when they have competitors that behave less ethically. Thus, it falls to policymakers to create a legal structure that rewards good industry behavior for fintechs, as they have for banks.
Lessons from Other Countries
America is not the only nation facing these questions. Since fintech innovation is a global phenomenon, there are already lessons—good and bad—that U.S. policymakers can learn from the experiences of foreign regulators.
Positive Lessons from the United Kingdom
During the 2008 financial crisis, former U.K. Chancellor of the Exchequer, George Osborne, recalled being flooded with calls to help small businesses get access to credit.4 The crisis and recession hit the United Kingdom’s small and medium-sized enterprises (SMEs) hard. Osborne and then Prime Minister David Cameron soon realized that the government had few tools available to address SME lending and thereby help stabilize the economy. Unlike the United States, which had a network of more than 5,000 community banks, over 80 percent of U.K. SME lending was done by four large banks, and all four were in trouble.
The crisis triggered aggressive steps by the U.K. government to help SME lending recover. There are several lessons from that effort, which the United States could do well to learn. These fall into five categories: (1) the benefits of creating a single oversight agency with a mandate to protect the financial system and encourage competition; (2) the need to create mechanisms in the regulatory environment that encourage and support innovation; (3) the adoption of a systematic review of the new rules that regulate new entities in order to make sure they are working properly; (4) the value of collecting data that allows policymakers to monitor the levels of and gaps in small business lending; and (5) that markets will be more innovative and more secure if consumers and small businesses control their own data.
The Financial Conduct Authority
In 2013, the British government created a new agency, the Financial Conduct Authority (FCA), to supervise the business conduct of more than 56,000 financial services firms to make sure that financial markets were “honest, fair, and effective.” It also became the prudential regulator for about 18,000 firms, charged with ensuring their safety and soundness.5
But unlike most regulators, the FCA was given a third strategic objective: to promote “effective competition in the interest of consumers.” This competition mandate allowed the FCA to take on a proactive agenda around fintech and innovation, in a way few regulators had ever envisioned. The approach led to the creation of Project Innovate, a much-discussed program for innovative fintech firms to try out some of their business ideas before taking them to the broader market. Perhaps the most interesting aspect of this initiative was the Regulatory Sandbox, a place for businesses to test innovative products, services, business models, and delivery mechanisms in a live environment without immediately incurring all the normal regulatory consequences of engaging in the activity in question.”6
For example, say a start-up has a new algorithm that might better predict the creditworthiness of potential borrowers. Once the firm was in the sandbox, they received individualized regulatory guidance from the FCA staff, became eligible to receive waivers or modifications of existing FCA rules, and could apply for “no enforcement action” letters that limited disciplinary action if the firm dealt openly with the FCA.7,8 All of these activities were designed to help start-ups test new ideas while simultaneously allowing the FCA to monitor industry developments. In the first year the sandbox was in operation, the FCA received 146 applications for its first two six-month cohorts, and accepted 50 of those into the program.9
Routine Reviews of Regulatory Effectiveness
In 2010, in response to the financial crisis, Her Majesty’s (HM) Treasury implemented a series of regulations that provided an oversight structure for fintechs involved in the U.K. peer-to-peer lending markets, which were growing rapidly. The regulations were enacted quickly, in less than nine months. Because the markets were new, HM Treasury officials built in an additional provision—the entire set of rules would be reviewed in one to two years to be sure they were working. This idea of quickly implementing, then reviewing and adapting legislation, is absent from U.S. lawmaking and may be hard to effect, but the concept would be useful as fintech regulation will need to evolve as products and markets respond to new innovations.
Mandated Industry Data Collection
The United Kingdom also took aggressive actions post-crisis on the data collection front. The newly created British Business Bank (BBB) became responsible for gathering quarterly data from banks and online lenders on loan originations and loan stocks, including metrics on costs and defaults, to better track the availability of credit and the progress of market reforms. The BBB focused particularly on the SME lending market and on the fintech marketplace in general. Further, banks were required to share commercial loan data in confidential formats with regulators and policymakers, and make this information available to competitors via credit agencies to improve credit assessments and oversight of potential discrimination. This effort appeared to be valuable for policymaking and monitoring of the market’s recovery.
Data Ownership—PSD2 and Open Banking
In 2018, a landmark set of regulations governing financial data took effect in Europe. The Revised Payments Services Directive (PSD2) upended the status quo in the financial system by giving customers explicit ownership of their financial data and requiring banks to share this data with third-party service providers through open application programming interfaces (APIs) at a customer’s request.10 PSD2 allowed third parties to more easily aggregate and analyze data from multiple sources and present it in a seamless way. It also leveled the playing field between banks and fintechs, since incumbent firms were not allowed to monopolize customer data. PSD2 included a number of other provisions, including efforts to better safeguard the privacy of data. The United Kingdom implemented its own version of PSD2, called Open Banking, which, in addition to requiring that banks share data with third-party providers, required banks to provide that data in a standardized format.11
Although the long-term impacts of PSD2 and Open Banking have yet to play out, they frame a critical question for U.S. policymakers: the ownership of data. Having small businesses own their financial data and be the decision makers about who gets access to it, changes the competitive dynamics of the market. Under this regulatory framework, new financial services provider would have an equal opportunity to gain access to the information and create novel small business products and applications. The new regulations will be closely watched to see if PSD2 and Open Banking make markets more competitive and innovative than if banks control their customers’ data.
Cautionary Tales from China
The regulation of alternative lending in China started out with a light touch approach, with the benefits and consequences one might expect. In China, peer-to-peer lending had a long history, with people lending directly to friends and relatives, and indirectly through rotating credit and savings associations.12 Online platform lenders built on this tradition and flourished, with rapid growth in the number of platforms.
The Chinese government encouraged innovation in the sector starting in 2013.13 By 2015, peer-to-peer trading volume in China was four times what it was in the United States.14 In that year, an average of three new lending platforms were coming online each day, and the volume of loans was growing by hundreds of percent annually.
Online lending proved particularly important for Chinese small businesses, which have long found it difficult to secure financing from traditional banks that are often at least partially controlled by the state. Even though SMEs account for 60 percent of the Chinese GDP and 80 percent of its urban employment, they receive only 20 to 25 percent of bank loans and are often forced to pay APRs of up to 60 percent for credit.15
Despite the fact that the Chinese financial regulatory system has been known as being heavy-handed and conservative in general, oversight of peer-to-peer lending was almost nonexistent until 2016. With no formal disclosure guidelines or regulation from national regulators, problems arose. As the number of online platforms mushroomed, so did the share that had been investigated by the police and those where the owners had walked away with investor funds or where loan repayments had ceased (Figure 11.1). The 2016 Blue Book of Internet Finance backed up this assessment, finding that more than one-third of Chinese platforms either had cases of fraud, or had gone or were going out of business.16
Figure 11.1 Number of Online Chinese Peer-to-Peer Platforms and Share of “Problem” Platforms
Source: Martin Chorzempa, “P2P Series Part 1: Peering Into China’s Growing Peer-to-Peer Lending Market,” Peterson Institute for International Economics, June 27, 2016.
In December 2015, authorities shut down Ezubao, an online peer-to-peer broker that turned out to be a giant Ponzi scheme that collapsed after collecting about $9 billion from more than 900,000 investors.17 Ezubao had promised some investors returns of nearly 15 percent per year, much higher than banks were offering. But one senior manager at the firm later said that “95 percent of investment projects on Ezubao were fake.” Near the end, police had to resort to digging up 80 travel bags full of financial documents buried six feet underground by company officials.18 Ezubao helped spark a government crackdown on numerous problems in China’s peer-to-peer lending market.
In 2016, the Chinese government announced a series of new guidelines and rules. They defined online lending, banned platforms from engaging in certain activities such as pooling lender funds or providing credit enhancement services, set registration rules for platforms, required that platforms use a qualified bank as a fund custodian, and set 65 mandatory and 31 encouraged disclosures.19 The China Banking Regulatory Commission announced additional transparency rules in 2017, including that peer-to-peer platforms had to disclose funding sources, details about outstanding loans and repayment plans, and lending activity with people and companies connected to the platform.20 Afterward, peer-to-peer loans continued to grow rapidly while the number of platforms fell by more than half between 2015 and 2018, indicating that the regulation may have had the desired impact of eliminating fraudulent players, but not stifling market growth.21
The Chinese market has also seen the rise of several large platform companies that have entered the small business lending space. In 2018, Ant Financial, the parent company for Alipay and an affiliate of ecommerce giant Alibaba, cemented itself as the largest fintech firm in the world by establishing a $150 billion valuation.22 Ant and Alipay have become “the modern gateway to an ecosystem of financial services,” not only dominating the mobile wallet and payments space, but also providing wealth management, insurance, credit scores, and consumer lending services.23
This growth has not gone unnoticed by the Chinese authorities, who have taken steps to limit Ant Financial’s ambitions, such as curtailing its effort to create a national credit scoring system. The success of Ant has drawn the ire of China’s traditional financial institutions, with one observer calling them “a vampire sucking blood from banks.”24 The banks have claimed that the company’s practices decreased deposits, forcing higher interest rates and branch closures. We do not yet know whether the rise of dominant players in China’s fintech market will be a positive or negative development for China’s SMEs. But it is worth watching carefully as an example of how platform companies such as Amazon could become a powerful force in financial markets in the United States.
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U.S. regulators can learn from the experiences of both China and the United Kingdom as they develop financial regulatory systems around the new fintech innovators. China’s initial experience showed the dangers of too little oversight. Left alone, the bad actors already present in the U.S. market could accelerate their activities to the detriment of small businesses and the economy. The U.K. model, in contrast, provides useful guideposts, as the government and regulatory activities have been robust yet measured, straightforward yet comprehensive, and have produced real successes. The U.K. example demonstrates an effective balance of encouraging innovation and risk-taking with oversight and data collection. Despite the rigidity and polarization of American politics around regulatory reform, this model would not be difficult for U.S. regulators to emulate.
Principles for U.S. Financial Reform
For the good of America’s small businesses, we must move on from the polarized view that any new financial regulation is bad for industry and consumers, as well as the opposing view that financial firms are untrustworthy, and must have ever-more rules piled upon them. In their 2003 book, Saving Capitalism from the Capitalists, Raghuram Rajan and Luigi Zingales make the argument that protecting free markets requires government intervention.25 Governments need to guarantee property rights for the large and small alike to ensure that incumbents don’t use their political advantage to benefit themselves, but also to provide a safety net for those who are the losers from economic displacement. The authors also suggest that too much government regulation of finance can actually benefit incumbents and insiders rather than encourage dynamic markets and benefit consumers and investors. Balance is the key.
Innovation has made its way into financial services, and the changes technology will bring to products and markets will continue. The entry of platforms and the more pervasive use of data and artificial intelligence are likely to impact lending markets dramatically. The Basel Committee on Banking Supervision summarized the moment: “fintech has the potential to lower barriers of entry to the financial services market and elevate the role of data as a key commodity, and drive the emergence of new business models. As a result, the scope and nature of banks’ risks and activities are rapidly changing and rules governing them may need to evolve as well. These developments may indeed prove to be more disruptive than previous changes in the banking industry, although as with any forecast, this is in no way certain.”26 Change is coming, and our regulatory system is not yet prepared to meet these challenges.
Remaking the U.S. financial regulatory system will be difficult, but we should make our best attempt to be proactive. The answer is not more or less regulation, but the right regulation—balanced, sensible rules that operate in a transparent environment. It is time for an active agenda of financial regulatory reform in small business lending that is guided by three broad principles: (1) supporting innovation; (2) enhancing protections for small business borrowers while ensuring the safety of the financial system; and (3) streamlining and simplifying the regulatory environment.
Principle 1: Promote Innovation
Allowing small businesses to have a wider variety of financing choices will benefit lenders, small businesses, and the entire economy. There are several ways that the regulatory system can help to achieve this goal.
Engage with Innovators
The United Kingdom has provided a model for how regulators and fintech innovators can engage to encourage responsible innovation. The FCA’s Regulatory Sandbox has given innovators a way to test their products and gain valuable feedback on how they should be designed to pass regulatory muster. This approach also helps regulators to unde
rstand changes in technology and methods, and how best to adapt to them. Many other countries have followed the United Kingdom’s lead and created fintech sandboxes of their own, including Australia, Singapore, and China.27
In 2017, the Office of the Comptroller of the Currency (OCC) created a new Office of Innovation, which included a “light” version of a sandbox. The proposal offered tools for fintechs and others with new ideas to collaborate with regulators, but did not have the ability to waive legal liability for participants.28 In another attempt, the Arizona State Legislature passed legislation in 2018 to create its own fintech sandbox, with other states considering taking similar action.29
These are a good start, but as the U.K. model demonstrates, regulators need to do more than pay lip service to innovation by saying they have a “sandbox.” A real effort requires clear direction to fintech innovators about the rules of engagement: what are the protections afforded by the admission to the innovation environment? How long do these permissions last? What rules need to be followed in terms of disclosures? How do they apply to become active under the sandbox? Coordination among the state and federal regulators to allow firms to enter the sandbox will also be a necessary component, given how many entities have oversight.
Fintech, Small Business & the American Dream Page 17
