Might fintechs become banks?

Financial () firms have been disrupting the financial landscape through innovative products and efficient operations. That disruption is now entering the realm of operating models, as leading recently initiated efforts to . SoFi1 and Square2 applied for Industrial Loan Company charters in June 2017 and September 2017, respectively. SoFi since withdrew its application, citing recent leadership transition as the primary reason3. Varo applied for a National Bank Charter in July 20174. Others may pursue Special Purpose National Bank Charters, should they become available. Achieving such charter status could increase fintechs’ ability to gain market share and would place them in direct competition with legacy providers. The decision on the applications—whether yay or nay—is likely to have significant implications for the future of the financial services industry.

Two legacy models fintechs typically use to grow business

The U.S. financial services industry is highly regulated. Bank charters are required for membership in the U.S. Federal Reserve System and to engage in a breadth of banking services, including accepting customer deposits. While fintechs offer a myriad of financial products and services, none have yet to obtain national banking status. This limits their ability to quickly expand nationwide and hold and lend against deposits. Fintechs typically rely, instead, on bank partnerships or state-by-state banking licenses to grow their businesses.

1. Bank partnerships—sometimes referred to as a “rent-a-charter” model—allow fintechs to leverage three key assets of their bank partner:

    • Existing charter and funding mechanisms to offer differentiated financial services (such as loans, savings accounts and deposit accounts)
    • Regulatory and compliance infrastructure
    • Lending limits and ability to export interest rates5 (allows the lender to potentially lend at rates higher than individual state caps)

In return, the partner bank gains fees or revenue sharing value generated by the fintech.

2. State-by-state bank licenses allow fintechs to obtain bank charters for the specific states in which they operate. While often helpful for small and new start-ups, established fintechs with national operations often find that differences in individual state laws limit their profitability and agility. State-by-state strategies can be costly and complex and, as such, typically serve as backup plans to the rent-a-charter model.

While fintechs, so far, have relied primarily on these two options to grow business, the array of viable options may be expanding.

New paths to fintechs becoming banks

Industrial Loan Company (ILCs) charters enable non-financial institutions to establish a bank to engage in lending and other specific banking activities. ILCs have two important distinctions: ILCs may be owned by a commercial company; and ILCs are exempt from the Bank Holding Act and are not subject to supervision or regulation by the Federal Reserve.

ILCs have been around for over a century, and are commonly used by automakers such as GM, Toyota, BMW and others to support their in-house financing activities. However, ILCs have fallen out of favor since Wal-Mart’s 2005 ILC application. An ILC would have enabled Wal-Mart to process its stores’ electronic check, debit card and credit card transactions, eliminating its cost of paying a third-party financial institution to perform these services6. Many large banks pushed back, claiming that an ILC would unfairly advantage Wal-Mart by allowing it to offer financial services without comprehensive regulatory oversight. The Federal Deposit Insurance Corporation (FDIC) implemented a statutory moratorium on ILC applications for commercial companies while it evaluated Wal-Mart’s application, which the retailer withdrew in 2007. The FDIC’s moratorium was followed by a Dodd-Frank imposed moratorium that lasted until 2013. At this point, no ILC applications have been approved in over a decade.

The FDIC recently eased the capital requirements for ILC applicants to encourage new participants.  Fintechs are testing the waters. An approval on their applications could re-open ILCs as an attractive, viable alternative to bank partnerships. It would enable fintechs to operate commercial businesses, make loans and accept deposits.

The other option available to fintechs is to apply for a National Bank Charter directly. Under this charter, a bank is not subject to individual state usury laws in exchange for consolidated regulation. While a National Bank Charter would allow a fintech to operate more easily across the country, it comes with significant regulatory burdens (outlined in the Bank Holding Act), which would likely constrain broader commercial activities. As such, most fintechs have chosen not to pursue this path. Varo Money is a recent exception.

Recognizing that modern innovation may warrant a different type of charter for non-banks offering alternative financial solutions, the Office of the Comptroller of the Currency (OCC) announced in 2015 that it was exploring a Special Purpose National Bank Charter for fintechs. Although still under review, recent proposals indicate that it will differ from a National Banking Charter by specifying which banking services fintechs may offer (for example, make loans but not accept deposits) and suspending the requirement for charter holders to comply with the Community Reinvestment Act or the Federal Deposit Insurance Act. Proponents of this charter view it as a responsible way to bring fintechs under the broader regulatory umbrella; opponents argue that the charter would unfairly advantage fintechs over regulated financial institutions. Whether the OCC will eventually offer Special Purpose Charters—and whether fintechs will apply for them—remains to be seen.

The outlook for fintechs becoming banks

Regulators have understandably struggled to keep pace with the evolving landscape of innovative financial services products and providers. Recent activities by the OCC and FDIC (for example, exploration of the Special Purpose Charter and easing of capital requirements for ILCs) suggest that regulators have a vested interest in ensuring that all banking activities fall under regulatory supervision. With this shift in sentiment, an approval of an ILC applicant (e.g., Square) in particular could very well encourage other commercial companies such as Amazon or Google to consider similar paths for their financial services. All eyes will be on the OCC and FDIC as these applications undergo the review process.

[1]TechCrunch, “Sofi applies to be a bank,” June 12, 2017. https://techcrunch.com/2017/06/12/sofi-applies-to-be-a-bank/

[2]TechCrunch, “Square will apply for an industrial loan company license this week, September 6, 2017. https://techcrunch.com/2017/09/06/square-will-apply-for-an-industrial-loan-company-license-this-week/

[3]LendEdu, “SoFi Withdraws Industrial Loan Charter Application, Cites Leadership Changes,” October 18, 2017. https://lendedu.com/news/sofi-withdraws-industrial-loan-charter-application-cites-leadership-changes

[4]BusinessWire, “Varo Bank, N.A. Applies for a National Bank Charter,” July 25, 2017. https://www.businesswire.com/news/home/20170725005537/en/Varo-Bank-N.A.-Applies-National-Bank-Charter

[5]Interest Rate Exportation refers to the way a bank will use its National Bank Charter to “export” the interest rate cap of its headquarter state, and therefore, potentially lend at higher rates than individual state caps.

[6]CNN Money, “Wal-Mart withdraws industrial banking push, March 16, 2007. http://money.cnn.com/2007/03/16/news/companies/walmart/index.htm

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