The term “Fintech” has come to mean essentially any application of technology for delivering financial services. More specifically, the term represents a rapidly growing space of alternative lending facilities that are outside of the traditional banking industry. This includes both consumer and, more recently, business lending.
The Rise of Fintech
Although lending options outside of traditional banks have always existed, Fintechs use technology to gain efficiencies. This includes not only the loan origination process but also leveraging digital technologies (including social media) for underwriting and pricing of credit as well as for expanding market share.
As any industry moves more deeply toward automation, the natural progression is to begin to integrate processes. The speed by which these processes are able to move today by virtue of the internet and mobile devices have served as a catalyst for phenomenal growth of the alternative lending space. Fintech, and all that it includes, is exploding, evolving, and adapting.
Financial services is perhaps the most heavily regulated industry in the world. The regulatory bodies, however, have some ground to cover to understand and keep up with the rapid and accelerating change of Fintech.
Fintech and Consumer Protection
Consumer protection is the bedrock of compliance for all forms of the federal regulatory compliance as well as that of the state regulators. At the risk of oversimplification, the consumer sector of Fintechs can be thought of as high-tech finance companies. Formerly brick-and-mortar facilities that were heavily localized as physical branches; they now have an enormous digital footprint with little or no human interaction in the transaction of business.
This, of course, provides the capacity to quickly take on enormous volume which in turn requires adaptive systems which can automate decisioning and pricing of loans. Marketing is one of the processes that is also integrated which makes for very fast-moving and complex systems.
As this space grows to encompass a larger share of the consumer market, a key question is how it may be regulated specifically in regard to fair lending. Some guidance in an article in the Fed’s 2017 Consumer Compliance Outlook by Carol A. Evans, Associate Director of the Division of Consumer and Community Affairs has been recently released that may provide some insights.
The article addresses risks from both a Fair Lending and UDAP perspective. Obviously, the UDAP component is fairly broad as it can encompass a seemingly infinite number of possibilities. We will forego that aspect for now and instead address the lending implications.
So what are the risks for Fintechs and the institutions that are sponsoring them? Fundamentally, the risks are those that are posed to any financial institution. For example, the (3) forms of fair lending discrimination of overt, disparate treatment and disparate impact are in play. Broadly, the key risks of underwriting, pricing, redlining, and steering are also relevant and apply to every aspect of the transaction. This includes servicing of the credits as well.
More specifically, there are risks that are similar to traditional banks, and then some that are more unique to Fintech. Here are some examples.
Fair Lending Risks Similar to Traditional Banks
- Not understanding processes – This is a fair lending risk germane to any lender. As odd as it may sound, it is not uncommon for institutions to misunderstand its process due to the multiplicity of moving parts.
- Inability to explain processes – To have successful outcomes when facing regulatory scrutiny requires an institution not only understand but also accurately explain its practices. This is often a challenge for institutions, again due to the number of moving parts and different staff involved in the processes.
- Understanding the impact of lending practices – Related to the different broad types of discrimination recognized by the agencies and the primary risks noted earlier, this remains a significant risk that must be appropriately managed.
- Marketing risks – Marketing activities impact everything from geographies distributions of lending to denial rates. In addition, marketing practices can also be unintentionally discriminatory even if not reflected in the data. This risk exists for traditional banks as well as for Fintechs.
Fair Lending Risks Unique to Fintech
- Complexity of underwriting and pricing models – Fintechs rely on large datasets to build models in which to predict behavior. Such models rely on correlations within the data. There is an implicit causal component to interpretation of those models, and as more factors are added the likelihood that spurious or distorted correlations are produced increases. This can lead to, at best, unintended disparate effect or, at worst, mistaken conclusions that create fair lending issues.
- Dynamic systems could prove problematic in an exam – Having access to and relying on vast datasets creates opportunities to have flexible systems which make adjustments in real time. Rapidly adapting processes undergo significant changes over the course of a year and, as such, can be difficult to track. This could prove difficult in navigating a fair lending examination.
- Use of alternative data may pose unknown risks – To the extent a firm uses so called “alternative” data for credit or pricing decisions may produce fair lending risks. Unlike proven measures such as credit scores, others that rely simply on correlations in data may produce unintended consequences. This can include disparate impact or treatment and, in some cases, overt discrimination. (Ms. Evans’ article cites a few examples.)
- Elevated marketing related risks – Over the last two decades, advertising has undergone a transformation from mass communication with information flowing in only one direction to more of an interactive process made possible by the digital age. Such systems again rely on correlations from data and can be thought of as “smart” systems that “learn” and change in real time. Because such systems are automated, there is little opportunity given to understanding the potential risks of such efforts, i.e., its potential for discriminatory effects.
As in the case with any major technological or otherwise dramatic change to the way an industry conducts business, many players in the financial arena feel they are being left behind. This, in turn, creates pressure to “keep up” which can materialize as a reactive posture rather than strategic business decisions. This can cloud the field of view in terms of adequately assessing risk.
The financial industry has undergone significant change in the last decade due to the regulatory environment. The rapid expansion of Fintech, however, has been more of a product of changing consumer preferences and expectations coupled with the possibilities offered by technology. While traditional institutions may be forced to adapt to these changes, they should be diligent to ensure their procedures for compliance and risk management not be comprised in the process.
How to cite this blog post (APA Style):
Premier Insights. (2018, January 04). Fintech In The Fair Lending Crosshairs [Blog post]. Retrieved from https://www.premierinsights.com/blog/fintech-in-the-fair-lending-crosshairs