The financial sector may not top the list of highly innovative industries, as it can often be slow moving and overly cautious. While some of this is driven by risk aversion on the part of financial service providers, much of it can be attributed to the restrictive regulatory regime in which they operate. Recently, however, the Consumer Financial Protection Bureau (CFPB) made an effort to address this issue when it released its new Compliance Assistance Sandbox.
To date, it has been virtually impossible for a firm to introduce a new financial service or product without spending copious amounts of money just to find out whether it complies with existing laws and regulations. As you can imagine, this is not feasible for many would-be innovators.
In fact, the financial sector is one of the most heavily regulated sectors in the United States economy. For example, the Dodd-Frank Act alone is over 840 pages long and contains at least 27,000 restrictive words. All of this regulation creates a system that takes a “precautionary” approach to innovation. This approach makes new products or services “guilty until proven innocent” and places the burden on financial entrepreneurs to prove that their innovation is both safe and necessary.
The new regulatory “sandbox” – think of it as a safe policy space to innovate – could help promote entrepreneurialism within a sector burdened by exceedingly restrictive regulation.
The precautionary approach within financial regulation often stems from a completely justifiable concern — that unfettered innovation may lead to risky products and services entering the market, which could harm consumers as well as the financial system more broadly. While the important role financial services play within the economy is often used to justify the scope and degree of financial regulation, it can have fairly stark unintended consequences when it comes to entrepreneurialism and innovation. All of this regulation may prevent some types of harm from occurring, but it also serves as a major hindrance to beneficial innovation. This is exactly what the CFPB’s regulatory sandbox was designed to combat.
It is important to understand specifically what a regulatory sandbox is — and what it’s not. While each one is unique, regulatory sandboxes can generally be defined as temporary testing environments where certain approved firms are able to experiment with innovative new business models, products or services with some combination of reduced regulatory burdens, safe harbors, increased communication with regulators and expedited decisions.
A regulatory sandbox is not, however, a free pass for a firm to do whatever it pleases, regardless of the regulations that are on the books. Firms admitted into the sandbox still have to comply with a variety of hardline rules designed to protect consumers as well as the stability of the financial system more broadly.
The CFPB’s sandbox centers around one specific form of relief: Safe harbors. A safe harbor allows regulators to assess whether an innovation complies with existing statutes and regulations and, if so, to grant that innovation protection from regulatory liability. This gives approved firms the ability to go forth and experiment with a new product without having to worry about regulators suddenly deciding that they are in violation of some law or regulation.
It can also help an entrepreneur gain clarity when a law is vague and when it is unclear whether a new product might violate the law. This can be incredibly valuable for a financial innovator. One of the major risks in creating a new product or service is that it will never see the light of day because it inadvertently violates some legal provision the creator did not know about.
The largest advantage to designing a sandbox around safe harbors is that it sidesteps the main issue critics have with regulatory sandboxes — that they allow firms to bypass regulations. By design, safe harbors ensure that new products or services meet the requirements of existing legal regimes. This helps to ensure that entrepreneurs are not wasting resources while also promoting regulatory compliance. Rather than undermining legality, safe harbors actively promote it.
While the devil will be in the details, and proper execution will be key, the CFPB’s new sandbox is a step in the right direction. Financial regulators at both the state and federal level should follow the CFPB’s example and ask what they can do to promote entrepreneurialism and innovation in a sector plagued with restrictive regulation.
Brian Knight is director of the innovation and governance project and a senior research fellow with the Mercatus Center at George Mason University. Trace Mitchell is a research associate with the Mercatus Center.