Regulating Fintech: One Size Does Not Fit All

This post is part of a series titled "Supervising Our Nation’s Financial Institutions."

In December, we looked at ways fintech companies are making inroads into banking: partnering with banks to offer their services, obtaining bank charters, or seeking alternative structures such as the industrial loan company (ILC) charter. This month we are examining some of the regulatory issues that have surfaced with these new entrants.

Fintech Regulation 101

Just as with banks, there is no single licensing or regulatory agency that oversees fintech companies. Depending on their activities, they can be licensed or supervised by local, state or federal regulators on a functional, or activity-based, basis.

Prudential (safety and soundness) regulation and licensing are generally handled at the state level for services such as lending, money transmission and insurance. For example, PayPal, one of the oldest fintech firms, has money transmission licenses in all 50 states and has a regulator for each state or territory in which it operates.

Because it offers financial services to consumers, PayPal is also subject to regulation by the Consumer Financial Protection Bureau (CFPB). The consumer protection laws most applicable to fintech firms relate to rules regarding lending and discrimination; the CFPB also has the authority to level civil penalties against fintech firms that engage in unfair, deceptive or abusive acts and practices. The Federal Trade Commission also has some oversight of these firms. Fintech companies that offer automated financial planning services and sell investment products—dubbed robo-advisers—may be required to register with the Securities and Exchange Commission or the U.S. Department of the Treasury’s Financial Crimes Enforcement Network.

Enter Banks

An increasing number of fintech firms have chosen to partner with banks to offer traditional banking services, and several have gone the extra step and obtained a bank charter. Fintech firms that partner with banks need to meet the required licensing requirements and submit to supervision from state regulatory authorities; their bank partners are still supervised by federal and state banking agencies, depending on charter type.

In cases where fintech firms provide services to a bank or its customers, there may be third-party risk management guidelines with which banks must comply, such as auditing and monitoring their fintech partners. Federal banking regulators thus have an indirect role in supervising the bank-related activities of fintech firms.

The partnerships go the other way too. The shift toward digital banking has led many community banks without adequate in-house resources to contract with fintech firms for back office support, such as software, loan servicing and accounting. These arrangements can increase operational risk for banks, so regulators hold banks responsible for meeting regulatory requirements for in-house and outsourced technology needs.Bank regulators’ authority to examine and regulate third-party vendors, including fintech firms, is outlined in the Bank Service Company Act and the Gramm-Leach-Bliley Act. For more details on this issue, see this Congressional Research Service report (PDF).

Fintech firms that obtain traditional bank charters and become what are known as challenger banks, like Varo, generally get all the benefits of being banks—access to deposit insurance, the payments system and the Federal Reserve’s discount window, among others.Varo, based in San Francisco, obtained its national bank charter in July 2020. But with those benefits comes more stringent oversight by federal or state banking supervisors, and consolidated supervision by the Federal Reserve if the new bank is part of a bank holding company.

Alternate Charters

Partnering with a bank or obtaining a bank charter are not the only ways fintech firms can offer banking services. The decision by the Federal Deposit Insurance Corporation (FDIC) to grant deposit insurance to some fintech companies that have applied for an industrial loan company charter gives many of them the option to provide a full array of banking products without the ILC’s parent company being subject to consolidated supervision by the Federal Reserve, as banks are.The Competitive Equality in Banking Act of 1987 exempts most parent companies of ILCs from being considered bank holding companies, thus relieving them of oversight by the Federal Reserve. The complete list of permissible banking activities differs by ILC chartering states.

The FDIC finalized a rule in December 2020 mandating that an ILC which was granted deposit insurance and its parent company must enter into a written agreement with the FDIC outlining safety and soundness and financial support expectations for any such company not subject to oversight by the Federal Reserve.

Special-purpose charters represent a novel way for fintech companies to offer banking services without partnering with a bank or obtaining a banking charter. In 2018 and again in 2020, the Office of the Comptroller of the Currency (OCC) announced fintech firms could apply for special-purpose national bank charters; the charter proposed in 2018 was geared toward lenders, while the 2020 version was targeted to payment companies. The authority of the OCC to issue these charters has been challenged, and cases are winding their way through the court system.

States are also experimenting with special-purpose charters. The Wyoming Division of Banking, for example, recently granted special-purpose depository institution charters to digital assets firms Kraken Financial and Avanti Bank. It is not always clear, however, whether institutions granted a special-purpose or other type of novel charter are eligible for federal deposit insurance, access to the payments system or access to the discount window.

Encouraging Innovation

State and federal regulators are also working behind the scenes with fintech firms, sharing information and providing opportunities to experiment with product offerings. Innovation hubs like the FDIC’s FDiTech and the Federal Reserve’s Fintech Innovation Office Hours provide standing opportunities for fintech firms and traditional banks to get answers to their regulatory questions about fintech.

The regulatory sandboxes launched in a number of states give fintech firms an opportunity to test their products with the public before going through licensing and registration. More than half of all states have joined the Multistate Money Services Businesses Licensing Agreement, a program launched by the Conference of State Bank Supervisors that seeks to simplify and harmonize the money transmitter licensing process.

Looking Ahead

As the banking landscape continues to evolve, and bank customers embrace new technologies, banks and other businesses will seek new ways to offer their products and services efficiently and innovatively. Institutions will choose the structure that they feel works best for them to accomplish their business goals.

Although not all innovations in banking services are taking place in the banking system, state and federal regulators are working with banks and fintech firms to find ways to ensure these new innovations and activities can operate in the regulated banking system.

Notes and References

1. Bank regulators’ authority to examine and regulate third-party vendors, including fintech firms, is outlined in the Bank Service Company Act and the Gramm-Leach-Bliley Act. For more details on this issue, see this Congressional Research Service report (PDF).
2. Varo, based in San Francisco, obtained its national bank charter in July 2020.
3. The Competitive Equality in Banking Act of 1987 exempts most parent companies of ILCs from being considered bank holding companies, thus relieving them of oversight by the Federal Reserve. The complete list of permissible banking activities differs by ILC chartering states.

Additional Resources

• On the Economy: The Basics of Fintech
• On the Economy: Fintech Interest in Industrial Loan Charters: Spurring the Growth of a New Shadow Banking System?
• On the Economy: Community Bankers Play a Vital Role in America’s Pandemic Response