5 policy hurdles thwarting federal regulators’ fintech ambitions

WASHINGTON — Bank regulators know better than anyone that their way of doing business can be a slog compared to the fast pace of the private sector. That mismatch is made more apparent as federal regulators grapple with the breakneck speed of financial technology.

According to regulators, the roots of those bureaucratic challenges can be found in laws that were passed 30, 40, even 100 years ago. They say that if fintech firms and the public demand a nimbler regulatory process, it may be time to revisit laws that underpin basic executive-branch functions.

To protect financial consumers, “there's an increasing awareness, all over the world, that modernizing the regulatory infrastructure itself and bringing better tech into it is going to be key,” Jo Ann Barefoot, CEO of the Alliance for Innovative Regulation and a former senior official Office of the Comptroller of the Currency, said at a Capitol Hill event last week unveiling the report.

Her alliance published a recent report in collaboration with the Buckley LLP law firm on the legal impediments to the regulators upping their tech game to modernizing their administrative processes. The report compiled feedback from employees across Washington’s financial regulators on how their work is often impaired by intersecting legal and regulatory murk — and on what to do about.

Barefoot said getting stakeholders to focus on regulatory reform, rather than other levers of government, is the first challenge.

In consumer protection, “the first thing that comes to mind is not that we need to modernize the regulatory structures,” she said. “We know we need to enforce laws and regulations and so on.”

Here are some of the obstacles to modernization — including specific laws — highlighted in the report, and recommendations for how to overcome them.

Franklin Delano Roosevelt
Administrative Procedure Act
The Administrative Procedure Act, or APA, is the bedrock of modern regulatory rulemaking. Passed in 1946 in the wake of President Franklin D. Roosevelt’s New Deal, the law dictates the basic function and forms of all administrative branches of government, including independent federal agencies.

The intricacies of the APA have long been a keen interest for banks, particularly after the passage of Dodd-Frank after the financial crisis.

“Almost no other industry has the same reliance on laws and regulations as the financial services industry. It really exists on those laws,” Jerry Buckley, founding partner of Buckley LLP and one of the lawyers who compiled the AIR report, said at the event last week on Capitol Hill. “The chartering system, the issuance of currency, the lending process — that entire process is dependent upon law, and depends upon the confidence of the public that this industry is properly supervised and regulated.”

But many of the APA’s basic requirements — like the steps agencies are required to take to notify the public about rulemaking — have become outdated, the report said. The process for updating longtime rules is seen by regulators as particularly onerous.

The “procedural strictures could dissuade agencies from amending outdated rulemakings from years or even decades ago,” the report said, citing anonymous interviews with agency staff. “As a result, rules that are not conducive to regulatory innovation may be more likely to remain in effect because agencies would have to follow the APA’s lengthy and resource-intensive procedures in order to pursue a revision or rescission.”

Citing one former senior federal official, the report said the APA may be “the single biggest factor that is slowing governmental progress in the fintech area.”

The APA isn’t beyond fixing and has in fact been amended more than 15 times since it was first passed. But the report said it may be hard for Congress to make reforming the law a priority.

“To this end, agencies and interested industry participants may want to explain the potential benefits for both the industry and its consumers from specific changes to the APA,” the report said. “Given recent congressional gridlock on even routine, bipartisan matters, it may be more effective to streamline the APA through other methods, such as an executive order. An executive order need only be signed by the president to take effect.”

Yet the report also suggested that regulators may want to take matters into their own hands to improve the rulemaking process. This could include folding in a mandatory review process for new regulations to ensure the agencies move as quickly as possible to address shortcomings in a regulation. Congress and the regulators could alternatively “create a streamlined APA process for rulemakings focused on research and development.”

“Several states have created their own regulatory ‘sandboxes’ to promote innovation, and federal agencies could follow suit by creating limited sandboxes focused on areas that are national priorities for growth,” the report said.

One agency staffer recommended a mandatory review of rules after a certain number of years “to ensure that they remained true to their original intention and that they were not slowing the development of innovation in the economy.”

A “coherent cross-agency regulatory scheme to encourage such reviews” of older rules could catch outdated procedures before they begin to slow down bureaucracy, the report said.

Another staffer recommended mandatory sunset provisions for some rules — in other words, if regulators opted not to review and reevaluate a given regulation, it would simply cease to function after a sunset date.
Former Sen. Claire McCaskill, D-Mo.
Senator Claire McCaskill, a Democrat from Missouri, speaks to members of the media in the basement of the U.S. Capitol in Washington, D.C., U.S., on Thursday, Nov. 30, 2017. Senate Republicans are looking to approve their tax-overhaul legislation as soon as Thursday night -- but wrangling continues over whether to include a trigger for tax increases if economic growth doesnt meet revenue targets. Photographer: Andrew Harrer/Bloomberg
Paperwork Reduction Act
Another law that the report suggested impedes regulators’ ability to keep up with fintech is the Paperwork Reduction Act. The 1980 law signed by President Jimmy Carter developed a uniform process for federal agencies to collect information from the public.

The PRA requires agencies to follow certain procedures when they want to gather information from more than 10 individuals or organizations, which includes a formal collection request, 60-day notice in the Federal Register, public comments and a review from the Office of Management and Budget.

But in 2020, the law’s requirements are frequently out of step with the ease and convenience of digital communication, regulators say. According to the report, some regulators see an “inherent tension between attempts to obtain broad perspectives from the public and compliance with the strictures of the PRA.”

“This tension is particularly acute in a world where email, online surveys, social media, and websites provide an abundance of low-cost, low-impact ways for the public to make their views known,” the report said. “One agency staffer noted that something as simple as emailing a voluntary survey to a dozen industry groups for feedback — or even setting up an online form for comment — can trigger the PRA’s requirements and lead to a multi-agency process to ensure that the public is not unduly burdened by the agency’s information request.”

As with the APA, fixing the paperwork act will almost certainly require action from Congress. But unlike with the APA, there has recently been fairly strong interest in revisiting the law from some parts of Congress.

The report by the Alliance for Innovative Regulation points to several bills that have been proposed in the past three years to clarify key parts of the PRA and allow for more flexible rules for digital communication. A bill sponsored by then-Sen. Claire McCaskill, D-Mo., in 2017 passed the Senate but has not passed the House. A similar bill introduced last year — co-sponsored by Sen. Maggie Hassan, D-N.H., and Rep. Brian Fitzpatrick, R-Pa. — is still pending.
Freedom of Information Act
The Alliance for Innovative Regulation report pointed to the Freedom of Information Act, or FOIA, as an obstacle for innovation for regulators, particularly when working with commercial enterprises paranoid about having sensitive information revealed to the public and used against them, like proprietary algorithms.

“Regulators cite FOIA as a significant impediment to companies’ willingness to share confidential and proprietary information, as well as a significant deterrent to agencies engaging in new activities or community outreach that, if publicized, could send distorted or inaccurate messages to an industry or the public at large,” the report said.

FOIA has exemptions for many different kinds of information, including materials related to national security or executive privilege. There are also exemptions in the law for the closely held “trade secrets and commercial or financial information” from regulated companies.

But regulators say that companies are often skeptical that the FOIA exemptions will protect trade secrets.

“These FOIA exemptions are broad and are subject to interpretation, leading to varying decisions about their application,” the report said. “Current agency staff might grant an exemption not recognized by future agency staff. Companies also cannot predict with certainty how a court would treat the information in the event of a FOIA lawsuit.”

The FOIA law technically derives from an amendment to the Administrative Procedure Act, and any significant revision would need Congress’s support. But the AIR report says regulators’ hands aren’t completely tied.

“Individual agencies — or multiple regulatory agencies acting in concert — may want to consider coordinating amongst themselves to develop consistent, reasonable policies for interpreting FOIA exemptions,” the report said.
National Oceanic and Atmospheric Administration
The Logo for the National Oceanic and Atmospheric Administration, NOAA, is seen near the entrance to the National Hurricane Center facility of the National Weather Service at Florida International University, Thursday, September 8, 2011 in Miami, Florida, USA. Photographer: Mark Elias/Bloomberg
Budgetary limits on fintech product testing
Some regulators weighing in for the report pinpointed two separate policies regarding agency expenditures that they said affect their ability to test new fintech products.

The Antideficiency Act dates to the 19th century and prohibits federal agencies from spending money without consent from Congress. It also limits federal agencies and their personnel from accepting free gifts, with criminal penalties attached to violations.

The other policy is the Federal Acquisition Regulation, a framework that governs the procurement process in the federal government. FAR dictates the proper procedures for when a federal agency wants to acquire something from the private sector above a certain threshold.

According to the AIR report, those two policies often put regulators between a rock and a hard place when they try to study new products from fintech and regtech developers. The ADA limits agency staff from accepting a product for free, even if just to test it, and FAR complicates the process for buying the product.

One staffer said that just to receive any sort of packaged information — like an academic study or research data — for free might constitute a violation of the ADA, because “this information has value in the market, as it requires time, money, and manpower to conduct this research and compile it into a usable format,” according to the report.

But when regulators try to pay for products they want to test, they’re forced to go through the steps of FAR, which include a cost-benefit analysis, evaluating a variety of bids, studying for antitrust violations, and so on.

There’s also the concern that “the market may misinterpret — or a company may outwardly market — a contract signed purely for evaluation purposes as demonstrating some sort of tacit government acceptance of a product,” according to the report.

Some agencies have already taken steps to avoid FAR through “other transaction authorities,” or OTAs, which can buy products and services on behalf of a government organization and sidestep FAR’s requirement. However, the report notes that such an approach “can result in a lack of transparency and abuse.”

“Nevertheless, OTAs remain a viable way for certain agencies (and their partner agencies) to rapidly acquire, develop, and test new technologies and prototypes,” the report said.

The paper noted, for example, how Congress has directed the National Oceanic and Atmospheric Administration to enter multiyear contracts for research on oceans and fisheries, effectively carving out an exemption for the agency from FAR requirements.

The report said adoption of OTAs by financial regulators might prove to be the best way for the agencies to cope with both FAR and the ADA as long as meaningful legislative reform is a distant priority. For agencies that don’t have OTAs, partnering with other agencies that do could make it easier to acquire and test fintech products.

Reform could also target the ADA and come from regulators if agency general counsels focus on developing “clarity and guidance” around an exception for regulators when it comes to paying for information, expertise, or product testing.
Sandbox tools
Sand toys in a sandbox
Regulatory culture
Away from the strictures of regulatory law and trappings of bureaucracy, the AIR report considers what effect leadership and agency culture can have on promoting innovation in general.

“An agency culture that prioritizes and pursues regulatory innovation can jumpstart change,” the report said. “By contrast, a culture of risk aversion and ‘siloing’ employees can be a barrier to innovation, even in the presence of external motivators like Congress and industry heavyweights.”

In conversations with regulators, the report’s authors found that “culture represented one of the most critical and deeply rooted impediments to the development and implementation of regulatory innovation and support for technology.”

As an example of cultural change from within, several financial regulators — including the Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Consumer Financial Protection Bureau — have launched innovation offices. Some such offices have studied creating regulatory sandboxes, where fintechs experiment with new products on a limited group of consumers under the close watch of agency supervisors.

Several regulators pointed to the tendency among regulators to reward and prioritize institutional expertise among employees, rather than “lifelong learning that can morph into gaining experience in new topics.” The result is often a “silo” effect, where regulatory experts become inflexible and poorly equipped to handle fast-paced industry change.

Then there is the matter of incentives. Examiners are frequently lauded by their management for clamping down on violations and, in general, shutting down any activity that could run afoul of the law. But what’s less common, the report notes, is any incentive for examiners to encourage the development of products that actually work.

"One of the issues that was identified as we talked to people was, are we in a culture that finds problems with everything and doesn't try to find the solutions?" said Buckley, the Buckley LLP founding partner. “Is this a culture where people are afraid to take risks — to propose experimentation, because there might be a criticism of that?"

Citing one agency staffer, the report said that among financial regulators, “there is more cultural support for saying ‘no’ to a new product or service than saying ‘yes.’ ”

Addressing culture goes deeper than any law or agency guideline, the report says, but any significant change “will require the unequivocal support of agency leadership and may even benefit from interagency coordination to show a shared commitment to prioritizing innovation.”
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