Upgrading Digital Financial Infrastructure for Fairness

The Challenge: Dated Financial Infrastructure is Exacerbating Inequality

The shortcomings of the United States’ retail financial systems became evident when the federal government responded to the economic fallout of the coronavirus pandemic. The payment system moved slowly: it took as long as three months to get payments to an estimated 100 million Americans, many of whom were facing sudden financial hardship.¹ In July 2020, months after many other countries had disbursed stimulus payments into bank accounts—often within minutes—millions had not yet received their prepaid cards.² In the absence of a national identity system, some payments were sent to deceased people, while fraudsters exploited state unemployment programs by using stolen identities.³ Challenges also emerged with the credit-history-based credit-scoring system. The government mandated forbearance on loans, but the patchy application of forbearance codes in the existing credit system will likely make it harder to rebuild credit eligibility when people need it most.⁴

Even before the crisis exposed these shortcomings, the dated financial infrastructure in the United States was a driver of inequality.⁵ Delays in getting paid push many individuals toward exploitative alternatives, such as small-dollar “payday” lenders or highcost check cashers, which rake in $2 billion in fees every year; or they are left to face bank overdraft fees, which totaled $24 billion in 2016.⁶ Prior to the crisis, an estimated 50 million Americans lacked sufficient credit histories to be scored by existing models, and another 80 million, many of them in minority households, paid higher prices or were denied financing because they had “non-prime” scores.⁷

The Solution: Upgrade the U.S. Digital Financial Infrastructure

The U.S. financial infrastructure needs to be upgraded for the digital age in three priority areas in order to make meaningful progress towards a fair system.

Instant Payments to Make Funds Available for Use Within Seconds

The United States needs a widely accessible instant-payment system where money sent from any bank account or digital wallet to another account or wallet is available for use within seconds. There are a number of ways to work toward this goal without wholesale changes to the underlying infrastructure. The Federal Reserve could extend the hours of operation of the instant automated clearing house system, the fastest retail payment system, as well as the underlying wholesale settlement system, Fedwire, to work around the clock.⁸ Alternatively, Congress could amend the Electronic Funds Availability Act of 1987 to eliminate or dramatically reduce the two business days that banks can hold funds.

Ultimately, wholesale changes might be needed. The Federal Reserve could expedite FedNow, a new real-time payments system slated to go live in 2024, by incorporating existing private-sector platforms with the requirement that they be interoperable and compliant with network rules. This would avoid unnecessarily duplicating existing private-sector approaches. A similar instant-payment system in India, launched in 2016, now has an estimated volume 50 times that of the Federal Reserve’s own instant automated clearing house, illustrating that a private-sector approach could achieve widespread instant payments faster.⁹ These steps could get payments into people’s pockets faster, reducing their reliance on predatory lenders and diminishing the prevalence of overdraft fees.

A System for Individuals and Businesses to Identify Themselves

The pandemic response in the United States has showed that the country needs a digital identity system that allows any individual or business to identify itself without compromising their privacy and security. Such a system can be implemented without universal biometrics or issuing a national ID card. A type of federated system could be built over time, leveraging existing data held by the government and the private sector, as has been done in Estonia.¹⁰ Another contribution to this collection builds on the Estonian model to offer a proposal for a national digital identity system in the United States.¹¹ In Singapore, linkages among existing government datasets allowed pandemic stimulus payments to be distributed instantly.

As a first step, regulated financial services providdiminishing the prevalence of overdraft fees. ers should be able to pull data on individuals from government agencies, such as the Internal Revenue Service (IRS), through secure application programmable interfaces (APIs). Congress has already required the IRS to begin building an income-verification API that could be part of an identification system based on government data; the creation of such interfaces should be expedited and expanded.¹² Ensuring the protection of sensitive personal financial data will be critical in such data-sharing schemes; another contribution to this collection offers a proposal for a cross-cutting federal privacy framework.¹³ Additionally, federal regulators could facilitate the portability of “know your customer” (KYC) data between regulated financial providers to expedite the KYC process, as in Luxembourg.¹⁴ These steps could realize some of the benefits of a national digital identity system in short order.

A Credit-Scoring System Based on Real-Time Data

The United States needs a credit-scoring system that operates in real time and relies on diverse sources of data. The existing system relies on historic credit usage and is likely to perpetuate inequities in lending.¹⁵ This will make it harder for those most affected by the economic fallout of the pandemic to rebuild their lives with credit.¹⁶ A new credit-scoring system needs to access better data and incorporate that data in models faster. For example, cash-flow data that reflects income and expenses is available for most consumers and businesses, and it can be captured in real time. Lever aging such data has substantial promise for inclusion and fair lending.¹⁷

Use of this data for new lending models could be scaled system-wide if existing models are adjusted and better data secured. Financial regulators have sig - naled increasing openness to allowing the use of cashflow data in credit underwriting.¹⁸ But they also need to encourage faster adoption. It took over five years after the last financial crisis for lenders to update their models and even today the most widely used models use pre-2008 data. Regulators and Congress should provide greater clarity to lenders about validation and compliance expectations, reduce lenders’ barriers to data, and strengthen consumer protections.¹⁹

Conclusion

These digital infrastructure upgrades are based on financial data flows in the digital age. The United States needs a modern framework for finance that updates rules for accessing, controlling, moving, and utilizing data. Congress can act on multiple fronts. Immediately, it can encourage the Consumer Financial Protection Bureau to enable financial data portability under the authority it was given in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.²⁰ In the medium term, Congress needs to upgrade laws on privacy and control in finance, such as the Finan - cial Modernization Act of 1999.²¹  By modernizing the infrastructure of the financial system, the United States can address inequalities, remove inefficiencies, and make its financial system fit for the digital age.

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^{Photo Credit: Sergey Nivens / Shutterstock}

Kabir Kumar is a director at Flourish Ventures.

Tilman Ehrbeck is a managing partner at Flourish Ventures and serves as chair of the Advisory Council to the U.N. Special Advocate for Inclusive Finance in Development.

^{1 Aaron Klein, “How to fix the Covid stimulus payment problem: Accounts, information, and infrastructure,” Brookings Institution, August 19, 2020.}

^{2 U.S. Government Accountablitiy Office, Coronavirus Oversight.}

^{3 Ibid.}

^{4 FinRegLab, Covid-19 Credit Reporting & Scoring Update, July 2020.}

^{5 Aaron Klein and George Selgin, “We shouldn’t have to wait for FedNow to have faster payments,” Brookings Institution, March 3, 2020.}

^{6 Theresa Schmall and Eva Wolkowitz, 2016 Financially Underserved Market Size Study, Center for Financial Services Innovation, November 2016.}

^{7 Unpublished mimeo, FinRegLab.}

^{8 Brookings Institution, How to make real-time payments real now, September 22, 2020.}

^{9 Aaron Chaze, “India Sparks A Real-Time Payments Revolution,” Global Finance, March 3, 2020.}

^{10 Economist, “Covid-19 strengthens the case for digital ID cards,” September 5, 2020.}

^{11 Toomas Ilves, “Unlocking Digital Governance,” in #Tech2021: Ideas for Digital Democracy}

^{12 Peter Renton, “Congress Passes New Law to Mandate IRS Modernization,” Lend Academy, June 17, 2019.}

^{13 Quentin Palfrey, “Advancing Digital Trust with Privacy Rules and Accountability,” in #Tech2021: Ideas for Digital Democracy.}

^{14 Jamie Leee, “MAS to reboot e-KYC project,” Business Times, November 13, 2019.}

^{15 Caroline Ratcliffe and Steven Brown, “Credit scores perpetuate racial disparities, even in America’s most prosperous cities,” Urban Institute, November 20, 2017.}

^{16 FinRegLab, Covid-19 Credit Reporting & Scoring Update, July 2020.}

^{17 FinRegLab, The Use of Cash-Flow Data in Underwriting Credit: Empiri - cal Research Findings, July 2019.}

^{18 Board of Governors of the Federal Reserve System, Consumer Finan - cial Protection Bureau, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, “Interagency Statement on the Use of Alternative Data in Credit Underwriting,” December 3, 2019.}

^{19 FinRegLab, The Use of Cash-Flow Data in Underwriting Credit: Market Context & Policy Analysis, February 2020.}

^{20 Consumer Financial Protection Bureau, “CFPB Announces Plan to Issue ANPR on Consumer-Authorized Access to Financial Data,” July 24, 2020.}

^{21 Unpublished mimeo, Financial Health Network.}