FinTech firms—a business category that typically applies to lending and other money services that are offered online and are either independent of banks, or work with traditional financial institutions behind the scenes—have become an increasingly prominent fixture in the financial services sector, despite having to deal with a hodgepodge of state-vs.-federal regulations.

FinTech lenders’ use of innovative underwriting metrics may allow them to offer some borrowers better prices than they are able to obtain from more traditional lenders, is one argument. FinTech can allow smaller banks the ability to lower overhead costs and diversify their loan portfolio with loans outside their traditional service area. Smaller loans can be offered, quickly and efficiently, to consumers and businesses that need them.

On paper, regulators seem to acknowledge their role in fostering, not inhibiting, FinTech innovations. The Office of the Comptroller of the Currency has established an Office of Innovation, tasked with enabling “responsible innovation” within the national banking system and has proposed non-depository “FinTech” special purpose national bank charters. The Commodity Futures Trading Commission established an innovation program called LabCFTC to “promote responsible innovation and fair competition.” The Consumer Financial Protection Bureau’s Project Catalyst is designed to provide guidance and, in some cases, regulatory relief (although, to date, only one firm has gone through that process).

All of this is well and good, FinTech evangelists say, but more needs to be done.

“There are several issues driving bank-FinTech partnerships, including a slowdown in FinTech start-ups—leading to a natural closing or consolidation of smaller firms—and the delay in introducing a national FinTech charter, which is also inhibiting growth,” says Cliff Stanford, a partner in Alston & Bird's Financial Services & Products Group and leader of the firm's Bank Regulatory Team. “Another driver is the potential threat posed to FinTech firms by a market downturn or jump in interest rates, as online lenders do not have or cannot offer the same kind of protection to consumers that FDIC-insured commercial banks provide.”

“There are certain structural benefits that each entity has and recognizes in each other,” he adds. “For example, banks have a built-in customer base and deposits available to support online lending platform investments. FinTech companies have incredible technology talent that banks may struggle to recruit. If bank and non-bank entities can reach agreement to work together, they may overcome regulatory and operational challenges that prevent easy growth. That said, there are many legal questions that must be explored before banks can embark on such partnerships or joint ventures.”

There are, of course, numerous regulatory roadblocks to ubiquitous FinTech, despite the lukewarm acceptance among agencies.

Among the most complicated challenges that exist for would-be FinTech firms conducting business nationally is the existing patchwork of state laws regarding money transmitters.

A proponent of federal alternatives to state money Transmission Licensing is Peter Van Valkenburgh, research director for Coin Center, leading non-profit research and advocacy center focused on the public policy issues facing cryptocurrency and decentralized computing technologies like Bitcoin and Ethereum. He addressed the challenge at a recent hearing before the House Financial Services Committee.

Money transmitters must still go regulator to regulator, explain their business, and become licensed in 53 states and territories under statutes that were originally drafted to keep check-cashers honest, he explained.

Van Valkenburgh also discussed that topic during a conference call organized by the Federalist Society.

“The first thing is that they have to have a federal safe harbor for novel businesses that do not create the sorts f risks to consumers that money transmitting licensing is meant to address,” he said. “These statutes are drafted broadly and a lot of things that aren’t actually money transmission can qualify under a broadly interpreted statute. We need a federal safe harbor to make sure that businesses that don’t create risks to consumers are never subjected to these state laws.”

Van Valkenburgh also gave the nod to a regulatory sandbox program where a business that would otherwise fall under the category of requiring a state license “could go to a state regulator and negotiate for flexible regulatory treatment.” Arizona is among the first states to develop such a scheme.

Would states agree to a national regulatory regime?

“Right now, I don’t believe any agency, the OCC included, has the statutory authority to create, through regulation, a federal alternative license or to direct the states to accept, reciprocally, all of their licenses,” Van Valkenburgh said. “That means in some ways that this is a pipe dream. I’m sure some states may rationally come to grips with something like this. Others will think the federal government is coming in and trampling over their power.”

There is, however, a modicum of optimism for federal legislation.

Prior to its conference call, the Federalist Society’s Regulatory Transparency Project released a white paper by Mercatus Center Senior Fellow Brian Knight, titled “Creating Pro-Innovation FinTech Regulation.” Knight also testified at the House Financial Services Committee hearing.

“As regulators and lawmakers come to grips with the dramatic and rapid changes to financial services they all too often seek to apply existing rules that do not fit the new reality,” he wrote.

For now, at least until a compromise between federal and state regulation is brokered, “FinTech lenders are at a disadvantage that many seek to redress by partnering with banks and having the bank initiate the loan which the FinTech lender then purchases and services,” Knight said.

“While the bank partnership model provides a work-around, it raises costs and increases complexity,” he added. “It is also hard to justify …Why should a bank, but not a FinTech lender, be able to extend credit nationwide on consistent terms, without the need to be licensed in every state?”

"While the bank partnership model provides a work-around, it raises costs and increases complexity. It is also hard to justify …Why should a bank, but not a FinTech lender, be able to extend credit nationwide on consistent terms, without the need to be licensed in every state?"
Brian Knight, Senior Fellow, Mercatus Center

Even “the second-best option” of bank partnerships is under attack through legal actions.

A federal court of appeals in New York recently ruled, in the matter of Madden v. Midland Funding, that a loan that was valid when the bank made it can become invalid under state law if it is sold to a non-bank, Knight explained.

“Courts are also conflicted as to whether the ‘true lender’ is determined by the loan contract, or by the court looking beyond the contract to determine the ‘economic reality of the transaction,’ creating a confusing morass of conflicting opinions and potentially undercutting the bank-partnership model further,” he said.

The risks created by litigation would be bad enough, but Knight said that whether regulators mean to or not, they are also discouraging banks from partnering with FinTech lenders. For example, the Federal Deposit Insurance Corporation’s proposed guidance for banks that partner with third-party lenders tells banks that they will be held responsible for everything their partners do as if it was the bank that acted.

This guidance, Knight said, “ignores that the FinTech lender is an independent entity that should be held responsible for its own actions, not the bank.” The prospect of liability for actions the bank has no knowledge or control over will discourage banks from working with FinTech lenders.

Meanwhile, state banking regulators have embarked on a program called “Vision 2020” that is designed to help make it easier for state-licensed financial services firms to operate in a multi-state environment. But, while the project seeks to make multi-state licensure and examination more streamlined “it remains to be seen whether these innovations will be sufficient,” Knight says.

Adam Levitin, professor of law at Georgetown University, also testified at the January 28 House hearing on financial services. He agreed that payment FinTechs would benefit from uniform regulation through the creation of a federal money transmitter license and concomitant insurance regime. 

In Levitin’s view, Congress can be as much a hindrance than help.

The Modernizing Credit Opportunities Act, H.R. 4439, for example, “would instruct courts to disregard economic realities and instead adhere to a legal fiction that the bank is the true lender simply because it is the originator of the loan.

“This is a terrible idea,” he said, explaining that the true lender doctrine “is an important doctrinal tool to police against abuses of the banking system.”

“It’s disgraceful that Congress would attempt to protect sham transactions, yet that is precisely what H.R. 4439 does,” Levitin added.

The Protecting Consumers Access to Credit Act of 2017, H.R. 3299 is a response to Madden v. Midland Funding.

H.R. 3299 would effectively overturn the Madden decision and provide that a loan that was “valid” with respect to usury laws when the loan was made would continue to be valid even after a subsequent assignment. In so doing, it purports to restore the “valid when made” legal doctrine that it claims is a cornerstone of United States banking law for more than 200 years.

“Contrary to the claims of H.R. 3299, there is no evidence that the Madden ruling has harmed consumers or that it will result in their substituting less-regulated credit for more-regulated credit,” Levitin testified. “If Congress believes that state usury laws and other consumer protection laws are bad idea, it should override them plainly and directly, rather than through an obfuscation such as pretending to restore a made-up legal doctrine.”

His suggestions for FinTech regulation: create a federal money transmitter license and facilitate portability of consumer account data. The CFPB, under its former director, had proposed the latter move.

“Federal chartering should not be a move to eviscerate state consumer protection laws,” Levitin added. “Federally chartered institutions should be held to a higher standard than state chartered institutions.”

Consider adopting a general federal “ability to repay” requirement for all forms of consumer credit excluding student loans,” Levitin says. Also, encourage federal regulatory agencies to use time-limited no-action letters for the use of underwriting with non-traditional data and require the CPFB to fulfill its Dodd-Frank Act mandate to collect data on small business lending.

Brian Peters is executive director of Financial Innovation Now (FIN), an alliance of FinTech firms. Member companies include Amazon, Apple, Google, Intuit, and PayPal.

He testified, before the House committee, that the Federal Reserve “is shepherding a commendable industry-led effort to achieve faster payments ubiquity by 2020.”

“It is FIN’s hope that real-time payments can soon be widely available twenty-four hours a day, seven days a week,” he said.

Among FIN’s policy recommendations:

Establish an optional federal money transmission license, managed by the Treasury Department, that oversees application and licensing, safety and soundness, BSA/AML compliance; incorporates a number of existing state money transmitter laws and Uniform Money Services Act requirements; preserves the current state structure for those wishing state licenses; and offers uniform federal law only for an applicant choosing a federal license.

Update reporting provisions of the Card Act to include regular assessment of the impact of card network requirements on consumer choice and access to payment methods; the process used to determine network requirements and standards, and its impact on market access and interoperability; the alignment of network fees with actual security risk and fraud cost; merchant barriers to consumer use of online and mobile payment options; and the potential for risk-based network fees to incentivize better security, decrease fraud, and lower costs for consumers and businesses.

Establish a Treasury Undersecretary of Technology, responsible for coordinating efforts across all federal financial regulators to foster technological innovation in financial services.