Striking the balance: Regulation and innovation in payments

Regulating financial services adequately without stifling innovation is a challenge. The trade-offs that occur between the often-competing demands of regulation and innovation were a theme in the National Payments Vision (NPV), published in November 2024. Regulation was mentioned over 100 times and innovation 65 times showing how integral both features will be to the future of payments. As we look ahead to the scheduled Q2 2025 announcement of the Payments Vision Delivery Committee's approach, we ask: can we ever truly balance regulation and innovation in payments?

The landscape and outlook of the payments industry is changing rapidly

Last year we saw a change of government, with the new Labour cabinet making no secret of its desire to drive the “highest sustained growth in the G7” for the UK.  For the new government to achieve the target annual GDP growth of 2.5%, regulation and innovation need to work more harmoniously. With this in mind, the Prime Minister has been clear that regulation should support growth and unlock investment. Yet this is set against a backdrop of declining profits and ever-increasing costs for most UK banks.

UK banks have grown at a fraction of the rate of US counterparts and big tech in the last decade

When comparing UK and European banks to their US counterparts, there has historically been a much stricter regulatory framework in the former. We have seen this through ringfencing requirements stifling many banks in Europe where it has been rigidly enforced. This is in stark contrast to the US where banks have been able to thrive. The effects of this burdensome approach in Europe are seen through the statistics.

Since the Global Financial Crisis, the EU banking sector has reported profitability levels, measured by return on equity, of around 5%, whereas this figure is double at around 10% for US banks.  

This imbalance could be attributed in a large part to the stricter regime of regulation in Europe. However, post-Brexit, UK banks and regulators have a genuine opportunity to reverse the previously burdensome approach in a responsible way.

The regulatory agenda absorbs change budgets, leaving banks with little opportunity to innovate

The reality is that meeting regulatory requirements is expensive and time consuming. At Baringa, we frequently see clients spending 75-90% of their change budget on mandatory and regulatory-driven change. This leaves very little room for investing in new innovation. While compliance and fraud obligations are being met, customers aren’t being offered innovative products and services.  

We have recently seen some of the most exciting new products on the market coming from firms who are not burdened by the regulatory wranglings that larger markets players face into. This is seen through the rise of embedded finance with many new players offering banking as-a-service (BaaS) solutions to corporates, without the regulatory overhead seen by other larger players.

Having said this, the ability for some of these new firms to bring products to market and scale is often encumbered by a myriad of regulatory hoops that not only require large fiscal demands, but also the ability to navigate complex European law.

An example of this is the safeguarding regime (CP24/20) that is being introduced for payments and e-money firms. The proposed rules introduce more stringent requirements for safeguarding customer funds, including enhanced record-keeping, reconciliation procedures, and internal controls. Smaller firms may need to implement significant operational changes to comply with these new requirements, which can be resource-intensive and costly. While currently opt in, if made mandatory it could be hard for smaller players to meet, thus preventing new entrants and ultimately limiting the choice of the end consumer. The extra burden created by CP24/20 could potentially see a stifling of innovation that this area requires to be a success.

So how do we move forward?

Regulation in financial services should ultimately serve the interests of the end consumers, offering required protection and choice, while promoting competition.

We’ve seen this executed well within payments through Strong Customer Authentication (SCA). Undoubtedly, SCA has heavily contributed to a reduction in fraud cases. The measures went a long way in preventing unauthorised fraud, which caused £261.7 million of losses in the first half of the year prior to introduction in 2021, with 73 per cent of retailers seeing a decline in online payment fraud following its introduction.  

However, while the customer was ultimately protected, improvements had to be made to SCA based on feedback from merchants that showed the regulation brought added friction to customer journeys, potentially resulting in basket dropout. This shows the tightrope that is walked to ensure that regulation and innovation do not stifle one another, but also the importance of a feedback loop in which all players in the payment’s ecosystem have their voices heard.

Big tech must play a role in how we shape the payments regulation of the future

In the way that feedback was imperative to improving SCA, one key area that remains relatively silent in this discussion is the role and hitherto lack of input that big tech and customer data has had on payments regulation. 

While big tech is becoming ever present in the payments landscape and driving some of the most innovative solutions, there is a void when it comes to its participation in regulation.

At Baringa, we welcome the government’s interest in ensuring data asymmetry between big tech companies and financial services firms. However, we also believe that this could go one step further and see parity between the way each are treated. This does not mean all big tech firms should face the same regulatory scrutiny as financial institutions but instead learn from the way big tech has been able to grow and innovate with less punitive regulatory regimes surrounding it. This is not to say that regulation is not required, instead, let’s look at areas that have done well and understand the reasons why.

How can the government balance regulation and innovation in payments ?  

We are now over six months into the new Labour government’s term and if they are serious about driving growth, we should start to see evidence of them keeping the customer interests first. 

This does not mean stifling all forms of innovation under the auspices of customer safety but instead recognising that there is inherent risk in using financial services. It also does not mean that enabling new and innovative firms to partake in the ecosystem carries any greater risk. Instead, enabling and supporting new players in the ecosystem, with an impetus on collaboration and shared responsibility, is imperative to the future success of financial services.

Tangibly, we at Baringa believe three actions could be taken moving forward:

• Firstly, continue to bring regulators closer together and working in lockstep with the industry to define the right options for UK PLC as recommended in the NPV is critical.
• Secondly, the government should plan to look holistically at Financial Market Infrastructure (FMI) and avoid siloes, such as those seen between New Payments Architecture (NPA) and Regulated Liability Network (RLN).
• Finally, to support its growth agenda, Labour should look at policies that make the UK an attractive option for new market entrants, leaving ability to innovate while also balancing protection to the customer.

If you’d like to discuss how to balance regulation and innovation in payments further, please get in touch.