Financial Services Law

What Banks Need to Do to Address Technological Change

By Joseph G. Passaic, Jr.

In the past few years the fintech industry has grown exponentially. According to a recent Forbes article, the existing number of fintech start-ups globally are between 5,000 and 6,000, all seeking to take a slice of the financial services marketplace. The fintech industry broadly includes any new technology that touches the financial world, and in many ways, this industry redefines forever the notion of traditional banking. More specifically, fintech includes new payment systems and currencies such as bitcoin, service aggregators such as robo advisors, as well as mobile applications, data analytics and online lending platforms. The fintech industry can also be divided into collaborators and disruptors, those businesses that provide services to banks and those that are competitors for services and looking to displace banks. As new technologies and approaches to delivering financial services are adopted, community banks will be challenged to meet the future expectations of their customers as well as to assess the additional risks, costs, resources and supervisory concerns associated with providing new financial services and products in a highly regulated environment.

The largest commercial banks have recognized the future competitive impact on their business as fintech companies create new and efficient ways to deliver services to their customers. Bank of America, for example, recently announced a fintech initiative and plans to target the start-up market for potential acquisitions. The large banks have the advantage of scale, deep pockets and the luxury of making bets on new technologies. If not by acquisition, other banks are partnering with new players that have unique capabilities to offer products outside of traditional banking. While community banks are not new to the benefits of fintech, the advancement and number of new technologies and potential competitors have been difficult to keep up with and integrate into a traditional bank's business model. On top of that, the fintech industry remains largely unregulated at the federal level, at least for now.

Competition, compliance and cost are the three critical factors that bank management and board members must assess in adopting new technologies or fending them off by trying to stick with traditional banking values. Good, old-fashioned service based on long-term banking relationships may become a thing of the past as the millennial generation grows older. Contactless banking by the end of this decade or sooner could rule the financial services industry. While in some small community banking markets, the traditional relationship model may survive, it is far from certain as the number of brick-and-mortar bank branches in the United States continues to decline.

Also falling under the fintech umbrella is the rapidly escalating online marketplace lending industry. While most banks may rationalize that these new alternative lending sources do not meet prudent credit standards in a regulated environment, the industry provides sources of consumer, business and real estate credit serving a diverse market in the billions. While the grass roots banking lobby has been around forever, longtime banks should take note that the fintech industry is also gaining support on Capitol Hill, as a group of Republicans are now preparing legislation coined the "Innovation Initiative" to facilitate the advancement and growth of fintech within the financial services industry.

Fortunately, the banking regulators are also supportive of innovation and the adoption of new technologies. The Comptroller of the Currency in March released a statement on its perspective on responsible innovation. As Comptroller Thomas Curry noted, "At the OCC, we are making certain that institutions with federal charters have a regulatory framework that is receptive to responsible innovation along with the supervision that supports it." In an April speech, he confirmed the OCC's commitment to innovation and acceptance of new technologies adopted by banks, provided safety and soundness standards are adhered to. The operative words here are responsible and supervision.

Innovation will come with a price, particularly for small and midsize community banks. Compliance costs as banks adopt new technologies will increase, with greater risk management responsibilities, effective corporate governance and advanced internal controls being required. Banks may find it necessary to hire dedicated in-house staff with Silicon Valley-type expertise, hire chief technology officers and perhaps even change the board's composition to include members that have strong technology backgrounds. In the end, banks need to step up their technology learning curve, find ways to be competitive and choose new technologies that serve the banking needs and expectations of their customers as banking and fintech continues to converge.

This article originally appeared on on April 27, 2016.

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The OCC on Innovation

Seeking to demonstrate its support for technological innovation, the Office of the Comptroller of the Currency (OCC) released a white paper offering a framework for approaching "responsible innovation." The white paper signals that the OCC's embrace of innovation will be tempered by concerns about risk management.

What happened

In its white paper, the OCC observes that the financial services industry is rapidly changing, with advances in financial technology disrupting the way traditional banks do business. National banks have responded by developing ways to make their operations more efficient, the OCC said, as well as investing in fintech firms or new financial technology.

Defining "responsible innovation" to mean "[t]he use of new or improved financial products, services, and processes to meet the evolving needs of consumers, businesses, and communities in a manner that is consistent with sound risk management and is aligned with the bank's overall business strategy," the agency cautioned that not all innovation is positive.

In published remarks before the Harvard Kennedy School's New Direction in Regulation Seminar on March 31, 2016, Comptroller Thomas J. Curry noted that "responsible innovation is one that is consistent with sound risk management practices. That means that the bank understands the product and the risk it carries, and has the capacity to manage those risks. It also means the product is compatible with safety and soundness and consistent with the bank's strategic business plan. And finally, responsible means that it complies with laws and regulations, particularly those aimed at protecting consumers."

"The OCC will support innovation that is consistent with safety and soundness, compliant with applicable laws and regulations, and protective of consumers' rights," the agency wrote in "Supporting Responsible Innovation in the Federal Banking System: An OCC Perspective."

The white paper offers eight principles that are intended to guide the OCC's development of its understanding and evaluation of innovative products, services and processes that OCC-regulated banks may offer or perform:

  • Support responsible innovation. To help support responsible innovation, the OCC is considering several reforms, such as the creation of a centralized office on innovation to serve as a forum to vet ideas before a bank makes a formal request, for example. Other possibilities include a less formal process where an existing unit within the agency assumes responsibility as the central point of contact on innovation as well as allowing banks to test or pilot new products or services on a small scale before committing the necessary resources for a full rollout. In addition, the agency plans to evaluate whether it can streamline some of its licensing procedures and consider whether additional guidance on new product development would be helpful.
  • Foster an internal culture receptive to responsible innovation. The OCC recognized that it has a reputation for having a low risk tolerance for innovative products and services and a deliberate and extended vetting process that can discourage innovation. The agency intends to evaluate its policies and procedures and enhance communication both inside the OCC and with stakeholders "to foster a more receptive culture and to improve the awareness and knowledge of financial innovations." For example, the OCC has already created an internal working group on marketplace lending and plans to augment its internal training.
  • Leverage agency experience and expertise. The OCC staff has a wealth of knowledge about the financial industry, the white paper notes, and the agency will make the most of expertise from OCC staff when considering innovation. In addition, the agency may draw on the support of designated lead experts within the agency.
  • Encourage responsible innovation that provides fair access to financial services and fair treatment of consumers. "Current innovations in the financial industry hold great promise for increasing financial inclusion of underserved consumers, who represent more than 68 million people and spend more than $78 billion annually," the OCC said. Innovative technology should not be a substitute for the stabilizing physical presence of brick and mortar branches, but new products—online and mobile banking, saving, budgeting, and financial management tools and improved payment services, for example—can help address unmet financial services needs of the unbanked and underbanked.
  • Further safe and sound operations through effective risk management. While striving for innovation, financial institutions must ensure that corporate governance and risk management meet supervisory expectations when considering new products, services and processes. Innovation can present new risks, the OCC cautioned, ranging from cyber risk to risks to customer data through data aggregation and third-party use.
  • Encourage banks of all sizes to integrate responsible innovation into their strategic planning. Innovation should be responsible and consistent with customers' needs and the bank's strategic plan. "A bank's decision to offer innovative products and services should be consistent with the bank's long-term business plan rather than following the latest fad or industry trend," the agency said.
  • Promote ongoing dialogue through formal outreach. To keep abreast of continuing trends and developments in the financial industry, the OCC plans an ongoing dialogue with all stakeholders to understand the reasons and customer needs driving changes and to promote awareness and understanding of the agency's expectations related to responsible innovation. The OCC plans a variety of workshops and forums as well as "innovator fairs," and will provide resources and guidance on its website.
  • Collaborate with other regulators. The OCC plans to collaborate with other regulatory authorities at the state, federal, and international levels to promote a common understanding and consistent application of laws, regulation, and guidance, the agency explained.

The OCC is seeking feedback on the white paper and specifically requests comments about how the agency can facilitate responsible innovation by institutions of all sizes and what additional guidance (or revised existing guidance) could support responsible innovation. The agency also asked about challenges community banks face with regard to emerging technology and financial innovation as well as whether establishing a centralized innovation office within the OCC would benefit responsible innovation. Comments will be accepted until May 31.

Why it matters

The white paper represents the OCC's "vision for responsible innovation," Comptroller Thomas J. Curry explained in a preface to the publication. The OCC has signaled, however, that it will continue to focus on the risk associated with innovative technologies, noting that "effective risk management is essential to responsible innovation."

The agency seems particularly interested in the promise innovation holds for expanding services to consumers, including the "underbanked," observing that "[t]echnology, for example, can promote financial inclusion by expanding services to the underserved. It can provide more control and better tools for families to save, borrow, and manage their financial affairs." Indeed, the OCC may be the most receptive to innovations purported to benefit these groups.

The OCC has scheduled a forum on responsible innovation for June 23.

To read the OCC white paper, click here.

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DOJ Announces Pilot Program for Self-Reporting FCPA Misconduct

In an effort to move forward with the Department of Justice's (DOJ) policy of individual responsibility, the agency announced a pilot program to encourage corporations to self-report Foreign Corrupt Practices Act (FCPA) related misconduct and cooperate with the agency. While the new DOJ pronouncement is specifically limited to FCPA cases prosecuted by DOJ's Fraud Section, it is likely that other units within the DOJ will look to the memorandum for guidance in defining corporate cooperation in other types of cases.

What happened

Last fall, the DOJ published what has come to be known as the Yates Memo, a document authored by Deputy Attorney General Sally Quillian Yates that emphasized the importance of holding individuals liable for corporate wrongdoing.

The "Individual Accountability for Corporate Wrongdoing" set forth six "key steps" for the government's new policy, including a requirement that in order to qualify for any cooperation credit, corporations must provide to the DOJ all relevant facts relating to the individuals responsible for the misconduct.

To further this policy, the DOJ launched a one-year pilot program on April 5 "designed to motivate companies to voluntarily self-disclose FCPA-related misconduct, fully cooperate with the Fraud Section, and, where appropriate, remediate flaws in their controls and compliance programs," explained Assistant Attorney General Leslie R. Caldwell.

In exchange for voluntarily self-disclosing misconduct and fully cooperating, the program allows corporations to receive mitigation credit of up to a 50 percent fine reduction from the bottom of the applicable Sentencing Guidelines fine range calculation.

To be eligible for the credit, corporations must meet several criteria: voluntarily disclose the misconduct and all relevant facts related "within a reasonably prompt time after becom[ing] aware of the offense"; fully cooperate with the DOJ investigation; take appropriate actions towards remediation; and disgorge all profits resulting from the FCPA violation.

Disclosures that a company is required to make—by law, agreement, or contract—do not constitute voluntary self-disclosure for purposes of the pilot program, the DOJ noted, and the voluntary disclosure must occur prior to an imminent threat of disclosure or government investigation.

As defined by the DOJ, "full cooperation" includes the "preservation, collection, and disclosure of relevant documents and information relating to their provenance," as well as making company officers and employees who possess relevant information available for interviews. All facts relevant to the wrongdoing at issue must be shared with the agency, including all facts "related to involvement in the criminal activity by the corporation's officers, employees or agents" and all facts relevant to potential criminal conduct by third-party individuals or companies. Information about the corporation's own internal investigation must be shared with the DOJ, complete with "timely updates."

"Cooperation comes in many forms," the DOJ recognized. Once the threshold requirements of the memo have been met, the Fraud Section will "assess the scope, quantity, quality, and timing of cooperation based on the circumstances of each case when assessing how to evaluate a company's cooperation" under the pilot program.

If all of the requirements are met, a corporation will be eligible for up to a 50 percent reduction off the bottom of the Sentencing Guidelines fine range and "generally" not be required to appoint a monitor if an effective compliance plan has already been established, the DOJ said. In some cases, the agency may decline to prosecute altogether.

"Of course, in considering whether declination may be warranted, Fraud Section prosecutors must also take into account countervailing interests, including the seriousness of the offense: in cases where, for example, there has been involvement by executive management of the company in the FCPA misconduct, a significant profit to the company from the misconduct in relation to the company's size and wealth, a history of non-compliance by the company, or a prior resolution by the company with the Department within the past five years, a criminal resolution likely would be warranted," the agency explained.

As long as the corporation self-reports during the pilot program, it will be eligible for the benefits, even if the program expires, although the DOJ said it will consider extending or modifying the program after the year ends. For those companies that do not voluntarily self-disclose but do provide full cooperation to the DOJ, the agency will consider granting limited mitigation credit, "at most" a 25 percent reduction off the bottom of the Sentencing Guidelines range.

Why it matters

The DOJ made clear that it is taking FCPA violations seriously. In addition to launching the pilot program, the agency revealed that it "is intensifying its investigative and prosecutorial efforts" and "substantially increasing" its FCPA law enforcement resources by more than 50 percent with the addition of 10 more prosecutors, with three new squads in the Federal Bureau of Investigation devoted to the FCPA. The Department also strengthened its coordination with foreign counterparts, adopting an international approach "to combat an international criminal problem." "The Department's demonstrated commitment to devoting additional resources to FCPA investigations and prosecutions should send a message to wrongdoers that FCPA violations that might have gone uncovered in the past are now more likely to come to light," the DOJ warned.

To read the Fraud Section's FCPA Enforcement Plan and Guidance, click here.

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Is the CFPB Constitutional?

Is the Consumer Financial Protection Bureau (CFPB) constitutional? A panel of the D.C. Circuit Court of Appeals is currently considering the issue after hearing oral argument in PHH Corporation v. CFPB.

What happened

In November 2014, an administrative law judge (ALJ) held that mortgage lender PHH Corporation violated the Real Estate Settlement Procedures Act (RESPA) by accepting kickbacks for loans in the form of mortgage reinsurance premiums that mortgage insurers paid to a subsidiary of PHH. The ALJ ordered a $6 million fine.

PHH appealed the decision to Bureau Director Richard Cordray, arguing that the CFPB's enforcement actions were subject to a three-year statute of limitations, even in an administrative proceeding. The company also argued that it had not violated RESPA.

In the first decision on an appeal of a CFPB administrative enforcement proceeding, Cordray affirmed the ALJ's determination that PHH illegally referred consumers to mortgage insurers in exchange for kickbacks, prohibiting the company from future violations. He also held that PHH violated RESPA every time it accepted an alleged kickback payment on or after July 21, 2008, whereas the ALJ had limited PHH's violations to kickbacks that were connected with loans that closed on or after July 21, 2008, and as a result increased the amount of the order from $6 million to $109 million.

PHH appealed again, this time to the D.C. Circuit Court of Appeals with a direct challenge to the constitutionality of the CFPB, contending that the Bureau's structure violates separation of powers principles by putting legislative, executive, and judicial power in the hands of a single director.

The company also argued that Cordray impermissibly applied new interpretations of RESPA retroactively to punish past conduct, as its mortgage reinsurance practices had long been understood to be legal and were widespread throughout the country.

The Bureau countered that the quid pro quo arrangement used by PHH had never been explicitly blessed by any federal agency and resulted in exactly the type of market distortion that the statute was intended to prevent. Further, the CFPB is entitled to deference under the framework established in the U.S. Supreme Court's 1984 decision in Chevron v. Natural Resources Defense Council, the agency said, and Congress can choose how an agency's leadership is structured.

Prior to the oral argument, the three-judge panel issued an order instructing the parties to be prepared to address additional questions: "What independent agencies now or historically have been headed by a single person? For this purpose, consider an independent agency as an agency whose head is not removable at will but is removable only for cause," and "If an independent agency headed by a single person violates Article III … what would the appropriate remedy be? Would the appropriate remedy be to sever the tenure and for-cause provisions of this statute? Or is there a more appropriate remedy? And how would the remedy affect the legality of the Director's action in this case?"

Only two of the judges attended the oral argument (the third planned to listen to the audio recording), where PHH characterized the CFPB as a "super-executive agency" with authority limited only by the judiciary.

When queried if the Bureau would be constitutional if the President could remove the Director for a reason other than cause, PHH told the court that other issues would continue to make the CFPB unconstitutional, citing the lack of congressional control over Bureau funding and the Director's ability to hire and fire agency employees and control their salaries. Counsel for PHH urged the panel to weigh in on the substantive RESPA issues presented by the appeal as well.

What if the panel finds the CFPB structure to be unconstitutional? PHH suggested Cordray would be out as Director and "Congress should come back and create in a constitutional way" a new agency.

Facing the court, the Bureau advocated that Congress can choose how the leadership of agencies are structured. While most agencies are made up of commissions whose members can only be removed for cause, a few agencies are headed by a single individual, the CFPB said. As for possible remedies, the CFPB argued that should the court find the structure unconstitutional, it could sever the for-cause provision and remand the case back to Director Cordray for reconsideration.

Why it matters

An opinion striking down the structure of the CFPB would have huge ramifications in the financial industry, but the panel members present at the oral argument appeared receptive to PHH's argument and wary of the extent of the CFPB's power, although they provided no hints about a possible remedy. U.S. Circuit Judge Brett Kavanaugh noted "there are very few precedents" for the Bureau's structure, expressing his concern that it is "very dangerous" to place so much power in one individual's hands. He also seemed to side with the mortgage insurer with regard to its position on RESPA, commenting to the CFPB's counsel, "Correct me if I'm wrong, but everyone was doing this … There was a widespread understanding, wasn't there, that this was legal." The Director's reversal of the ALJ and increase in the order from $6 million to $109 million may have affected Judge Kavanaugh's views. A decision from the panel is expected in the coming months.

To read the Director's decision in In the Matter of PHH Corporation, click here.

To read PHH's brief in PHH Corp. v. CFPB, click here.

To read the CFPB's brief, click here.

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Federal Trade Commission to Consider Fintech

The Federal Trade Commission is joining the fintech party, announcing a series of events to explore emerging financial technology.

What happened

First up: The agency will host a forum this summer to explore "the growing world of marketplace lending and its implications for consumers." The June 9 event will be the first in a series for the agency to consider consumer protection issues across different areas of emerging financial technology.

"Marketplace lending is a developing and fast-growing sector offering new ways for many consumers and small businesses to secure credit," the FTC said in a press release about the event. "As technological advances expand the ways consumers can store, share, spend, and borrow money, the FTC is working to keep consumers protected while encouraging innovation for consumers' benefit."

The forum will examine the various models used by companies in the industry as well as the potential benefits to consumers and possible consumer protection concerns, bringing together consumer groups, researchers, government representatives, and members of the industry. Participants will also discuss how existing consumer protection laws "might apply" to companies participating in the marketplace lending space.

The burgeoning online marketplace lending industry has caught the eye of other regulators as well. Last year, the Department of the Treasury published a Request for Information (RFI) posing 15 questions regarding online marketplace lending, seeking comment on the various business models and products offered by such lenders to both small businesses and consumers.

In November, members of the agency shared some of the takeaways from responses to the RFI, including concern that the new underwriting models have yet to be tested through a full credit cycle and the growing number of partnerships that online marketplace lenders are forging with banks, community development financial institutions, and other businesses.

California's Department of Business Oversight also inquired into the industry, sending an online survey to 14 lenders for more information and the Consumer Financial Protection Bureau (CFPB) recently announced that it will now accept complaints about online marketplace lenders.

Why it matters

The FTC has yet to announce the other topics for its Fintech Series and said it will release a full agenda for the marketplace lending forum closer to the event. Given the growth of the industry—and the attention being paid by other regulators—the Commission's interest in and decision to start its series with the marketplace lending industry is not surprising.

To read the FTC's press release about the forum, click here.

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California DBO Reports on Marketplace Lending Inquiry

The results are in from the California Department of Business Oversight's (DBO) investigation into online marketplace lending.

What happened

Last December, the regulator sent a survey to 14 online marketplace lenders specializing in both personal and small business loans with a request for trend data about their loan and investor funding programs between January 1, 2010, and June 30, 2015.

While the agency expressed "no desire to squelch the industry or innovation," the DBO said it remained obligated to "protect California consumers and businesses," particularly as the industry demonstrates rapid growth.

In a report with aggregate data of the 13 responses received by the regulator, the DBO revealed just how much the industry has grown in recent years, finding the total dollar amount of transactions increasing from $1.99 billion in 2010 to $15.91 billion in 2014—a jump of almost 700 percent. California saw even faster growth, with an increase of 936 percent from 2010 to 2014. And respondents were already on pace "to far outstrip" their prior performance through the first half of 2015, the DBO noted, having already amassed $12.47 billion of transactions.

The dollar amount of the companies' consumer financial and small business financing transactions reflected a similar rise, growing by 715.7 percent and 629.5 percent, respectively, to $12.97 billion and $2.94 billion. On a national basis, the number of small business financing transactions exploded 1,767 percent from 12,868 in 2010 to 240,277 in 2014.

For consumer transactions, the median APR ranged from 5.74 to 34.01, with a higher range for business transactions (15.5 to 51.8 percent). Over the time period, median APRs generally declined, the DBO found, both nationally and on a state level.

Delinquency rates for consumer transactions (defined as 30 or more days past due) ranged from 0.03 to 17.94 percent of the total outstanding transactions for the first half of 2015; in California the range was slightly higher, from 0.90 to 25.30 percent. As for delinquencies in small business financings, the numbers were lower. At the end of the first half of 2015, they ranged from 0.36 to 8.96 percent on a national basis and 0.48 to 8.45 percent in California.

The DBO's survey also requested information about online marketplace lending business models and platforms. That information remains to be analyzed, the regulator noted, and may require supplementary requests for documentation and information from lenders.

Why it matters

"Clearly, California has a lot at stake in this growing segment of our financial services market," DBO Commissioner Jan Lynn Owen said in a press release about the investigation results. "It's crucial that we better understand the industry. These companies are providing needed access to financing. But we want to make sure our regulatory structure adequately protects the interests of our consumers and small businesses, and works effectively for industry." What the DBO does with the information it gathered remains unclear. While the stated goal of the investigation was "to determine whether market participants are fully complying with state lending and securities laws," the regulator acknowledged it was also an attempt "to assess how the state's regulatory regime is working, and should work, with respect to the industry."

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