Bank regulators are getting serious about innovation

I predict we’ll look back on 2019 as the breakthrough year when the U.S. financial agencies moved, each and all, to begin the digital modernization of regulation and compliance.

Regulatory change is slow by nature — by design, really, because getting things wrong can do so much damage. It’s also buffeted by political winds that complicate every effort to change the laws and rules. As a result, many people think financial regulation can’t fundamentally change. Nevertheless, it is going to do just that. The same huge technology trends that are transforming everything else, from communications to medicine to driving, are transforming finance, which means they are going to change financial regulation, too. It is becoming more risky for regulation to hold still than to speed up. As one regulator has put it, if they don’t move forward, they will be “accelerating backwards.”

Consider these events from just the final weeks of 2018.

Federal Deposit Insurance Corp. Chairman Jelena McWilliams announced plans for an office of innovation that will “transform” how the FDIC oversees banks.

The Consumer Financial Protection Bureau issued proposals to encourage and guide innovation through both a fintech “sandbox” and regulatory no-action letters that give innovators limited but attractive safe harbors.

The outgoing chairman of the Commodity Futures Trading Commission, Christopher Giancarlo, gave a speech on “quantitative regulation” and described plans to create “CFTC 2.0.”

The four financial institution supervisory agencies — the FDIC, the Federal Reserve, the National Credit Union Administration, and the Office of the Comptroller of the Currency — issued a joint statement with Fincen encouraging banks and credit unions to combat money laundering through regtech.

Square resumed its bid to become a bank that would be chartered as an FDIC-approved industrial loan corporation, or ILC — if approved, it would be the first in a decade. Momentum also developed around the OCC’s proposed fintech charter, despite the litigation threats surrounding it. This is driven in part by having a comptroller — Joseph Otting — who comes from banking and is taking on the problem of regulatory complexity and barriers to innovation.

Regulators from multiple countries are working on plans to meet this summer for a two-week “tech sprint,” or hackathon, to design out new ways to enable safe sharing of encrypted data. Meanwhile Congressman Greg Budd introduced regtech legislation, and regtech ideas are under discussion in Congress for improving anti-money-laundering as well.

Innovation efforts also accelerated across the government, including at the Federal Reserve, the Securities and Exchange Commission, the Financial Industry Regulatory Authority, the Federal Trade Commission and also in a growing number of states.

Four new things are happening here, even at agencies that have been embracing innovation for some time.

First, agency efforts reflect innovation not only in regulatory content, but also in the actual process of regulatory change, with an explicit focus on how to move fast enough to keep up with the exponential pace of technology change. The agencies are learning lessons from the tech world about accelerating their work through experimentation, intensive collaboration, and rapid learning.

Second, their efforts feature rising interagency collaboration and consultation.

Third, these initiatives increasingly aim not at incremental improvements, but rather at transformation.

And fourth, the transformation is increasingly being driven by the agency heads themselves, as core priorities of their agendas.

Consider Chairman Giancarlo’s speech on CFTC 2.0. He spoke of data being “king” and talked about using it to produce “agile regulation” — perhaps the regulatory equivalent of a “dynamic speed limit” that would adjust automatically to changing risk conditions. He talked about ways to automate processes which “previously required mindless and error-prone human effort.” He looked ahead to “machine-executable regulatory rulebooks.”

Giancarlo said, “In the next decade, the CFTC and, indeed, all market regulators, have no choice but to transform alongside modern digital markets and become quant-driven agencies conducting robust data collection, automated data analysis, and state-of-the-art artificial intelligence.”

The FDIC’s McWilliams used the same word — “transform” — in her speech unveiling plans for the office of innovation. As the newest agency head to formalize such a function, she is arguably staking out the biggest vision. She asked, “How can the FDIC transform — in terms of our technology, examination processes, and culture — to enhance the stability of the financial system, protect consumers, and reduce the compliance burden on our regulated institutions?” She said the agency actually plans to “reverse” the normal trend in which regulatory agencies “play catch up” on technology change. She promised to work collaboratively with industry to improve the “velocity of transformation,” and she spoke of laying a foundation for “this next chapter of banking.”

Among other things, the FDIC’s effort can help assure that community banks won’t be left behind as technology advances. The FDIC also plays a unique role in regulating fintech at the federal level, since it supervises most of the “partner” banks that specialize in serving the fintech industry. Its program will deepen federal expertise.

The breathtaking complexity of financial regulation makes people think that transformation plans are not realistic. But change is coming.