Fintech Must Lead the Way to Free Finance

Fintech companies can bring our financial system to the next level – but only if they disrupt finance on the regulatory level as well. Here is how they should proceed.

Only a couple of years ago, Fintech entrepreneurs wanted to become a disruptive force. Ambitious startups had the vision to democratize finance and break the power of banks. About five years ago, Renaud Laplanche, CEO of Lending Club, hoped companies like his could eventually replace traditional banks.

In recent years, the disruptive stance gave way to a collaborative one. Laplanche now hopes that in 10 years, “you see banks being participants on both sides of the [Lending Club] marketplace.”

Laplanche’s change of attitude is representative for the entire Fintech industry. Banking is no longer seen as the empire to conquer, but as the partner in crime that can provide large amounts of funding, regulatory expertise, and access to payment systems.

Many see this move towards more collaboration as a sign of a maturing industry. But it is highly unusual for digital disruptors to play nice with the incumbents. AirBnB never helped hotels to fill their beds, and Uber, well, they did not make many friends in the taxi industry.

So what is different with finance and banking?

Why Collaboration?

The current regulatory environment heavily favors the collaboration approach. With government guarantees and access to central bank liquidity, banks have a large risk appetite and almost unlimited access to funding. They can fill marketplace loans faster than anyone else, and provide the funding to quickly scale Fintech solutions. If you do not team up with banks, you will find yourself losing market share.

In addition, banks are the experts for the regulatory framework that was essentially built to tame them. Fintech companies are subject to many of these regulations as well. However, they lack the army of lawyers and compliance officers to address all rules. Partnering with banks is often the best approach to ease the regulatory burden.

Finally, banks are the gatekeepers to the payment system. They are the only ones with direct access to the central clearing and settlement system operated by central banks. Most payments that do not involve cash eventually make use of this system. Fintech Payment providers might build more convenient interfaces for customers and merchants, but they cannot work around banks for final clearing and settlement.

Like a gravitational field, the regulatory environment pushes Fintech companies towards banking.

Is this the right choice?

Fintech stands at a crossroads. Should it give in to the gravitational field and collaborate with banks? Or should it resist the pull and try to disrupt them? The right answer depends on the regulatory environment. The current regulatory environment favors collaboration.

But a regulatory environment is not set in stone. Fintech companies can rally the support to change it.

As such, the more important question is: Is it worth to jeopardize collaboration profits and wield another attack on finance?

It is totally worth it!

Finance is a several trillion dollar market and dominated by bureaucratic, inefficient, gigantic and unpopular banks. If the Fintech sector can level out the regulatory environment, the old dinosaurs will not stand a chance.

A plan for attack

What concrete regulatory measures would do the job and open up a path for disruption? A Fintech license.

Mark Branson, the head of the Swiss banking regulator Finma, aired a similar idea. On the one side, licensed Fintech companies could offer financial services without being subject to many of the costly regulations that apply to banks. On the other side, licensed Fintech companies would not be allowed to conduct activities that expose them to systemic liquidity or interest rate risks.
Branson´s idea is great and it originates out of his concern that the regulatory environment favors the incumbent banks over the new Fintech companies. Let us take his idea some steps further and detail the restrictions and benefits that should come with this Fintech license.

No Systemic Risks

The main justification for the complex regulatory framework in finance is systemic risk. We learned in 2008 that failures of individual banking institutions can lead to the collapse of the entire financial system. If Fintech companies do not create systemic risks, then we also do not need any regulations to counter systemic risks. In our book, The End of Banking, we have developed a systemic solvency rule that can be used to prevent Fintech companies from creating systemic risks. In a nutshell, the rule prohibits any company from financial speculation with borrowed money. It prevents that the failure of one Fintech company can have any knock on effects on another one.

It is the nature of Fintech business models that they rather act on an agency basis. Many marketplace lenders, payment service and information providers, or investment advisors do not take any principal risk. They rather connect borrowers with lenders, merchants with customers, or investors with entrepreneurs. These types of business models are aligned with the systemic solvency rule: they will feel zero impact by this constraint.

However, in a world where banking institutions still exist, a systemic solvency rule alone will not be sufficient to prevent Fintech companies from becoming vulnerable towards systemic risk originating from the banking sector. As such, the Fintech license should also implement a barrier between the banking and the Fintech sector.

Regulated banking institutions should not be allowed to invest in any assets or liabilities issued or sold by Fintech companies, be it directly or indirectly via intermediaries, or subsidiaries. The same restriction should apply to anything that has been underwritten by licensed Fintech companies.

Does this mean that Fintech companies who collaborate with banks have to find a new business model overnight? No. These companies do not have to apply for a Fintech license, and thus they will not be subject to the systemic solvency rule. Nothing will change for Fintech companies which do not apply for this license.

So why should Fintech companies apply for a license?

Free Fintech

Being subject to a systemic solvency rule seems like a restriction, but it actually frees Fintech. Since Fintech companies are subject to the systemic solvency rule, they are no longer creating systemic risks. Consequently, all the financial regulation that aims at addressing systemic risk no longer need to be applied to Fintech companies.

Many costly regulations fall away: Basel III, Dodd-Frank, and Volcker, and most of the national regulatory frameworks were all introduced to prevent systemic events. Fintech companies should no longer be bothered by any of these regulations. They should, however, still adhere to regulations that protect consumers, investors, and borrowers, and prevent that financial services are used for money laundering or the facilitation of illegal activities.

Implementing the right processes and controls to comply with such rules is costly. Fintech companies need to know their customers, have detective controls in place to identify money laundering activities, adequately disclose financial risks to customers depending on their level of sophistication, and many more. Especially startups struggle to get all of this right.

Regulators can ease the burden for licensed Fintech companies by proactively engaging licensed Fintech companies in a collaborative manner. They should advise startups about the regulations to consider and take a more active role in setting up the right compliance processes and controls. Regulators should make it as easy as possible for Fintech companies to be fully compliant with all consumer protection and anti-money laundering regulations.

In addition, regulators should also relieve licensed Fintech companies from regulations if amounts are small and risks are immaterial. For example, they could allow Fintech payment providers not to conduct substantive “know your customer” procedures if the monthly transaction amounts are below a certain threshold.

Giving more leeway where possible without relaxing anti-money laundering control or consumer protection standards would help tremendously to make the Fintech license attractive for tech savvy financial startups that still need to build the experience in compliance and regulation related matters.

Empower Fintech

As licensed Fintech companies do not create systemic risks, and as regulators ensure that they fulfill the same standards in terms of consumer protection and anti-money laundering, they should also be allowed to offer the entire range of financial services. Broadly speaking, Fintech companies should be allowed to offer payment services, operate a commercial lending business, and provide investment advice.

Today, most payment providers have to cooperate with banks, or with credit card companies that use the banking clearing system to settle transactions. For example, PayPal, Venmo, or ApplePay are fully dependent on the existing banking system. All those providers link customer accounts to a credit card, debit card, or bank account, and also process the payments via banks.

If the banking system fails during a crisis, ApplePay and Paypal cease to operate. Licensed Fintech companies need to circumvent the banks completely; otherwise, they are exposed to systemic risks originating in the banking system.

As such, licensed Fintech companies should be allowed to hold reserves – basically just electronic cash – with central banks and use its clearing and settlement systems. They should get the same conditions on the market for central bank reserves as any other commercial bank.

However, Fintech companies do not need access to the central banks emergency liquidity facilities. Since the systemic solvency rule effectively prevents them from becoming systemically relevant, a failure of a Fintech company will not be something that has to be avoided at all costs. There are simply no financial chain reactions to be afraid of if a systemic solvency rule is in place.

Furthermore, licensed Fintech companies should get the same privileges as licensed banks to lend money, apply credit ratings, provide capital market services, and offer investment advice.

Stand the test of time

It is important to stress that a Fintech license only adds opportunities. Companies who build their business model around cooperation are not forced to apply for a Fintech license; they are free to team up with banks. Their business model is not at risk with the new regulatory category we are proposing. Such companies could even take a bifurcated approach. Fintech companies that have close ties with the banking industry could create separated legal entities. These new legal entities can then operate under the Fintech license and so be active in both fields.

A Fintech license comes with the disadvantage of being constrained by the systemic solvency rule, and their interaction with banking institutions is restricted. But they receive a regulatory relief that results in direct cost savings, and they can offer the entire range of services without having to share the profits with partnering banks.

For example, Lending Club could spin off a retail division that operates under the systemic solvency rule and separated from the banking industry. This division could focus on serving retail investors. While retail investors might require slightly higher returns than the institutional investors that are ultimately backed by the subsidized banking industries, a retail division would no longer need the partnership with Webbank, and could expand the business model easier towards secondary trading and payment services. The lower risk appetite of retail investors could be compensated with lower regulatory costs and more business opportunities

And there is another advantage in the long run, and this one could turn out to be the most important one.

Imagine that a couple of years down the road, a critical mass of Fintech licensed companies offer the entire range of credit, payment, and advisory services. As they do not take systemic risks and operate independent from the banking system, they will not be directly affected if the financial system is struck by another Lehman moment.

Would politicians approve another bailout if an entire Fintech sector stands ready to take over the payment and loan business from the – once again – failing banking sector? If all the infrastructure is in place and scalable to process transactions, cash withdrawals, and loan applications for the whole economy? What will be the fate of banks when their survival again depends on another bailout?

In this situation, it is likely that politicians let banks fail and only bail out the depositors. Big banks could disappear virtually overnight, leaving a huge gap in the financial market. Just as mammals had free reign over our planet after the extinction of Dinosaurs, licensed Fintech companies could take over. We would finally see the disruption that this financial system is in such desperate need of.

The Fintech industry has nothing to lose but much to win if it can convince regulators to introduce a Fintech license. Being better is not enough. Fintech has to truly disrupt financial markets. Only by doing so, they will be able to stand the test of time.