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FINRA provides 2019 risk monitoring and examination guidance
On January 22, the Financial Industry Regulatory Authority (FINRA) issued new guidance on areas member firms should consider when seeking to improve their compliance, supervisory, and risk management programs. The 2019 FINRA Risk Monitoring and Examination Priorities Letter (2019 Priorities Letter) examines both new priorities as well as areas of ongoing concern, including the adequacy of firms’ cybersecurity programs. FINRA notes, however, that the 2019 Priorities Letter does not repeat topics previously addressed in prior letters, and advises member firms that it will continue to review ongoing obligations for compliance. Topics FINRA plans to focus on in the coming year include:
- Firms’ use of regulatory technology to help compliance efforts become “more efficient, effective, and risk-based.” FINRA will work with firms to understand risks and concerns related to supervision and governance systems, third party vendor management, and safeguarding customer data;
- Supervision of digital assets, including coordinating with the SEC to review how firms determine whether a given digital asset is a security and whether firms are implementing adequate controls and supervisions related to digital assets, such as complying with anti-money laundering and Bank Secrecy Act rules and regulations;
- Assessment of firms’ compliance with FinCEN’s Customer Due Diligence rule, which requires firms to identify beneficial owners of legal entity customers (as previously covered by InfoBytes here); and
- Financial risks, including credit risks, funding and liquidity planning.
Waters announces subcommittee chairs, including newly formed Subcommittee on Diversity and Inclusion
On January 24, Chair of the House Financial Services Committee, Maxine Waters, announced that Joyce Beatty (D-OH) will serve as the first Chair of the newly formed Subcommittee on Diversity and Inclusion. According to Waters’ policy speech on January 17, the new Subcommittee will be “dedicated to looking at diversity and inclusion issues under the Committee’s jurisdiction.” Specifically, Waters cited to low representation of minorities and women in the financial services industry, particularly at the management level, as a reason for the creation of the subcommittee. Using the Offices of Minority and Women Inclusion of the federal financial services regulators as an example, Waters suggested that the subcommittee be responsible for overseeing diversity in management, employment, and business activities in the financial industry. In addition to diversity and inclusion, Waters noted that, among other things, fair housing, including conducting “robust oversight” of HUD, and fintech would be top priorities for the subcommittee.
U.S. government watchdog studies fintech lending trends, recommends need for clarity on use of alternative data
In December, the Government Accountability Office (GAO) issued a report entitled “Financial Technology: Agencies Should Provide Clarification on Lenders’ Use of Alternative Data,” which addresses emerging issues in fintech lending due to rapid growth in loan volume and increasing partnerships between banks and fintech lenders. The report also addresses fintech lenders’ use of alternative data to supplement traditional data used in making credit decisions or to detect fraud. The report notes that many banks and fintech lenders would benefit from additional guidance to ease the regulatory uncertainty surrounding the use of alternative data, including compliance with fair lending and consumer protection laws. The report’s findings cover the following topics:
- Growth of fintech lending. GAO’s analysis discusses the growth of fintech lending and several possible driving factors, such as financial innovation; consumer and business demand; lower interest rates on outstanding debt; increased investor base; and competitive advantages resulting from differences in regulatory requirements when compared to traditional state- or federally chartered banks.
- Partnerships with federally regulated banks. The report addresses two broad categories of business models: bank partnership and direct lending. GAO reports that the most common structure is the bank partnership model, where fintech lenders evaluate loan applicants through technology-based credit models, which incorporate partner banks’ underwriting criteria and are originated using the bank’s charter as opposed to state lending licenses. The fintech lender may then purchase the loans from the banks and either hold the loan in portfolio, or sell in the secondary market.
- Regulatory concerns. GAO reports that the most significant regulatory challenges facing fintech lenders relate to (i) compliance with varying state regulations; (ii) litigation-related concerns including the “valid when made” doctrine and “true lender” issues; (iii) ability to obtain industrial loan company charters; and (iv) emerging federal initiatives such as the Office of the Comptroller of the Currency’s (OCC) special-purpose national bank charter, fragmented coordination among federal regulators, and the Consumer Financial Protection Bureau's (CFPB) “no-action letter” policy.
- Consumer protection issues. The report identifies several consumer protection concerns related to fintech lending, including issues related to transparency in small business lending; data accuracy and privacy, particularly with respect to the use of alternative data in underwriting; and the potential for high-cost loans due to lack of competitive pressure.
- Use of alternative data. The report discusses fintech lenders’ practice of using alternative data, such as on-time rent payments or a borrower’s alma mater and degree, to supplement traditional data when making credit decisions. GAO notes that while there are potential benefits to using alternative data—including expansion of credit access, improved pricing of products, faster credit decisions, and fraud prevention—there are also a number of identified risks, such as fair lending issues, transparency, data reliability, performance during economic downturns, and cybersecurity concerns.
The GAO concludes by recommending that U.S. federal financial regulators, including the CFPB, Federal Reserve Board of Governors, Federal Deposit Insurance Corporation, and the OCC communicate in writing with fintech lenders and their bank partners about the appropriate use of alternative data in the underwriting process. According to the report, all four agencies indicated their intent to take action to address the recommendations and outlined efforts to monitor the use of alternative data.
District Court rejects dismissal bid, determining plaintiff sufficiently alleged ICO tokens were unregistered stock
On December 10, the U.S. District Court for the District of New Jersey denied a motion to dismiss a putative class action, finding the plaintiff sufficiently alleged that a company’s sale of unregistered cryptocurrency tokens were “investment contracts” under securities law. According to the opinion, the plaintiff filed the proposed class action against the company alleging it sold unregistered securities in violation of the Securities Act after purchasing $25,000 worth of tokens during the company’s initial coin offering (ICO). The company moved to dismiss the complaint, arguing that the tokens were not securities subject to the registration requirements of the Act. The court applied the three-prong “investment contract” test from SEC v. W.J. Howey Co.—“the three requirements for establishing an investment contract are: (1) an investment of money, (2) in a common enterprise, (3) with profits to come solely from the efforts of others”—and determined the token sales met the requirements. Focusing on the second and third prongs, because the company acknowledged the first was satisfied, the court concluded that the plaintiff sufficiently alleged the existence of a common enterprise by showing a “horizontal commonality” from the pooling of the contributions used to develop and maintain the company’s tasking platform. As for the third prong, the court determined the investors had an expectation of profit rather than simply a means to use the tasking platform, as demonstrated by the company’s marketing of the ICO as a “‘unique investment opportunity’ that would ‘generate better financial returns[.]’”
California DBO requests comments on future rulemaking for commercial financing disclosures
On December 4, the California Department of Business Oversight (DBO) released an invitation for comments from interested stakeholders in the development of regulations to implement the state’s new law on commercial financing disclosures. As previously covered by InfoBytes, on September 30, the California governor signed SB 1235, which requires non-bank lenders and other finance companies to provide written consumer-style disclosures for certain commercial transactions, including small business loans and merchant cash advances. Most notably, the act requires financing entities subject to the law to disclose in each commercial financing transaction —defined as an “accounts receivable purchase transaction, including factoring, asset-based lending transaction, commercial loan, commercial open-end credit plan, or lease financing transaction intended by the recipient for use primarily for other than personal, family, or household purposes”—the “total cost of the financing expressed as an annualized rate” in a form to be prescribed by the DBO.
The act requires the DBO to first develop regulations governing the new disclosure requirements, addressing, among other things, (i) definitions, contents, and methods of calculations for each disclosure; (ii) requirements concerning the time, manner, and format of each disclosure; and (iii) the method to express the annualized rate disclosure and types of fees and charges to be included in the calculation. While the DBO has formulated specific topics and questions in the invitation for comments covering these areas, the comments may address any potential area for rulemaking. Comments must be received by January 22, 2019.
FDIC encourages more de novo bank applicants, launches initiatives to streamline and promote transparency in deposit insurance applications
On December 6, the FDIC announced several initiatives designed to streamline and promote transparency in the federal deposit insurance application process, while encouraging more applications from de novo banks. According to FDIC Chairman Jelena McWilliams, the “application process should not be overly burdensome and should not deter prospective banks from applying.” As part of its initiative, the FDIC issued a request for information (RFI) soliciting feedback on all aspects of the deposit insurance application process—the RFI applies to all institutions, including those with less than $1 billion in total assets, as well as traditional community banks. The RFI seeks comments on: (i) suggestions for modifying the application process as it relates to traditional community banks; (ii) potential ways to “support the continuing evolution of emerging technology and fintech companies . . . [and whether there are] particular risks associated with any such proposals”; (iii) aspects of the application process such as legal, regulatory, economic, or technological factors that may discourage potential applications; and (iv) other suggestions for addressing stakeholder concerns regarding the application process, as well as methods for improving effectiveness, efficiency, and transparency. Comments on the RFI will be accepted for 60 days following publication in the Federal Register.
The FDIC also discussed a new, voluntary process for new deposit insurance applicants to request feedback on draft applications before filing formal submissions. “The new process is intended to provide an early opportunity for both the FDIC and organizers to identify potential challenges with respect to the statutory criteria, areas that may require further detail or support, and potential issues or concerns,” the announcement stated.
In addition to updating publications related to the application process (available through FIL-83-2018), the FDIC also released FIL-81-2018 and FIL-82-2018, which respectively provide application processing timeframe guidelines and an overview of the review process for draft deposit insurance proposals.
FINRA proposes permitting the use of electronic signatures for certain accounts
On November 28, the Financial Industry Regulatory Authority (FINRA) filed a proposed rule change with the SEC to amend paragraph (a)(3) of FINRA Rule 4512(a)(3)—“Customer Account Information”—which will permit the use of electronic signatures consistent with the E-SIGN Act. Specifically, under the proposed rule, firms will be allowed to obtain electronic signatures of personnel exercising discretionary trading authority over customer accounts maintained by a member. FINRA acknowledges that “[g]iven technological advances relating to electronic signatures, including with respect to authentication and security” it now believes that the requirement for manual signatures is obsolete. If approved by the SEC, the proposed rule change will be published in a regulatory notice no later than 60 days following approval, and will take effect within 30 days following publication.
OCC Comptroller discusses state of banking system; emphasizes areas of economic opportunity and innovation
On November 14, Comptroller of the Currency Joseph Otting discussed the condition of the U.S. federal banking system at the “Special Seminar on International Finance” in Tokyo. Otting highlighted three areas where the OCC is working to promote economic opportunity and service to bank customers: innovation, short-term small dollar lending, and supervision of international banks operating in the U.S. Specifically, Otting discussed, among other things, the importance of (i) providing a path for fintech companies to become national banks to promote modernization, innovation, and competition; and (ii) encouraging banks to provide responsible short-term small-dollar installment loans—typically between $300 and $5,000—to help consumers meet unplanned financial needs.
Notably, while noting that foreign banks have the option to operate under a state license and that the OCC strongly supports the dual banking system in the U.S., Otting stressed that the OCC is well qualified to supervise foreign banks’ federal U.S. branches, and noted that there are “supervisory efficiencies” to be gained when switching from state-by-state oversight and “consolidating the supervision of branches of foreign banks with the supervision of the national bank subsidiary of the parent company, which the OCC already supervises.” According to Otting, operating under a single regulatory framework with one prudential regulator—the OCC—would achieve a “more complete, more efficient, and, importantly, more thorough regulation of the institution.”
Federal Reserve Governor, FDIC Chairman discuss fintech
On November 13, Federal Reserve Governor Lael Brainard spoke at the “Fintech and New Financial Landscape” conference hosted by the Federal Reserve Bank of Philadelphia to discuss the potential implications associated with artificial intelligence (AI) innovation and advise regulators to remain diligent in their approach to understand and regulate the use of AI by financial institutions when augmenting or replacing traditional financial processes. Brainard’s prepared remarks emphasize the benefits and potential risks to bank safety and consumer protection that new AI applications pose. Noting, however, that many AI tools are proprietary and may be shielded from close scrutiny, Brainard suggested that existing regulations and supervisory guidance such as the Federal Reserve Board’s guidance on model risk management and vendor risk management could prove helpful in this space, which requires strong controls. Among other things, Brainard discussed the use of AI models to make credit decisions, and noted the risk of “opacity and explainability” challenges, which would make it difficult to explain how consumer credit decisions were determined and could “make it harder for consumers to improve their credit score by changing their behavior.” However, Brainard noted that the “AI community is responding with important advances in developing ‘explainable’ AI tools with a focus on expanding consumer access to credit.”
Brainard also commented that “[r]egulation and supervision need to be thoughtfully designed so that they ensure risks are appropriately mitigated but do not stand in the way of responsible innovations that might expand access and convenience for consumers and small businesses or bring greater efficiency, risk detection, and accuracy.” Moreover, supervisory guidance to firms must be read in the context of the “relative risk,” and the “level of scrutiny should be commensurate with the potential risk posed by the approach, tool, model, or process used.”
At the same conference, FDIC Chairman Jelena McWilliams also discussed the use of innovation to expand banking access to more consumers, including lower transaction costs and increases in credit availability, but emphasized that millions of “unbanked or underbanked” U.S. households do not experience these technological benefits. McWilliams stated that “[i]t will be up to institutions to leverage technology and develop products to reach these consumers.” McWilliams also discussed the FDIC’s planned Office of Innovation, which will, among other things, evaluate ways to support community banks with limited resources for fintech research and development and explore policy changes to encourage more innovation, particularly “in the areas of identity management, data quality and integrity, and data usage or analysis.” Additionally, McWilliams stated that advances in technology and data analytics will present opportunities for managing risk and change the process in which regulators handle oversight in areas such as Bank Secrecy Act/anti-money laundering compliance and consumer privacy.
SEC announces first settlement with a digital currency exchange
On November 8, the SEC announced its first enforcement action settlement with a digital currency platform for allegedly operating as an unregistered national securities exchange. According to the cease-and-desist order, the founder of the digital currency exchange, who has since sold the exchange to foreign buyers, allegedly violated federal securities laws by providing an online platform for secondary market trading of digital assets, including ERC20 tokens, without registering with the Commission or operating pursuant to a registration exemption. ERC20 tokens are digital assets issued and distributed on the Ethereum Blockchain using the ERC20 protocol, which, according to the SEC, is the standard coding protocol currently used by a significant majority of issuers in initial coin offerings. The order emphasizes that 92 percent of the trades on the exchange took place after the SEC released its Report of Investigation Pursuant To Section 21(a) Of The Securities Exchange Act of 1934: The DAO (the DAO Report) in July 2017, advising that non-exempt digital currency exchanges must register with the Commission. Without admitting or denying the findings, the founder agreed to pay $300,000 in disgorgement plus interest and a $75,000 penalty.