WASHINGTON — The Dodd-Frank Act’s Volcker Rule was meant to protect the financial system by prohibiting banks from engaging in certain risky activities. But it may also be stopping community banks from being able to reap significant benefits from the fintech revolution.

“One of the unintended consequences of the Volcker Rule is that we can't invest in funds that make investments in fintechs,” said Tom Fraser, the president and CEO of the $1.6 billion-asset First Federal Lakewood in Ohio.

The Volcker Rule tackles two areas policymakers deemed risky: banning proprietary trading and limiting bank investment in hedge and equity funds. Under the rule finalized by regulators implementing the ban, that includes investments in privately owned funds that fintech ventures generally belong to.

Tom Fraser, the president and CEO of First Federal Lakewood
Tom Fraser, the president and CEO of First Federal Lakewood

As a result, banks that want to have a stake in fintech can either develop their own technologies in-house or invest in individual companies. That is not a problem for larger institutions, which have far more resources and more flexibility to take risks.

Smaller banks, however, have far few options.

“They can, in an undisciplined fashion, throw money on the wall and see if something sticks,” said Joe Maxwell, the managing partner of a fintech fund called Cultivation Capital, whose limited partners do not include any financial institutions. “You can have a very risky investment strategy, but you're not allowed to go to the experts.”

Even if small banks choose to invest in individual companies, they might be confined to a certain ownership level in the firm, depending on what kind of charter they have.

The limits underscore the uneven impact of the Volcker Rule on small and large banks. While large institutions have been able to work within the rule’s permissible activities, including an exception for “market making,” small banks have generally tried to steer clear of anything that might conflict with the rule for fear of running afoul of examiners.

“Community banks generally do not undertake a level of Volcker Rule investments and deals,” said Gerard V. Comizio, a partner at Fried Frank. “When their investments are more modest or limited in this area, is it appropriate for them to have a one-size-fits-all Volcker compliance program?”

Regulators are aiming to modify the Volcker Rule. The Treasury Department in June recommended “significant changes” to it, including that banks with assets of $10 billion or less should be exempted.

Since then, the federal financial agencies have made other moves to revisit the rule, including a recent request for comment by the Office of the Comptroller of the Currency about how the Volcker Rule could be modified.

Some argue a blanket exemption is needed soon before small banks have completely missed out on the fintech boom.

“An investment in a fintech company or fintech fund goes hand in glove with the bank's fintech strategy,” Fraser said. “It helps banks become aware of solutions that are emerging. It gives insight into what business models in fintech are working. And it allows the bank to get insight into how to deploy the technology inside its company.”

In addition, fintech experts say, the Volcker Rule narrows small banks’ exposure to new technologies as they are being developed.

If community banks were to become investors in his fund, “they could have early access to some of the greatest technology that's out there,” Maxwell said. “It not only gives them feedback on the market, it gives them early access to technology, which equips them to better compete.”

The other alternative, developing fintech solutions in-house, is too expensive for most small firms.

“Developing cutting-edge new technology inside of a bank, it's hard to create the right environment to make that happen,” said Dan O’Malley, the CEO of Numerated Technologies, a lending software company that was spun off from Boston mutual Eastern Bank earlier this year. “You're trying to blend two cultures.”

That’s not to say it never happens. The $10.3 billion-asset Eastern Bank, which provided the original innovation lab that fostered Numerated Technologies, retains an ownership stake in the company.

But “we don't have anybody on the board [coming] from a community bank,” said O’Malley, though he added that “we engage pretty deeply with Eastern and with First Federal,” another client of the fintech company.

Those arrangements are few and far between, however. Community bankers warn that they could be left behind if they are not allowed to broaden their investments in the emerging fintech industry.

“A lot of current banking law was put in place and designed at a time prior to fintech,” Fraser said. “The law is trailing innovation right now.”

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Lalita Clozel

Lalita Clozel covers fintech regulation, anti-money-laundering, cybersecurity and the Federal Deposit Insurance Corp. in American Banker's Washington bureau.