Regulation – in some still-to-be-determined format – is forthcoming for fintechs.
That parks them at a fork in the road: Do they prioritize continuing to chase lofty growth goals? Or adopt practices demanded of well-managed operations?
Savvy fintechs should pursue both in parallel paths, because soundly structured operations – which is what oversight agencies generally look for – will only support their business strategy, be that to grow as an independent, profitable business or to exit. We believe these start-ups’ reputations for rapid growth and iterative innovative can peacefully coexist with calls surfacing for them to implement and adhere to buttoned-up policies and procedures.
By tackling this smartly and creating operational checks and balances that put customers’ best interests first, fintechs would be taking a good step in the right direction toward complying with any financial services regulation. We might not agree with every banking regulation’s applicability to this financial services segment, but these rules propel sound business practices and protect consumers (and even traditional banks find it hard to cover every rule). Going a step further, we argue this isn’t even a regulatory issue at heart, because as these start-ups mature, their volumes grow – and offerings quickly become more complex and overwhelm their initial systems.
When fintechs should embrace that overlap, they can, as the saying goes, kill two birds with one stone. A road map for building well-managed systems can be easily pieced together from established regulations, even if those practices and procedures are spelled out for more traditional banks. By applying the tenor of these rules, in general, fintechs will find their business runs more efficiently and safely for them and their customers.
What we don’t want to sacrifice in this transition is the “what can be” mindset and flexibility of these visionary companies. Fintechs with their innovative ideas combined with technical execution are the driving force behind significant gains in financial freedom for consumers. These new experiences include faster access to cash and easier point-of-sale loans – basically an overall reduction in friction between people and the financial services they want and need. Fintechs also deserve credit for delivering new payday services and other offerings to meet the 22% of U.S. adults who are underbanked or unbanked.
With speed-to-market fueling them forward, fintechs have been moving so fast that many haven’t paused to look back to see if they’re having any problems in their processes, if they have even defined specific processes. Frankly, as they’re growing rapidly, the structure that comes with well-managed functions and regulatory alignment can help them manage through that storm and effectively build their back-office functions.
As the fintech industry matures and attracts greater regulatory attention, it’s time for them to support their growth goals with an equal focus on well-managed systems. Together, that will pay dividends as customers find greater comfort in companies that are responsive to their needs – and the companies benefit from cost-effective, compliant operations. This holds true for all operating processes from customer onboarding through servicing and even into collections/recoveries stages if consumers falter on their fiscal responsibilities.
In recent years, conversation among federal legislators and oversight agencies about how to watch over fintechs has been growing as the line continues to blur with banks. A common theme coming from those discussions is that fintechs don’t deserve to maintain what some consider an unfair market advantage and should play by the rules – but should they be forced to follow the same rules as banks?
Fintechs, with their young history, generally are startups built to solve a specific customer pain point. With their leading-edge technology and AI-powered capabilities, they are the definition of non-banks. Banks, on the other hand, have deep histories rooted in their organizational charters, the oldest continually operating company dating back to 1784 with those famous duelists Aaron Burr and Alexander Hamilton among its founders. As fintechs augment their core features with additional capabilities, including deposit products, they begin to look more like banks, at least on paper. On the other hand, as banks acquire fintechs or develop in-house boutique services, they take on some fintech attributes.
For now, we largely can agree that fintechs aren’t banks (even as some are starting to buy banks), but they are financial services providers serving a growing number of consumers.
Mobile payments are one of the larger fintech offerings, with 29% of Americans using a platform from small players like PayPal (10 million users) to large players like Apple (220 million users). That translated into $3.6 billion in revenue in just this category last year, creating a pretty big reason for regulators to pay attention. On a trust level, banks and fintechs are on near equal footing, with 40% of financial decision-makers reporting they use at least one fintech platform, mostly for general banking rather than for specialty services.
After four years of relaxed regulatory oversight, the new administration sent signs right out of the gate to expect a tightening of the reins – particularly aimed at consumer protection – and fintechs sit squarely among their targets. Already taxed with minding operations at some 5,000 banks, the traditional banking regulators lack the bandwidth to oversee fintechs, leading to predictions that this oversight might land in the lap of the CFPB. As a related outcome, banks – which really aren’t facing any material threats as fintechs have only claimed 3-4% of market share – will understand where these upstarts can play in an overcrowded space.
With nothing officially proposed, fintechs might not be feeling much regulatory pressure yet, but it’s coming. Where they’re focusing their worries, so to speak, is getting their originations engine scalable and well run so they easily grow their top line. That’s why we think this is a pivotal moment, especially for those willing to invest in the post-origination efforts required for a well-run financial services company. Fintechs that do that right will stand as robust, sound organizations positioned for growth – and exist as financial organizations that check off key risk management requirements. These are so interconnected because the more you grow, the more risk you generate.
All of this depends on where fintechs are in their evolutionary cycle. Companies with greater levels of sophistication recognize the need for functioning regulatory compliance and risk management teams, and a startup doesn’t have to go too far along the growth curve before questions about these functions come up. For fintechs hungry to be acquired or issue an IPO, part of readying themselves – beyond window dressing – is identifying and closing risk issues and putting compliance protocols in place. Their greater challenge is deciding when to get in front of that, so it doesn’t hinder growth or ding their business strategy.
Consumers are demonstrating their willingness to move beyond just general banking with fintechs. The fastest-growing digital banking platforms are for investments and lending, and fintechs need to be ready with robust back-office operations down to collections protocols. Companies need to think through the entire product life cycle and have the policies, people and systems in place before going to market or they’re putting their business at risk in safety and soundness measures. Maybe they think they have months before they need practices in place, but it takes more time than that to build, test and refine quality operations. We know fintechs have the technology chops, but well-managed practices require a new set of expertise.
Of course, a bad move on their part that puts even one customer at risk will give fintechs a reputational black eye and potentially dry up their well of capital.
At this point in the industry’s evolution, many fintechs recognize that regulation will help to validate who they are and remove some public skepticism that they’re flying under the radar. They must proactively engage in this evolution to protect their nimbleness, which has allowed them to experiment and disrupt. They need a framework and safe harbor so they can continue to innovate and lean into change, which delivers benefit to the larger financial services ecosystem. Our point is that it’s easier to do this when you’re creating those essential processes and practices, rather than having go back and fix them once they’ve become ingrained in your company.
Fintechs need operational parameters and regulators who allow them to pass through rather than stick in a single lane, as they keep pushing boundaries in financial innovation. Consider payday loans, which banks have shunned but a certain consumer segment needs to put food on the dinner table. Any regulatory requirement must let fintechs innovate in this space with short-term, fee-based products to be of value to consumers but not get them into trouble.
In protecting consumers, these regulations then become assets for fintechs. On the capital front, as fintechs advance to greater funding needs, investors want to have some security that it’s a safe place to inject their money. That stability, which is a byproduct of regulatory oversight, will be critical for fintechs to close larger deals.
To date, fintechs have demonstrated clear strengths in product development, marketing and even a willingness to take on risk, to a degree, if their business is growing. Moving from zero to a robust risk management program that meets regulator expectations is a major undertaking.
We see great potential for alignment between fintechs building scalable, controlled and growing organizations and implementing risk management and operational guardrails that regulators expect. In helping fintechs pursue those initiatives in tandem – from identifying relevant regulation to designing sound operating practices – Spinnaker can help these organizations continue to drive the spirit of innovation in a more managed and palatable manner for consumers.
Scott Hamilton, Senior Director of Spinnaker's Customer Channels & Operations Management practice, contributed to this blog.
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