For release on delivery
5:20 p.m. EDT (11:20 a.m. HST)
March 14, 2023
The Innovation Imperative: Modernizing Traditional Banking
Remarks by
Michelle W. Bowman
Member
Board of Governors of the Federal Reserve System
at
Independent Community Bankers of America
ICBA Live 2023 Conference
Honolulu, Hawaii
March 14, 2023
I would like to thank the ICBA for the invitation to speak with you today. It is a pleasure
to be with you to discuss innovation in the U.S. financial system, the emerging trends that are
shaping the industry, and the influence of regulatory approach on this evolution.1
Before turning to the main theme of my remarks, I would like to take a moment to
acknowledge the events of the past week, and the actions taken by regulators in response. As
you are aware, last Friday, March 10, the California Department of Financial Protection and
Innovation closed Silicon Valley Bank. On March 12, the New York Department of Financial
Services closed Signature Bank. In both cases, the Federal Deposit Insurance Corporation
(FDIC) has been appointed as receiver. One significant factor leading to the stress and
subsequent closure at each institution was the rapid outflow of deposits, specifically uninsured
deposits above the FDIC-guaranteed amount of $250,000 per depositor, per account type.
On Sunday, several specific actions were announced that are intended to limit the direct
and indirect risks to the U.S. financial system resulting from the closure of these two financial
institutions. The Federal Reserve Board announced that it will make additional funding available
to eligible depository institutions through a newly created Bank Term Funding Program.2 This
program will offer one year loans to institutions that pledge U.S. Treasury securities, agency debt
and mortgage-backed securities, and other qualifying assets as collateral. The facility will
provide an additional source of liquidity to banks and eliminate the need for institutions to
quickly sell these securities during a time of stress. The FDIC also took action to protect all
depositors, including uninsured depositors, of both Silicon Valley Bank and Signature Bank.
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Beginning Monday morning, these depositors were able to access all of their funds on deposit
with these banks. The federal regulators, including the FDIC, the Federal Reserve Board and
U.S. Treasury Secretary Janet Yellen approved the actions to protect depositors.
The U.S. banking system remains resilient and on a solid foundation, with strong capital
and liquidity throughout the system. The Board continues to carefully monitor developments in
financial markets and across the financial system.
Now, turning to the main theme of my remarks today, I will discuss the imperative of
fostering innovation in the banking system.
Often, when innovation is discussed within the context of the banking system, the focus
is not on traditional banks engaged in core banking activities, like taking retail deposits and
making loans. I think this perception misses the mark. Innovation has always been a priority for
banks of all sizes and business models, from small community banks to the largest global
systemically important banks (G-SIBs), and for good reason. Banks in the U.S. have a long
history of developing and implementing new technologies. Innovation has the potential to make
the banking and payments systems faster and more efficient, to bring new products and services
to customers, and even to enhance safety and soundness. Yet, some have criticized the banking
regulators for being hostile to innovation, at least when that innovation occurs within the
regulated financial system. Regulators are continually learning about and adapting to new
technologies, just as banks are, and regulators can play an important, complementary role,
making the regulatory rules of the road clear and transparent to foster bank innovation.
Innovation does pose challenges within the regulated banking system, which can be
amplified for community banks. Along with presenting new opportunities, innovation can
introduce new risks and create new vulnerabilities. Banks, and really, any business today that
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adopts new technologies must be prepared to make corresponding improvements to manage
these risks and vulnerabilities, including improvements to risk management, cybersecurity, and
consumer compliance. Regulators must continue to promote efforts that are consistent with safe
and sound banking practices and in compliance with applicable laws, including consumer
protection laws. As I am sure you appreciate, this is not always an easy task, and the regulatory
response to innovation must reflect the changes in how banks engage in this process.
It is absolutely critical that innovation not distract banks and regulators from the
traditional risks that are omnipresent in the business of banking, particularly credit, liquidity,
concentration, and interest rate risk.3 These more traditional risks are present in all bank
business models but can be especially acute for banks engaging in novel activities or exposed to
new markets, including crypto-assets.4 Whatever the cause, many traditional risks can be
mitigated with appropriate risk-management and liquidity planning practices, and effective
supervision, and without stifling the ability of banks to innovate.
Today, I will address three issues related to innovation. First, I will briefly discuss how
bank regulation and supervision can best support responsible innovation. Second, I will touch on
the unique challenges that apply to smaller and community banks pursuing innovation. Finally, I
will mention a few key actions that the federal banking regulators have taken to date, and how I
think about future regulatory and supervisory actions to support innovation. And before I
conclude, I will also quickly touch on a few other issues that may be of interest to you.
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Supporting Responsible Innovation
In the past, I have spoken about the principles that I believe should guide bank regulation
and supervision.5 I have noted the value of independence-tempered by public accountability-
in the Fed's role as a bank supervisor. I have also stressed the need for clear rules of engagement
and predictability in the bank applications process. And I have emphasized that transparency of
expectations in rules and guidance are critical to a bank regulatory system that is fair and
efficient. I think these principles are instructive when it comes to how regulators should address
innovation.
As both consumer needs and their preferences in accessing financial services change, so
too must the banking industry. Banks of all sizes see new opportunities to develop enhanced and
customized products for their customers, introduce faster payments, and improve efficiency.
If our goal is a banking system that leverages the many benefits of innovation, regulators
need to make deliberate choices about how we regulate and supervise. Further, we need to be
aware of and sensitive to the unintended consequences of our regulatory framework. The
Federal Reserve and the other federal banking agencies have an important role to play in helping
ensure banks can innovate in a safe and sound manner, and that role includes transparency in
5
See Michelle Bowman, "Welcoming Remarks" (speech at the Midwest Cyber Workshop, organized by the
Federal Reserve Banks of Chicago, Kansas City, and St. Louis, February 15, 2023),
https://www.federalreserve.gov/newsevents/speech/bowman20230215a.htm; "Independence, Predictability, and
Tailoring in Banking Regulation and Supervision" (speech at the American Bankers Association Community
Banking Conference, February 13, 2023),
https://www.federalreserve.gov/newsevents/speech/bowman20230213a.htm; "Brief Remarks on the Economy and
Bank Supervision" (speech at the Florida Bankers Association Leadership Luncheon Events, January 10, 2023),
https://www.federalreserve.gov/newsevents/speech/bowman20230110a.htm; "Large Bank Supervision and
Regulation" (speech at the Institute of International Finance Event: In Conversation with Michelle Bowman,
September 30, 2022), https://www.federalreserve.gov/newsevents/speech/bowman20220930a.htm; "Technology,
Innovation, and Financial Services" (speech at the VenCent Fintech Conference, August 17, 2022),
https://www.federalreserve.gov/newsevents/speech/bowman20220817a.htm; "My Perspective on Bank Regulation
and Supervision" (speech at the Conference for Community Bankers sponsored by the American Bankers
Association, February 16, 2021), https://www.federalreserve.gov/newsevents/speech/bowman20210216a.htm.
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expectations. And of course, we must ensure that regulation and supervision do not place
unnecessary burdens on small banks. The vast majority of banks want to meet regulatory
expectations. By publishing clear guidance and developing tools to help assist these banks,
regulators can improve regulatory transparency and facilitate compliance.
Transparency is a tool that can serve the supervisory goal of promoting a safe, sound, and
fair banking system, particularly when it comes to innovation. In exercising supervisory and
regulatory authority, the federal banking agencies must be aware of not only the risks to the U.S.
financial system, but also the harm that can be caused to U.S. consumers and businesses when
we don't achieve sufficient clarity and transparency in our expectations and when our regulations
are disproportionately burdensome to the risks they are intended to address. With innovation, the
risk is that a regulatory approach based on subjective, ad hoc judgments-as opposed to clear
guidance and regulatory expectations-could cause new products and services to migrate to the
shadow banking system. We have already seen a similar phenomenon in some markets, as with
nonbank lending, which has proportionately increased when compared to bank lending in recent
years.
A lack of transparency, and the corresponding limits on bank innovation, has adverse
consequences for consumers, businesses, and communities. Therefore, it should be a regulatory
priority to ensure our approach continues to support innovation that is conducted in a safe and
sound manner and is consistent with applicable laws, including consumer protection.
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The Innovation Challenges for Community Banks
I think everyone here today recognizes the valuable role that small banks play in the U.S.
financial system, and just as important, in the communities they serve.6 Small banks provide
credit and financial services to businesses and individuals through personalized services and
relationship banking. Small banks have a deep commitment to their communities and understand
their unique customers, including how they may weather the ups and downs of economic cycles.
If we look at the financial health of small banks today, we see an industry that is well-
positioned to support economic growth. Across a broad range of metrics, including capital,
liquidity, earnings, credit quality, and loan growth, small banks have been performing well.
But small banks also face unique challenges, especially when it comes to innovation.
Small banks tend to have fewer resources to devote to these activities and fewer staff members
with the technological expertise to develop products in-house. Therefore, small banks tend to be
more reliant on third-party relationships to support innovation, including the critical relationship
between small banks and their core service providers. However, third-party relationships can
also increase operational risk, data security and cybersecurity vulnerabilities, and create other
compliance issues. And of course, a bank's use of third parties does not diminish its
responsibility with respect to the activities conducted by the third-party service provider.
I think the principles I mentioned earlier can be particularly relevant when thinking about
how regulators can support small bank innovation. Transparency in expectations is important for
the smallest banks, who may view innovation as a strategic priority, but may lack the resources
of larger peers to engage in innovation and third-party partnerships or cover costs of legal advice
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to address ambiguous regulatory expectations. One way we can adopt a tailored approach is by
providing additional resources and tools for smaller institutions to assist with compliance.
Regulators have already successfully developed compliance tools. These include the Board's
recently developed tools to assist community banks estimate their losses under the Current
Expected Credit Loss, or CECL, accounting standard. The federal banking agencies also
published a guide for community banks on conducting due diligence for financial technology
companies.7
I think these types of efforts are very important as we introduce new regulations and
requirements. Clear guidance and practical implementation tools can reduce the burden of
regulation while also promoting compliance.
The Evolving Regulatory Response to Innovation
Innovation allows banks to become more efficient and better meet customer demands.
So, while bank regulators do not want to hinder innovation, we also have a responsibility to
ensure that the banking industry adopts new technologies appropriately. To help balance these
two goals, it is incumbent upon regulators to prioritize clear guidance to banks. Having clear
(and public) regulatory expectations not only supports public accountability, but also gives banks
greater flexibility to innovate and experiment with new technologies.
Across a range of activities, both banks and regulators are working to make innovation
accessible to all banks, with clear guidance and additional tools and resources to help small
banks. I'll now turn to a few specific examples where regulators have been working to develop
transparency and clear expectations.
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Crypto-asset activities
Many bank customers have expressed interest in crypto-assets over the past several years,
with some banks exploring how they can meet this customer demand. There are a multitude of
design and use cases for new and innovative technologies, such as distributed ledger technology
and crypto-assets, which can pose unique challenges for regulators. The variability of these
activities complicates the development of clear regulatory expectations around safety and
soundness and risk management, and raises questions about legal permissibility. The lack of
clear and timely regulatory guidance creates a real challenge for banks interested in exploring
these activities.
Crypto-asset activities remain an important focus for the Federal Reserve and other bank
regulators. While some banks continue to explore offering crypto-asset-related products and
services to their customers, the extreme volatility of these assets creates significant challenges
for banks. These assets also vary widely in terms of their structure, the markets for trading, and
whether they are backed by any assets. Until clear statutory and regulatory parameters exist to
govern these types of assets and the exchanges on which they are traded, I think some of the
uncertainties about how the banking system can engage in crypto activities will remain unsettled.
While there is more to do, there have been some helpful initial steps to provide clarity on
regulatory expectations. First, the Board published guidance clarifying that all state member
banks should notify their lead supervisory point of contact prior to engaging in crypto-asset-
related activities.8 The letter also clarified the broad requirements of a firm's obligations,
including the need to analyze the legal permissibility of the activities, and to develop adequate
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systems, risk management, and controls to conduct these activities in a safe and sound manner
and consistent with all applicable laws.
More recently, the bank regulators published additional guidance to highlight the risks of
crypto-asset-related activities. In January, the federal agencies released a statement highlighting
crypto-asset risks and recently issued a statement on liquidity risks resulting from crypto-asset
market vulnerabilities.9 Federal Reserve staff continues to develop guidance on crypto-asset
activities, including on custody, trade facilitation, loans collateralized by crypto-assets, and the
issuance and distribution of stablecoins. I think these are critical next steps to provide clarity
around regulatory expectations.
Third-party risk management
Third-party relationships can provide smaller banks access to new products, services, and
technology. The scope of these partnerships can be quite broad, including fintech companies,
partners who use the bank's "Banking as a Service" products, cloud service providers, and many
others. But third-party partnerships designed to bring innovation into a bank can also create risk-
management and due diligence challenges, particularly with respect to identifying the risks that a
third-party partner may pose and to managing these risks.
For small banks, these compliance problems can be amplified by a number of factors.
Small banks may have limited experience and in-house expertise conducting due diligence on
third-party partners like fintech companies. And small banks likely have limited leverage in
negotiating contracts and informational rights with third-party partners. Small banks may also
encounter friction with nonbank partners who fail to understand the bank's ongoing
responsibilities to ensure that even outsourced activities are conducted in a safe and sound
manner and in compliance with consumer protection laws.
The Federal Reserve and other federal banking agencies can play an important role in
helping banks continue to innovate through third-party partnerships. Specifically, the agencies
have been working to develop joint guidance to clarify regulatory expectations around third-
party risk management, which will be an important step in supporting innovation built on third-
party partnerships.
This guidance could be particularly helpful for small banks. But clearer guidance and
regulatory expectations will not fully address these challenges. Guidance alone cannot address
the challenges that a small bank faces in conducting due diligence on third parties and the
difficulty in negotiating a contract with larger nonbank service providers and partners.
ICBA has taken some important first steps in determining if there are opportunities to fill
these knowledge gaps by leveraging collective action to help with due diligence. In addition,
some interesting preliminary work has been done to consider whether a standards-setting
organization, in the form of a public-private partnership, could expedite due diligence on third-
party fintech partners. A centralized, standards-setting organization could help develop
minimum standards to ensure better consistency in the diligence banks apply to these
partnerships. I see a great deal of promise in these efforts, and I support continued work to
develop these mechanisms to help small banks innovate through third-party partnerships.
Another area in need of attention is in assisting small banks achieve similar treatment in their
contracts in comparison to larger nonbank service providers and partners.
All banks should understand regulatory expectations with respect to due diligence, risk
management, and ongoing compliance when engaging in third-party relationships. Banking
regulators can support this approach by providing clear expectations and the tools smaller banks
may need to help them meet these expectations. For example, in 2021 the Federal Reserve began
providing state member banks with supervisory reports on their third-party partners that are
subject to supervision under the Bank Service Company Act. These reports contain information
that may provide helpful insight in assessing the performance of bank service providers,
depending on the services used and the risk the services pose. As we are considering additional
opportunities to provide resources in this space, your feedback and experience would be helpful
to understand where we should focus our future efforts.
Bank service company oversight
Another area that complements third-party risk management is the agencies' regulatory
authority over bank service companies. While banks who engage in partnerships with third
parties continue to bear responsibility for due diligence and compliance, we should also consider
whether the bank itself, or the third-party service provider, is best positioned to address risks.
The regulatory burden of third-party relationships falls heavily on banks (particularly
small banks), and sometimes bleeds over to their core service providers, because the core service
providers often make the technical changes to core systems to enable integration with innovative
new products and services. Core service providers are already subject to activities-based
supervision under the Bank Service Company Act. But with the expansion of third-party
relationships, it is worth considering whether this allocation of responsibility remains sound, or
whether additional parties-like fintechs and other technology companies-should be subject to
closer scrutiny for the products and services they provide to banks. If third parties provide
products and services to bank customers, it also may be appropriate for these providers to bear
greater responsibility for their own products and services, including to ensure that they are
provided in a safe and sound manner and in compliance with financial and consumer laws and
regulations.
Cybersecurity
We do not often talk about cybersecurity in the context of innovation, but improving
cybersecurity can complement innovation. When a bank is planning to develop new technology
or pursue innovation, those new activities often bring new risks. As you know, bankers often
refer to cybersecurity as one of the top risks facing the banking industry, and the Federal Reserve
has issued guidance and examination procedures on a range of cybersecurity issues to help banks
prepare for cyber events when they occur.
Cyber threats constantly evolve, and banks' cybersecurity efforts must be dynamic in
response. Banks must respond to emerging threats by adapting risk-management practices,
engaging with regulators and law enforcement when an attack occurs, and participating in
training and exercises to ensure cyber preparedness. As I have noted in the past, the Federal
Reserve continues to work closely with banks to support these efforts.10
Other Important Trends
Although I won't be able to take questions today, I would like to address a few other
issues that may be of interest to this group related to bank regulation and supervision.
Community Reinvestment Act reform. As you all know, last May, the federal banking
agencies issued a notice of proposed rulemaking that would amend the Community
Reinvestment Act. The agencies received extensive comments on the proposal, including
comments describing the costs and benefits of the proposal and how it would impact banks.
Chair Powell noted last week that there is essentially agreement among the three agencies.
While we are hard at work, it is expected that it will take some months to complete.
I am continuing to review and understand this proposal and the costs it will impose.
From my perspective, it will be important to consider how the costs imposed by any final rule
compare to the benefits of the rule, not just in the aggregate, but for institutions of different sizes
and engaged in different banking activities.
Climate risk management and regulation. Climate risk-management and regulation
efforts include the recent launch of a climate scenario exercise for the largest firms and a climate
guidance proposal for a broader range of large firms. The Federal Reserve's role in this space is
very limited and generally is confined to ensuring banks operate in a safe and sound manner,
relying on appropriate risk management.
With respect to climate change risks, it is important to think carefully about the costs and
benefits of any guidance and the scope such guidance may include. As proposed, the climate
risk-management guidance would apply only to the largest firms. Of course, all banks below this
threshold, including small banks, would remain subject to robust risk-management expectations,
which includes managing all material risks. In many instances, these expectations may require
banks to manage a range of related risks, especially from extreme weather and natural disasters.
Capital. As you know, the banking agencies are currently engaged in a holistic bank
capital standards review and are working to implement the Basel III "endgame" reforms. With
respect to the Basel III capital reforms, the agencies recently reaffirmed their commitment to
implement these standards to strengthen the resilience of the U.S. financial system. As I think
you all know, there are no plans to propose changes to the community bank capital framework as
part of this capital review. It remains to be seen how broad the proposal will be, and for the
larger firms, which firms will be affected.
Bank merger policy. There are significant consequences for firms when applications are
not acted on in a timely manner, including increased operational risk, the additional expense
associated with running two institutions in parallel over a longer period, employee retention
issues, and perceived reputational risk. In my mind, this is an area that we need to improve;
delays in the processing of applications are not exclusively an issue for large banks.
Small banks are also subject to timing issues when engaged in bank merger transactions.
In fact, small banks that operate in more rural areas with few competitors who try to merge with
other local banks can raise competitive concerns under the Federal Reserve's traditional merger
standards. As I've previously noted, one way to improve the timing of small bank merger
transactions is by considering all competitors when evaluating the competitive effects of
mergers.11 In many rural markets, credit unions, farm credit system institutions, banks without a
branch presence, and nonbank lenders can all be significant competitors in different product
markets. In some cases, these smaller banks face greater issues in pursuing merger transactions
than larger banks that operate in dense urban centers with many bank competitors. For all banks
engaged in merger transactions, delays should be the exception, not the rule.
Efforts to support minority depository institutions. Minority depository institutions, or
MDIs, play an important role in our financial system. MDIs often provide credit and financial
services to low and moderate income and minority communities. The Federal Reserve is
committed to preserving minority ownership of depository institutions, and providing technical
assistance to MDIs, through the Fed's Partnership for Progress program. Federal Reserve staff
frequently meets with MDI management teams to discuss emerging issues, provide technical
assistance, explain supervisory guidance, and respond to management concerns. This
engagement not only furthers our efforts to support these banks, but also provides valuable
insight and feedback on the challenges facing MDIs. It is also an opportunity to gather feedback
on regulatory proposals.
Overdraft fees. Banks often provide limited overdraft protection to customers and
historically have charged a fee for this service. Recently, as you know, this practice has come
under some regulatory scrutiny. For example, many banks have taken a close look at their
practices to ensure that they are subject to appropriate disclosures and are operated in a way that
is fair to consumers.
The Federal Reserve's approach in evaluating overdraft practices has been to prioritize
compliance through the review of these practices, ongoing engagement with bank management,
and most importantly, transparency in our regulatory expectations. Regulatory expectations
should never come as a surprise to regulated institutions, and our examiners find that
transparency is an effective tool to promote compliance.
I would like to address one specific overdraft practice that has been the focus of recent
attention-authorize positive, settle negative (or APSN) transactions. These transactions occur
when a bank authorizes a consumer's point-of-sale transaction based on sufficient funds in the
consumer's account, but at the time the transaction posts, the consumer's account has insufficient
funds. In some cases, the institution imposes an overdraft fee on the consumer when this occurs.
Over the past decade, the Federal Reserve has focused on this issue as part of our
supervisory activities. For example, in July 2018, we published an article in the Consumer
Compliance Supervision Bulletin that explained our concerns that charging consumers overdraft
fees based on APSN can constitute an unfair practice.12
At the same time, we recognize that some of this risk is driven by system limitations of
the core service providers, which can pose a real challenge to community banks confronting this
issue in their own transaction processing operations. In some cases, core service providers need
to implement changes to their systems to allow banks to avoid charging these fees. While this
issue is a narrow one in the context of broader discussions about overdraft fees, it is important.
We encourage banks to continue working with their service providers to implement fixes to
system-based issues, and we encourage service providers to support their bank clients in
providing compliant products.
Conclusion
Innovation has long been a high priority for banks, and I expect it will continue to be a
key issue for the future. New technologies have created significant opportunities for banks to
become more efficient and competitive and to provide improved products and services for
customers. While innovation brings new opportunities, it also introduces additional risks.
But a transparent regulatory posture for these activities can help banks of all sizes
embrace new technologies, to the benefit of their customers and the broader economy. The
specific innovations I mentioned today only scratch the surface of the technologies and
innovations that banks are exploring, which also include the use of artificial intelligence and
machine learning; efforts to develop faster payments, clearing, and settlement technologies; and
many others. For all areas of innovation that banks are interested in pursuing, regulators should
continue to prioritize timely, clear, and transparent guidance.
I would like to again thank the ICBA for the invitation to speak to you today, and also to
recognize the incredible commitment and efforts of the bankers in this room and beyond in
support of their communities and the ongoing strength of the U.S. economy.