Fintech is everywhere these days, and for good reason. The financial technology sector, which includes companies like LendingClub, Square and Kabbage (together termed Marketplace Lenders (MPLs) has disrupted traditional banking practices like loans and payments.
Many people have embraced this, and the result so far has been easier online offerings and more competition. There is, however, a possible negative effect of fintech’s rise too: the increase in risk for the financial system as a whole, as fintech tends to be un- or under-regulated. Regulators therefore have the unenviable task of regulating fintech innovations in a way that reduces systemic risks while also allowing for their further development.
The rewards for regulators should outweigh the costs: If regulated well, fintech could have a positive impact on SME financing, jobs and growth in otherwise anemic economic conditions in most countries. That prospect is already making them look at novel ways of crafting policies.
The Central Bank of Kenya, for example, originally issued a limited license allowing Safaricom to test out the mobile money service M-Pesa. In the UK, the FCA is encouraging dialogue with the industry by opening up an innovation hub. In Singapore, the monetary authority is spending USD225 Million on research.
But country specific regulatory frameworks remain the rule, whereas fintech itself is often inherently borderless. For example in the US, consumer and business lending are regulated by CFPB and SEC respectively, while in the UK, it is the FCA which now regulates the consumer credit. On the other hand, in China, the platforms were until recently un-supervised. CBRC now regulates the industry by treating the platforms as “infomediaries” and does not allow them to assess borrower’s creditworthiness. Some other countries do not even have a regulatory body responsible for Marketplace Lending.
As regulators are becoming aware of the need for appropriate and coordinated regulatory reforms, where should they start? At the World Economic Forum, we sat down with startups, regulators, bank and insurers to discuss this. The result is 12 things regulators could do to catch up with fintech innovations, taking into account the various stakeholders:
For the good of consumers and SMEs, they should:
1. Require stronger controls on consumer data to improve investors’ and borrowers’ confidence in MPLs
2. Expand traditional data sources in addition to technology and alternative data to fill the gap in credit information
3. Include Fintech innovation in their response to the SME funding gap
4. Provide tax incentives to promote the development of market place lenders as a significant source of funding, particularly for Small and Medium Enterprises(SMEs).
For systemic and regulatory safety they should:
5. Improve regulatory reporting requirements so they can understand the risks and benefits of the MPL model better
6. Establish a single licensing agency which allows for a more defined business and regulatory scope
7. Clearly define roles and responsibilities in the debt collection process of MPLs
8. Balance the interest of borrowers and the profitability of the MPL industry.
And to protect and incentivize fintech investors, they should:
9. Protect Investors through strengthening existing securities laws as investors take on riskier forms of investment through the MPLs
10. Rely on the traditional banking sector for clearing and settlement and combine it with strong rules regarding the handling of client money, engendering confidence in the burgeoning industry.
11. Introduce Risk retention and capital requirements for fintech companies, to help ensure that firms operate prudently in managing financial risks and align their interests with investors
12. Allow secondary servicer agreements to reduce counterparty risk and provide additional investor protection against exposures to potential bankruptcies or operational failures
As the size of the industry increases, it is likely that the regulators will look at this emerging industry from the context of the risk it poses to the financial system, especially if the institutional involvement is substantial. There are already concerns that marketplace lending may reduce systemic risk by putting the risk of individual loan default on the individual lender rather than on the intermediary, but larger institutional participation incentivizes MPLs to take on high risk loans, reminiscent of pre-crisis era.
Most regulators understand that there needs to be a balance between creating a regulatory framework that ensures MPLs activities do not create future supervisory issues, while still encouraging innovations that will provide borrowers with the necessary liquidity and financing. But depending on a country’s broader regulatory approach, existing system of financial service regulations, and competing regulatory bodies, developing a clear system of rules can be tricky.
How a government sets up its regulatory structure for the financial market can broadly impact innovation, particularly when taking either a principles-based or rules-based systems of regulation. Regardless of which model regulators deem most appropriate, the most important objective for policy-makers should be to increase the coordination among regulatory institutions – not just domestically, but also, if possible, internationally.