The real problem with bank-fintech partnerships

Between the enactment of the Dodd-Frank Act in 2010 and roughly the beginning of the Trump administration in 2017, there was one core meta question floating around banking regulation: How much capital — and of what type — do banks need to hold to prevent another 2008 from happening again?

I'll spare us all the tedium of explaining why it's important for the global economy not to have another financial crisis and start from the assumption that the banking system was undercapitalized and needed both greater capitalization, and to some extent, more effective supervision. But just how much more capital and how much more supervision was necessary to pass the "no more 2008s" threshold without inflicting duplicative or counterproductive levels of capital and supervision was — and remains — an unknowable and subjective question to answer, especially in the absence of a real-time crisis to see how Dodd-Frank holds up.

The economic fallout from COVID-19 was a pretty good example of the kind of stress test that regulators and banks wouldn't see coming, and at least according to former Federal Reserve Vice Chair for Supervision Randal Quarles, the banking industry came out of it relatively unscathed. That is not exactly a consensus view, and certainly most economic shocks don't bring a glut of bank deposits along with them. But the pandemic seems to have discredited the extreme arguments that Dodd-Frank was unnecessary in its entirety or that banks are just as vulnerable today as they were in 2008, at least for most bank customers.

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That is not to say there are no further refinements that may be necessary, and new regulators will probably always be working around the edges to make the post-crisis prudential and macroprudential rules more effective. But as regulators and lawmakers seek-and-destroy new sources of financial stability risk, there is a lesson from Dodd-Frank that policymakers may be missing.

Last week, acting Comptroller of the Currency Michael Hsu called out bank-fintech partnerships as a potential source of systemic risk, and his argument was compelling. Bank information technology concerns, Hsu said, account for a quarter of all of the OCC's supervisory concerns, and while those are the "known unknowns," he said, there are likely many more unknown unknowns that are lurking in the shadows.

"Technological advances can offer greater efficiencies to banks and their customers," Hsu said. "The benefits of those efficiencies, however, are lost if a bank does not have an effective risk management framework, and the effect of substantial deficiencies can be devastating."

Do banks and fintechs need to rethink their partnerships?

Fintechs make their money in countless ways, and some of them may pose a risk to the financial system and others may not. But to the extent that fintechs or other nonbanks are offering the same kind of services that banks do without the prudential oversight that banks have been required to have for almost 100 years presents a glaring inequity that sooner or later will have to be reckoned with.

By way of illustration, let's run back the tape on the COVID crisis. The Federal Reserve used its Section 13(3) authority to lend to nonbanks in a big way in 2020, and the financial entities that sopped up most of that liquidity were money market funds, broker-dealers and other large businesses — entities that don't have prudential requirements at the federal level.

None of this is to say that fintechs are unregulated — many are at the state level and most are required by their bank partners to comply with relevant rules. Nor is this to say that fintechs should be treated the same as banks as a matter of course. What I am saying is that what's good for the goose is good for the gander, and without a doubt the banking industry has become far more stable since the implementation of more rigorous prudential rules than it was before the 2008 financial crisis. So why not do the same in the fintech industry?

Doing that, of course, is not as easy as writing a column about it. If Congress passed a law requiring, say, all publicly traded companies to be subject to some kind of minimum capital and liquidity requirements, many companies would go private, prices for things would likely go up and lawmakers would likely not win reelection. 

But policymakers would not have to go that far to get nonbanks that are engaging in banklike activities to cleanse themselves in the healing waters of capital, liquidity and supervision. And the sooner they articulate that prudential regulation is the way to help nonbanks weather the unknown unknowns, the better poised they will be and the less risk the taxpayer will have to assume.