Creating a Future-Proof Regulatory Framework for Hybrid Financial Institutions: Article 2 of 3 inspired by Dubai’s D33 Vision

Dubai’s ambition to be among the top four global financial hubs by 2033, as outlined in the Dubai Economic Agenda D33, demands bold innovation in financial services. Traditional banking, while essential, most likely isn't adequate enough to achieve this ambitious goal. To achieve the next wave of financial innovation, Dubai could foster a new breed of financial institutions as explained in the first article in this series. There I exemplified this with what I (not too creatively) simply named FinBanks, that combine the strengths of traditional banking with the cutting-edge developments in fintech, blockchain, and AI.

However, for such hybrid institutions to flourish long-term, a supportive but also robust regulatory framework is important. So here I look into some of the regulatory implications of such FinBanks, the need for innovation-friendly regulation, the potential for what I choose to call dual banking books, and how in this case the Dubai Financial Services Authority (DFSA) can create an innovation-enabling regulatory sandbox. With the right policies and frameworks, Dubai could be the birthplace of such new Financial Institutions, supporting becoming a global financial powerhouse, and leading the way in next stage fintech-driven banking.

FinBanks: Example of a New Era of Financial Institutions

FinBanks here represent a fusion of traditional banking models with fintech innovations, leveraging technologies like blockchain, AI, and decentralised finance (DeFi). These hybrid institutions can offer both traditional services—such as loans, deposits, and wealth management—and cutting-edge financial products, like tokenised assets, blockchain-based payments, and AI-driven investment tools.

As financial services evolve rapidly, regulators play a critical role in ensuring that innovation is balanced with the need for financial stability, security, and trust. Dubai, with its forward-thinking approach, is well-positioned to create the regulatory environment that enables FinBanks to thrive.

However, the success of FinBanks will depend on a regulatory framework that encourages innovation without compromising systemic safety. To achieve this balance, regulators must rethink traditional capital requirements, risk management strategies, and how FinBanks manage both traditional and innovative products.

Key Regulatory Challenges and Opportunities for FinBanks

FinBanks, as hybrid financial institutions, bring unique regulatory challenges that differ from those faced by traditional banks. To ensure their success and alignment with Dubai's D33 agenda, the Dubai Financial Services Authority (DFSA) will need to address several critical areas, including:

1. Capital Requirements for Hybrid Financial Institutions

2. Managing Interest Rate Risk and Credit Spread Risk

3. Potentially Allowing Dual Banking Books and Balances

4. Creation of a Regulatory Sandbox for FinTech Innovation

5. Innovation-Friendly Regulation to Balance Risk and Opportunity

Each of these areas presents opportunities for regulatory adaptation and innovation, ensuring that FinBanks can contribute to Dubai’s goal of becoming a global financial hub while managing the unique risks they introduce.

1. Capital Requirements for Hybrid Financial Institutions

Traditional banks are subject to strict capital adequacy requirements under frameworks like Basel III/IV, ensuring they hold sufficient capital to absorb losses and protect depositors. For FinBanks, these requirements must be adapted to account for the unique risk profiles of both traditional and fintech-related operations.

Tailored Capital Adequacy for Traditional and Innovative Products

FinBanks as described in the first article would operate across two distinct product categories: traditional banking services (e.g., deposits, loans) and innovative products (e.g., tokenised assets, DeFi solutions). Regulators will need to establish tailored capital requirements that reflect the risk profiles of each category.

- Traditional Banking Products: These products should continue to be regulated under traditional frameworks, with risk-weighted asset (RWA) calculations and capital ratios aligned with Basel III standards. This ensures that FinBanks maintain enough capital to cover the risks associated with credit, liquidity, and interest rate exposure.

- Innovative Products: Tokenised assets, blockchain payments, and AI-driven lending represent different risk profiles compared to traditional products. As such, regulators should consider implementing enhanced capital buffers for these activities, accounting for their volatility and the for the time being less predictable risks they pose. The introduction of dynamic capital ratios, which adjust based on the performance and risk level of these products, could potentially allow FinBanks to innovate while safeguarding against excessive risk.

Hybrid Capital Buffers

Given that FinBanks blend traditional and fintech operations, regulators could require these institutions to maintain hybrid capital buffers—a combination of traditional and innovation-specific capital. This buffer would provide an extra layer of protection, ensuring that FinBanks can absorb potential losses from fintech products without jeopardising their overall stability.

By striking the right balance between prudence and flexibility, regulators can create a framework that supports innovation while minimising the potential for financial instability.

2. Managing Interest Rate Risk and Credit Spread Risk

One of the critical risks for any financial institution is exposure to interest rate risk on its banking book and credit spread risk from non-trading book activities. For FinBanks, these risks become more complex due to the diverse range of products they offer, spanning both traditional and new fintech categories.

Interest Rate Risk on the Banking Book (IRRBB)

Interest rate risk on the banking book arises when financial institutions hold long-term assets but fund them with shorter-term liabilities. This can lead to losses if interest rates rise, and the institution then must reprice its liabilities at higher rates. FinBanks, with their mix of traditional and innovative assets, may face this challenge acutely.

- Advanced ALM Systems: FinBanks will need to implement advanced asset-liability management (ALM) systems, which use predictive analytics and AI to monitor interest rate exposure in real time. These systems should cover both traditional banking products and innovative offerings like blockchain-based lending, providing a comprehensive view of interest rate risk across the institution.

- Hedging Strategies: FinBanks may employ sophisticated hedging techniques, such as interest rate swaps and caps, to mitigate interest rate risk. However, regulators must ensure that these strategies are well-managed and transparent, particularly given the complexity of fintech products. So the fit and proper requirements as well governance standards here need to remain high.

Credit Spread Risk from Non-Trading Book Activities

Credit spread risk occurs when the market value of non-trading book assets fluctuates due to changes in credit spreads. For FinBanks, which may hold tokenised assets or other non-traditional instruments, this risk can potentially be significant.

- Granular Credit Spread Models: FinBanks should develop granular models that assess credit spread risk across their various asset classes, including both traditional loans and innovative products like tokenised assets. These models must account for the liquidity, volatility, and creditworthiness of each product, ensuring that FinBanks can manage credit spread risk effectively. This would be in their own interest, as it would allow them the most efficient offerings to their customers anyway.

- Capital Charges for Spread Risk: Regulators could impose capital charges specifically for credit spread risk, ensuring that FinBanks hold sufficient capital to cover potential losses from changes in credit spreads. This would be particularly important for fintech-related assets, which may be more volatile than traditional products.

3. Allowing Dual Banking Books and Balances

Given the diverse range of products and services that FinBanks offer, regulators could allow these institutions to operate with dual banking books—one for traditional products and another for innovative offerings. This structure would provide clear distinctions between the risk profiles of each category, enabling FinBanks to innovate while maintaining the stability of their traditional operations.

Separate Risk Management for Traditional and Innovative Products

By operating with dual banking books, FinBanks can manage the risks of traditional and innovative products separately. This allows for more targeted regulation and oversight, reducing the potential for cross-contamination between high-risk fintech products and stable traditional services.

- "Traditional" Banking Book: This book would include conventional products such as deposits, loans, and traditional securities, subject to traditional risk management frameworks.

- "New" Banking Book: This book would cover fintech-driven products, such as tokenised assets, DeFi solutions, and blockchain-based payments, with tailored risk management strategies that reflect their unique risks.

Wind-Down Capital Requirements

To further protect against potential financial distress, regulators could take special considerations to the wind-down capital requirement. This would ensure that FinBanks maintain sufficient capital to cover the costs of an orderly wind-down, either voluntarily or in the case of involuntary liquidation. The wind-down capital requirement would act as a safety net, providing FinBanks with the resources needed to manage voluntary or involuntary liquidation without disrupting the broader financial system. The capital would be held as liquid, low-risk assets, ensuring it is readily available in times of need.

- Orderly Wind-Down: If a FinBank were to face financial distress, the wind-down capital would cover the costs associated with liquidating assets, paying off liabilities, and protecting depositors.

- Pre-Defined Exit Strategies: Regulators could require FinBanks to submit detailed wind-down plans that outline how the institution would handle an orderly closure. These plans would thus support that customers, creditors, and other stakeholders are protected in the event of a failure.

By allowing dual banking books and implementing wind-down capital requirements, regulators can create a framework that fosters innovation while minimising the risks associated with fintech-driven products.

Enhanced Governance and Transparency

With dual banking books, regulators can introduce enhanced governance frameworks to ensure that FinBanks operate with full transparency and accountability. This would include:

- Clear Reporting Lines: FinBanks would be required to report separately on the performance, risks, and capital adequacy of their traditional and innovative products, ensuring that regulators have full visibility into both segments of the institution.

- Proactive Risk Mitigation: Segregated risk management would allow FinBanks to respond more quickly to emerging risks within their innovative banking book, containing potential issues before they impact the broader financial system.

4. Creation of a Regulatory Sandbox for FinTech Innovation

It would be important to allow such FinBanks to innovate their products and services across their traditional and new books. To ensure that FinBanks have the flexibility to innovate while remaining compliant with regulatory standards, the Dubai Financial Services Authority (DFSA) could establish a regulatory sandbox specifically designed for hybrid financial institutions.

The Role of Regulatory Sandboxes

A regulatory sandbox allows financial institutions to test new products, services, and business models in a controlled environment. By operating within the sandbox, FinBanks can experiment with innovative offerings without being subject to the full burden of regulatory requirements, as long as they operate within predefined limits.

- Controlled Innovation: FinBanks can develop and test new fintech products, such as blockchain-based payment solutions or AI-driven credit scoring systems, within the sandbox. This allows them to innovate while minimising the risk of widespread financial instability.

- Regulatory Feedback Loop: The sandbox provides a feedback mechanism between regulators and FinBanks, allowing regulators to observe the impact of new products in real-world conditions. This feedback can inform future regulatory frameworks, ensuring that they support innovation while managing risk.

Specific Benefits for FinBanks

For FinBanks, a regulatory sandbox applied here would offer several key advantages:

- Tailored Compliance: FinBanks can operate under tailored compliance requirements while testing new products. This reduces the regulatory burden and allows for faster innovation cycles, enabling FinBanks to bring new products to market more quickly.

- Risk Mitigation: The sandbox environment ensures that any risks associated with innovative products are contained within a controlled space. FinBanks can test and refine their risk management strategies before scaling their products to a broader market.

- Collaboration with Regulators: By working closely with regulators during the sandbox phase, FinBanks can gain insights into compliance requirements while demonstrating their ability to innovate responsibly. This collaborative approach fosters trust and transparency between financial institutions and regulators while building the necessary skills and knowledge on "both" sides.

5. Innovation-Friendly Regulation: Balancing Risk and Opportunity

To realise Dubai’s vision under the D33 agenda, it is crucial that regulation supports innovation without stifling it. The regulatory framework must strike a balance between encouraging creativity in financial services and maintaining the stability and security of the financial system.

Proportional Regulation for FinTech Activities

FinBanks, by their hybrid nature, would engage in both traditional banking and new fintech operations. Regulators could adopt a proportional regulation approach, where the level of oversight and compliance requirements varies depending on the product’s risk profile.

- Low-Risk, Traditional Products: Traditional banking activities, such as loans and deposits, could continue to be regulated under established frameworks, ensuring customer protection and financial stability.

- High/Less known-Risk, New Products: FinTech offerings, particularly those related to blockchain and DeFi, could be subject to enhanced oversight. However, regulation should remain flexible enough to accommodate the experimental nature of these products, allowing FinBanks to iterate and improve.

Regulatory Flexibility and Adaptive Oversight

We see that Fintech products evolve rapidly, often outpacing regulatory frameworks. To address this, regulators must adopt an adaptive oversight approach, where regulatory guidelines can be updated in real time to respond to new developments in the financial landscape.

- Dynamic Regulation: Instead of imposing rigid regulations that might limit innovation, the DFSA could implement a dynamic regulatory model that adjusts in response to the evolving risks and opportunities posed by FinTech products.

- Encouraging Responsible Innovation: While flexibility is key, FinBanks must remain accountable. Regulations could encourage responsible innovation, where financial institutions are rewarded for demonstrating sound risk management practices and transparent reporting, particularly when dealing with new and untested products.

Dubai is Well Positioned to Lead in the Creation of Hybrid Financial Institutions

Dubai is already a leader in embracing innovation and fostering an environment where bold ideas can thrive. The creation of hybrid institutions such as the likes of FinBanks described here, would be a next logical step in this journey. However, for these institutions to succeed, Dubai must also make a forward-thinking regulatory framework that supports innovation without compromising financial stability.

By allowing FinBanks to operate with dual banking books, creating an innovation-friendly regulatory sandbox, and implementing tailored capital requirements for hybrid financial institutions, Dubai can position itself as a global leader in fintech-driven financial services. These regulatory measures will allow FinBanks to innovate responsibly, while offering integrated products that meet the needs of both traditional and tech-savvy customers.

The Dubai Financial Services Authority (DFSA) now has a unique opportunity to lead by adopting proportional regulation, dynamic oversight, and the right levels of capital requirements. These measures will ensure that Dubai remains a safe, stable, and attractive hub for financial innovation, supporting the D33 agenda.

Now in order for hybrid institutions such as described here to operate efficiently and prudent while maintaining the necessary force to innovate, the right approach to data management, architecture and use will be important. What this means will be discussed further in the next and last article in this series.