Bank regulators need to overhaul their digital capacity

The recent flood of news about cryptocurrencies, the financial performance of fintech firms, banks experimenting in the metaverse and the emergence of new artificial intelligence use cases highlights the extent to which digital technology continues to remake financial services. There has never been a better time for regulators to prioritize their own digital makeover.

How financial regulators carry out their safety and soundness, consumer compliance and investor protection mandates in the face of exponential technological change has been a topic of intense discussion in the years following the Great Recession.

Ben Torres/Photographer: Ben Torres/Bloombe

But that policy debate has sharply accelerated in just the past few weeks as governments around the world mull the creation of their own digital currencies and as the dramatic collapse of the Terra stablecoin has intensified focus on a regulatory construct for cryptocurrencies.  

With the digital revolution showing no sign of abating, the year 2022 should be the moment when regulators once and for all adopt a new playbook, moving from legacy, analog systems for monitoring financial services companies to a necessary overhaul of their own technology infrastructure to catch up with the financial sector’s digital renaissance.

The federal regulators here in the U.S. have responded to tech developments throughout their histories. Within the past six years, they have created special internal divisions focused on industry innovation and data. But lately, regulators appear to be heightening their adoption of an innovation-focused mindset, bulking up on their hiring of technology specialists and crafting policies that signal a sharper focus on stablecoins, central bank digital currency models, AI-driven models for credit underwriting, faster payments and other digital offerings.

These moves are encouraging signs that a regulatory system still largely built on analog technology is poised for a digital overhaul. Such a turnaround is sorely needed for a regulatory sector whose own technology is light years behind the industries that it regulates.

Financial regulatory agency leaders should be lauded for their dedicated and deliberate approach to regulating tech innovation in the financial services sector. But they still have a ways to go to strengthen their digital capacity. They should now build on their recent progress and interest in digital innovation by embarking on more direct upgrades of their own systems — that still largely rely on 30-year-old technology — to adopt a digitally native design.

Consider what policymakers have said and done just in the past three months.

On April 18, Federal Reserve Chair Jerome Powell said the Fed is “hiring people with … [digital currency and payment technology] expertise at a greater rate.” On March 25, American Banker reported on an Office of the Comptroller of the Currency memo pointing to plans to designate a senior official for “novel banks and technology service providers.” Meanwhile, the Securities and Exchange Commission and Commodity Futures Trading Commission are weighing how to jointly oversee crypto trading platforms.

Additionally, Congress is also focused on creating new regulatory structures and requiring more internal supervision of these innovative products and/or markets. On April 6, Sen. Pat Toomey of Pennsylvania, the top Banking Committee Republican, unveiled legislation to establish a new federal stablecoin license. Meanwhile, as the stablecoin sector tries to move on from the collapse of Terra and its associated Luna token, Sens. Cynthia Lummis, R-Wyo., and Kirsten Gillibrand, D-N.Y., have pushed a bipartisan legislative plan to create a crypto regulatory framework. 

Other recent developments include President Biden’s executive order calling on federal agencies to develop policies to address the growth of the digital asset sector, the Fed’s exploration of whether to issue a digital dollar, and the recommendation by the President’s Working Group on Financial Markets that all stablecoin issuers be insured depositories. Most recently, the Biden administration signaled interest in addressing the carbon footprint of the crypto sector. The government’s sharpening focus, meanwhile, corresponds with the industry's continuing to innovate as the metaverse opens up new digital possibilities.

Given the clear interest among regulators and other officials in how to supervise new innovations in the financial services industry, the agencies’ decision to hire more tech experts is particularly encouraging. But this is also an opportunity for the regulatory system to do much more to stay on top of the technology wave by digitizing its own technology. For all of the regulators’ progress over the years, many are still relying on an internal technology framework that was built for 1992, not 2022.

A priority for regulators should be to develop processes powered by artificial intelligence to analyze the enormous amounts of data that have become available about activity in the financial market due to digitization of the financial sector. If synthesized effectively, this data could be used to fight money laundering, crack down on cyber threats and lending fraud, detect redlining, identify trends in the new crypto markets and expand financial inclusion. But without those tools, regulators have more data than they know what to do with. In 2019, then-Bank of England Gov. Mark Carney said the bank receives 65 billion pieces of data annually from companies it oversees and that reviewing it all would be like “each supervisor reading the complete works of Shakespeare twice a week, every week of the year.”

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Most of the federal financial regulators have initiatives underway to develop and deploy supervisory technology, or “suptech,” that will move them in the right direction. However, merely layering upgrades on top of analog-era technology — which sometimes still utilizes paper-based filing systems — will not be enough to position them to regulate a rapidly changing financial system spurred by digitally native innovation.

To adequately monitor a digitally robust financial sector, the regulatory agencies must themselves become digitally robust. During the COVID-19 pandemic, regulators honed digital reporting and monitoring methods to support offsite examinations. But they also must be more aggressive about transferring regulatory data into a format that utilizes artificial intelligence techniques like machine learning and natural language processing to match the processing power that private companies have already mastered. Otherwise, they will be ill-equipped to regulate the innovations that are drawing their attention.

The benefits of a more digitally sophisticated regulatory framework would include better analysis of lending data to identify signs of redlining and other discrimination, effective oversight of crypto firms by federal and state regulators, the ability to catch money launderers and other financial criminals among the piles of suspicious activity reports submitted by the industry, and better systems to address authentication risks of more households gaining access to a bank account.

To be clear, the regulators should not be criticized for their deliberative pace in addressing the rise of financial innovations. Rome wasn’t built in a day, nor should federal agencies tasked with protecting consumers and the financial markets rush their digital makeover. But these innovations will only continue and advance — the time is now for regulators to begin their digital awakening.