RegFi Episode 32: Hurdles to Innovation at Financial Regulatory Agencies
21 min listen
RegFi co-hosts Jerry Buckley and Sasha Leonhardt in 2020 collaborated with the Alliance for Innovation and Regulation (AIR) to author a report titled “Financial Regulators’ Dilemma: Administrative and Regulatory Hurdles to Innovation.” The report — based in large part on interviews with heads of innovation at the principal federal financial regulatory agencies — outlines technological, structural and cultural impediments to regulatory innovation.
In this episode, Jerry and Sasha provide an overview of their research and the report’s key findings. The conversation then zooms out to consider how technological developments in recent years have confirmed — or challenged — some of these conclusions, as well as administrative and legislative efforts to spur innovation at federal financial regulators.
Links:
- Financial Regulators' Dilemma: Administrative and Regulatory Hurdles to Innovation
- Alliance for Innovation and Regulation (AIR)
- Orrick Financial & Fintech Advisory
- RegFiPodcast.com
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Jerry Buckley: This is Jerry Buckley, and I am here with my RegFi co-host, Sasha Leonhardt. Today, Sasha and I will be discussing some issues which are central to the premise of this podcast series, that financial regulation driven by technology will change more in the next 10 years than in the last 50. And we will be considering what regulators must do to keep up with the deployment of new technology by regulated entities. Both core safety and soundness regulation and compliance requirements related to consumer protection are going to have to change rapidly. Much more rapidly than in the past.
Several years ago, working with the Alliance for Innovation and Regulation, or AIR as it's sometimes called, Sasha and I interviewed the heads of innovation at the principal financial regulatory agencies.
The report we produced, titled "Financial Regulators' Dilemma: Administrative and Regulatory Hurdles to Innovation and Regulation," recited the areas where regulators self-identified statutory, regulatory, personnel and cultural stumbling blocks that are making progress at innovating their regulating processes harder. Sasha, we can't cover all these issues in this short podcast episode, but maybe you could share with our listeners some examples of the hurdles to innovation that we identified.Sasha Leonhardt: Thank you, Jerry. Just to set the stage here, we wrote this hurdles report back in the heady days of 2019 and published it in January 2020, which, as I look back and was reading it to get ready for this discussion, feels like a world ago. I'd also be remiss if I didn't thank AIR for reaching out to us and partnering with us and putting this report together. I think their participation was critical and helped us really open some doors.
Our premise in 2019 was that the world was evolving, with banks and fintechs becoming ever more technologically sophisticated, but financial regulators did not seem to be increasing their capabilities at the same pace. You and I had been working in this space for years, and we noticed that rule writing was done by the same process, examinations were conducted in the same way, and even enforcement matters involved significant manual processes by the government and the agencies responsible for overseeing the financial industry.
Now, we appreciate that the government moves more slowly in the industry when it comes to technology. For myself personally, I think that's probably right. The government is in charge of the stability of the entire financial system, so any steps they take should be done so with caution. And because it has enforcement powers, including in some instances criminal prosecution authority, I'd want the government to move more deliberately when making changes that could affect these areas. And perhaps most importantly, there is just one government. We don't have redundancies like multiple financial firms, so if the government missteps, there can be consequences that are significant without a lot of room to move around them.
But all that said, the gap between industry and regulators seemed to be growing and on a scale that seemed more exponential than linear. So, you and I and AIR partnered to try and figure out why. The government is going to need to address technology, and if nothing else, it should understand it better and understand what may be impeding its ability to work with and adopt to technology.
Our report involved two key research approaches. First, we undertook a listening tour with the innovation heads of a number of federal financial agencies, as well as individuals who had previously served in these roles and since left government for the private sector. All these interviews were done not for attribution, so we could get some real candor from our participants. We also conducted a literature review regarding innovation in the financial services tech space. Now, as you might imagine, that literature review took a fraction of the time of our actual interviews because there simply was not much written on this topic. There's not much today, and there was far less in 2019.
So based upon all this, we put together a report. It's available on AIR's website; if anyone wants to read to it, we'll link to it in the show notes. And I also note that it was published by the George Washington Business & Finance Law Review since I was a lecturer at GW at the time. In the report, we built on what we learned during our listening tour, and we identified eight different areas where the people we interviewed saw that there were opportunities to improve how financial regulators could do their jobs.
Broadly, I divide the areas we addressed into three different categories. The first one would be rote administrative laws: the Administrative Procedures Act, the Federal Advisory Committee Act, the Paperwork Reduction Act and the Freedom of Information Act. Second, there were financial hurdles to agencies adopting technology. The Antideficiency Act and the Federal Acquisition Regulations were top of mind. Finally, there were what I will call human resource concerns: the personnel and hiring processes within the agencies, and agency culture.
Just to go through these real quickly, because for some of these, it's relatively obvious how they affected agency innovations. For others, it wasn't immediately evident to us why they were issues. And it was interesting to hear the interview participants speak up.
On the Administrative Procedures Act, the delays there were relatively obvious to us. The APA has been around since the '40s and requires a very deliberate process to write rules. But it's slow, it's time-consuming, and once a rule is enacted, you have to go through the exact same extended process to modify it. Now, that creates stability in the law, but it also slows the ability to change laws when that change is necessary or could be helpful.
Under the Federal Advisory Committee Act, this ensures that committees advising agencies hold open meetings. But some of our interviewees noted that it discourages agencies from soliciting input since it creates additional administrative hurdles and can apply to even limited discussions. The Paperwork Reduction Act we initially thought would help because it would encourage agencies to keep their rules and their work to a minimum. But the Paperwork Reduction Act also has a lengthy review process prior to any statements being put out for public comment.
As a result, it often served to slow the process of soliciting input, even as it forced agencies to write shorter submissions to the public. And the Freedom of Information Act encourages good government and sunlight is said to be the best disinfectant. But agencies noted that they were constantly concerned about how FOIA analysis could open up their deliberations to public scrutiny.
Again, I think that's the point. But in all candor, they said that that often would slow deliberations because they spent so much time thinking about how things would look in the future. They also noted that private industry was often less likely to participate when they realized that their submissions and information they provided could be subject to FOIA. The trade secret protections around that were helpful, but also were not well-defined and were sometimes interpreted differently agency to agency. So those were the administrative hurdles we saw.
In terms of the financial hurdles, we discussed the Antideficiency Act and the Federal Acquisition Regulations. Under the ADA, it prohibits the government from spending money that is not permitted, but it prohibits the government from accepting anything on a voluntary basis or for free. So, if the government wanted to test a technology at low or no cost, it often ran into issues with that.
The Federal Acquisition Regulations ensure that money isn't wasted, but they also create a long, extended procurement process for government agencies. And in some instances, trying to make even a small purchase to test a technology would take more time than it would for the technology to be simply renewed or outdated.
And human resources concerns are prevalent in every agency. Both agency culture and hiring policies can limit the ability for agencies to acquire people from the private sector or those who want to try some time in government. When hiring takes months on end, on average, it can be a real discouragement for people who recognize they're taking a pay cut and just want to serve their country.
So, Jerry, those are kind of the high thoughts that we got from the Hurdles Report. I would welcome any thoughts you have on the work we did together.Jerry: Well, first of all, Sasha, that was a very good summary of what is a relatively extensive report, so thank you for that. And yes, it was a, I think it was a monumental effort and I give Jo Ann Barefoot, who leads AIR, the credit for coming up with the idea and in fact helping to line up some of the people we interviewed. Really very helpful, and I think it did receive coverage in the press and on Capitol Hill.
But, you know, Sasha, there are some who think that it might be useful to go back after the lapse of four years to update the hurdles report and to assess what has been accomplished and what remains to be done. Given the astounding advances in technology that have occurred since the report was written four years ago, any fresh look would have to do a lot more than look at just how the previous identified issues have been addressed, but also consider what framework agencies have established to come to grips with rapidly advancing technology.
Regulators are not alone in facing the challenges of keeping up with technology changes and the staffing that will be needed to manage those changes. Every for-profit and every not-for-profit entity will face the same challenges and same management issues, including law firms like our own.
I'd be interested in your thoughts, Sasha, but it seems to me that every government agency and every business and nonprofit would benefit by assigning an individual, let's call them a Chief of Change Management, with the responsibility for producing an annual report envisioning what tech and personnel changes are needed over the coming year to fulfill the organization's mission.
This report would not only be a one-time annual assessment but would be a dynamic report adjusted regularly as the organization's business needs and technology needs advance. I know every organization is, or at least I hope every organization is, doing this in one way or another. But focusing on the rapid change in technology and the need for staff to deal with this phenomenon and what is needed to allow the organization to fulfill its mission is important. And this means understanding the organization's evolving mission as it is influenced by the tech environment.
I'm not sure whether regulators or private sector companies have yet laser-focused on this aspect of their operations. I've not seen any report of this kind from a federal regulator. Your thoughts?Sasha: No, Jerry, I agree. I think this is an important area. You know, as I said, we wrote this, frankly, in a different world it feels like. But I'll note that for years and predating our 2019-2020 Hurdles Report, financial regulators have required banks and credit unions to have their own change management policies, which at their core are meta-level policies that govern the changes in other policies. It's essentially a playbook for innovation in response to changes in law and regulation.
But things have changed even more in these four or five years. We've seen increases in state privacy law. We're seeing more rapid change at the federal level, both in terms of regulations, proposed regulations under 1033 and 1071 from the CFPB. We're seeing increased pronouncements from federal agencies and enforcement actions in areas that previously we did not see a lot of action. We're also seeing just a different world in the way people work. Remote work from Covid has spiked up and certainly enough ink has been spilled on whether that is good or bad. But I think it's fair to say that that is certainly here to stay in some capacity, and it's affecting both the government and private sector workforces.
So, I think with all of this in place facing the financial agencies, I think it's right that we continue to look at how the government is doing this, how the regulators themselves are approaching this, and what they can do to more improve. And I think your call out about AI and Gen AI is exactly on point.
Chat GPT wasn't a word that anyone knew in 2019, 2020, '21. But just in the last two years or so, that and generative AI has completely opened the door to a new way that technology is moving forward. So, I think your point is exactly right, that continuing to think about this and look at this by the federal regulators, just as the regulated entities have to, sounds exactly right.Jerry: And it's not only true for regulators, I think, Sasha, it's true for all of us. Having it articulated as opposed to just understood that it's an issue, having the issues defined and saying, "What is our action plan now and for the future," really is something that, and this is not just pointing to regulators, but for all of us, it's something we're going to have to do. And understanding the fact that those changes in technology will actually change our business, whether it's in a law firm, at a financial services firm, at the regulator. That focus, I know people are very aware of it, but coming up with the processes that define that and give it a focus, I think would be very important.
Sasha, there have been several nudges from Congress to regulators to move forward getting their arms around the tech needs that they have in this quickly evolving environment. We know there was a GAO report, which was requested by House Financial Services Chair McHenry, and has been delivered. And there is a nascent legislative initiative in this area. Would you tell us a little bit about that?Sasha: So, part of the reason that you and I have been thinking about our prior research in this space is that both the GAO and Congress have been looking at innovation for the financial regulatory agencies. From the GAO, as you know, they were asked to look at how the regulatory agencies can improve both their workforce and innovation offices. And in September of last year, they published a nearly 100-page report with their findings. The GAO looked at the five major federal financial regulators: CFPB, OCC, Federal Reserve, FDIC and the NCUA.
All five of these agencies reported to the GAO that they were using technology to improve their supervisory capabilities. The NCUA, for example, said it is using machine learning to identify errors in call reports, while the FDIC says it uses machine learning in off-site supervisory monitoring and is training its examiners to use AI. Nevertheless, the GAO identified 12 recommendations among the five agencies that are fairly broadly written. There was a focus on workforce planning, training on advanced technology and creating tangible performance goals and measures related to these areas. And as helpful news to many of our listeners, the GAO specifically recommended that these agencies increase their outreach to industry participants. So that's welcome to hear.
As for legislation, Congress is currently considering the Fostering the Use of Technology to Uphold Regulatory Effectiveness in Supervision Act or, more succinctly named, the FUTURES Act. As of the time of recording this, the FUTURES Act is still in committee. But if it passes in its current form, the FUTURES Act would require the same five federal agencies above to take 180 days and assess their current technology and procurement practices, identify any challenges, and submit a joint report on their findings to Congress.
This joint report would need to cover a number of topics, including technology, workforce recruiting, supervision, interagency sharing of information and their future innovation plans. And the FUTURES Act would not just be a one-time look, but it required the agencies to conduct this exercise again every five years.
Now, we'll see how this legislation progresses, particularly in an election year. But even if it does not become law, the FUTURES Act indicates that Congress is looking at many of the same issues that we flagged in 2020 and considering how agencies may need to evolve.Jerry: Turning to the large body of law that seeks to protect consumers of financial services. As technology advances, these laws from 50 years ago may need to be revisited to see if there is a better way of protecting consumers and at the same time reducing regulatory uncertainty. These protections and the principal regulator that enforces them, the CFPB, are an important part of our financial system, but new technology will introduce, and may even require, new and better ways of protecting consumers, maybe with less regulatory risk to financial services providers. Sasha, will I get in trouble for making this suggestion? Sasha: I won't tell if you don't, Jerry. No, look, I think there's certainly opportunities to improve upon the current regulatory system and the laws that are in place. It's an old trope that the law is playing catch-up to the facts and the world. Frankly, most of the common law system is built upon the fact that there are laws in place and then we need to apply them to facts that change. I think that's — that is the way it is, and that is, I think, in some sense, the way it should be.
But as I said earlier, I think the fact that we're dealing with laws that you note are in some instances 40 and 50 years old and regulations that are meant to move more quickly, but in some instances haven't been touched in 10, 15, 20, coming up on 25 years for some of them, or only marginally tinkered with, is worth thinking about.
You know, I'm not going to say that we should throw out all of it at once, but I think continuing to reassess and consider how these should change is important. You know, we certainly see that from the private side. I'll note that you and I sit in the financial and fintech advisory team at Orrick, and it's a significant part of the practice here. “Fintech” wasn't a word when most of these laws were written.
So, I think we really are in a different world here. And I think it's worth thinking about the laws and the regulations and those who enforce them in light of those changes.Jerry: The danger, it seems, is that people will feel that when you look at laws designed to protect consumers, they may lose something in the process, that — or they may be overcome by technical difficulties in assessing their rights. But the whole system of laws that were written many years ago, unfortunately, I was present on the banking committee when they were written, I have to admit. At that time, there — as I've said before, the computers at the Defense Department, the big boxes that they had there, didn't have the power of our handheld. There was no way of envisioning what could be done using technology to enhance consumer understanding.
And really, that's what we're about. We're trying to give consumers an understanding and build into the system the protections that they need so they don't have to read reams of disclosures and try to understand them. So, yes, the current regime is as good as we could do. It's working in many ways, but it probably could be vastly improved. Whether we are up to this as a nation is another question.
And so, on that happy note, let's end this podcast and thank you to our listeners for their attention.Sasha: Thanks, Jerry. Great to chat with you about this.