While the early innings of the fintech revolution focused on attacking specific niches of the financial value chain, some fintechs are now looking to leverage superior customer-acquisition-and-experience engines to springboard into direct banking products and services like deposits and cash management.
Developments within the broker-dealer, payment and lending verticals have made it clear that many fintechs view traditional banking products as a way to acquire customers, deepen customer relationships through a broader suite of financial products, diversify revenue and potentially access lower-cost, more stable funding. Case in point: Varo Money just became the first fintech to receive a national bank charter.
Fintechs that want to offer traditional banking must make a key choice: enter the market via partnership or pursue a charter, either by applying for one or buying an existing bank. There are challenges, advantages and implications for each option, but Novantas increasingly sees partnerships as just a first step on the path to becoming a bank.
A Good Starting Point
The COVID-19 pandemic is accelerating the move by fintechs to expand into traditional banking, particularly as digital adoption rates have quickened in recent months while states were on lockdown. This trend, which Novantas expects to continue even as the economy reopens, has benefited neobanks like Chime and Varo considerably. Additionally, certain fintech players are experiencing wholesale funding stress for the first time in their existence, an issue that stable deposit funding would remedy – at least in part.
The expansion of the fintech ecosystem has given rise to “banking-as-a-service” (BaaS) providers that enable non-banks to offer regulatorily-compliant, FDIC-insured deposit accounts. Novantas believes that these partnerships are a good way for fintechs to get their foot in the banking door, although they likely aren’t sustainable long term.
Partnership models allow fintechs to manage the customer relationship while the banking partner holds the deposits on balance sheet. Fintechs can either enter into an exclusive arrangement with one bank, as in the case of N26 and Axos Bank, or choose multiple banking partners as Chime has done through deposit partnerships with Stride Bank, N.A., and The Bancorp Bank. The latter is becoming more common as a growing number of banks open their doors to BaaS services.
Market entry through partnership is a flexible, low-cost alternative to pursuing a banking charter. The BaaS ecosystem has brought down entry costs to as little as $500,000, according to QED Investors, a venture-capital firm that focused on fintech.
Partnership models allow fintechs to avoid expensive infrastructure investments by leveraging an existing bank’s systems. Launch times are largely limited by contract negotiation and preparation of front-end technology, creating a significant advantage over the regulatory hurdles required by the charter option. This option can be useful for fintechs that want to offer extra utility without a large investment. It is also a good training ground to refine the business case and determine the viability of a deposits business.
Limits of Partnerships
On the flip side, shared-product economics can reduce profitability for the fintech and limit options for product design. In addition, banks and fintechs may have different corporate objectives, creating the potential for an unstable relationship.
Part of the economic challenge is that the deposits generated via these partnerships are treated as brokered, which have limited value for banks. Furthermore, brokered rates are particularly low in today’s environment, leading banks to prefer to use their limited brokered deposit capacity on funding sources that are cheaper than the rates many fintechs must offer to acquire new customers. The FDIC has proposed changing these rules, but there has been no formal action.
The value created by these deposits must be divided between the banking partner and the fintech through margin and interchange splits. Partnership negotiations set the terms for which party must cover costs such as overdraft, ATM fees and call-center support. Fintechs that want to provide superior customer experience with features such as free ATM access, flexible overdraft and 24-hour customer service will often end up bearing these costs. These costs, along with customer-acquisition costs like marketing, can dwarf the revenue that is generated.
Novantas analysis suggests that typical deal structure can result in negative account-level economics to the tune of roughly $5 per customer/month for checking products. While negative product economics may be an acceptable tradeoff for some fintechs that want to capture a broader relationship, the costs more often than not outweigh potential benefits.
Choosing the Right Path
Once a fintech understands the benefits and challenges of each approach, it must consider a number of issues to help decide if it wants to begin its transformation with a bank partnership or jump right to becoming a bank.
First, the fintech must determine how its business model would benefit from everyday banking, whether it is through attracting more customers or deepening ties with their existing base, and then determine if there is added value in holding deposits on balance sheet. While deposit funding provides clear value for some key players, fintechs should develop a well-executed business case to understand the true costs and benefits. The includes analyzing deposit pools, determining the realistic costs to acquire these deposits (both operating expense and interest rate) and the prospects for additional sources of cross-selling. Being able to quantify the realistic benefits of acquiring deposit relationships, whether on balance sheet or off, will go a long way in helping assess whether it is worthwhile to enter the market.
If the partnership path seems appealing, the fintech must identify the main goals in pursuing a partnership and the economic challenges associated with these tie-ups. A deep understanding of the underlying economics of each component of traditional banking will provide a great baseline for contract negotiations with a banking partner. The fintech should also set a timeframe for the partnership that lays out an ultimate path for either seeking a charter or buying a bank.
If a fintech decides that a partnership doesn’t go far enough toward achieving its goals, it can pursue a charter or seek to obtain one by buying a bank. In either case, prudent preparation, targeted investment and experienced leadership can help fintechs clearly communicate their understanding of deposits to regulators. Early engagement with deposit experts, both externally and in the form of experienced banking hires, can provide fintech leadership teams with necessary education on deposits. This additional knowledge can also be valuable in communicating with investors and customers.
There is no question that more fintechs will seek to enter traditional banking. In all cases, the outcome of these efforts will be based on pursuing the right market entry approach and taking the appropriate steps to prepare for the challenges to come.
Becoming a Bank
There is a long list of fintechs that are in line after Varo. LendingClub (through its acquisition of Radius Bank), Square and Nelnet (through bank charter applications) are all going through the regulatory process and other players aren’t far behind. While the acquisition of a charter gives fintechs full license to operate as a bank, the charter process has its own distinct challenges.
A bank charter enables fintechs to hold customer deposits on balance sheet – a transformative profitability lever for companies that previously relied on wholesale funding. Retail deposit funding has clear advantages over alternative funding sources: it is low-cost, long duration and generally counter cyclical. Deposits can reduce funding costs by 10 to 30 basis points below wholesale rates – an even larger advantage in times of stress and higher rates. Fintechs that have a clear understanding of deposit behavioral life can invest funding in longer-term, higher-rate investments with greater certainty, increasing margin while optimizing their investment strategies. And those that aren’t in the lending business need an asset strategy.
Still, the process of acquiring a bank charter isn’t for the faint of heart. Indeed, it took Varo three years to win a national charter. FDIC and OCC regulators hold charter applicants to a high bar, resulting in a challenging approval path for previous applicants. Applicants must demonstrate clear knowledge of core banking concepts and an ability to effectively manage deposits – skills that are often outside of fintechs’ core capabilities. Regulator skepticism can impose additional post-approval costs, as evidenced by the FDIC’s requirement for Square and Nelnet to maintain capital levels that are higher than typical FDIC-insured banks. Acquiring a bank may speed up the process slightly, however, regulators will demand similar requirements before approving the deal.
Source: S&P Global, Company Websites
NBC=national bank charter, ILC=industrial loan company