The COVID-19 pandemic prompted critical changes in a financial services industry that was forced to take unprecedented steps to maintain liquidity and oversee the critical flow of capital in a world pummeled by the crisis. These measures raise important issues and carry enduring ramifications going forward. Chief among them are timely responsiveness, an improved regulatory landscape, tools to help businesses streamline their operations, the intertwining role of banks and fintechs, the responsible use of digital assets, and promoting transparency in fintech. Ranjit Jaswal and Gina Omolon, advisors to financial services firms, respond to questions these issues raise and highlights how businesses and consumers can navigate this new environment as it continues to unfold.
1: Regulators made significant changes to cope with the financial needs of companies and consumers during the pandemic. How are these changes ensuring the financial system’s strength and protecting companies’ operational resilience?
Mazars Observations: In her remarks to The Federalist Society on May 11, 2021, FDIC Chair Jelena McWilliams reviewed the FDIC’s commitment to decisive actions, with particular attention paid to vulnerable industries. Examples are accounting relief for the treatment of loans modified as a result of the pandemic, and more relaxed examiner guidance to protect banks from being criticized for making good-faith decisions that relied on statements from regulators. Also included are several regulatory reliefs related for instance to the community bank leverage ratio, the new expected loss standard impact on large banks, deferral of obtaining appraisals, and a grace period for filing of annual
reports. These changes have provided ongoing flexibility in meeting companies and customers’ needs and protected the stability of the financial system in an unprecedented period.
In November last year, the agencies published a paper entitled, “Sound Practices to Strengthen Operational Resilience,” that provided helpful guidance on key areas such as governance, operational risk, business continuity management, third-party risk management, scenario analysis, secure and resilient information system management, and surveillance and reporting. Its Appendix A outlines methods to guard against cyber risk, which is at the forefront of companies’ concerns, given the recent Colonial Pipeline and JBS ransomware attacks.
We monitor the dialogue among state banking commissioners, Congress, consumer groups, and supervised institutions on areas relating to fintech supervision, the use of artificial intelligence or digital assets. These consultations further demonstrate the regulators’ commitment to transparency and faster action to meet the economic challenges, as well as their continued support for strengthening the resilience of institutions and the industry.
2: Complex regulation typically has been an impediment for innovation. What are some steps regulators are taking to foster innovation now?
Mazars Observations: The FDIC and other agencies have issued supervisory guidance encouraging institutions to explore innovative products and services. Use of alternative data, artificial intelligence and machine learning, and digital assets are some of the key focused areas. Regulators are requesting information to better understand the usage, benefits, and risks of these technologies. In addition to forming strategic partnerships with major universities and the private sector, the FDIC also announced a new Deputy Director of the Office of Innovation and appointed its first Chief Innovation Officer to promote innovative technologies in financial services.
China’s recent launch of a national digital currency is a story of accelerated innovation. To say that the US government is focused on this development is an understatement, with the Federal Reserve having announced it is exploring a virtual currency that will shore up the country’s reserve currency status and give low-income and unbanked Americans access to the financial system. The Treasury has also announced it is performing its own research in this area.
3: As businesses face margin pressure, what are some examples of how tools such as AI and alternative data help banks streamline banking operations and processes to remain competitive yet also control risk?
Mazars Observations: Artificial intelligence (AI) relies on computer programs that use data to identify patterns. Some areas we see include the verification of a potential client’s identity—know your customer (KYC)—to determine the proper credit product and assess the client’s creditworthiness. It also expedites the steps needed to ensure compliance with the 2001 Patriot Act.
AI is also particularly useful for corporate customers who require a complex decision-making process, including a host of document assessments. Features such as optical character recognition and subsequent text analysis let AI quickly sift through the information to enable a faster, better-informed decision.
AI also helps streamline lending institutions’ credit determining processes, which typically are time and labor intensive, sometimes taking weeks to reach a decision. Because some alternative data allows for automation, a decision can be made in hours, saving the lender both time and money.
However, organizations relying on these innovations are vulnerable to operational risk stemming from weak governance, risk management, and noncompliance to applicable regulations. The FDIC issued a request for comment on financial institutions’ use of AI and machine learning, signaling the agency’s role and commitment to taking immediate action to ensure sound application by institutions.
4: As banks continue to develop new ways of serving consumers, how flexible should the regulatory environment be in encouraging partnerships between banks and fintechs?
Mazars Observations: Providing a strong and flexible avenue for banks and fintechs to collaborate is important to facilitate rigorous deployment of new ideas, opportunities, and products and services while remaining competitive on a global basis. The FDIC recognizes that being too risk averse can restrain technological advances, imposing serious consequences on America’s households and businesses. As banks must innovate to survive, one of the FDIC’s recent actions was to relax many regulatory hurdles by updating and clarifying the brokered deposits regulations (the first significant update in nearly 30 years), thereby removing many fintech partnerships from the brokered deposit classification.
Further underscoring the FDIC’s commitment to nurturing these partnerships is a plan to establish standards, through a private/public entity, for vendor due diligence and the technology services they bring to the marketplace. This voluntary program could reduce both costs and uncertainty for new technologies developed by financial institutions.
5: Regulators have expressed concern about the rapid developments in digital assets. How can regulators encourage responsible use of and confidence in digital assets in financial markets systems?
Mazars Observations: In swhis May 19, 2021, testimony before the Committee on Financial Services of the U.S. House of Representatives, Michael J. Hsu, Acting Comptroller of the Currency, reiterated how mass adoption of digital technology, and the rise of new payment systems, are changing the banking business. One of the OCC’s key priorities is adapting digitalization to the federal banking system while controlling risk. The OCC also plans a deliberative process to evaluate the role of digital payments and currency to ensure it is safe, sound, and fair. This will ensure that businesses can meet the needs of their communities and customers while complying with laws and regulations.
Another focus is licensing of fintechs, most of which are involved in digital technologies. Those opposed to fintech charters note that fintechs would receive benefits without concomitant regulatory responsibility. On the other hand, denying a charter could encourage another shadow banking system beyond the reach of regulators. How digital technologies and assets fit into the banking system must be considered, which will require coordination among the Federal Reserve, the FDIC, and each of the 50 states.
On May 17, 2021, the FDIC issued a request for information on digital assets to lay the proper foundation for responsible innovation. Banks are encouraged to comment on its use cases, risk and compliance guidelines, as well as additional areas requiring clarification or additional supervisory guidance, such as insuring digital assets. These comments will help lay the groundwork to better understand the use cases and risk management processes necessary to build confidence in digital assets.
6: The Biden Administration has signaled a need for tighter financial services regulation, compared with the more lax environment in which companies operated during the previous administration. How can regulation ensure fintech companies are transparent with customers regarding how they may be charged?
Mazars Observations: In his appearance on CNBC’s Squawk Box on May 5, 2021, SEC Chair Gary Gensler discussed plans to make rules and regulations more transparent. The goal is to protect investors, as new apps encouraging active trading through behavioral prompts raise the bar for updating the rules regarding sales practices, including the largely self-regulatory FINRA. The SEC is reviewing and seeking comment about these new apps and their use of behavioral psychology approaches designed to get investors to trade more.
Investors may not realize the conflict of interest between companies’ apps that tout ‘no fees’ and the reality of those companies selling customers’ order flow and data. Merely disclosing the real cost to investors may not suffice, as obtaining best execution is also important. Whether trades go to wholesalers, or the NYSE, NASDAQ, or the CBOC, it is important that customers be informed and receive best execution. The SEC plans new rules on payment for order flow and is considering the proper market structure required to best serve investors and issuers. We can expect to see regulations to address these concerns.
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