Only three new banks have opened in the United States since 2010. Before the financial crisis, over 100 banks set up shop each year, on average, according to data from the Federal Deposit Insurance Corporation, the agency that approves new banks.
Why? Why is the USA failing at banking innovation?
In the UK, over 30 new banks are launching, many of them digital. In Germany, there are a number of innovative new banks. Across Europe, Africa and Asia, we see digital innovations from Alibaba to M-PESA to mBank. What is there to discuss in America? Urmmm ….
I was asked the question the other day as to why there is no new digital bank start-up in the USA and was stuck for an answer. I wanted to say Moven or Simple, but Moven partners with CBW and Simple is part of BBVA. Radius and a few other community banks are innovating in US markets, but where is the flagship digital start-up?
GS Bank? Not really, as it’s been launched by Goldman Sachs. Bluebird? Not really. It’s a joint venture between WalMart and American Express based upon a card. Tangerine? Not really. It’s Canadian and owned by ScotiaBank. To be honest, it’s bemusing. If I look at a conference like American Banker’s Digital Banking 2016, there is not a single new bank on the list, except maybe Fidor. But Fidor is launching in America with a bank behind them, and so becomes another Simple or Moven.
What’s the problem?
Duh … regulations. Dodd-Frank was like a boa constrictor on the US banking industry and has not only made big banks more stable, but created zero interest in launching a new bank in the US markets. Bank-like operations yes, which is why we see the FinTech world exploding in Silicon Valley and New York, but a bank? No way.
In fact, whilst America dominates investment banking, which some would claim is higher systemic risk, their regulations for retail banking are quite draconian. This is best summed up in a column in TechCrunch that I spotted the other day and decided to replicate here:
Legislation allowing ordinary American investors to invest in the shares of startups and small businesses was first introduced in the U.S. Congress in 2011. Despite bipartisan support and the approval of President Obama, it is only now becoming a reality.
As an Anglo-American — born and raised in the United States, living and working in the United Kingdom and a dual citizen — I have a great deal of loyalty to both sides of the Atlantic. But as I look back on the last few years, and ahead to the commencement of American equity crowdfunding, I am amazed by how two countries with such similar commitments to enterprise, free markets and innovation have taken such different paths.
The U.K. has embraced not only equity crowdfunding, but innovative finance generally, and now has a thriving industry that is benefitting small businesses, investors and the economy alike.
The United States, on the other hand, has gotten so bogged down in the strictures of an outdated regulatory system that it is lagging far behind — and is likely to continue to do so.
A tale of two regulatory systems
Much of the difference between the British and American approaches to innovative finance can be attributed to the history of their respective regulatory systems.
When the stock market crashed in 1929, a lot of ordinary Americans lost a lot of money. The 1920s had seen swathes of retail investors enter the U.S. capital markets, often with very little information about what they were investing in. Sometimes investments were even sold door-to-door, and rarely were the risks of investing made clear.
So when share prices fell, not only were ordinary investors caught by surprise, but because many had invested far more money than they could afford to, they often found themselves losing their homes and their livelihoods.
The U.S. government responded by enacting the world’s first truly comprehensive system of financial regulation, designed in large part to protect ordinary people from investing beyond their understanding and means. It is a system designed around the way in which investments were bought and sold — and the relative lack of communication and investor sophistication — in the 1920s and 1930s.
And because lawmakers at the time did not contemplate that those things would change, they built the system as “rules-based,” meaning that investment transactions are governed by detailed sets of rules covering nearly every aspect of their conduct. With limited modifications, this rules-based system is the one that remains in force today.
A system of financial regulation that requires a new statute every time an innovation emerges will never be able to keep up.
The 1929 market crash affected Britain too, but in a different way. In the U.K., as in most of Europe, investing in those days was still the preserve of institutions and a small group of well-connected, wealthy individuals. Ordinary people had not had much money in the stock market, so they didn’t lose much, and there was no great impetus to change the laws to protect them. The British financial sector would remain relatively self-governing, with limited legislative intervention, for decades.
It was only in the 1990s, when a sufficiently large base of retail investors emerged in the U.K., that the government felt a comprehensive system of financial regulation was needed. The result was the Financial Services and Markets Act 2000 (FSMA), which remains the governing piece of legislation today.
By the time FSMA was enacted, the Internet was already in mass use. Perhaps more importantly, it was clear that the ways in which investments are transacted, and business in general is conducted, were evolving, and that technology was likely to create many further changes in the years to come.
So FSMA was designed to have the flexibility to adapt to changes in the market — a sort-of future-proofing. Instead of the American “rules-based” approach, FSMA adopted a significantly more “principles-based” approach: Financial services firms were expected to abide by key sets of principles around investor protection (among other things), but they were given significant discretion in exactly how they did so.
The evolution of innovative finance on either side of the Atlantic can only be understood through the lens of these two regulatory systems.
A principles-based approach was always destined to be more accommodating of innovation: Whole new areas of finance could emerge under existing principles with limited or no change to the actual laws. This is not to say it is a free-for-all: The U.K. regulator (the Financial Conduct Authority, or FCA) would need to sign off on most of these new models as part of its authorization of the firms conducting it. But that is a significantly simpler and more flexible process than trying to get a whole new law passed — which is exactly what is required for innovation to happen in the United States.
The history of equity crowdfunding provides a great example of how this has worked in practice.
When my co-founder and I decided we wanted to set up a platform that allowed ordinary people to invest in small and early-stage businesses, we started by looking at FSMA and related regulation. The main issue was around whether we would even be able to offer these kinds of investments — which are very high-risk, although not particularly complicated — to ordinary investors.
What we found is that the rules required any firm offering these investments to assess whether the investors understood and accepted the risks involved. It would be up to the firm (us) to make that assessment, and, while the regulator would review our processes and authorize us only if they were happy with our approach, there was no prescribed form or structure for how we did it.
Innovation will always move faster than legislative processes.
So we did what innovators do: We went off and invented a new assessment method. In the past, firms tended just to ask investors how much money they had or how many investments they had made before. We didn’t think this was the right approach for equity crowdfunding: With a £10 minimum investment, we saw no reason why someone’s net worth was relevant; and because these were not particularly complicated investments (even a basic mortgage or insurance policy is more complex than shares of a company), prior investing experience also did not seem very relevant to us.
But what we did care about, regardless of whether or not someone was rich or had invested loads before, was whether they actually understood the risks of this sort of investment. So we created a quiz: Investors would have to pass an online, multiple-choice quiz showing us that they understood the key risks and considerations of investing in this asset class.
We presented the quiz to the FCA as part of our authorization process; they indicated they thought the approach made sense, we got our approval and the rest is history.
Now consider the American approach. U.S. law has no principle about making sure investors understand the risks. Instead, there was a bright-line rule that says that unless an investor is wealthy (exceeding specified income and net worth tests), then with very limited exceptions, he or she cannot be offered shares in private companies. There is no exercise of judgment, no flexibility for the regulator (the Securities and Exchange Commission, or SEC) to make a case-by-case call.
As a result, equity crowdfunding would not be possible without three things happening: Congress would need to pass a bill; the president would need to sign it; and the SEC would need to implement it.
Remarkably, the first two of these happened relatively quickly. A bipartisan groundswell of support for equity crowdfunding emerged and, in roughly seven months in 2011-2012, a piece of legislation made it through both houses of Congress and onto the president’s desk for signature.
But two-thirds of the way there isn’t enough, and when it got to the regulator for implementation, everything stalled. The SEC was supposed to finalize the process by December 31, 2012. In the end, they missed their target by nearly three years, only adopting the necessary implementation rules on October 30, 2015 (and they don’t take effect until May 16, 2016).
But the story doesn’t end there. The original legislation, passed in 2012, had a lot of flaws in it — flaws that have become significantly more evident as European platforms have grown and people have come to better understand how equity crowdfunding works in practice.
The SEC was cognizant of those flaws (and some think that that’s why they delayed implementation for so long), but they were powerless to change them. So now a new piece of legislation will be needed to fix them.
In late March 2016, Congressman Patrick McHenry, who authorized the original crowdfunding bill in 2011, introduced a new piece of legislation called, very simply, the Fix Crowdfunding Act. And so begins the process all over again. (I happen to support the Fix Crowdfunding Act very strongly, and I think equity crowdfunding will only really take off in the U.S. if and when it has been adopted. But that’s for another post.)
The “Innovation Initiative”
The story of equity crowdfunding is just one example of how the different regulatory systems on either side of the pond have fostered very different cultures of innovation in finance. Similar types of issues can be seen in a range of financial services and fintech sectors.
So is all hope lost for financial innovation in the United States? Maybe not. Congressman McHenry, together with House Majority Leader Kevin McCarthy, recently launched what they are calling the “Innovation Initiative.” The initiative will include a series of proposals designed to make it easier for American entrepreneurs to create fintech ventures; in particular, those that serve the needs of small businesses and ordinary individuals.
It is early days, but it is an encouraging sign that U.S. leaders have woken up to the increasing deficit the United States faces in this space relative to Britain. And it is fitting that Congressman McHenry announced the Innovation Initiative at an event in Washington that was dedicated to discussing Britain’s lead over America in the fintech space.
But as much as I support this Innovation Initiative, it still does not fix a fundamental problem: Innovation will always move faster than legislative processes, and a system of financial regulation that requires a new statute every time an innovation emerges will never be able to keep up.
Until — and unless — the United States builds a level of future-proofing into its financial regulation — perhaps through a principles-based regime like that in the U.K., or perhaps some other way —Britain’s lead over the United States in innovative finance will continue to grow.
Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, TheFinanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal's Financial News. To learn more click here...