Square’s ILC bid may open floodgates for fintechs

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WASHINGTON — Trends pick up fast in Silicon Valley and for financial innovators, the up-and-coming regulatory strategy is to seek a bank charter.

In June, the online lender Social Finance, or SoFi, applied for an industrial loan company charter in Utah to process certain depository accounts and credit cards. A month later, the mobile-only bank Varo submitted a first-of-its-kind application for a traditional national bank charter.

The latest entrant is Square — a payments giant launched by Twitter co-founder Jack Dorsey in 2009 that has been slowly branching out into small-business and consumer loans. On Thursday, the company announced it would also seek to open a Utah-based ILC to expand its lending arm.

These bids may be all it takes to open the floodgates of bank chartering activities among new financial companies — especially given the tech industry’s keen awareness of the first-mover advantage.

“We're likely to see more interest,” said Kevin Petrasic, a partner at White & Case. “Part of it is a bit of pent-up opportunities that are suddenly being played out.”

Today, financial innovators have no shortage of options for seeking out a bank. In addition to the ILC and the traditional bank charter, a third possibility could emerge soon: the Office of the Comptroller of the Currency’s fintech charter.

“This is the beginning of a very interesting time,” said Petrasic, “in which we will see a number of players evaluating all sorts of options.”

The question is which option — the ILC, OCC nondepository charter, or even a traditional bank— will be be most attractive to fintechs. So far, ILCs seem to be in the lead.

Square and SoFi are most likely the avant-garde of a broader uptick in interest in the controversial charter. Theirs are the first applications fielded by the Utah Department of Financial Institutions since 2008.

“The interest in the charter probably has picked up a little bit,” said Shaun Berrett, the supervisor of industrial banks at Utah’s financial regulator. “We hear from more fintech firms than we used to,” he added, “but not exclusively.”

This is likely the result of two factors, Berrett said. One, the moratorium on ILCs imposed by the Dodd-Frank Act — an echo of the debacle that ensued when Walmart applied for its own ILC last— ran out in 2013.

In addition, the aftershock of the financial crisis is wearing off: The FDIC recently decided to slash the phase of stricter regulatory requirements faced by new depository institutions to three years from seven.

But that does not mean that fintechs will have a free pass at ILCs.

“One potential challenge for fintech companies is their newness,” said Berrett, who stressed that he was not speaking about any specific firm, but about the industry at large. “Most of these companies didn't exist five years ago. Some may not be able to demonstrate sustained profitability yet.”

In addition, Berrett said, fintech firms could have a hard time convincing regulators that their ownership structure does not pose undue risks.

For companies backed by venture capital, “the ownership may not be diluted down to where there are no issues regarding ‘control,’ as defined by applicable banking statutes,” he said.

And though the FDIC has made efforts to signal it is open for business, it is unclear whether the agency is ready to begin approving ILCs specifically. The FDIC had also responded to Walmart’s application by imposing its own moratorium on all ILC applications prior to the congressional action.

“There hasn't been a strong record of approval, so generally folks understand that any ILC application that's put in is going to have many challenges,” Petrasic said.

Square itself acknowledged, through a spokesperson, that the application may take some time. While it awaits a verdict, the company still plans on pursuing state-by-state licenses to grow its lending arm.

But since FDIC Chairman Martin Gruenberg’s term ends in November, some are hopeful that his successor — who has not yet been nominated by President Trump — will be more ILC-friendly.

“There's a change of administration,” said Petrasic. “There's a different environment now. I think there's a much better understanding of the roles that fintechs are playing in the marketplace.”

With a possible charter from the OCC, fintech firms would not be obligated to obtain FDIC approval for deposit insurance. But that route would be rougher in other ways.

When the OCC fintech charter was first announced by former Comptroller of the Currency Thomas Curry last year, it immediately stirred controversy from consumer groups, progressive politicians and state regulators.

Its main draw — and main point of contention — is it could offer the benefits of federal preemption for fintech companies that are currently saddled with a costly multistate licensing system and dozens of different regulatory requirements, depending on where they operate.

“The scope of preemption you're going to get is going to be wider,” said Scott Pearson, a partner at Ballard Spahr. “But you're also going to be regulated more closely.”

A fintech charter would attract both OCC and Federal Reserve Board oversight, while an ILC bank would answer to the FDIC and a state regulator.

But the OCC’s fintech charter is currently in limbo. Before the agency could even issue a formal set of requirements, it was challenged in court by state regulators — twice. As a result, the OCC has not yet started accepting applications — which could be a point in favor of ILCs.

“You have to ask yourself if the OCC is losing ground because of its pending litigation,” an industry source said, speaking on the condition of anonymity. “If this is going to go for five years, are the fintech folks going to wait around for it?”

Perhaps the biggest selling point for the ILC charter is that it offers exemption from Bank Holding Company Act requirements, meaning that the parent company could engage in commercial activities while still owning a bank.

This was the deciding factor for Square, which also sells point-of-sale hardware and runs a food delivery business.

But this feature of the ILC is also what incenses its critics, who view it as a loophole to the separation of banking and commerce enshrined in traditional banking laws.

“The enforcement apparatus on an ILC is much weaker than it is for another institution,” said Brian Simmonds Marshall, a policy counsel at Americans for Financial Reform.

For instance, he said, the parent of an ILC would not necessarily be subject to restrictions on expansionary activities if the bank were to fare poorly on its obligations to serve poor and minority consumers, as required by the Community Reinvestment Act.

“One of the consequences for consumers is that low- and moderate-income consumers may not be served by an ILC,” said Marshall. “They won't have the same level of incentive that banks do now.”

And critics are already raising the same type of slippery-slope arguments that were made in opposition to the OCC fintech charter.

“If SoFi and Square were successful, one would certainly imagine that the payday lenders would come in as well,” said Arthur Wilmarth, a law professor at George Washington University.

A third option for fintechs would be to flip the script and apply for a traditional national bank charter, which would require approval from the OCC as well as a green light for deposit insurance from the FDIC.

This would offer a company the benefits of taking deposits — a cheap source of funding for loans — as well as federal preemption and the cachet of OCC approval.

But at this point, obtaining the go-ahead from both OCC and FDIC for a nontraditional business model seems like a tough sell.

“It is such a high hurdle,” Colin Walsh, CEO and co-founder of Varo, said in an interview earlier this year. “This is incredibly demanding and complicated, and both the OCC and the FDIC have been very clear that while they're interested in what we're doing, it's not going to be easy.”

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Fintech regulations ILCs Fintech Law and regulation Square SoFi Varo Money OCC FDIC State of Utah