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Regulation as a Driver of Fintech?

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The following is an edited extract from Financial Technology.

In the aftermath of the global financial crisis (GFC) in 2008, regulators and policymakers were roundly criticized for being too soft on banks in the years before the crisis.

As a result, large financial institutions have since had to endure greater regulatory scrutiny and more stringent capital requirements. However, no regulator has infinite resources as they have to employ staff to supervise the institutions they regulate.

This means that regulators have had to prioritize their supervisory efforts and focus on firms that pose a comparatively greater risk to their regulatory objectives. Though such objectives vary by jurisdiction, they, broadly speaking, involve protecting consumers while ensuring the financial system’s stability.

Consequently, regulators devote more staff time to supervising larger institutions; as these have more customers, they tend to pose a greater potential threat to regulatory objectives than, say, a fintech start-up.

In some jurisdictions, this has meant that fintech start-ups, by virtue of their small size, incur less regulatory scrutiny than their larger rivals. Thus, the absence of a significant regulatory burden can be a competitive advantage for a small company, both from a cost perspective and, more crucially, from a business agility perspective (ie ‘getting things done’).

Less regulatory scrutiny means that fintech start-ups tend to worry less about what regulators might think before rolling out innovations – unlike their larger rivals.

Indeed, empirical evidence suggests that countries with comparatively liberal regulatory systems exhibit greater rates of fintech start-up formation than those with less flexible systems. This presents regulators and policymakers with a dilemma. On one hand, they must fulfil their regulatory responsibilities; on the other, they do not want to discourage financial innovation.

As a result, some regulators choose to engage with the fintech sector proactively. Perhaps most notably, the UK’s Financial Conduct Authority (FCA) has a specialist unit dedicated to engaging with fintech start-ups: as part of this, the FCA aims to reduce regulatory barriers to innovation whilst maintaining robust consumer protection standards. Seemingly, the FCA is attempting to embed a basic level of regulatory best practice into fintech start-ups.

By making regulation easier to engage with, this will perhaps help foster a more robust compliance culture in the fintech sector, which was so badly missing at many banks in the run-up to the GFC.

Furthermore, some policymakers have attempted to make the legislative backdrop more accommodating for smaller firms. These changes are, at least in part, designed to address the ‘too big to fail’ problem in banking, which many see as the GFC’s root cause: large banks were allowed by their shareholders to take on excessive risk because their failure would endanger the entire financial system, thereby securing an implicit government bail-out (which they got!). This moral hazard allowed large banks to access cheaper financing than their smaller competitors, causing them to grow even larger, thereby exacerbating the problem.

To address the too-big-to-fail problem, some policymakers have sought to make the financial system more competitive, in an effort to reduce concentration in the banking sector. In the UK, for example, Open Banking seeks to encourage innovation: in this way, new and better-run institutions can emerge to chip away at the market share of larger banks. In an ideal world, no institution will be too big to fail; in practice, this is a long, long way off.

In this way, the GFC, its resulting regulatory forbearance and accommodative legislation have helped ease the compliance burden on smaller firms. As a result, regulation is no longer as significant a barrier to entry in the financial sector as it once was; particularly for fintech start-ups, which attract comparatively little regulatory attention.

Thus, large incumbent institutions can no longer rely on their scale to keep fintech challengers out.