A global seminar, focusing on financial technology innovations and the developing financial regulatory framework was held at Saltsburg, Austria wherein Ms. Michelle W. Bowman, of the U S Federal Reserve was invited to give her lecture on the above subject. Initiating a heated discussion of innovations in the supervisory and regulatory functions of the august body, she dealt with the fundamental aspects of the abstract innovations and actual supervisory and regulatory innovations following the progressive reforms followed by the banking institutions. His speech followed the following range of order of discussion.
1. Introduction to innovations
2. Benefits of innovations
3. Understanding innovations:
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- Understanding technology and the landscape
- Understanding the use case
- Understanding the consequences
4. Openness to innovations
5. Innovation as a Priority in the Regulatory and Supervisory Agenda
6. Conclusion
7. My observations summarising the innovations at supervisory and regulatory levels.
Our discussion need not necessarily follow the order of the discussion followed by the governor of the federal reserve since we may use a simple way of understanding this salient topic.
The discussion mainly deals with specifically innovation within the “regulatory perimeter” in which regulated institutions—banks, holding companies, and their affiliates—operate.
The fundamental question is whether regulation can easily support and promote innovation on all levels, internationally.
Regulators love innovation so long as it remains in the realm of abstract thinking. Innovation in banking has helped to develop a faster and more efficient banking and payments system, reduction in cost of the transactions and the expansion of the banking products and service among the largest numbers of consumers from the richest city to the remotest villages in Himalayas.
While the speaker quoted ATMs as the model of excellence, we are aware of the most prolific financial products and services available to us from both banking and non-banking players of various sizes.
The speaker emphasized three principles, namely, developing an understanding of the technology, having an open approach to innovation, and making innovation a priority in the development of regulatory frameworks.
Proper coordination among the innovators who introduce new products in the banking system and the regulators who want to safeguard the safety and security of these innovations among the ultimate users, the consumers.
What will lay the future landscape for innovation in regulation and supervisory functions?
Understanding the technology and the future landscape
Hailing from a high level of technological component introduced by different parties of the most excellent levels of excellence, the regulators need to understand the use of the technology. An example was introduced by the speaker to explain the nuances.
Introduction of the distributed ledger technology (DLT) including blockchain, which forms the core of the most innovations being introduced in the financial system.
What is DLT, the most debated technology in the annals of banking reforms?
Let me incorporate the exact views of the distinguished speaker at this moment.
“DLT provides a way for parties to record transfers of digital assets without the need for any centralized authority and relies on multiple participants who coordinate to maintain a synchronized version of the “ledger.” DLT combines a number of different design elements—like distributed data storage, cryptography, and consensus mechanisms—that support the transfer process, information visibility, and transaction recordkeeping. These design elements can be combined in a number of different ways, and different parties may play a role in its ultimate use.”
An amazing example. In a layman’s understanding a ledger without maintenance by one body, God knows its existence and the resultant confusion in our minds.
But the simple explanation that DLT combines a number of different design elements—like distributed data storage, cryptography, and consensus mechanisms—that support the transfer process, information visibility, and transaction recordkeeping and that different parties would play their roles for designing various elements that would conclude the transactions.
Yes, the regulators are expected to have professional competence to understand these complex transactional details and base their faith with the players in the game by using their role as regulators with the required legal backing.
Though most of the banks/other parties involved in the details of the highly developed technologies may like them to be called as disruptors, the regulators are the final authority to develop a suitable regulatory framework to protect the common man.
However, the use of new technologies like DLT, AI or any other one will need validation for their usage, their security and cost benefit analysis to serve a common customer.
Now having understood the new products behind the innovations, the consequences of specific innovation will invite the close attention of the regulators.
In the analytical thinking process of the august speaker, but within the regulatory perimeter of the banking system, we need to be cautious about the risks of new technology, not only to the safety and soundness of individual financial institutions, but also to financial stability concerns, all the more in the age of rapid technological developments on the banking products/processes/service to reduce the cost for the banking customer.
One can fondly recollect crores of rupees of even educated customers of banking/non-banking channels who get entangled with unwanted information from unknown financial crooks who use the latest technology to mislead and cheat. Simple obtaining of credit card details, bank accounts or even mutual fund accounts has wrecked the financial health of customers.
Rightly pointed out as increasing interest in tokenization, tokenized platforms could duplicate existing bank deposits and payment rails, but the curious question whether will the products and platforms emerged out of tokenization provide the same legal protections to customers who have taken it granted that their financial institutions or those who manage it with the security provided by the current regulators?
Yes, in the sanguine views of the speaker, enormous security and supervision will be needed to enable the new technology to be effective in evolving a bright future for its customers.
Openness to innovation
It is not questionable to avoid innovation by regulator normally in the olden days but with the ever-evolving technological tools will produce new services like banking operations by cell phones, looking into banking operations at the click of the computer or in many cases, even banks do visit the senior clients, high net worth clients or businesses who need high speed transactions unheard by normal customers. Yes, demanding times expect the best services.
The speaker in a validatory tone enquired whether intended or unintended outcomes of new technology outweigh the risks involved?
Will the regulators at state/federal levels or at regulatory agencies like the federal reserve or even the top managements of the banks or other bodies take the responsibility?
For clarity, will the openness of the innovation risk even the fundamental existence of the customers accounts for no fault of their own?
Instead of prejudging the innovation in newly evolved financial world as with only suspicion or prejudge its failure, both the regulators and banks would have to collaborate and learn the processes for a bright financial future for the customers at a reduced cost.
The speaker was of the firm opinion that hostility to innovation within the banking system will enable the activities outside the banking system causing less transparency, no regulation, or transparent risks to the whole financial system.
Let us understand the case quoted by the learned speaker popularly related to nonbank mortgage servicing by the U S Financial Stability Oversight Counsil which released a report on nonbank mortgage servicing, documenting the growth of nonbank mortgage servicing since 2008, and the potential vulnerabilities that these servicers pose, vulnerabilities that could manifest as shocks to the U.S. financial system. Though surprising by its actual happening, nonbank mortgage companies had servicing rights on 4 percent of U.S. mortgage balances in 2008; by 2022, this percentage had risen to 54 percent since post 2008 regulatory reforms made it costly for banks to carry out these activities.
Yes, it is true but the shift did not insulate U.S. Financial system from the risks of these activities.
Innovation as a Priority in the Regulatory and Supervisory Agenda
The following views were expressed by the learned speaker on the invocation of innovation as a priority in the normal regulatory and supervisory roles.
1. Regulators to lift their conservative attitude of reactive for any innovation to be a proactive within the parameters of open transparency, more communication, and engage themselves at the development process itself.
2. He explained in detail how the cross-border payments had their own friction points with many regulating agencies from different countries, to be utterly careful to deal with criminal elements though technical upgrades in usage of processes have consistently been taken care of. Active involvement of innovation with the willingness of regulators can expedite the process of payment of transactions.
3. The speaker involved the usage of “sandboxes” which would be actively involved by the regulators, the banks, and other technical brains to experiment with new ideas in innovation with the clear objective of optimum results of better financial products with reduced cost for banking customers while allowing all involved to experiment with newer ideas, processes and risky ventures with adequate protection. Yes, innovation in the financial system at the best.
Conclusion
It is interesting to know the views of one of the most learned governors of the American Federal Reserve advocating active involvement of the regulators, the banks, governments concerned and of course, the most important part of this circle, the banking customers who would help in ushering in new technologies, risky ventures, or active feedback for new ventures to educate the innovators.
A frequently asked question is that what would happen if the regulating authorities, the banks or customers confine themselves to cocoon themselves from any innovation in banking reforms and hence zero initiative for regulators to introduce innovations.
The spurt of non-banking activities by anti-scrupulous persons, institutions, territories or anti-social elements in siphoning off the legal funds into the hand’s illegal ones from good tax paying citizens.
Introduction of BEPS or cooperation among nearly 160 plus nations portend the involvement of innovations in the regulatory or supervisory role.
Please do read my earlier article “ https://taxguru.in/rbi/innovations-banking-rbis-vision-artificial-intelligence-ai-generative-ai.html”
Which speaks the extra ordinary steps taken by RBI to introduce innovations in banking and hence upgrading its role as a supervisory and regulatory role. India is ahead of the times in its role in financial world.
Reference
https://www.federalreserve.gov/newsevents/speech/bowman20240617a.htm
For intellectual pleasure and disperse knowledge the above article was written. For expert treatment, please do consult experts.
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