How to Stay Out of Trouble With Regulators When Innovating

If digital transformation and other innovative shifts are looming, then a financial institution's key regulators shouldn't be the last to know. In fact, the sooner banks and credit unions talk to their agencies the better.
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Tech innovations, new entrants and changing consumer expectations are making financial services evolve. Financial institutions of all sizes are innovating more rapidly than ever before by offering new products and services and engaging with new partners and third-party providers.

Bankers are often surprised when we tell them that most regulators fully understand that traditional financial institutions need to innovate to continue to serve their people well.

Innovation-Readiness Opens Doors:

Contrary to what many in the industry think, regulators are not anti-innovation. They simply want to be sure banks and credit unions understand the risks of innovations they pursue and have strong risk mitigation controls.

The best way for banks to provide assurance to their regulators on this is to have robust up-front conversations. However, our collective regulatory experience indicates that traditional banking players rarely do this well — if at all.

As former regulators, we can promise you that regulators appreciate these conversations. Initiating them shows thoughtfulness up front that can give regulators confidence in the management team’s ability to engage in new activities.

How and Why Financial Institutions Trip When Innovating

We have observed several types of missteps among institutions trying to innovate. The single worst mistake institutions can make is to let fear of regulatory criticism or sanction stop them from pursuing well-thought-through innovations. Sadly, some institutions regularly fall into this trap.

Where they pursue innovations, some are naïve about the effect of not talking to regulators and simply don’t engage them before launching a new activity that is significantly different from current offerings.

Others who do engage don’t do it intelligently. They don’t approach the regulators in a thoughtful manner and are ill-prepared to explain what they are planning to do and, more importantly, why they want to do it. They are unable to speak to the risks and how they will be addressed.

Such bankers appear to be asking for permission rather than proactively communicating a game plan and asking for feedback. The net result is they often either hit a regulatory roadblock before launching or get criticized post-rollout because risks aren’t being managed appropriately.

Yet for any financial executive of experience, regulatory issues shouldn’t entail surprises. The kinds of things that can get a bank or credit union into trouble with its regulator are pretty straightforward.

Near the top of the list is engaging in activities without the right level of approval or knowledge. This means that innovators are leaving out key players in the organization when developing and rolling out a new product. Engaging in new activities without appropriate risk identification and mitigation is always going to cause problems in the regulatory relationship. Likewise, a good path to trouble is failing to self-identify, self-correct and self-report issues to regulators.

Clamming Up Leads to Shutting Down:

Lack of candor and open communication in the regulatory relationship can cause regulators to lose confidence in management precisely when the team seeks to make strategic changes.

Our experience is that periodic proactive discussions not only help keep financial institutions out of trouble, but also allow them to consider regulatory views before finalizing a rollout plan.

A bonus: Talking before launching helps create a relationship that makes it easier to work through problems when they do arise.

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How Financial Institutions Should Talk to Regulators

What is less clear to many financial institution leaders is how they should talk to their regulators about innovation. The key: Walk confidently “through the front door” of the regulator with a clear plan of what you want to do, why you want to do it, and how you are going to make it happen in a well-controlled way.

In our experience, it works well when institutions:

1. Frame the initiative in the context of the institution’s strategic goals and the benefits to consumers.

2. Show that management has assessed the risks and the systems and controls that will be needed.

It often makes sense to conduct a needs assessment to find gaps between bank systems and controls versus those needed for the planned initiative. This leads to a pre-implementation action plan that helps give regulators confidence the institution has fully thought through the innovation’s control implications.

3. Provide a phased rollout plan.

This shows how the institution will evaluate each stage of the innovation project and how it will identify any necessary course corrections.

4. Anticipate questions that will arise.

This should not just be seen in terms of the initiative itself. Consider whether any recent examination findings or other regulatory concerns may raise doubts in regulators’ minds about the institution’s ability to execute on the initiative.

5. Allow time for questions and open dialogue to hear the perspectives of your regulator.

However, under no circumstances ask for permission to proceed. Actually, putting that on the table is even more awkward for your regulator than it is for you.

Use the 'Goldilocks Principle':

Don't reach out to regulators too soon. It's never a good idea to share half-baked ideas. On the other hand, it's too late if rollout has started. The sweet spot: When you have a firm plan, including risk management elements.

All of the effort necessary for this process goes a long way in avoiding problems down the road.

The first conversation is likely to be the most difficult — they do get easier the more you have them. And, life is much easier for everyone if you have a productive and open dialog with your regulator.

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