It's harder for fintechs to become banks. And that's good.
Thanks to a new ruling from a New York federal judge, fintech firms no longer get a “fast pass” to becoming traditional banks. Now, they have to go through the same drawn-out process as everyone else.
Varo Money applied with the Federal Deposit Insurance Corporation (FDIC) last summer and learned that it had been approved in February 2020 — though it is pending authorization from the Office of the Comptroller of the Currency (OCC) and the Federal Reserve. If it gets the green light, Varo would be the first fintech company to gain federal approval.
Conversely, a lot of fintech firms balked at the barrier, not happy about having to pump the brakes on their banking dreams. Financial services startup Robinhood even withdrew its application for a federal banking charter. But this uproar begs the question: Why were fintech companies so eager to become banks in the first place?
It’s hard for fintech firms to resist the call of net interest margin: the net interest they can make off of all their loans. Banks use capital from people’s deposits, other lenders, and shareholders to make loans. The interest on those loans are offset by the interest they pay on savings and checking accounts, and what they’re left with is their net interest margin.
So oversimplifying for the sake of making the point, let’s say someone walks into a bank and deposits $1,000 in a checking account. A friend comes in the next day and asks for a $1,000 loan. The bank gives it at 13%. Essentially, the bank just transferred the $1,000 from one friend to the next, but now, the bank is making an extra $130 that year in interest. Not a bad deal.
The allure of that “free” interest just for transferring money is enough to convince some fintech firms they should become banks. If a traditional bank is backing the fintech’s loans, most of the net interest margin goes to the bank. If the fintech gets a bank charter and stands on its own, it can command a much larger share of the net interest margin. Square Capital, for example, processed 70,000 loans worth $508 million in just the first quarter of 2019, according to a shareholder letter.
For these reasons and more, financial tech companies, from Varo to Square, have been scrambling to get bank charters. They claim a national banking charter would help reduce costs and give their consumers a wider variety of products, including credit cards, unsecured loans, and robo-advising.
I’d argue that fintech companies only think they want to be banks. Sure, banking may, at first, seem like a natural evolution from the other financial services they offer, but that doesn’t mean fintech firms should become banks. In fact, there are a few reasons why they shouldn’t.
It seems most fintech firms want the benefits of being a bank without the responsibilities. On the fintech side, these firms can leave their partner institutions to bear the brunt of the compliance risk. The banks are the ones that have to deal with the real implications — should something go wrong. It’s why Stripe partners with Cross River Bank and Chime partners with The Bancorp Bank and Stride Bank.
When fintech firms start to get starry-eyed at the idea of becoming banks, they forget that the title comes with a hefty amount of regulation and compliance. And the FDIC and OCC are not groups you want to anger.
To even get on the ground floor of transitioning into a banking institution, fintech firms have to have a big group of committed people who are willing to shell out money to a still-unstable institution.
Think of a venture capital-backed company that has to have a billion-dollar exit plan within 10 years. Banks have that same need for aggressive growth, but they have regulators putting a cap on it. That limits fintech leaders’ ability to influence how quickly they grow, which they don’t usually anticipate.
In some cases, becoming a bank makes sense for fintech firms — but only if they are already enormous. Once these companies get to scale and are valued at multiple billion dollars, they tend to think: “Well, we’re big now. At this point, our banking partners are actually increasing our risk, so we should probably take that on ourselves.” This is much easier said than done.
Unfortunately, most fintech firms just aren’t large enough to take on that level of risk or financial commitment. They’re better off just partnering with a bank and sticking to their core competencies.
The allure of becoming a bank is real. Many fintech leaders are attracted to the idea of net interest margin, the ability to offer more products, and the capacity for growth. This desire comes from a good place (wanting to better solve customers’ problems), but in most cases, it’s just not realistic. Risk, regulations, and money are just too tall of hurdles to overcome. Fintech firms would be wiser to focus on what they do best and leave the banking to the bankers.