After the financial crisis in 2008, Americans’ confidence in banks dipped to an all-time low and has remained low ever since. However, the crisis also opened an opportunity window for newfangled technological innovation businesses to enter the financial services industry and gain more customer trust. Companies like Square (SQ), founded in 2009, seized the opportunity to offer payment services at a lower price and faster speed than traditional banks could. Less than a decade later, Square is used by millions of small businesses to provide a seamless transactions system that accepts credit cards for payment, tracks sales and inventory, and allows customers to obtain financing. Traditional banks are keenly aware of this phenomenon and eager to stay competitive.
The fintech boom has disrupted the entire core of the banking business and has been reshaping the financial industry for the last two decades. As of 2021, there are 8,775 fintech startups in the U.S., with its most significant segment—digital payment—being valued at over $1.2 trillion in 2021. Quoting JPMorgan Chase CEO Jamie Dimon, “Fintech is an ‘enormously competitive’ threat to banks.” By developing narrowly defined but easy-to-use, intuitive, and highly effective solutions, fintech has managed to step into and take over segments neglected by traditional banks.
What can the traditional banks do to survive this challenge? One strategy is to acquire fintech firms to enhance the efficiency and speed of banking. JPMorgan pursued this strategy when it acquired wealth management startup Nutmeg and 55ip, a provider of automated tax-smart investment strategies. Another strategy is to make investments in fintech through venture capital (VC) investment. For example, Goldman Sachs, JPMorgan, Citi, Capital One, and others have acquired equity stakes in several startups in wealth management, capital markets, and cryptocurrency through VC funding rounds. Finally, the third strategy is to enter into a strategic partnership with a tech firm to leverage the expertise of both companies. Goldman Sachs’ partnership with Apple to issue a new credit card seems like a good template for such a model: Goldman brings in its financial and regulatory expertise, whereas Apple brings its technological prowess.
Ironically, while bank-fintech partnerships have become more common, some fintech lenders are in the process of bankification. Several notable digital lending companies that began with some form of partnership, wholesale funding or marketplace model are in some stage of shifting into a banking model. Square, SoFi, and Lending Club may be seen as pioneers in this movement, but we can expect to see more “chartering” activity as online lending overtakes brick & mortar lending originations.
Square now has its own lending license that it can use to issue business loans. The company obtained the Industrial Loan Company license from Federal Deposit Insurance Corporation (FDIC) and the Utah Department of Financial Institutions. In contrast to Square, to obtain a national bank charter, Sofi Technologies sealed the deal to acquire Golden Pacific Bancorp, Inc. Similarly, Lending Club announced the completion of its acquisition of Radius Bancorp, Inc. and its digital bank subsidiary, Radius Bank (“Radius”) earlier this year.
Strategic corporate acquisitions of banks and fintech lending companies will undoubtedly expand the bank’s loan business by channeling the low-cost fund deposits to their fintech company. Although the loan growth might be higher, the yield might be lower as credit costs creep back up to normal levels and become less attractive to the investor. Similarly, even though Fintechs will get a cheaper source of funds backed by strong institutional financial institutions, their return might also be lower.
Further, after acquiring a national bank, fintechs no longer need to apply for the fintech charter, the controversial charter that the Office of the Comptroller of the Currency (OCC) proposed back in 2017. With a national bank charter, fintechs can bypass states’ usury laws by applying the rate exportation rules, permitting them to “export” to out-of-state borrowers the interest rates that are permissible in their home states.
Regardless of the advantages of these acquisitions, there are some regulatory factors to look out for, such as any changes to “true lender” rules that might make it harder to originate loans via a partner. The true lender doctrine generally disregards the form of a lending arrangement and examines the substance to determine which entity is the actual, rather than the nominal, lender. On top of that, the fintech-bank acquisition trend might change the regulator’s perspective on future charter grants to fintech companies, and it might impose detailed financial requirements such as capital reserves.
While fintech has reshaped the financial services industry for the past decade and poses a substantial challenge to the traditional banks, the fintech-bank acquisition trend will continue to pressure the traditional players to embrace new strategies to reshape their business.