The banking system is no stranger to technological advances, whether it is the introduction of data processing and ATMs long ago or, more recently, the creation of online banking. What’s different about the financial technology (fintech) innovations of today is the “exponential” disruption it has made in the marketplace, said Keith Noreika, acting comptroller of the currency, in this conversation with Wharton finance professor Richard Herring. “There are new ways of doing that very old business of taking deposits, making loans and paying checks,” he said at the recent “Fintech: The Impact on Consumers, Banking, and Regulatory Policy” conference at the Federal Reserve Bank of Philadelphia.
But a sticking point remains: How does one categorize a fintech company? Should it become a nationally chartered bank? A thrift? A tech company that takes deposits? Depending on which bucket a fintech firm falls into, it would be subject to different regulators and rules. Noreika said the OCC, which regulates about 1,400 of the nation’s banks and other financial institutions, is discussing these issues. However, he is adamant that for innovation to flourish, fintech companies cannot be subject to “draconian” legal liabilities nor rules that can strangle their dynamism. The challenge for regulators is that they cannot be so married to the old mental frameworks that they cannot apply their statutory mission in new ways.
In an exclusive interview for Knowledge at Wharton, Noreika continued to speak with Herring offstage about the current regulatory climate that fintech companies are facing. An edited transcript of that conversation follows.
Richard Herring: Although your title is Acting Comptroller of the Currency, you’ve really taken a very active role, which I guess is in keeping with — although it’s not necessarily true of — interim leaders. There are lots of things on your agenda; one of the most interesting I think is looking at financial innovation. You actually have a special unit looking at it.
The world is producing all kinds of new configurations of fintech firms that are not regularly looked at in a normal regulatory framework. They come in a multitude of ways, they do partnerships with banks, they’re sometimes freestanding firms, they can have state charters, they do partnerships. So far there isn’t really a federal charter except that you all have described what one might look like. And as I understand it, you are holding office hours in San Francisco and New York to talk with actual companies to see what might fit.
Keith Noreika: First, let me say that in the history of the Acting Comptrollers of the Currency — at least in my lifetime — they have all been very active. John Walsh, who was the interim between Tom Curry and John Dugan, was a very active acting comptroller. Julie Williams before that was quite active. These were formative people of my youth who, as Julie used to say, [exemplify how] an acting comptroller is meant to act. That’s the philosophy I took.
Herring: What’s unusual about your situation is that you came in from the outside. They were both deputies … and so it was sort of natural to continue on course.
Noreika: Julie was sort of exceptional. She took it to a different level. John was as well, in the sense of certainly going in a different direction than necessarily others were going at that time. Look, we have this opportunity. My own view is that I wouldn’t have left my career in private practice if I were meant to be a caretaker — that [role] could be taken by anyone.
The real opportunity or reason I was asked by the administration was that they wanted a change, that the people voted for change and they needed to effectuate that change, and they needed somebody to step up and do that. Now, ironically, the topic that we’re talking about involves both change and continuity in the sense that it was an initiative started by my predecessor, Tom Curry.
“I would always characterize anything with innovation and financial technology as an opportunity rather than a problem.”
But as I think we talked about at the Philly Fed forum, the notion of innovation in the national bank sphere has just been inherent in the 154-year history of the office that I know hold. The office itself was really an innovation designed to finance the Civil War by setting up a national currency. That hadn’t existed since the Second Bank of the United States folding.
Herring: That was Salmon P. Chase, wasn’t it?
Noreika: That’s right, it was. He was the treasury secretary [under President Lincoln] at the time and he ended up being the chief justice of the Supreme Court after that. And what we’ve seen after that is that innovation has been an inherent part of the business of banking, and certainly the business of banking under the National Bank Act for national banks.
There have been questions about whether annuities are part of the business of banking, ATM machines, data processing, and internet banks. What we’re seeing today is maybe an exponential curve of disruption of technology in the way that people bank, but it’s sort of what’s old is new.
Herring: It’s not qualitatively different.
Noreika: It’s not qualitatively different. When I walked in, the Office of Innovation was new, and yet it was something done by my predecessor. As I have told a lot of people, it’s almost something I couldn’t imagine not having now. It was a stroke of brilliance, and it just really captures the full history of our national banking system, of which I am proud to be a part of and maintain that continuity.
But it will change. People often ask me what my successor will do, and I can tell them a little bit of what he would do, but we don’t know because of the changing nature of technology what the issues will be presented. We always know that there will be that core of the business of banking of taking deposits or making loans or paying checks — that will be at the heart of it. But the various natures and methods by which that may be delivered will change over time, and it should.
Herring: Keith, what is the statutory language that allows you to be flexible over time?
Noreika: There are two phrases in Section 247 of the National Bank Act, which was enacted in 1864, that talks about the enumerative powers of a national bank of taking deposits, making loans, and all such incidental powers to the business of banking.
Those two phrases — incidental powers and business of banking — are broad phrases subject to really the discretion of the person holding my office, the Comptroller of the Currency, to construe in a manner that best fits the business of banking at that time. That has been upheld by unanimous Supreme Court cases for the past 154 years. So it’s really been something where there has not been a lot of partisan disagreement.
Herring: But it is subject to regular challenge by other regulators, isn’t it?
Noreika: It is, and it should be. I think with anything, there is discretion. The discretion cannot be exercised arbitrarily or in a way that doesn’t make sense given the precedence. But with respect to the special purpose fintech charter … this is another example of doing old things in new ways.
The regulation that is being challenged now in court really is a regulation that dates prior to the fintech area — from about 2002, 2003. There was an entirely different reason it was adopted. It was meant to allow banks and subsidiary entities to do things like mortgage lending that would be part of a national bank system when there were challenges to doing that through state-chartered entities. That was a case that went ultimately to the Supreme Court that I litigated, and they sided with the banks and the OCC in a 5-3 ruling.
Ultimately, that regulation at that time became moot because it could be done through a state chartered entity. What we’re seeing now is that the regulation itself says that the business of banking means one of three things: taking deposits, making loans, or paying checks. The dispute is whether deposits always have to be taken. Why I feel very confident is that Congress itself in 1994 when they allowed interstate banking actually defined the business of banking undertaken in interstate branches as one of the three. So it wasn’t conjunctive, it was disjunctive.
That made perfect sense for us as an agency in 2002, 2003 to adopt that as a basis of interpretation of the business of banking for purposes of a special purpose charter, and it will serve us well in the future if we decide to grant one of those to a financial technology company that doesn’t take deposits.
Herring: Most of the attention, in fact, has been on the prospect of this new charter, although as I understand it nobody has actually gotten the charter yet. But it’s not the only option that you can offer a fintech firm if their particular business plan and their qualities meet your standards. You have special charters such as trust banks, and credit card banks, and bankers’ banks I believe. Some of the fintech activity could presumably fit in those as well.
“My own view is the system in America has been much more conducive to innovation over time.”
Noreika: Very much so. I approach this as, ‘let us get our feet wet as regulators who are getting our hands around this massive disruption — financial technology in the banking system.’ And what we know how to do is to regulate full service banks, but also these special purpose banks that have been around for decades, if not longer, such as trust banks, credit card banks, bankers’ banks.
There are a lot of fintech business models that fit well within them, such as being a custodian or trustee for a virtual currency ledger, that could easily fit within a trust bank. Certain payment mechanisms could easily fit within a credit card bank charter. So that would be an easy way….
It wouldn’t be subject to the restrictions of the Bank Holding Company Act. So there would be the freedom to do this without those draconian restrictions on what you could be affiliated with. Also, it has the benefit of giving us an education … it’s a step into a pool, and we’re getting a little bit further in while we decide whether we want to exercise our right to use this special purpose charter for something that may be beyond those authorities.
Herring: We in the United States are understandably obsessed with what is happening here, but we shouldn’t lose sight of the fact that this is a worldwide trend, and other countries are confronting exactly the same kinds of problems. In fact, the fintech business has probably penetrated further in some other markets than in the United States.
What seems to be very different about the U.S. is the challenge we have in establishing a regulatory framework. I’m thinking in particular about the regulatory sandbox that the Bank of England has established that is intended to promote innovation and encourage competition, but within a sphere that is carefully monitored by the supervisors who are learning from it and trying to figure out how in fact these entities should be regulated if they graduate from the sandbox. Why is it so difficult do to the same thing here?
Noreika: Well look, I think that first I would always characterize anything with innovation and financial technology as an opportunity rather than a problem. So these are opportunities — and opportunities come with obstacles to be overcome. I mean, that’s the nature of technology and its disruption in the first place.
We have a unique regulatory system in the United States. Maybe that is an understatement of understatements, but it’s organically developed. There are many different regulators, and in my own view having labored in these venues for the past quarter century I actually think it works pretty well.
Now the challenge is when we have these new technologies that you want to try to insulate and incubate in a type of controlled environment without subjecting them to heavy potential legal liability. That is very problematic and can be a barrier to entry. To me, we as regulators have to focus on, ‘okay, that is an obstacle.’ We want to try to do as much as we can to have a controlled environment.
But on the other hand, because our system is fragmented, I as the Acting Comptroller don’t have the authority, say, to waive the Truth and Lending Act because that’s not a statute that I administer or write the rules for, that’s the Consumer Financial Protection Bureau (CFPB). We can try as much as we can to educate and to insulate and to have pilot programs where we can [have opportunities for] like-minded regulators to act alike. But we’re obviously having a little disruption politically in the sense that the regulators are turning over.
“It certainly is much easier to regulate them through a bank charter if they do present those types of risks than if they don’t have one.”
I wouldn’t be surprised if at some point that we do have a little bit more regulatory coordination to encourage these types of activities. But on the other hand, I must say having been on the outside, there are opportunities here. Innovation usually surmounts obstacles, and this is one of those obstacles that has to be overcome, but I think for a worthy purpose.
The alternative is a system where you may have a regulatory sandbox but you have one monolithic regulator that determines the rules for all circumstances. It can actually squelch innovation if you don’t fit within the narrow parameters of the sandbox. So there are pros and cons to both things, but my own view is the system in America has been much more conducive to innovation over time.
Herring: I think that is undoubtedly true. I used to say that if you weren’t currently on the ‘Ten Most Wanted’ list of the FBI you could probably get some bank or bank-like charter somewhere. But that’s no longer true. We’ve seen very few de novo banking operations arising since the financial crisis, basically. Some of it undoubtedly is just adjustment, but there is a sense in which the barriers to entry have become much larger, and not the least of which is the huge fixed cost of supervision, which is very difficult for a small bank to be able to bear in a competitive way. Do you view fintech as a way of opening up the competitive space?
Noreika: Undoubtedly. I think technology generally is changing the way that Americans conduct commerce, and banking is part of commerce. … That may be a controversial topic [here at the Federal Reserve Bank]. But look, I think that technology can help overcome those fixed costs, clearly. What we are trying to design, with a responsible approach to innovation, allows people, through their private choices, to order their affairs in a way that allows them a regulatory streamlined approach. So in the sense of our special purpose banks, trust banks, credit card banks, and bankers’ banks, or the special purpose fintech charter if we get there, they are themselves a way to order your affairs, and only have … one regulator basically, the OCC, to operate on a 50-state basis. You don’t have to worry about being classified as a bank for purposes of the Bank Holding Company Act.
So someone can own those institutions without being subject to regulation by the Federal Reserve, and it doesn’t necessarily have to get FDIC insurance. And depending on the activities, they may or may not be subject to regulation by the CFPB. But there won’t be any state by state regulation attached either. So I think we have the opportunity to establish choices, at least that individual market actors can exercise, if they want to opt in to some more streamlined regulatory approaches to do that.
Another aspect even outside of the fintech realm is, you are seeing, for instance, a lot more banks get rid of their bank holding company, and issue their shares to the public market directly from the bank itself so they can, by operation of law, streamline their regulatory approach. It’s not just even in the special fintech charter or the special purpose charter — you are seeing market actors, because of the incredible regulatory cost associated with the business of banking after the Dodd Frank Act, take these measures themselves to minimize their regulatory exposure.
“What we’re doing is just giving people a choice.”
Herring: You’ve implicitly answered one of the key questions that has always troubled me, which is if you are looking at an area in the shadow banking sphere like fintech, which has grown and become profitable at least in part because they’ve been able to avoid bank-like regulations, what is the incentive for them to seek a bank, even a limited bank charter? Given that, why do a federal charter rather than a state charter? Or just be a company within a state, or even just partner with banks that are already authorized?
We’re seeing some of each, but what is the new opportunity that a federal charter provides? What I think I’ve heard you say is unified, streamlined regulation. I would add probably a reputational fact, because being known as a federally regulated bank, as long as you guys manage your business well, enhances your reputation, and conveys trust. But it does come with additional costs. How do you think fintech firms are going to weigh the cost of benefits?
Noreika: Well look, it’s in our advantage as regulators, as a society, to incentivize those institutions to come into the banking system because I think that makes it easier to regulate for purposes of [preventing] bad stuff happening like criminal activity, like threats to national security.
Herring: And if they get big enough, even systemic risk, presumably.
Noreika: That’s true, exactly. It certainly is much easier to regulate them through a bank charter if they do present those types of risks than if they don’t have one. Look, I think you’ve put your finger on what the potential benefits are in the sense that there is uniform regulation of a national bank on a 50-state basis. There is also the ability, if they loan money, to do that on a nationwide basis subject to one state’s interest rate cap. So they won’t be subject to 50 state laws. There’s more of an opportunity to have a nationwide banking business, which is one of the purposes of the National Bank Act in the first place.
Herring: The point of persuading these institutions to enter the regulatory structure I think is a really interesting one, and an important one. There are certain carrots you can offer, and I think this new charter may well be a significant one. But there are also implicit sticks. There are a lot of regulations that they really can’t avoid entirely by not being recognized as some species of bank.
“We have to give market actors choice about the best way to structure their business and achieve innovation, and bring better products at lower prices to consumers.”
For example, my impression is that bank regulators are increasingly insistent that banks look into their vendors in terms of occupational risks, cyber risks, a whole range of things that they have to do for their own operations. Are there other things that are changing the balance of how you think about whether you want to be regulated or not?
Noreika: In many ways, what we’re seeing … is that those third parties that may partner with banks may find themselves subject to that scrutiny regardless of partnering with a bank or being a bank themselves. Those are just the realities of regulating the financial institution for systemic risk, and for the type of risk that may give rise to some type of systemic event.
Certainly, what we see a lot of in the partnerships, because of the benefits of a bank charter, there really needs to be a bank involved, say, in the origination of loans. My own view is that it would probably be better to keep that within the banking system rather than have a partnership, but everyone has to order their affairs to the best of their ability.
What we’re doing is just giving people a choice. First, we have our options of a full service bank, limited purpose banks. But if we get to the special purpose charter, it would be another potential choice for people to order their affairs. And they may just want to bite the bullet and think, ‘well, I’ll get regulated having a partnership with a bank, wouldn’t it be better for me to get on the map and just do this myself?’
Because when you have more than one actor, say if you have to partner with a bank, that presumably stands to reason that that would be more expensive than just getting a bank charter yourself because you have to pay for all of their infrastructure. You’re still paying for all of the same costs undertaken by someone else, and paying them a premium for the partnership, and presumably you can internalize a little bit more of that yourself. But that obviously will be a decision taken by private market actors depending on the state of the industry and the market at that time.
Herring: Well, incentives are changing. We don’t really have that charter yet on offer.
Noreika: That’s true.
Herring: And the costs I think are actually increasing as the intensity of this responsibility for third-party operations continues.
Noreika: Right.
Herring: Let me conclude with a more general question, because you have been a participant on both sides of the regulatory world, and have thought a lot about what would make a better system that would provide services more efficiently, yet safely. Presumably that takes into account not only innovation but streamlining regulation. What kinds of reforms do you think would be useful? We’re now eight or nine years after the Dodd Frank Act, and surely it is time to reconsider several dimensions.
Noreika: We’re headed in the right direction in the sense of we have to give market actors choice about the best way to structure their business and achieve innovation, and bring better products at lower prices to consumers. That has to be the hallmark of it. Now generally, in my own view, that is accomplished in a free market economy through the government trying to set down rules that you can meet, and the government accesses the policemen if those aren’t followed but generally stays out of private market actors’ activities. The exception traditionally has been in the banking realm where there are runnable demand deposits that require some more prescriptive ex ante regulation of the activities of these institutions.
But to me, that is an anomaly in the way we regulate that industry and also very expensive as a society. I would like to keep that to a minimum at all costs, and only to regulate those activities of those institutions that could potentially cause systemic risk. Everything else done by those institutions, and the risks presented by them, should be regulated more in the way that you would regulate a normal business outside of the banking sphere — if it doesn’t present systemic risk.
To me, we should fundamentally step back and say, ‘why are we doing this? We’re doing it for the purposes of systemic risks transferred through runnable liabilities, demand deposits. OK, what do we need to do to prevent that type of risk, and do no more than that?’ Everything else that we might regulate those institutions for has to be separated out and treated more like the way you would regulate the mattress company down the street or a supermarket or something like that, or speeding on the highway. If you do it, you get fined and that’s it. But we don’t go in there and prescriptively stop their business because they happen to also have demand liabilities.
Herring: You’re raising an interesting question, though, and the example certainly is one that most people would agree with — that runnable liabilities are the crux of vulnerability. But the kinds of systemic risk we’ve seen emerge are broader than that in a way. The crisis with securitization involved assets that suddenly became liquid, and liabilities that were not deposit liabilities but liabilities nonetheless that had to be repaid very quickly.
It raises for me the question of, how do we monitor systemic risk? Like banking, it’s not going to be static, it will change over time. We need to have some way of trying to anticipate rather than simply trying to patch things up once it happens.
Noreika: It’s a dynamic industry that changes over time. So what may have been a risk in the past may still be a risk in the future, but there may be other variants of it to emerge. The way historically we’ve handled that is there will be new banking legislation every five to 10 years. It just has happened.
Mostly in our history, it has been very bipartisan and consensus-based legislation. Dodd Frank was the exception. That was a rather partisan bill, but every other law before it, certainly that I had experienced within my lifetime, was bipartisan. Gramm-Leach-Bliley was, Riegle-Neal was. You keep going back in time — FIRREA, FDICIA, CEBA. … We should take a look as a society and decide what those risks are, and the activities that present them. Then you can regulate them in the same way as banks. We do it through clear rules, that if you engage in the activity you’re subject to the rule.
The other way to do it was occasioned in Dodd Frank through the Financial Stability Oversight Council (FSOC). One of their authorities is to look at activities that can present systemic risk. That could be another way — to use a body like that to set clear rules for specific activities that companies may engage in.
My one issue with the FSOC is I don’t like picking out specific firms of being systemically risky or not, because I think there’s too much mischief to be had there of picking winners and losers based on who is in favor and who is not at the time. It’s better to clearly define activities that give rise to regulation, and let private market actors decide whether or not they want to engage in them.
