Two Ways to Strengthen, Protect and Prepare the U.S. Financial System for the Future

The U.S. banking system is truly remarkable. Banks, credit unions and other financial institutions, supported by tech companies, policy makers and regulators, have overcome and adapted to unimaginable crises over the last 100 years-the Great Depression, two World Wars, the S&L Crisis, the terror attacks of 9/11, and more recently the Great Recession and COVID, to name a few.

We've led the response to these events, working with other countries to shape policies, norms and even technologies. For example, the Bretton Woods Conference in 1944 was a transformative global summit. Forty-four Allied nations joined together to adopt policies and create new institutions to promote global economic stability and attempt to prevent future economic disruptions by addressing systemic issues that had, in part, led to the Great Depression and the World Wars.

Bretton Woods positioned the United States as the global leader in the world's economy and shaped post-war economic norms, leading to decades of relative stability and prosperity here and abroad. Together we created the International Monetary Fund and the World Bank Group and established the U.S. dollar as the reserve currency. Since then, the U.S. banking industry has learned, adapted and is, by most all metrics, thriving today.

But despite our extraordinary history, the industry is facing serious threats and pressures. Reliance on outdated legacy systems impair product innovation, wastes precious resources and increases enterprise risks. U.S. financial institutions need to invest in new technologies and build new products to satisfy changing customer expectations and stay ahead in an increasingly competitive global market, and the current regulatory framework needs to evolve to support new forms of financial institution charters to inspire competition. Innovators that do pioneer new products often operate in uncharted compliance waters with regulatory uncertainty, and their customers may also be exposed to unknown or even unacceptable risks. If not addressed quickly, these issues could jeopardize our role in the global economy and stifle innovation at home. But if we act now, we can rise to these challenges.

The current strength of U.S. markets obfuscates the threats to U.S. leadership in global financial services and the U.S. dollar as the reserve currency. China is leveraging massive foreign investments in shipping hubs, natural resources and foreign infrastructure to encourage adoption of new trading paradigms that bypass the United States. Specifically, their push for a common BRIC currency would undermine the U.S. dollar and provide an alternative to the U.S. financial system. Meanwhile, we're dealing with geopolitical and military conflicts around the world, leading to sanctions prohibiting many financial institutions with good customers from transacting with the U.S. financial system, all of which raises the stakes for the U.S. dollar and our financial system.

Add this to our own internal banking technology deficits and policies that discourage investment in financial innovations, and this one-two-three punch could do serious damage.

I've outlined two ways, a mix of offense and defense, to ensure the United States continues to lead and innovate while adding strength, resiliency and adaptability to our financial system. These recommendations would open the door for greater financial choices for consumers and businesses while fueling our economy.

As one U.S. banker shared with me, "Banks are museums of technology." It's true. Core banking systems are ancient, and countless supporting systems are woefully outdated, which makes them extremely expensive and difficult to maintain and operate, while also creating significant obstacles to innovation. Another former board member of a top-10 European bank reported having more than 10,000 different software applications that require regular maintenance. Given the age and diversity of these systems, there's a shrinking pool of engineers skilled in their obsolete coding languages and the systems themselves. At the same time, these legacy systems are consuming more energy to operate than newer software, cloud services, and other technology-except for Bitcoin and some blockchains, which are energy hogs.

We need to motivate U.S. financial institutions to invest in major overhauls to their technology-now. Banks, credit unions and other financial institutions, regardless of size or market focus, face unrelenting obstacles to innovation. Product and technology executives at banks lament that 75% to 95% of their annual IT and product development budgets are consumed by:

Moreover, the interpretation and implementation of Basel Ill will increase capital reserve requirements, putting more pressure on publicly traded financial institutions to deliver higher profits and dividends.

These foundational issues threaten our ability to be financial services leaders across all types of products, but few more pronounced than cross-border payments. Despite being essential to global commerce and, in some cases, the survival of millions of families of foreign workers, these payments, which Statista estimates will reach $290.2 trillion by 2030, are considered high risk by most all central bankers and regulators.

As Federal Reserve Chair, Jerome Powell, noted in a 2021 speech at the "Pushing the Frontiers of Payments" conference, hosted by the Committee on Payments and Market Infrastructures in Basel, Switzerland, the current cross-border payment system "suffers from frictions, including processes that make it difficult to comply with anti-money-laundering and countering-terrorist-financing requirements, difficulty in managing payments across time zones, and, in certain areas, a reliance on outdated technology. Moreover, these frictions contribute to higher costs for cross-border transactions." To be more specific, scores of the processes, Chairman Powell alluded to, are manual across the ecosystem. What's more, international transfers from banks typically require recipients to have bank accounts, excluding 70-90% of populations in many countries.

Technology is sorely needed to automate complex manual tasks across the crossborder value chain, including at central banks and regulators, not only for better security, risk management and compliance but to cut costs and process payments faster. At the same time, creating an electronic audit trail makes compliance, reporting and auditing much more efficient. Fixing these issues is not only paramount to ensure a better, more secure flow of funds; it's also central to keeping the U.S. dollar on firm footing as the world's reserve currency.

Cross-border payments are just one of many areas of the U.S. banking system that demand a technological refresh. Because banks have many competing and increasingly expensive priorities vying for resources, compelling motivation is necessary to address the considerable shortcomings of their entire tech stack.

We must rise above partisanship, put country first, and work to create a form of the Community Reinvestment Act (CRA) for financial technology investment at banks, credit unions and other state and federally chartered financial institutions. The CRA is the right model for this legislation because this investment incentive will have a major effect on the U.S. job market. Structuring the incentive so it's tied to domestic technology development will stimulate a thriving sector of high-paying technology jobs.

We can't afford to wait for a catastrophe to force our hand. Let's learn from the past. For example, the Fed pushed to modernize check processing and clearing for more than a decade by allowing the electronic transmission of check images instead of physically transporting paper checks. But the industry was unable or unwilling to invest in tech to support this until airplanes couldn't transport paper checks between check processing centers after 9/11. It took this horrific act and a range of painful consequences to get the industry to support change and to get Congress to pass and President George W. Bush to sign Check 21 into law.

We need a well-designed incentive for banks to replace outdated core banking systems, risk management and fraud detection tools and so much more. This is more than adding Al or machine learning or an API wrapper around an archaic core banking system.

And let's require U.S.-based resources to drive these changes which will generate high-paying technology jobs across the U.S. Given the large number of highly dispersed banks, credit unions and other financial institutions, and the scores of software companies that support them, the impact will be far-reaching for workers and U.S. businesses.

What can we learn from the Office of the Comptroller of the Currency's (OCC) decision in 2020 to begin accepting applications for special purpose national bank charters from fintech companies? First, let's acknowledge that the comment period raised many rational concerns. Sadly, instead of thoughtfully addressing these concerns while also being determined to support new forms of financial institutions or regulated entities, the result was a new bank charter that looked a lot like the old bank charters. It was a big yawn. Moreover, it's been mired in expensive and distracting legal battles at the federal and state levels for years. What a waste of precious resources when we need capital for innovation.

Whether it's tackling the bias toward maintaining the status quo, resisting pressure from big banks, reassuring state regulators who don't want to lose ground, educating consumer groups or rising above partisan politics-we need to come together to protect our financial future by evolving our licensing and regulatory framework.

Specifically, we need a federal regulatory framework that encourages safe innovations in financial services to include:

For example, requirements to ring-fence customer funds and charters that prohibit extension of credit would eliminate many of the larger risks and ensure the protection of customer funds without FDIC insurance and taxpayers being on the hook for new forms of regulated entities that fail.

The U.K. and many members of the European Union have been issuing Payment Institution and Electronic Money Institution licenses for capital requirements from less than $200K to about $400K for more than 10 years. These institutions offer safe, innovative relatively narrowly defined products that are easy to oversee and are valuable to customers.

This wouldn't exclude banks from participating in the leading edge of innovation. In fact, it has proved to be the opposite. Many banks in other countries have funded or partnered with Electronic Money Institutions, Payment Institutions or similar special-purpose entities to deliver innovative, cost effective products faster than they could build them in house.

But we need to act fast. Some new business models or products, like Banking-as-a-Service (Baas), embedded finance, open banking, buy-now-pay-later and digital currencies and assets, face regulatory uncertainty or wake to find unexpected rules. Matt Harris, a partner at Bain Capital Ventures, posted on Linkedln that "The crackdown on Baas shows that regulators, in their hearts, despise non-bank financial services. The future of financial services belongs to truly tech enabled banks and then, over time, defi protocols." This energetic position highlights the regulatory quagmire facing new fintech entrants, which threatens to discourage new investments.

My experience with prepaid cards in the late 1990s was that regulators permitted this new card product, but they thoughtfully monitored issuers and observed if policies and practices protected the safety and soundness of the payment system and that consumers had clear disclosures and protections. But not all early players followed these principles. It was a messy process, as state and federal regulators tried to understand these new products, which were far from uniform, and figure out how to regulate them.

We need a faster, more proactive and engaged way to formulate rules for new products to stimulate investment and innovation by reducing regulatory uncertainty as well as protect the system and users.

Given the diversity of new financial products and business models, we need a fresh approach to defining special-purpose charters to support and fuel innovation while making clear rules of the road. As part of this, any new charters must include a master account at the Fed to prevent dependence on fearful or reluctant commercial banks for deposit holding and access to the U.S. payment systems.

For example, I believe the U.S. version of an Electronic Money Institution would reduce costs to card issuers and open the door to new types of issuers, clarify and simplify oversight and ultimately benefit users while also protecting the system and taxpayers from default.

The situation is so pressing that if federal policy makers are unable to figure this out, then ambitious, economically minded states could fill the void. State governors may find that creating a special-purpose charter of their own could be a boon to attracting capital and creating good jobs in their states. This would create a messy patchwork of disparate regulations akin to what Money Services Businesses have spent decades trying to rectify.

The U.S. banking system is remarkable in its size, scope, complexity, creativity and resilience. However, it can and must improve for the United States to remain the global leader in financial services that fuel not only the world economy but our own.

We need to incentivize banks and other financial institutions to replace outdated software and systems to better protect customer information, deliver new products faster, leverage new software like Al, and defend against a growing list of well-funded external threats.

And we need to overhaul our regulatory framework to inspire investment in new, creative forms of financial institutions and regulated entities that operate safely and efficiently for the benefit of U.S. and global customers, leap-frogging other countries with common-sense regulations that protect users while encouraging innovation.

We can' t be distracted by all that's happening around us or complacent in the strength of the U.S. market. We can' t be stuck in a "this is how it's always been" mentality or fearful that these ideas are too big to tackle. The consequences of not acting are severe and will be felt by every American for decades to come.

About The Author

Gary Palmer has worked with banks, financial institutions, regulators and central banks globally for nearly 30 years. His first company, founded in 1996, built the first-ever prepaid card issuing platform, launching the prepaid card industry globally. He also co-founded one of the early Electronic Money Institutions in Europe and served as the company's CEO. Gary is a former Vice-Chairman and Chairman of the Network Branded Prepaid Card Association, now the Innovative Payments Association and served a 10-year term as a director at the Chicago-based Center for Financial Services Innovation, now the Financial Health Network. Since its founding 20 years ago, the non-profit has become a nationally respected voice in uniting and educating financial services leaders, employers, policymakers and innovators to design solutions that equitably advance financial health for all people-especially the most vulnerable among us. He was a founder, chairman and financial backer of one of the first companies to repurpose the U.S. PIN-debit/EFT networks for 24x7 real-time domestic bank transfers. Mastercard bought the firm in 2015, and it became Mastercard Send. Gary's current company, Payall Payment Systems, has pioneered a first-of-its-kind infrastructure to help banks and other financial institutions offer secure, fast, low-cost, transparent and inclusive cross-border payments as well as safely clear foreign-initiated payments.

If you'd like to discuss more on this subject contact Gary via Linkedln.