Notes from the Vault

Larry D. Wall
September 2016

Many firms in the so-called sharing economy such as Airbnb and Uber provide services that compete with more traditional service providers like hotels and taxis. In doing so, many sharing economy firms are, at a minimum, avoiding the intent of long-standing regulations designed to restrict who can supply these services and on what terms. In many but not all cases, these firms have been able to reach an accommodation with the regulators, allowing them to continue operation outside the framework of historical regulations.1

Many technology firms specializing in finance (fintech) firms similarly have sought to offer services on terms that were not necessarily authorized under existing regulation.2 Yet fintech firms have been largely unsuccessful in getting financial supervisors around the world to make substantial changes to regulations to accommodate their business models. For example, the Financial Crimes Enforcement Network (FinCEN) fined Ripple Labs for operating a money services business without registering and maintaining an adequate anti-money laundering program. This Notes from the Vault post considers the economics of regulating finance and fintech to explain why fintech firms have thus far been less successful than disrupters in other industries. It also discusses why and how financial supervisors are trying to accommodate fintech firms.

Regulation of innovative substitutes
Commercial regulations and regulators do not arise out of thin air. Rather, regulations and regulators arise because those who perceive regulation to be beneficial exert more political influence than those who are opposed. However, whatever the social merits of the policy, regulations that have a binding effect on someone's behavior by definition increase the costs of those who would rather not comply with the regulation.

In response to binding regulations, some businesses seek to reduce the cost by complying with the literal requirements while using loopholes in the regulation to reduce their own costs. This reaction, of course, also reduces the regulation's effectiveness. Another response frequently adopted by sharing economy firms is that of "asking for forgiveness rather than permission," that is, to conduct business as if the rules did not exist and ask for forgiveness, or fight new regulations, if challenged. Sharing economy firms have adopted aspects of both approaches depending upon exactly how the local rules are written and who is interpreting their application to the new technology.3

Regardless of whether the regulation is being undermined by loopholes or simply ignored, those who originally favored the regulation have an incentive to seek changes that would restore the regulation to its earlier effectiveness, as Boston College Professor Edward J. Kane has previously discussed (1977). At this point it once again becomes a political contest about whether those favoring more effective enforcement have more political influence than those opposed. In order to understand why some challengers are successful and others fail, it's helpful to understand the economics underlying the regulation.

Economics of service regulation
The regulations related to hotels and taxis typically require licensing and compliance with some minimal standards of conduct. These standards can help consumers by lowering their costs of searching for an acceptable quality of service. Incumbents (that is, existing businesses) benefit to the extent that government enforcement of minimum standards in an industry encourages people to consume more of its products. For example, health inspections of restaurants provide diners with some confidence that their dining options meet minimum sanitary standards and this may lead to an increased demand for restaurant services over the option of cooking at home.

However, incumbents also benefit to the extent that licensing and minimal standards discourage competition by raising the cost of entry. Indeed, incumbents have an incentive to seek stricter regulation to restrict entry and allow incumbents to charge a higher price.4 Over time, the balance can shift so that the gains to incumbents from reduced competition exceed the benefits to consumers from the setting of minimum performance standards. In this case, the incumbent firms have a large incentive to lobby supervisors and political authorities to keep regulation stringent. Consumers may not perceive the opportunity cost, in terms of a lack of new firms or higher prices, or they may view the minimum standards as sufficiently important so they do not lobby to get regulation eased.

Where the primary effect of regulation is limiting competition, a new method of delivering the service can break the old political equilibrium by showing a large number of consumers that they would receive significant benefit from reduced regulation. The key is reaching a sufficient number of consumers and providing them with what they perceive as superior value before efforts to close loopholes and/or tighten enforcement can be effective. Arguably, this is what has happened with ride services. Those who own and drive locally licensed taxis have fought for tighter regulation, but their efforts have been overwhelmed by those consumers who benefit from services such as Uber and Lyft.

The financial services industry is not immune to this dynamic. For example, limits on the interest rate paid on bank deposits were established in the 1930s on the grounds that such regulation made the banking industry safer by preventing banks from engaging in ruinous competition. The restrictions on deposit rates were later adapted to help channel funding to residential housing by authorizing depositories that specialize in mortgage finance to pay a slightly higher rate on savings. This rate differential had the effect of encouraging those involved in building, financing, and marketing housing to support continued limits on deposit rates.

The limits set on deposit rates exceeded generally available market rates for extended periods of time. However, when these regulations were bound, banks sought to get around them partially by offering other forms of payments, such as a new toaster to anyone opening a new account. The pressure to relax the rate limits increased in the late 1970s as open market interest rates soared above the ceilings. Federal Reserve Bank of St. Louis economist Alton Gilbert shows the ceiling on savings deposit rates during this period was below 6 percent, but three-month Treasury bills rose above 10 percent. Kane (1970) discusses how the federal government, under pressure from those benefiting from the ceilings, increased the minimum denomination of Treasury securities to restrict this source of competition and force smaller savers to accept lower rates from thrifts (and banks).

Ultimately, however, the limits became indefensible as smaller depositors shifted their funds to money market mutual funds (MMMFs). MMMFs invested in short-term obligations that paid market rates and passed almost all of the interest through to their investors. These MMMFS were regulated, but by the Securities and Exchange Commission, which did not have an interest in protecting banks, thrifts, or the flow of funds in residential mortgages. Moreover, the MMMFs had to invest the inflow of funds into something, and a large part of those investments merely recycled the funds into the banks, using accounts with high minimum deposits that were not subject to rate limits. Eventually, many banks objected that the primary effect of deposit rate restrictions was not to reduce their funding costs but rather to make the banks dependent upon the MMMFs. The combination of consumer pressure and many banks' preference for deregulation resulted in the gradual deregulation of rates in the 1980s.

Although finance can be subject to outside disruption, to date, fintech firms have not been very successful in forcing changes in regulation. Arguably, one of the main reasons for this failure is that most of the regulations are not primarily about protecting incumbents from competition. To be sure, the regulation of the financial services industry raises the cost of entry and provides some protection to incumbents. However, most of the rules that were primarily enacted to protect incumbent firms were swept away as a part of deregulation in the late 1980s and 1990s. Most of what remains exists primarily to serve other purposes such as consumer protection (such as truth in lending and equal credit opportunity) and anti-money laundering (which requires financial firms to conduct due diligence on their customers). Thus, even where consumers see some benefit from a fintech product offering that does not comply with existing regulations, they will compare these benefits against those they receive from the regulation and may prefer to keep regulation as is. Additionally, many of these rules are written so they cover not only banks and other traditional financial firms but would also cover fintech firms. As a result, the regulators can often take action long before a fintech achieves the scale needed to gain a devoted customer base.

The future of fintech and regulation
Although fintech firms are unlikely to avoid the intent of financial regulation, there are also reasons for some optimism about accommodations being reached with the regulators. Regulators have a variety of reasons to want to facilitate fintech developments that are not inconsistent with their regulatory goals. However, there are also several constraints that limit the likely extent of accommodation.

One reason for some optimism is that precisely because the regulations are not principally about limiting competition, there is scope for allowing fintech entry while still achieving the goals of the regulation. Indeed, there is increasing discussion of how fintech could help existing financial services firms provide better services at lower costs as suggested, for example, by a recent report from McKinsey consultants Miklos Dietz, Jared Moon, and Miklos Radnai. The hope is that lower-cost services will not only benefit existing financial services consumers but also help in reaching consumers who are currently unbanked or underbanked, as discussed by Chairman of the Council of Economic Advisers Jason Furman.

A second reason for optimism is the recognition that the technologies in fintech can also help supervisors meet their regulatory responsibilities at lower cost. For example, Crowell and Moring LLP attorneys Jenny Cieplak and Mike Gill discuss how distributed ledger technology could facilitate Commodities Futures Trading Commission access to trade records. Third, many regulators recognize that they cannot block successful financial innovation; at most they can delay its adoption in their jurisdiction. Venture capitalists are making large investments in fintech in a variety of places around the world as documented in a report by KPMG. Some of these investments are likely to result in products that become widely used by consumers of financial services. If a regulator blocks early adoption in its jurisdiction, the technology may instead be developed in another market and imported into the blocked market. The end result could be the regulator's jurisdiction would obtain a smaller share of the new jobs created by the technology and the regulator's ability to influence the evolution of the technology would be reduced.

Reflecting these reasons for seeking an accommodation, bank supervisors in a number of jurisdictions have expressed an interest in working with fintech firms to allow innovation to proceed within some regulatory bounds. The United Kingdom’s Financial Conduct Authority (FCA) and the Hong Kong Monetary Authority have each created a "regulatory sandbox" for firms to try out innovative products, and a number of other countries are working on similar measures. U.S. supervisors have also taken various initiatives.5 The Office of the Comptroller of the Currency (OCC) has issued a white paper on responsible innovation. The Bureau of Consumer Financial Protection has issued a policy statement on no-action letters, which can give fintech firms greater confidence they will not be subject to disciplinary action.

Two limits become clear, however, in reading the various supervisory statements related to fintech. First, although the regulatory agencies want to find ways to accommodate fintech firms, these accommodations will not be done at the expense of meeting the regulators' underlying objectives. Rather, the proposals tend to focus on ways of allowing fintech firms to test their products without bearing the full costs of regulatory compliance but doing so within a limited "sandbox" that includes constraints on the length of the exemption and/or the number of customers served. These proposals also typically include some other mechanism for protecting consumers. Moreover, as these startups expand, they will eventually be expected to comply fully with goals of the regulations.6

Second, agencies still have to accomplish their day job of regulating traditional providers, in some cases with no significant increase in resources. Moreover, the more innovative the fintech approach, the more likely it is the agency will want to work through the implications for its area of responsibility. This need to do more without a commensurate increase in resources will tend to increase the lag between when a fintech firm contacts a regulatory agency and when that agency is likely to respond.

To these limits on individual agencies around the world, there is the third issue of the difficulty of reaching accommodation with the various agencies that have jurisdiction over a particular financial activity—especially in the United States. The United States has developed a complex regulatory structure with multiple federal financial regulatory agencies as well as regulatory agencies in each of the states.7 This regulatory structure assures that more of the goals of regulation will not be overlooked by an agency focused on its primary mission. However, the multiplicity of agencies creates several problems for fintech firms. First, there's the simple problem of determining which federal and/or state agency (or agencies) has jurisdiction over a particular product. Second, the assignment of specific goals to individual agencies can result in those agencies drawing "red lines" to protect their individual goals, rather than taking a holistic view of a new product. Third, in some cases different states may set different standards for compliance, which will raise the cost of expanding services. U.S. Representative Patrick McHenry (R-NC) has proposed legislation that would require the federal regulatory agencies to create financial services innovation offices and to better coordinate with one another.

The approach taken by many firms of asking for forgiveness rather than permission has not proven to be very effective for fintech firms. Most financial regulations are less vulnerable to being overridden because the primary purpose of these regulations is not incumbent protection. Further, the regulators generally require fintech firms to comply with the regulations, making it difficult for firms to obtain the scale and popularity needed for political clout. On the other hand, financial regulators are not necessarily hostile to innovation in financial services, and many see innovation as something to be supported rather than fought. The difficulty will be in the ability of the different fintech firms to provide various types of financial services, and financial supervisors tasked with a variety of different regulatory goals to determine efficient ways to meet them without imposing unnecessary burdens on new innovations.


Kane, Edward J., 1970, "Short-Changing the Small Saver: Federal Government Discrimination against Small Savers during the Vietnam War: Comment." Journal of Money, Credit and Banking, 2(4), 513–522.

Kane, Edward J., 1977. "Good Intentions and Unintended Evil: The Case against Selective Credit Allocation." Journal of Money, Credit and Banking, 9(1), 55–69.

Wall, Larry D., and Robert A. Eisenbeis, 1999. "Financial Regulatory Structure and the Resolution of Conflicting Goals." Journal of Financial Services Research 16(2–3), 223–245.

Larry D. Wall is executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Brian Robertson and Paula Tkac for helpful comments. The view expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email


1 For example, commissioners in Broward County, Florida, rescinded regulations requiring "transportation network companies" to make fingerprint and FBI background checks and other tests on drivers. In contrast, the Anaheim, California, City Council recently voted to outlaw short-term rentals of residential properties, including the 363 formerly permitted and taxed short-term rentals, and New York has legislation awaiting action by the governor that would impose fines on advertising short-term rentals.

2 FinTech Weekly defines fintech as "a line of business based on using software to provide financial services." However, this definition would include almost every financial firm of any consequence over the last few decades, whereas fintech is usually taken to be a smaller set of firms developing innovative technology. Thus, FinTech Weekly continues on with the qualification that "Financial technology companies are generally startups founded with the purpose of disrupting incumbent financial systems and corporations that rely less on software." However, even this is not obvious in the current environment where many technology-based firms working on financial issues are working with incumbent systems and firms.

3 The ambiguity of many situations is highlighted in an NPR discussion of Uber's early expansion where the company is accused of "asking for forgiveness rather than permission" but in which there is also discussion of changing laws to restrict its operations.

4 The issues behind licensing businesses are in many ways similar to occupational licensing, which is discussed in a recent White House report "Occupational Licensing: A Framework for Policymakers."

5 See also FCA Director of Strategy and Competition Christopher Woolard’s discussion of the thinking behind its sandbox.

6 However, it is at least conceivable that the testing of innovative products in sandbox-like structures may permit the firm to develop and the regulators to accept methods of compliance that were not contemplated when the original rules were written.

7 See Larry Wall and Robert Eisenbeis (1999).