Innovation in an Era of Regulation: Is it the Impossible Dream?

In times when survival, not growth, is the primary objective, innovation is often first on the chopping block. Functions such as research and development, strategy, business development and innovation are viewed as luxuries during difficult economic times. Nowhere is this truer than in the financial services industry today.

Banks, in particular, face difficult choices as they consider whether to eliminate or reduce investments in the wake of regulatory and financial forces that are driving some institutions to curtail innovation altogether. This environment has evolved, in part because of innovations in mortgage lending, student lending and investment banking, all of which have led to the current financial crisis. As a result, many traditional bankers and regulators fear innovation. And the populist cries in newspapers, on radio talk shows and on Capitol Hill -- all calling for new safeguards and laws to prevent the excesses of the past -- add to those fears.

And yet, financially vulnerable consumers and businesses still need reliable financial services from reputable institutions to repair their lives and businesses. Unfortunately, these same customers may be turned away from traditional banks or steered toward less-regulated, "non-banks" such as money transfer companies, payday lenders, prepaid card providers, and bill-pay kiosk companies. Many of these so-called non-banks are not capable or interested in helping customers build long-term fiscal fitness.

Now more than ever, it is critical to ask the question: Is banking industry innovation possible in an era of heightened regulatory scrutiny? This article argues that innovation is imperative for traditional banking for two key reasons: aggressive regulation, which threatens the industry's profitability and viability, and increased competition in high-profit industry segments from less-regulated non-banks. 

Regulation, litigation and product maturity

Even as traditional banks struggle to deal with today’s economic crises, banks’ current strategic investments will continue to affect their future. Therefore, it is critical that efforts to regulate past problems do not unintentionally prevent banks from innovating in the future. This is particularly important since many non-bank innovations start in completely unregulated environments, with all the attendant potential risks.

At the same time that business fundamentals are challenging profitability, increased regulatory scrutiny threatens many of the still promising profit pools in consumer banking. For example, proposed Unfair and Deceptive Advertising Practices (UDAP) legislation may severely constrain banks’ ability to charge fees for overdrafts, late payments and other adverse activities. In addition, due to the financial crisis, Congress, the FDIC and other national regulators may impose other stricter laws and regulations on banking across the board, which could both limit revenue opportunities and increase the cost of doing business. Although well-intentioned, these added rules and regulations could have a burdensome effect on bank costs and priorities, without solving the underlying issues.

Many retail bank fees have also come under increased legal scrutiny in the last five to 10 years. From ATM fees to interchange fees, class action lawyers have targeted banks, challenging almost every type of fee revenue bankers have imposed. In some cases, these fees are the not the only source of revenue for a particular product (e.g. credit cards and deposit accounts). In other cases, however, popular, widely-used products and services like debit cards, ATMs and gift cards have no other source of revenue besides the fees that are being challenged.

Most traditional banks depend on a series of mature businesses for profitability. Deposits and mortgages, the two most basic banking products, are heavily impacted by business cycles, rate environments, and population trends, driving heavy competition. These basic banking products face intense public scrutiny that could impact profitability. For example, credit cards, once a significant engine of interest income, have been surpassed by debit cards, as consumers rationalize debt and borrow less. At the same time, customers with lower credit scores, once a source of growth in the credit card industry, are defaulting at higher rates than ever. Even rewards programs and “elite” cards, once strong product differentiators, have become ubiquitous and commoditized. The combination of these trends places significant pressure on the core banking businesses at a time when bank viability is critical to the US economy.

The relevancy factor

Given these severe challenges to core bank revenue streams, new product and business model innovation may be the only way to protect bank profitability and viability. These challenges are compounded by the fact that less-regulated, non-banks continue to enter high-profit areas of financial services. In addition, many of these non-banks have found novel ways to offer financial services at a profit in segments where banks historically have been irrelevant. In fact, some of the fastest growing US consumer populations are already being served by innovative non-banks, populations working, for example in hourly (often minimum wage) service sector jobs who need help managing finances and bill payment between paychecks. Growth in the Hispanic population growth brings another large group of customers to the US with no historical experience with traditional banks. Finally, as the tech-savvy “millennial generation” grows up, consumer expectations will continue to shift to new and evolving technology platforms.

Less-regulated non-banks, which typically face less regulatory scrutiny than traditional banks, are extremely interested in these high profit areas and have introduced a range of innovative products and services for underserved customer segments with the expectation of healthy profits while doing so. Many of these companies are reputable and responsible but some have been associated with serious consumer complaints, and others are fraudulent, involved in money laundering and usury.

To combat the “bad actors,” a host of federal and state laws have been enacted to reign in excess and protect consumers. Pro-consumer laws including Unfair or Deceptive Acts or Practices (UDAP), Equal Credit Opportunity Act (ECOA), Community Reinvestment Act (CRA), Fair Housing legislation, the Talent Amendment, state money transmitter laws, all aim to reduce abusive financial services practices while ensuring equal access to financial services. Recent economic events make it clear that these regulations failed to prevent all abuses, and some laws created unintended, negative consequences. For example, some critics argue that aggressive ECOA and CRA targets led to unsustainable innovation in the subprime mortgage segment. Most of these innovations were pioneered by non-banks.

Another example is the cap on military loans enacted in 2007. The original legislation was in response to the findings of a Pentagon study on the financial health of the armed services. The legislation passed quickly as part of the Defense Authorization Act, but before an analysis could determine what effect the loan cap would have. After the law was enacted, according to an article in the Small Loan Interest Rate Cap Review, the Department of Defense concluded that provisions in the amendment would have the unintended consequence of “severely restricting” access to fair and affordable credit for countless service members and their families.

Likewise, more recently passed legislation could also have unintended consequences creating innovation opportunities for non-banks, while adding to compliance costs for traditional banks. The Home Ownership and Equity Protection Act (HOEPA), the SAFE Act, UDAP, Protecting Consumers from Unreasonable Credit Rates Act, and the Interest Rate Equity Act all are examples that could have positive or negative consumer impacts. Some critics express concerns that this legislation could ultimately limit access to credit, and even drive consumers with legitimate credit needs toward unsavory credit sources.

Conclusion

Financial institutions have proven that they can innovate during stable times. Mobile banking, remittance and unsecured credit solutions are examples of this kind of successful innovation. Increased scrutiny from regulators, legislators and the press may threaten these tendencies. For example, Anti Money Laundering and Office of Foreign Assets Control regulations have caused many banks to reconsider remittance products and commercial relationships with money service providers. State regulations combined with some serious lawsuits caused many banks to exit the gift card and other prepaid businesses. At the same time, companies like Vodafone and Obopay jumped in with remittance innovations, while non-banks came to dominate the prepaid card market.

Similarly, banks with compliant unsecured loan programs struggled with profitability and press backlash stemming from claims that these products targeted illegal immigrants. CRA home loans also came under attack as part of the subprime debacle. Each setback caused banks to become more conservative, even as less-regulated players continue to innovate.

The lesson here is that innovation will occur with or without regulation, and thus it is important to ensure that “good actors,” including banks and traditional financial services companies, aren’t handicapped around innovation. In an environment of aggressive regulation, this is more important than ever.

Author bio

Margaret Weichert is the Founder and CEO at The Morgan Weichert Group, LLC, a financial services consulting firm. Weichert recently served as the eCommerce/ATM Business Planning and Analytics Executive at Bank of America (BAC), with responsibility for strategy, innovation, business development, business intelligence and analytics for eCommerce, ATM and mobile channels.