Weekend Reading: Regulatory Reform — The Mandate to Innovate

By: Stephen J. Scott , Founder & CEO of Starling

In my weekend writings since last month’s US election, I've explored how new political realities appear to be shifting the financial sector regulatory agenda, globally, upending the priorities that have been emphasized for the past 15 years.?

In the wake of the Global Financial Crisis, regulators had rightly emphasized “safety and soundness,” and this agenda persisted throughout the Covid-era disruptions. But even as regulators seek to put the final pieces in place and to conclude the “Basel III Accords,” priorities have shifted — sharply.

As I discussed?last weekend, interest in “safety and soundness” has been supplanted by an emphasis on “growth and competitiveness.”?

Broad economic malaise drove decisions at the polls and, across the world’s democracies, newly elected leaders have been installed. With electorates issuing a mandate for change, these leaders are asserting new policy narratives and establishing a new socio-economic “cultural configuration.” Future policy priorities favor nationalistic primacy, in global economic affairs, and domestic economic policies that promise a redistribution of wealth, and the re-enfranchisement of disillusioned masses.

As a policy goal, financial system “safety and stability” is, of course, essential. As a political narrative, however, it is no longer palatable.

And because voters have lost faith in the post-Crisis agenda, and its associated narrative, so have they lost trust in those who espouse it and the status quo it implies. Yesterday’s Crisis has been eclipsed by today’s malaise, and the public has entrusted those who assert a pro-growth agenda with the power to deliver on that promise. Politicians and regulators who would continue emphasize “safety and soundness” over “growth and competitiveness” will likely find themselves increasingly marginalized.

This confronts financial sector regulators with a confounding question: How are they to promote growth and competitiveness — as politicians and the public demand — while, at the same time, maintaining obligatory levels of safety and soundness in a world grown far more risky and uncertain??

I will attempt to provide a more fulsome answer to this question in my Weekend Readings over the coming weeks. Today, I’d like to discuss how regulators can overcome perhaps the primary barrier to squaring this circle: an aversion to culture change that favors innovation.

Overcoming Skepticism & Suspicion

In a speech delivered at the Salzburg Global Seminar last June, Fed Governor Miki Bowman argued that regulators must be more supportive of innovation in the financial system. Regulators tend to view new activities with skepticism and suspicion, rather than openness and acceptance, Bowman said.

“A reflexive ‘no’ from regulators can encourage activity to migrate out of the banking system,” she argued. Indeed, the dramatic expansion of “Non-Bank Financial Institutions,” and the migration of capital outside the regulated space, is a growing concern to regulators worldwide.

“We tend to think that the ‘stakes’ are confined to a particular technology or innovation, but this is a misleading approach,” Bowman continued. “Instead, we should adopt a broader approach that considers financial system stability.” And, while a healthy dose of skepticism is understandable and perhaps necessary, “the challenge is one of balance,” Bowman said.

Legislators in the US have demanded that regulators strive towards such a balance. In April this year, the US House Financial Services Committee, led by Rep. Patrick McHenry,?reported 13 pieces of legislation to the House of Representatives for consideration. Among the proposed reforms were bills that would advance the oversight of regulators, demand that they promote innovation in the financial sector, and increase accountability for those who fail to do so.

Included in that legislative agenda was an updated draft of the "Financial Services Innovation Act of 2024," which would establish Financial Services Innovation Offices (FSIOs) within each of the federal financial regulators, and establish a federal sandbox for financial innovation. The FSIOs would be responsible for assessing how regulations impact innovation and for evaluating and approving alternative options for firms that wish to offer innovative products and services.

Notably, the package also featured a bill focused on how regulators manage innovation within their own buildings. The "Fostering the Use of Technology to Uphold Regulatory Effectiveness in Supervision (FUTURES) Act” would require federal financial regulators to assess the challenges and risks resulting from their outdated supervisory technologies. The regulators would report their findings jointly to Congress every five years.

Such calls have been echoed abroad. Last month, the UK Science Secretary announced the launch of a Regulatory Innovation Office. The mandate is clear: "By speeding up approvals, providing regulatory certainty and reducing unnecessary delays, we're curbing the burden of red tape so businesses and our public services can innovate and grow."

In a recent “remit letter” to UK Financial Conduct Authority (FCA) CEO Nikhil Rathi, UK Chancellor of the Exchequer Rachel Reeves laid out ‘recommendations” for how the regulator could fulfill its secondary objective for growth and competitiveness. Reeves urged the FCA to promote growth by facilitating competition and innovation, including by “encouraging newer and more innovative firms to startup, scale-up and remain in the UK.”

“A thriving, internationally competitive financial services sector, regulated by independent expert regulators with a global reputation for promoting stability and facilitating innovation, is essential for creating the conditions for businesses and consumers to invest with confidence,” Reeves explained. A similar remit letter was forwarded to the Bank of England’s Prudential Regulation Committee. “I ask you to explore opportunities to facilitate innovation by the financial services sector,” it reads.

From Policy to Practice

These calls have not fallen on deaf ears. Last week, FCA COO Emily Shepperd explained that the regulator’s new 5-year strategy would focus on four key themes: economic growth and innovation, financial crime, consumer resilience, and becoming more efficient and effective. “All of which are supported by our approaches to technology, data and how we develop our workforce to match the needs of the future,” Shepperd said.

Over the Summer, the UK Prudential Regulation Authority hosted a pilot roundtable on innovation with banks, insurers, and other stakeholders to discuss how its regulation can facilitate safe innovation. Through the roundtable, the PRA aimed to explore the interaction between prudential regulation and innovation. Discussants also considered how the PRA can collaborate with the industry to facilitate innovation that will benefit the wider UK economy.

The European Central Bank (ECB) has also emerged as a global leader in regulatory and supervisory innovation. In the Preamble to Starling’s 2024 Compendium, ECB Supervisory Board Member Elizabeth McCaul recounted the central bank’s experience in enacting its “Digitalisation Blueprint” since it was launched in 2020. “We have deployed several cutting-edge suptech tools alongside a powerful set of core IT systems that are having a tangible impact on our supervisory work every single day,” McCaul wrote.?

In a September speech, McCaul further explained why emerging risks in the financial sector require that supervisors invest in new capabilities. “Disruptive technologies like AI are playing a growing role in banks' day-to-day activities, and access to technology is becoming widespread,” McCaul said. “At the same time, banks are becoming ever more dependent on data, IT platforms and third-party providers.”

“To keep the banking sector safe and sound in the face of these trends,” McCaul added, “we need to equip the supervisors of the future with the right tools and skills.” In this direction, she outlined the ECB’s 2024-2028 tech strategy, built around necessary investment in both people and technology.

In an In Focus interview for the 2024 Compendium, Adrienne A. Harris , Superintendent of the New York State Department of Financial Services (DFS), explained how the state banking supervisor is using technology to improve its internal effectiveness and promote financial sector competitiveness. “In revising the Department’s mission statement, it was important to me that we specifically articulated DFS’s commitment to driving economic growth through responsible innovation,” Harris said.

The DFS has also waded into the conversation surrounding the use of AI in financial services, launching an AI Steering Committee to explore new approaches to regulating and utilizing AI. “I think good public policy can be both pro-innovation and pro-consumer,” Harris argued.

“Looking at the financial industry-specific implications of AI, it is helpful to consider not only how it may change the financial system, but also how regulatory frameworks should respond to this emerging technology,” Fed Governor Bowman recently remarked.

Regulators must consider whether existing frameworks are sufficient to address these new technologies, Bowman urged. If not, “how can regulators best balance the risks AI may pose to bank safety and soundness and financial stability with the need to allow for continued innovation?” she questioned.

Failure through Avoidance

In a 2023 paper, the European Banking Institute argues that a “right to good administration” makes the adoption of improved regulatory (“RegTech”) and supervisory (“SupTech”) tools obligatory. “AI can enhance the cognitive ability of human supervisors and support them in achieving more accurate decision-making outcomes,” the EBI paper argues.?

Moreover, “AI-enhanced banking supervision could ensure that decisions are grounded in a comprehensive assessment of all pertinent facts, reducing reliance on subjective interpretations and leading to more transparent and objective decision-making processes.” Few would question whether such improved capabilities are desirable.

But if regulators are to become champions of innovation, they must first overcome cultural barriers. “Regulatory experimentation can help promote adaptive learning and innovative and better-informed regulatory policies and practices,” the OECD offered in an April 2024 paper, “Regulatory Experimentation: Moving ahead on the Agile Regulatory Governance Agenda.” But if regulatory experimentation is to be embraced, the OECD warned, “regulatory culture needs to evolve regarding several key aspects.”

Most particularly, a readiness to embrace regulatory experimentation “requires an organisational culture acknowledging that experiments revealing a policy to be flawed or ineffective is essentially a success, insofar as it helps avoid potentially greater political or economic costs,” the OECD urges us to recognize.

In short, experimentation must allow for failure. Indeed, the OECD recommends that regulators embrace “failure as an ally.” 美国哈佛商学院 Professor (and Starling advisor) Amy Edmondson argues for precisely this in her most recent book, Right Kind of Wrong. Successful innovation requires creating environments where it's safe to fail, Edmondson writes.

Alas, such a cultural predisposition is not common among most regulatory agencies. It’s only one anecdote, of course, but I’m reminded of a discussion I had not long ago with a senior US banking regulator. “Stepping into this building is like stepping back into 1998,” he said. The organization struggled to innovate, and so was limited to the use of legacy technologies. “Innovation means risking failure,” he explained, “and no one wants to be associated with failure.” As a consequence, few were ready to risk innovative undertakings.

New technologies in the RegTech and SupTech space allow for dramatically improved “Dynamism in Financial Market Regulation.” But adoption of such tools necessarily involves initial trials, and a readiness to conduct such trials hinges on “Permission to Fail.”?

Regulators need not seek to emulate the culture of tech startups, of course. But the success of the “fail fast” strategy that characterizes Silicon Valley culture should be seen as instructive: success is achieved through experimentation, and failure is an unavoidable part of the process.

When cultural norms instead operate such that individuals are reluctant to risk innovation, for fear of personal failure, as a group, they unwittingly make failure their likely shared outcome. When regulators fail to innovate, it undermines their?raison d'être, whether that is taken to be in service of “safety and soundness” or as a critical support for “growth and competitiveness.”?

A reluctance?to risk failure is no longer acceptable; banking sector regulators have a mandate to innovate.

This piece first appeared in Starling Insights' newsletter on December 1, 2024. If you are interested in receiving our thrice-weekly newsletter, among many other benefits, please consider signing up as a Member of Starling Insights.