Saturday , October 31 2020

Fintech in chains

"Fintech can come out of the shadows" is the title that Wall Street Journal editors gave to  Brian Brooks and Charles Calomiris' oped last week. I have not in a long time seen a title that more utterly contradicts the content of the essay.  For what they advocate is exactly the opposite: Fintech in chains, hemmed ...

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"Fintech can come out of the shadows" is the title that Wall Street Journal editors gave to  Brian Brooks and Charles Calomiris' oped last week. I have not in a long time seen a title that more utterly contradicts the content of the essay.  For what they advocate is exactly the opposite: Fintech in chains, hemmed in by  the sort of regulatory stranglehold that fintech was created to escape. 

What is fintech? Basically companies that offer  

services—consumer loans, credit cards or payment processing—that banks have traditionally offered.

but, crucially, fintech does not accept deposits. 

The issue? 

The Office of the Comptroller of the Currency determines which companies qualify for charters as national banks or federal savings associations and supervises the activities of those banks.

But not fintech companies, because fintech companies don't take deposits. And that is the legal issue prompting the oped -- Brooks and Calomiris, coincidentally acting comptroller of the currency and chief economist of the OCC, want the OCC to regulate fintech just like banks. (Calomiris is a topnotch economist who normally writes very good papers. ) 

So what's so awful about fintech? 

..Fintech unicorns such as Square, PayPal and Stripe have similarly captured a large and growing segment of the payments business that national banks previously dominated.

...technological changes have created new fintech competitors that can form [?] banking transactions.... Many customers—whether consumers with minor credit blemishes, or small retailers [that banks don't serve]—have voted with their feet and taken their business to specialized (and often cheaper) marketplace lenders and payments providers.

Traditional bank lending and payments have earned low or negative returns in recent years, compared with returns of 50% to 150% for specialized fintech providers in payments, bank and capital markets technologies, information services, and payroll services.

Technological change, customer preferences and market performance tell us that unbundling is inevitable—services that banks have historically provided will increasingly be offered by specialty firms, often with a fintech flavor. 

...banks must adapt or die. In a market economy, customers will obtain loans and receive the payment and other financial services they need in the manner they choose.

This sounds like a classic free-market success story! A sector (regulated banks) is sclerotic, over-regulated, complacent, and protected from competition by regulators.  New competitors innovate their way around regulations to provide better, cheaper, more tailored services. Consumers flock. Read Uber vs. Taxicabs. Why should we not celebrate? And why should the taxi commission regulate Uber? 

What is the theory of regulation here? There is enough free-market economics left in the world that the baseline remains freedom and competition. You need some problem, some market failure, some reason for regulators to exist.

For banking there is a reason for regulation, and it is precisely deposits. Deposits are open to runs. Runs are bad for all sorts of reasons. Financial crises are runs. Hence we have banking regulations. That's not a defense of current banking regulation. But there is a problem and a reason for some regulation.

But fintech doesn't take deposits. The one central problem with banking is gone. Why should they not get a gold star, a thank you for not endangering the financial system plaque, and be sent on their way to better serve customers in a ruthlessly competitive market? (Much more on banking without deposits here. )

So what is Brooks and Calomiris' theory of regulation? Why do we need the OCC to regulate fintech just like banks, and deliver us the hearty innovation and competition their regulated banks have shown (sarcastic tone)? 

The Office of the Comptroller of the Currency determines which companies qualify for charters as national banks or federal savings associations and supervises the activities of those banks to ensure fair access to financial services and the safety and soundness of America’s federal banking system. The commitment to safety and soundness has a record: National banks fail less often than state-chartered banks and lose less money when they do.

That's it as far as I could see. "Fair access'' and less failure. 

Why do we care about failure? Is the purpose of federal regulators to make sure businesses never fail? 

Sure, there is a reason to worry about failure in banks that take deposits. Such failures cause runs. But no deposits, no runs.  So what's the problem if a fintech company fails? 

Hot dog stands are regulated by cities, largely for cleanliness. Do we need a federal hot-dog stand regulator, to make sure hot-dog stands are "fairly" distributed, and evaluated by making sure hot-dog stands never fail? Should the OCC give federal hot-dog-stand charters? 

The number one way that regulators stop businesses from failing is by limiting entry and protecting them from competition. Is this not exactly what the OCC has done to banks, which is why shadow banks are growing?

Look through your economics textbook on justifications for regulation. Protecting business from failure is not one of them. 

What about "fairness?" In their first paragraphs Brooks and Calomiris pointed out that fintech is growing and  making a ton of money by lending to and serving people that regular banks wouldn't touch! So much for "fairness" imposed by regulators vs. fairness that comes from a competitive market searching for under-served customers. 

This is hilarious: 

So why are New York and other states fighting the OCC’s authority to charter national banks that engage in many core banking services but happen not to take deposits? They could simply be protecting turf. Or they could be worried about losing the money they earn from licensing shadow banks. In 2019, New York alone oversaw 113 state-licensed money transmitters, 18 nonbank lending companies, 92 sales finance companies, and other companies, some of which might qualify as national banks. Regulatory assessments alone earned Albany more than $100 million.

Recall that the authors work for the OCC, which is... well, protecting turf and at least the budget and bureaucracy it gets by regulating banks!  

No. An ideal OCC should be working to encourage migration to fintech companies, that are not financed by short-term debt, and hence  pose no risk to the financial system, and are not regulated by the OCC. And then, like the Rural Electrification Administration, its job complete, it should fade away. 

(Almost all mortgage originations now go through fintech companies not banks. A good paper: Buchak Matvos Piskorski and Seru.) 


Updates. My benevolent treatment of fintech presumes that they are financed by equity and long-term debt, not short term debt. Buchak et al find that to be the case, but obviously a fintech that financed itself 99% by overnight borrowing in financial markets is systemically dangerous. 

Macro di Maggio and Vincent Yao have a very nice paper on fintech. From a quick read, I see confirmation that fintech does lend to people that regular banks will not or cannot for regulatory reasons. Isil Erel and Jack Liebersohn  also show "that FinTech is disproportionately used in ZIP codes with fewer bank branches, lower incomes, and a larger minority share of the population, as well as in industries with little ex ante small-business lending." 

There is an elephant in the room, which we might as well bring up in this context. The Fed is moving into further into inequality and racial justice. The OCC seems to be moving in that direction as well, see for example their (regulatory, that's what they do)  effort to "promote investment and lending in underserved areas and to highlight activities supported by the Office of the Comptroller of the Currency’s (OCC) new Community Reinvestment Act (CRA) rule." The Democratic Party Platform states "Democrats support making racial equity part of the mandate of the Federal Reserve." 

Whether you like or dislike the idea, clearly a movement is building for regulatory agencies and Congress to steer credit in certain directions, to specific areas, businesses, and organizations, and away from others. This includes where the Fed sends its prodigious money, but more deeply how the Fed and other regulators use regulatory tools to push banks and other institutions under their control to lend.  A parallel movement for central banks to squeeze out fossil fuel companies and subsidize green bonds is underway in other countries. 

You can see a storm brewing: politicians want to control where credit goes and squeeze some organizations out of credit, and they will want to control the fintech flow as they do the flow from regulated banks. That academics find fintech on its own reaching out to serve minorities, low income etc. will not persuade them, because politicians like to take credit for it, they will object that companies are (heavens) making profits by doing it, and they also like to subsidize organizations not people.  

Another big unanswered question for fintech: It uses AI algorithms to screen borrowers. AI is notoriously hard to unpack -- just why did the algorithm give a loan to Joe but not to Sally? You can see a storm brewing over whether the AI uses statistical discrimination -- conditional probabilities of repayment based on a huge range of characteristics -- in ways regulators do not like, or that we all might not like. This is not directly about race or other protected characteristics, which fintech does not use because it is illegal. But there are lots of statistical facts that people might not like being used, and are correlated with race and other protected characteristics. Just because I live in a zip code, work at a job, eat kinds of foods, buy certain products, am of a gender, own a car model, and browse the internet in a way people who don't pay back their loans do, why should I not get a loan? The DOJ suit to automobile finance is a tip of this iceberg. 

My opinions on whether these moves will promote racial harmony, income equality, or a cooler climate are irrelevant to the present discussion. Let's just put above board that these trends are big important drivers of financial regulation today.  

Also, a commenter points out that one uniform national regulatory standard for fintech might not be a bad idea, and suggests that Brooks and Calomiris have such a proposal. If someone has seen it, send a link. Their oped certainly did not mention such. 

The pros and cons of one uniform regulation vs. multiple competing regulations are obvious once you state the question. And there are both pros and cons. 

If the one uniform regulation were just immense capital standards, then do what you want I  might be for it. 

John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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