Alternative credit options can mean the difference between financial well-being and financial hardship for many borrowers. Fintech advancements such as buy-now-pay-later, plus the combination of credit models driven by artificial intelligence and machine learning, may pave the way for a fairer and more inclusive future of credit.
But lessons from the financial crisis ring clear: When only one part of the market is required to comply with regulations, the other will compete by offering disadvantageous and risky products.
Regulators are now faced with how to advance a regulatory framework that encourages innovation while protecting consumers.
Balance Access With Growth
Buy now/pay later options spurred marked industry growth, as well as artificial intelligence and machine learning advances during the pandemic, with implications and improved assistance for underserved communities.
More broadly, bank partnerships with fintech companies have increased. Everyone wants to bank digitally and quickly, despite the data security risks.
Algorithmic underwriting and process automation have recalibrated how credit risk is gauged by reducing the role of humans in such decisions.
A 2012 study shows that more than 50% of loans to Black-owned businesses under the pandemic’s Paycheck Protection Program came from fintech lenders—doubling such lending executed from manual-process small banks.
The improvement is easy to understand. Automation can empower smaller lenders, increase financial inclusion, and reduce reliance on payday lenders.
AI tools can tap into a cache of data not used in traditional credit reports to create more accurate risk assessments essential to obtaining credit and other financial services.
By expanding credit availability, AI can enable historically underserved communities to gain credit and build wealth.
Other benefits of incorporating AI/ML tools into financial services include lowering overhead costs where lenders can afford to make smaller loans, extending service to communities with fewer bank branches, and overall, keeps established financial players honest.
But machinated finance is no panacea. The fintech industry is facing new challenges and regulatory scrutiny to combat the increasing risk of abuse and fraud.
Regulatory Considerations
This dynamic belies a common misconception that fintech is unregulated. Sharp questions must be asked as the likelihood of further regulatory action in 2023 grows clearer:
- How can rigorous Consumer Reinvestment Act and fair lending standards be applied?
- How can protections against data-driven bias be strengthened?
- How can all parties be better inoculated against unwarranted data and privacy disclosures?
- How can the efficacy of such protections be signaled to wary borrowers?
Bridging the small lender gap helps safeguard consumers and enable transformation and innovation. Credit scores under the status quo are typically calculated using 25 to 30 data points, whereas ML/AI can integrate perhaps 300, countering the privileging of legacy wealth metrics over a potential borrower’s emergent performance.
Other advances can be realized through revisions to electronic fund transfer regulations to banks that pass on unauthorized charges to consumers.
What to Expect
The CRA encourages financial institutions to address credit needs in communities where they operate, including low- and moderate-income neighborhoods.
Applying CRA requirements to fintechs could help curb abusive lending while motivating them to offer more loans, investments, and services in LMI communities.
When applying for licenses or charters, fintechs must expect rigorous CRA and financial inclusion plans with measurable performance goals. Periodic CRA exams and fair lending reviews should be rigorous to provide incentives for fintechs to meet and/or exceed their performance goals.
The creation of lending assessment areas could ensure fintechs are making considerable efforts to serve LMI borrowers and communities. Given the novelty of fintech underwriting and marketing, fair lending reviews must be comprehensive and certify that fintechs aren’t blatantly or inadvertently discriminating in their lending.
Last October, the Consumer Financial Protection Bureau outlined options to strengthen consumers’ access to, and control over, their financial data. This includes the freedom to safely walk away from companies offering bad products and poor service and move toward lenders with alternate or innovative products and services.
A recent Treasury report encourages collaboration and partnerships between traditional banks and fintech, provided it is done safely and with guidelines. This can be achieved using existing regulatory authorities but guided by evolved principles.
Bank-fintech partnerships that are delivering services by an insured depository institution should operate within IDI regs.
Regulators should balance the needs for innovative underwriting with increased credit visibility, reduced bias, and careful expansion to extend credit to the underserved.
Consumers should be able to switch lenders to improve and/or escape poor services.
Regulators must address threats from legacy lenders that could monopolize personal data and block competitors’ access to such consumers.
The CFPB is considering several rulemakings worth watching, including looking at requiring firms to make consumer’s financial information available to them or a third party at the consumer’s direction, allowing consumers to transfer their account histories so they don’t have to start from scratch with a new provider, and limiting any party’s ability to resell authorized data.
The CFPB will receive written feedback until Jan. 25.
A regulatory balancing act is integral. Improving the financial inclusion and health of underserved communities would benefit all, but if that comes at the expense of industry innovation, the progress will be undercut.
If executed thoughtfully, fintechs could help close the racial wealth gap by providing underserved populations and communities with increased virtual access to banking.
Continued encouragement of industry transformation and dry-eyed assessments of results on the ground will help ensure fairer lending.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Robin Nunn is a partner and co-leader of the Banking Industry Team at Morgan, Lewis & Bockius. She advises domestic and international banks, investment advisers, broker-dealers, mortgage servicers, and emerging financial services providers.
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