INSIGHT: Fintech: Old Banking, New Methods

By Michael Mancusi, Christopher Allen, and Kevin Toomey

Arnold & Porter partner Michael Mancusi, resident in the firm’s Washington, DC office, represents domestic and foreign banks, credit unions, and other financial services clients in a wide range of state and federal regulatory, compliance, and enforcement matters. He also has substantial experience representing clients in government and corporate internal investigations, including entities facing claims or issues related to cybersecurity and financial technology products or services.

Arnold & Porter partner Christopher Allen, resident in the firm’s Washington, DC office, represents clients in a broad range of regulatory compliance and investigative matters before federal and state government agencies. Mr. Allen’s practice focuses on advising bank and nonbank financial industry participants on their compliance obligations under federal and state law.

Arnold & Porter associate Kevin Toomey, resident in the firm’s Washington, DC office, represents banks and nonbank financial services companies, along with their boards of directors, executives, and senior management, in a wide range of enforcement, regulatory, compliance, and governance matters before the federal and state banking agencies, Department of Justice, CFPB, FinCEN, and OFAC.

“FinTech” -- short for “Financial Technology” -- has become a ubiquitous buzzword of the financial sector. Encompassing a broad array of new technologies for producing and delivering financial services and products, FinTech means many things to many people. New technologies have dramatically changed how we deliver and consume basic banking functions such as lending money, making payments, and cashing checks, as well as many of the less visible but equally important banking functions such as credit scoring and fraud monitoring. But while the innovations fueling the current “FinTech” boom are certainly new, the legal challenges presented by them are not. Indeed, the history of the regulation of the financial services industry is that of constant innovation and the accompanying need to incorporate changes into an existing legal framework that may never have contemplated the new technology.

In this first of a series of articles exploring the FinTech landscape, we take a look at ways in which technological innovation has impacted the financial services industry and the law in modern times. In future articles, we will explore industrial loan companies and other chartering options, strategic partnerships and investments in FinTech, and consumer protection issues unique to the FinTech industry.

Technological innovation has been leaving its mark on the financial services world for as long as there have been financial services. This fact has never been more true than in the past one hundred years. Indeed, there is no aspect of financial services that has not been touched, directly or indirectly, by innovation. To explore this phenomenon, we need look no further than the evolution of the very basics of banking.

The “business of banking” is often defined as taking deposits, paying checks (or “payments” in general), and making loans. The first, taking deposits, has been around for centuries -- arguably millennia if one counts commodities such as grain. Deposit-taking has not changed much over time. It remains a basic concept: the deposit-taker accepts the depositor’s funds in exchange for a promise to return the same amount of funds, possibly with interest, at a later time. However, the ways in which deposits are received, returned, and used -- in other words, payment and loan mechanisms -- have changed dramatically over time, and in particular over the past century. These changes have forced the law to adapt, or to be changed, in order to continue to achieve its purpose.

Checks

The check has long been a mainstay of consumer payments. Although its demise has often been predicted, and while check volume is down significantly from its peak of nearly 50 billion checks in 1995 to roughly 17 billion in 2016, the check continues to be an important payment method in the United States. In fact, a 2017 Federal Reserve study found that year-over-year decrease in check use has notably declined, suggesting that the check still has life in it. The history of checks in the United States, moreover, reflects how changes in technology help drive changes in the law, as well as how what’s good for banks can also be good for consumers, and vice versa.

For years, checks were processed and cleared manually. As check volume increased, the banking industry looked for ways to automate the process. In 1958, the American Bankers Association introduced the Magnetic Ink Character Recognition (MICR) system -- the computer-readable account and routing numbers at the bottom of checks -- to help automate the clearing process. But while for years the clearing process was becoming more efficient, concerns were growing that the gains were not resulting in faster access for customers to their deposits. Banks were receiving their money faster, but the benefits were not flowing down to their depositors.

To respond to these concerns, Congress in 1987 passed the Expedited Funds Availability Act, and the next year the Federal Reserve adopted Regulation CC to implement the law. The new law and its Regulation CC established how quickly banks were required to make deposits available to customers. At that time, checks had to be moved physically around the country for clearing, and accordingly under the new law banks were generally allowed more time to make funds available the farther a check had to travel.

As check volume continued to grow into the 1990s, banks were eager to find ways to further streamline the check-clearing process. An obvious target of such efforts was the billions of paper checks that had to be transferred each year among institutions. Technology again presented a solution: if banks could send images of checks electronically instead of moving around the actual paper instruments, the efficiency gains would be enormous. In 2003, Congress again responded, passing the so-called “Check 21” Act, which allowed banks to transfer images of checks instead of the paper checks themselves.

Consumers benefited from this development, too. Without the need to ship paper checks around the country, the clearing time for checks was significantly reduced. A check drawn on a bank across the country could be cleared in the same time it took to clear one drawn on a bank next door. As banks no longer had a justification to withhold deposits for different periods of time based on where the check had to be sent, Regulation CC was changed to require the same funds availability period for all similar domestic checks.

Another benefit of the Check 21 Act, and an example of technology taking advantage of legal adaptation, was the creation of “remote deposit capture” (RDC). In its early days, RDC was primarily used by large businesses that received large volumes of checks from their customers. Instead of bringing hundreds or thousands of checks to the bank for deposit, corporate customers could scan the checks using special equipment provided by the bank. These check images would be transmitted to the bank, which would place the images into the clearing process as permitted by Check 21. Years later, this same service would make its way onto banks’ mobile apps to allow consumers to deposit checks using their smartphone cameras.

Even as Check 21 made possible new technologies, it still is an example of how technology remains a challenge for the law. For example, the Federal Reserve has recently had to amend Regulation CC to make it better align with the fact that checks overwhelmingly are processed electronically, a product of the success of Check 21. Concepts must also now be addressed that 30 years ago would have had no meaning, such as an “electronically created item” -- an image that in all respects looks like a check but that never existed in paper form. These challenges continue to drive innovation in both technology and the law, even for the simple check.

Accessing Funds

If checks have persisted, it is not for want of competition. The ability to access, move, and use funds electronically has probably altered the financial services landscape over the past century more than any other development. In 1918, laying the foundation for modern “online” payments, the Federal Reserve System, then only five years old, linked the 12 Reserve Banks, the Board of Governors, and the U.S. Treasury Department by telegraph to create what would become the Fedwire service. From that point forward, technology has allowed the financial system to make great leaps forward to increase the speed and ease with which customers access, move, and spend their money, and the law has had to keep up.

Automated Teller Machines

An early instance in the modern era of technological advancements driving statutory and regulatory adaptation is the advent of automated teller machines (ATMs). Originally introduced by Barclay’s Bank in London in 1967, ATMs had become popular in the United States by the early 1970s. But their status under U.S. law was unclear.

Although no longer the case, for much of the history of banking most states prohibited, or at least significantly restricted, banks’ ability to open branch offices. To maintain competitive equality between state-chartered and federally chartered (or “national”) banks, national banks had to conform to the branching laws of the states where they operated. ATMs, which could dispense money and receive deposits, raised the question of whether a machine that could conduct these core banking activities were “branches.”

Seeking a competitive advantage, national banks in 1974 obtained from their regulator, the Office of the Comptroller of the Currency, interpretive guidance that ATMs were not “branches” for national banks, opening the door for such banks to place the units virtually anywhere they wished. Understandably upset, state-chartered banks challenged the OCC in court, and in 1976 the Comptroller was overruled and ATMs were declared branches. While subsequent state and federal legislation (including a 1996 bill exempting national banks’ ATMs from the definition of “branch”) has chipped away at the restrictions on banks’ ability to establish branches, the history is one that underscores that technology has been “disruptive” for decades and often requires application of old law to new circumstances.

Addressing New Ways to Lose (or Take) Money

Prior to the 1950s, consumers had limited options for accessing their funds: they could write (and cash) a check, or they could go to the teller window of their bank and withdraw cash directly. To the extent problems arose, such as lost or stolen checks, existing laws sufficed to address those problems. But the advent of new ways to access money would necessitate new laws to protect consumers.

In 1950, the first multipurpose charge card, Diners Club, was introduced. American Express would follow with its own travel and entertainment card in 1958, the same year that BankAmericard -- later Visa -- debuted. Master Charge, later to become MasterCard, arrived in 1966. Although very popular, there were concerns as to the sufficiency and consistency of disclosures surrounding these consumer credit products, as well as the manner in which they were being marketed.

Prompted in part by these concerns, Congress passed the Truth in Lending Act in 1968, which among other things specified the types of disclosures that were required for various forms of consumer credit and standardized the manner in which certain terms, such as the interest rate, were calculated to make it easier for consumers to compare products. Two years later, the law was amended to prohibit the practice of sending credit cards to consumers who had not requested them -- a practice that was somewhat responsible for the early proliferation of credit cards. Five years after that, Congress again added to the law in the form of the Fair Credit Billing Act, which addressed billing practices and limited consumer liability for unauthorized card use. Amendments were made in 1998 and again in 2008 to further enhance credit and charge card disclosures as industry practices and products evolved.

ATMs and automated clearing house (ACH) networks that could debit and credit accounts electronically, and automated telephone services that could be used to transfer funds between accounts, prompted similar legislative concerns and legislative responses. Lost debit or ATM cards, or unauthorized ACH transactions, presented the possibility that a consumer’s money could be taken without his or her permission or immediate knowledge. Throughout the 1970s numerous states sought to deal with these problems through targeted laws, but it was not until 1977 that Congress began considering federal legislation to create a framework for “electronic fund transfers.” Ultimately, the Electronic Fund Transfer Act was enacted in 1978, through which consumers gained substantive protections, provided they exercised a reasonable degree of diligence in monitoring their accounts for improper activity.

More recently, “e-commerce” and online banking have continued to benefit from these consumer protection enactments. Although the Electronic Fund Transfers Act could not have envisioned in 1978 the creation of “online banking” or “e-commerce,” its concept of an “access device” has been adapted to cover unauthorized electronic transfers online. Likewise, online credit card fraud is equally protected by the Truth in Lending Act, even though the 1975 revisions that limited consumer liability for lost credit cards could not have contemplated online “hacking.” Fortunately, the concepts were sufficiently flexible to adapt to evolving technology.

Lending

Without a doubt, the internet and the online economy have presented some of the most significant challenges in adapting old financial laws to fit new circumstances. Although key pieces of federal legislation govern financial services transactions and institutions, financial services are largely governed by state law. This is especially true in the nonbank space, such as money transmitters and small-dollar consumer lenders.In the pre-internet age, when transactions were primarily conducted in person, the question of which laws applied was relatively straightforward. It was unlikely that a consumer in one state would use the services of a lender in another state without actually being present in that other state. But when a consumer in California can visit the website of a money transmitter in Texas to send money to a recipient in New York, or when a borrower in Illinois can get a loan from a lender in Connecticut to fund a purchase from a website in Washington, it becomes more complicated.

Adding to the challenge is the increasing number of participants in financial services transactions. Whereas historically a lender might source, originate, retain, and service its own loans, modern transactions have many entities involved. Websites may pull credit reports to match would-be borrowers with lenders for a referral fee. The lender, in turn may use third-party servicers to interface with customers, process loan applications, and apply underwriting standards. Specialized loan servicers may be used, and different servicers may be used for current and delinquent debt. Some loans are “peer-to-peer,” where funding comes from “investors.” Once originated, loans may be packaged into securitization vehicles whose equity interests can be sold to more investors. Each of these roles implicates various state and federal regulatory and licensing regimes that in many cases were not created with these arrangements in mind but that have been adapted to fit modern practices.

The Last Word

Innovation in the financial services world is nothing new, nor is the need to apply the law to such innovations. In the never-ending quest to provide better, faster, and cheaper services, innovation will always be present. In our upcoming articles, we will examine the developments impacting the financial services markets, explore how they can be addressed by existing law, and discuss what changes may be necessary where current law falls short.

***** AUTHOR INFORMATIONArnold & Porter partner Michael Mancusi, resident in the firm’s Washington, DC office, represents domestic and foreign banks, credit unions, and other financial services clients in a wide range of state and federal regulatory, compliance, and enforcement matters. He also has substantial experience representing clients in government and corporate internal investigations, including entities facing claims or issues related to cybersecurity and financial technology products or services.

Arnold & Porter partner Christopher Allen, resident in the firm’s Washington, DC office, represents clients in a broad range of regulatory compliance and investigative matters before federal and state government agencies. Mr. Allen’s practice focuses on advising bank and nonbank financial industry participants on their compliance obligations under federal and state law.

Arnold & Porter associate Kevin Toomey, resident in the firm’s Washington, DC office, represents banks and nonbank financial services companies, along with their boards of directors, executives, and senior management, in a wide range of enforcement, regulatory, compliance, and governance matters before the federal and state banking agencies, Department of Justice, CFPB, FinCEN, and OFAC.

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