On September 7th, Acting Comptroller of the Currency, Michael J. Hsu, addressed the audience as a keynote speaker at The Clearing House and Bank Policy Institute’s Annual Conference in New York.
He listed four areas that he saw as long-term threats to banking and should-be priorities for the Office of the Comptroller of the Currency (OCC):
- Adapting to digitalization,
- Managing climate-related risk
- Addressing inequality
- Guarding against complacency.
Hsu devoted over half the speech to the first threat, adapting to digitalization.
While many expected Hsu to primarily address issues involving bank engagement with cryptocurrency, the focus of his speech centered around his rising interest regarding bank and fintech partnerships. Hsu made it clear that he thought fintechs demand more attention from the OCC. The rapid growth of bank-fintech relationships and banking-as-a-service (BaaS) models are becoming increasingly popular methods of managing the demand for innovation in the financial industry.
Michael Hsu understands the appeal of bank-fintech partnerships. All industries are moving more online, going fully digital and/or mobile. Some banks are struggling with the Web2 presence when there is already pressure for a Web3 presence. As financial services move online, success depends on a host of new features – those named by Hsu include online engagement, customization, big data, fraud detection, and machine learning.
Most banks do not have the expertise and budget to implement these competitively, so they turn to big technology companies to assist them. Through bank-fintech partnerships, banks can gain quicker access to innovation and often at a lower cost than building on their own.
Most, not all, financial institutions pursue this kind of development; there is an ideal size for these partnerships to be the most productive. As Hsu noted, “…this is not a large bank issue.” The largest banks in the U.S. do have the economies of scale to oversee software development and design in-house. Controlling the development internally can certainly be attractive, keeping tight control of design and freedom from the variations that come with working with a vendor.
Often, smaller banks do not focus on fintech partnerships as they feel they must prioritize their existing business and not take any risks until revenue increases or is more secure. Therefore, the banks most likely to partner with fintechs or utilize third-party technologies — and gain the attention of the OCC — are midsize banks.
Popular fintechs include BNPL (by now, pay later) companies, P2P (peer-to-peer) payment companies, paycheck advance apps, payment processors, and loyalty apps powered by software companies to provide convenience, speed, variety, and savings to consumers.
Customer needs are not the only thing pressuring these partnerships. For some fintechs, it is a matter of existence. Michael Hsu added in his speech, “Valuations in the fintech space have fallen significantly.” At one time, market research predicted fintechs would replace banks; now some experts expect a mass disappearance of fintechs amid a recession as they are fully acquired by financial institutions or as they close their doors in an oversaturated market. Many fintechs have been launched with a powerful mission statement and millions in seed investments without the necessary expertise or a finished product.
Hsu argues that many of these fintechs are dependent on these strong partnerships with banks for funding, trustworthy reputations, and longstanding customer bases. However, for most financial services, some level of partnership with a financial institution is a requirement for actual funds to be held, insured, or transferred via ACH. On the other side, banks are consolidating in the presence of recession, and mergers between financial institutions accelerate the diffusion of tech innovations.
Michael Hsu specifically addressed many elements of bank and fintech collaborations that he considered would warrant further investigation from the OCC.
One concern from Mr. Hsu regarding bank-fintech partnerships is their lack of consumer transparency. “Banks and tech firms … are teaming up in ways that make it more difficult for customers, regulators, and the industry to distinguish between where the bank stops and where the tech firm starts.” For him, this level of transparency bears resemblance to the shadow banking practices which contributed to the 2008 Global Financial Crisis.
Another matter Hsu discussed was the potential risks involved in outsourcing. He compares the outsourcing of financial services to tech firms to the global outsourcing of manufacturing that started in the 1970s. In both scenarios, outsourcing provides efficiency and savings for the providers and consumers. In the case of physical manufacturing, outsourcing did not reveal many serious risks until the last few years when the pandemic severely impacted the global supply chain. Michael Hsu poses the question for banks, “How might confidence be lost in a banking services supply chain disruption and what would it take to regain it?” Without a competent risk management framework accompanying the partnerships, the customer benefit could be easily lost.
Aside from consumer protection, Hsu worries about the “unlabeled” and “unseen” risks of this digital transition. He asks, “When do customers go from being the client to becoming the product and how are consumer protections maintained?”
All industries must answer this apprehension, not just banking. However, the models of recent bank-fintech partnerships can be the most reassuring of consumer protections. The marks of success in financial service digitization – mobile apps, new user interfaces, and customization – are all customer-focused and consumer-motivated. Fintechs gain attention beyond bank operators because consumers themselves are attracted to the innovation.
Michael Hsu also asks how the competing business models of banks and fintechs may “…lead to a race to the bottom with pressure to cut compliance corners and to monetize user data in novel ways?” Data is undeniably an asset, user data especially, and as mentioned above, infringement on privacy rights via unapproved use of client data is a growing concern across many industries. However, in many cases, Big Data can seriously sharpen solutions to stop financial fraud, money laundering, and other criminal activity. The transition to the digital space has increased the volume, velocity, and variety of data, and banks continue to separate and silo their data, weakening their ability to stay within regulation. Taking control of data assets is the best way to handle compliance.
The OCC is looking to “subdivide bank-fintech arrangements into cohorts with similar safety and soundness risk profiles and attributes.” It is unclear what the financial services community should expect to follow this subdivision, but research appears to be in its early stages. The FDIC will likely follow suit in this increased scrutiny, and BaaS banks will likely be the first targets of investigations.
Banks and other financial institutions looking to enter partnerships to stay competitive, lower costs, and scale should be aware of the real and regulatory risks involved. Third-party software, like that from DataSeers, can work alongside bank-fintech partnerships to keep financial institutions compliant and reduce fraud with increased efficiency. DataSeers has been a top choice for BaaS banks across the U.S. as its enterprise software delivers clear, actionable, and profitable insights into the data that financial institutions are already in possession of.