New legislation would rein in 'shadow banking' system

The Consumer Financial Protection Bureau isn't the only entity in Washington that wants to reign in big technology firms that have ventured into payments. A new bipartisan bill in the Senate would ban nonbank financial entities from operating like banks, and benefiting from federal deposit insurance, without first passing muster with the Federal Reserve.

The Close the Shadow Banking Loophole Act, introduced by Senator Sherrod Brown, the Ohio Democrat who chairs the Senate Banking Committee, and Senator John Kennedy , R-La., takes direct aim at industrial loan companies (ILCs). ILCs are state-chartered institutions that first opened for business back in the early 20th century as a way to lend money to industrial workers. (At the time bank accounts were a rarity among working class Americans.)

Over time, ILCs have expanded their offerings, and have become a vehicle for companies that want to offer financial services comparable to banks and credit unions, but without regulatory strings attached.

They do this by leveraging a loophole in the Bank Holding Company Act, which established the Fed as primary federal regulator of bank holding companies. The result is a "shadow banking system," the Senators asserted, adding that the Federal Reserve needs to regulate these companies as banking companies.

Square (now Block) has an ILC charter. In 2020 it secured a license for Square Financial Services Inc., which operates Square Loans and Square Savings. As state-chartered FIs, these entities have FDIC coverage for deposits up to $250,000. Under the proposed legislation Square Financial Services would be regulated by the Fed in accordance with the rules for bank holding companies.

Recent reports out of the Federal Reserve Bank of New York reveal explosive growth, along with growing delinquency rates, among fintechs that serve low-income consumers.

Don't give Square a leg up

The Close the Shadow Banking Loophole Act could also be described as the "don't give Square a Leg Up" bill. As Sens. Brown and Kennedy, along co-sponsors Sens. Chris Van Hollen, D-Md., and Bob Casey, D-Penn., pointed out in a press release announcing the bill, the current lack of regulatory oversight gives nonbanks unfair advantage over banks and credit unions.

"Letting big tech and commercial companies operate banks without proper oversight will only open doors for predatory lending, invasions of consumer privacy, and broader financial instability," Sen. Brown said. "American consumers deserve confidence that our financial system is stable and accountable to protect consumers," Sen. Kennedy said. "Allowing companies to run their own full-service banks without effective oversight puts individual Americans and the U.S. financial system at risk."

Regulatory tightening

The Senate legislation came just weeks after the CFPB proposed a plan to supervise big-tech companies like Block that offer payment services, such as digital wallets and payment apps.

The Close the Shadow Banking Loophole Act, which adds the Fed to the oversight of these entities, has received broad support from groups representing financial institutions, and consumer groups, too.

In a letter to lawmakers, the Bank Policy Institute (which represents bank and consumer groups) urged lawmakers to close the loophole "before it is further exploited by firms seeking to gain all the advantages of an FDIC-insured bank charter without the concomitant supervision and regulation that Congress has established for the corporate owners of full-service insured banks."

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