Federal Reserve Governor Speaks to Community Bankers on Innovation Trends Within the U.S. Financial System

 On March 14, Federal Reserve Governor, Michelle W. Bowman, addressed the continuing innovation in the financial sector. Though some have criticized the bank regulators as being “hostile to innovation,” Bowman applauded regulators for their continual efforts toward learning and adapting to facilitate a clear and transparent road to bank innovation.  

While innovation presents new opportunities, it also creates additional risks and vulnerabilities that “can be amplified for community banks.” Bowman warned banks not to allow innovation to distract them from traditional risks, and reminded them that they must be prepared to make improvements in risk management, cybersecurity, and consumer compliance. In fact, these more traditional investment efforts are even more necessary for those innovating banks as the risks to credit, liquidity, concentration, and interest rate are especially high for “banks engaging in novel activities.”  

Whatever the cause, Bowman stated many traditional risks can be mitigated with appropriate risk-management, liquidity planning practices, and supervision “without stifling the ability of banks to innovate.” Bowman highlighted three issues related to innovation: supporting responsible innovation, the unique challenges to smaller and community banks pursuing innovation, and key actions that the federal banking regulators have taken to date.  

Supporting Responsible Supervision 

Independence, predictability, and transparency is important in banking regulations. The banking industry must adapt and develop to suit the needs and preferences of their customers, and bank regulators have an important role in ensuring banks can do so without implementing undue burdens. By publishing clear guidance and providing assistance to banks, “regulators can improve regulatory transparency and facilitate compliance.” 

The Innovation Challenges for Community Banks 

Because small banks tend to have fewer resources devoted to innovation and developing in-house products, they tend to be more reliant on third-party relationships than their larger counterparts. Small banks should beware of the risks of utilizing third-party relationships to support innovation. Regulators have developed compliance tools, such as the tools to assist community banks estimate losses under the Current Expected Credit Loss (CECL) account standard and published a community bank guide on conducting due diligence for financial technology companies. Bowman suggested providing smaller banks with similar, additional tools to “reduce the burden of regulation while also promoting compliance.” 

The Evolving Regulatory Response to Innovation 

Bowman also touched on steps bank regulators’ have already taken to address the new technologies being utilized by banks, including crypto-asset activities, third-parties, bank service company oversight, and cybersecurity.  

The variability of crypto-related activities creates a lack of “clear and timely regulatory guidance” for banks. Still, the Federal Reserve Board of Governors has “published guidance clarifying that all state member banks should notify their lead supervisory point of contact prior to engaging in crypto-asset-related activities.” The guidance also gave broad requirements for firms’ obligations to analyze the legal permissibility of the activities, and to develop adequate systems of risk management and controls to conduct the activities in accordance with applicable laws. Bowman stated that the Federal Reserve will continue to develop further guidance on crypto-related activities. 

Bowman expanded on the risk of third-parties, stating that even clearer guidance and regulatory expectations will not adequately address third-party risk management. Regulators are considering addressing the issue by “leveraging collective action to help with due diligence” by implementing a standard-setting organization to ensure consistency. While the regulatory burden of third-party relationships often falls on banks, Bowman questions if the third-parties themselves should be subject to closer scrutiny.  

As banks develop new technology and improve innovation, Bowman highlighted the need to conversely improve cybersecurity. Banks are encouraged to adapt their risk-management practices to deter cyber threats, as well as contact regulators and law enforcement when a cyberattack occurs. 

Conclusion 

While recognizing that the changes mentioned “only scratch the surface,” Bowman concluded by suggesting that regulators prioritize clear and timely guidance for all areas of innovation that banks are interested in. 

The speech came just days after the California Department of Financial Protection and Innovation closed on both Silicon Valley Bank and Signature Bank. Despite the two high-profile failures, Bowman stated that the United States banking system remains resilient. “Regulators have become targets in a blame game” regarding what could have been done to prevent the crisis, Axios commented in an article on March 14, 2023. Axios also pointed to the 2019 ruling intended to “loosen certain regulations for mid-sized banks,” to which Bowman voted in favor of.