As noted in a previous post, increasing financial inclusion is a multifaceted and complex issue. While designed to preserve a safe and sound financial system, regulatory reporting requirements have created incentives for financial institutions to exclude certain groups of individuals from receiving the financial services they need.
I explored this topic further with Phil Goldfeder and Amit Sharma in a recent webinar called "Tech Stacks, Embedded Compliance, and Policy Reform for True Financial Inclusion.” The topic that resonated most with me was our discussion on how existing regulations, such as regulatory reporting requirements, can limit banks’ abilities to increase financial inclusion. We also explored opportunities to change this dynamic through tech innovation and regulatory reform.
How does regulatory reporting affect financial inclusion?
Regulatory reporting provides regulators with the requisite information to determine risks posed by financial institutions’ activities. At the heart of all banking activity is risk. How banks manage risk and ensuring that they are operating in a safe and sound manner is a mix of requirements established by regulators and the oversight of bank personnel. While regulatory reporting is meant to mitigate risks, it has historically led to the exclusion of some individuals who are incorrectly deemed as “too risky to serve.”
For example, in a 2018 survey, the U.S. Government Accountability Office (GAO) found that “derisking,” which is a situation that occurs when financial institutions attempt to limit certain services or terminate customer relationships as a result of corresponding regulatory concerns, occurred frequently at bank branches on the southwest U.S. border. The apparent aim of these efforts was due to banks’ concerns about violating the Bank Secrecy Act (BSA) and its implementing regulations on anti-money laundering controls and to limit account offerings to consumers deemed “high-risk” for money laundering and close branches in high-risk areas.
Derisking practices like the one described above are not uncommon in the financial services sector and are not necessarily suggestive of violative behavior or ill intent on the part of financial institutions or regulators. Both financial institutions and regulators seek to operate in support of a safe financial services industry. Ensuring that nefarious actors, such as drug traffickers and terrorist organizations, are unable to move funds through the financial system is a practice supported by both industry and government. The challenge, however, is that derisking practices can incorrectly label innocent individuals as bad actors, which thereby limits true financial inclusion.
Using innovation and regulatory change to achieve financial inclusion
From the technology side, the use of embedded compliance solutions that leverage artificial intelligence (e.g. machine learning) to assess accurately the risks could identify new and subtle distinctions between those individuals and businesses performing illicit activities and those who are not. In short, machine learning could make us better at identifying bad actors.
The Financial Crimes Enforcement Network and the Federal Deposit Insurance Corporation demonstrated a positive first step to improving regulatory reporting by conducting a TechSprint on digital identity in 2022.1 This effort demonstrated possible solutions for financial institutions to meet their BSA reporting requirement in a way that allows the institution to keep pace with developing technology.
However, technological innovations alone cannot improve financial inclusion issues stemming from regulatory reporting. While federal banking agencies recognize the issues with regulatory reporting and derisking, agencies need to move beyond recognition of the issues and find solutions.
Concepts that regulators should consider include the following:
Understand and accept innovation available to improve compliance and reporting processes;
Create a more collaborative environment between regulators and financial institutions as it relates to the inputs and outcomes of regulatory reporting; and
Incentivize financial inclusion throughout the regulatory landscape.
It is possible that a path toward increased financial inclusion is to combine technological solutions with regulatory reforms discussed above. From this effort, regulators and financial institutions can remedy the shortcomings of risk prevention and financial inclusion.
Financial Crimes Enforcement Network. https://www.fincen.gov/news/news-releases/fdic-fincen-digital-identity-tech-sprint-key-takeaways-and-solution-summaries