Fine-tuning licensing for fintech banks

Financial innovation is everywhere. You may have been checking your account balances on your smartphone app or looking at an online advertisement for an instant loan this morning. With the Internet of Things, everything is becoming smart. And smart things need smart banking solutions.

Technological innovation in the banking sector is also spurred by developments in artificial intelligence, big data and e-identification. One indication of these developments is the growing number of players entering the market that have fintech business models. This, in turn, is leading to an increasing number of fintech bank applications submitted to the European Central Bank (ECB) for approval.

“Fintech” is an umbrella term, generally used for a wide variety of activities. But how does the ECB, as banking supervisor, define fintech banks in the context of their work? Given the diversity of institutions and technologies across the countries participating in the Single Supervisory Mechanism (SSM), ECB Banking Supervision defines a fintech bank as having “a business model in which the production and delivery of banking products and services are based on technology-enabled innovation”.

The ECB aims to facilitate innovative market participants to make a positive contribution to the financial sector. At the same time, and in accordance with its mandate to ensure the safety and soundness of the European banking system, it needs to maintain adequate prudential standards for newly licensed banks. Innovation can speed up services, make life more convenient for banks’ customers and reduce operational costs. It is essential that supervisors closely follow technological innovation in the banking sector and understand all the functionalities of the fintech ecosystem. Only then can they detect emerging risks or supervisory challenges.

In this context, ECB Banking Supervision has developed a “Guide to the assessment of fintech bank licence applications”. The purpose of the guide is to make the process more transparent for potential fintech bank applicants and increase their understanding of the procedure and criteria applied by the ECB when assessing licence applications. This transparency should also facilitate the application process. The guide seeks to neither support nor discourage fintech banks from entering the market; it treats them on the same footing as banks with traditional business models.

From a supervisory perspective, the guide serves to introduce a consistent approach when assessing licence applications for both entirely new fintech banks and existing banks setting up specialised subsidiaries with a fintech business model. This ensures that fintech banks are held to the same licensing requirements as all other types of bank.

For fintech bank applicants, the guide identifies areas of particular attention for the supervisor’s assessment process. One example is governance. Do the managers of the fintech bank have the required technological expertise – but also banking skills and experience – to perform their duties? Every bank should have an adequate governance structure in place and, in the case of fintech, managers’ technological skills are as critical as banking experience.

Another example is the risk arising from the automatic allocation of loans offered to clients on the basis of their payment history. It goes without saying that such mechanisms should be subject to limitations and based on sufficient and reliable data.

In some cases, traditional banks partner with a specialist fintech bank to strengthen their technological know-how in a cost-efficient way. As a result, the new functionality becomes part of the traditional banks’ broader business model, and so do related risks.

In other cases, fintech banks roll out such functionalities as a standalone product which then becomes their main business. Associated risks become more prominent for the fintech bank, and the supervisor needs to pay proportionate attention to them.

There are more cases still where fintech banks require specific attention. The nature of their highly innovative business makes it more likely for start-up losses to occur or to be relatively larger than for a traditional bank. Thus the supervisor needs to follow up and pay closer attention to profitability. This can lead to requests for the fintech to hold initial capital that could potentially cover up to three years of losses.

To sum up: while the underlying assessment criteria apply equally to all banks, the supervisor may pay particular attention to these areas given fintech banks’ specific business models.

In the future, and building on the experience gained from the fintech licensing guide, ECB Banking Supervision will work on further fintech-related areas. It will also analyse regulatory sandboxes, a concept which refers to the testing of new products or services in a controlled environment. Entering such a controlled environment is also subject to a licence application process and assessment by the supervisor.

ECB Banking Supervision is also in the process of implementing an SSM-wide fintech hub – a central point of contact for information and questions about fintech – to ensure consistency across the growing number of national fintech initiatives in the euro area.

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