It's up to state banks to lead the way in payments innovation

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One of the fastest growing areas for digital innovation is payments, a previously stagnant sector marked by legacy incumbents and technologies that, in the past decade, has been disrupted by new, digitally native competitors focused on increasing the speed, efficiency and transparency of payments, while reducing cost.

Many leading global jurisdictions, including the EU and U.K., have been eager to foster this competition and innovation, including by granting such digital-native companies banking charters and concomitant access to central bank payments systems. These forward-leaning approaches have succeeded in driving competition with legacy banks, increasing economic dynamism and advancing the modernization of payments systems.

According to recent research, many banks in Europe expect neobanks to be their "biggest competitors" in the next five years, and they anticipate competition to be most fierce in the payments space. Perhaps unsurprisingly, consumers are welcoming improved digital offerings, with challenger banks accounting for roughly 17% of new account openings in Germany in 2022.

The U.S., meanwhile, has taken important modernization steps by launching FedNow, its real-time payments system. But beyond calls for exploring ways to introduce more payments competition, it has not adopted policy changes to increase the number of new entrants. This means that payments companies in the U.S. must continue to work through a bank partner to facilitate payments through Fed systems, adding cost, operational risk and inefficiencies caused by unnecessary intermediation.

Fortunately, the existing dual banking system in the United States holds promise in ensuring that the country's payments systems can keep pace — and nothing "new" is required of lawmakers or regulators. More specifically, under the U.S. dual banking system, financial institutions can choose to pursue state-based or national banking charters. An entity may then choose to apply for FDIC insurance (if seeking to be insured) and/or apply for a Federal Reserve master account to become part of the Federal Reserve System. A participating bank can subsequently directly settle payment transactions through its master account. 

So how can this dual banking system move payments innovation forward?

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A good example is the leadership demonstrated by the state of Connecticut. Under Gov. Ned Lamont, the state is exercising its broad bank chartering authority to issue charters to uninsured depositories focused on improving particular areas of financial services, including payments. The Connecticut "Innovation Charter" tailors its regulatory requirements to the business activities and risks posed by the particular banking model, which allows such entities to focus on solving existing pain points in the financial services industry, including making cross-border and domestic payments easier, less costly and more accessible for small businesses and merchants across the U.S.

In order to maximize the benefits of state-based charters, however, there are three specific actions federal and state policymakers can take. Each of these actions already falls under existing authorities and requires no further legislation or rulemaking.

First, it is important for the success of state banking charters that other states reciprocally recognize the authority of such charters and their preemptive effect over state money transmission requirements. A failure to do so will create uncertainty and inefficiency with respect to applicable regulations. States should further look to modernize their own chartering frameworks in order to reflect the fact that the business of banking is constantly evolving. Forward-leaning state efforts would be consistent with the dual banking system in the United States and its success in fostering competition and diversity in the offering of financial services.

Second, the Federal Reserve should continue to apply its recently updated guidelines for the review and approval of master account access applications, including for well-regulated state-chartered banks that meet the Fed's "Tier 3" requirements. Successful Tier 3 applications will help develop regulatory clarity for applicants regarding regulatory expectations and advance public policy interests, including increased competition that benefits consumers and businesses and reductions in concentration risks posed by the largest banks in the payments space.

Finally, federal policymakers should recognize new entrants as the critical underpinning of payment system modernization in the country. More specifically, well-regulated payments-focused companies can increase adoption of FedNow — a key Fed priority — and facilitate small and community bank access to real-time payments. Such companies can further bring a digital-first approach to customers, thereby enhancing access, usability and transaction efficiency.

While the world continues to move forward at a breakneck pace to modernize and improve payments systems, the U.S. holds all of the ingredients necessary to maintain its historic leadership role in this space. Fortunately, there are already available and well-established regulatory frameworks capable of recognizing and facilitating new market entrants that can advance much-needed competition and development of payments technologies. The dual-banking system — and its inclusion of forward-leaning state-based chartering models — remains fit-for-purpose and capable of leading us to the next generation of payments system innovation.