Small banks you’ve never heard of are quietly enabling the tech takeover of the financial industry

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Instead of trying to beat a wave of high-growth financial technology start-ups at their own game, a group of small banks is opting to join them.

These low-profile community banks quietly run the plumbing underneath billion-dollar fintech firms such as Square, Stripe and Robinhood — handling mundane banking activities for them like holding customer deposits and underwriting loans — while the tech firms remake finance for a digital age.

For some, it’s a match made in heaven. These smaller banks, with names like Cross River, Celtic, Sutton Bank and Evolve, say they don’t care about having a household name so much as they need new lines of business as consumers increasingly switch to mobile banking. And the fintech companies, adept at luring new customers at a low cost, need the blessing of federal regulators and someone else to handle the money.

The booming fintech industry has been pegged as the ultimate bank “disruptor.” Technology spending has put pressure on even the biggest banks, which are trying to compete with the likes of J.P. Morgan’s commitment to spend $10.8 billion on technology in 2018. Southern regional giants BB&T and SunTrust announced a $66 billion merger last week, which will make them the sixth-biggest U.S. bank by assets. A huge motivator of that deal was the need to compete on technology, both CEOs said.

Community banks that work with fintech companies have found a way to do that without the heavy lifting.

“A few years back there was a lot of disruption talk about how the fintechs were going to destroy the banks,” said Jo Ann Barefoot, co-founder of Hummingbird Regtech and a former deputy U.S. Comptroller of the Currency, which regulates national banks. “There’s much more talk in the last few years about the need to partner.”

Reviving community banks

Large and small banks alike needed a face-lift after the 2008 financial crisis. The number of commercial banks has dropped to 4,703 as of the end of last year from more than 7,000 a decade ago, according to the Federal Deposit Insurance Corporation. There were more than 12,000 banks in 1990. Since then, banks have failed or folded into larger competitors.

“All banks were struggling after the financial crisis,” said Karen Mills, a senior fellow at Harvard Business School and former head of the U.S. Small Business Administration during the Obama administration. “It was tough for community banks to recover, particularly in small business lending.”

Fintech companies filled a void left by some of those struggling banks. These young companies are still moving into everything from lending to mobile payments to financial advising, making the most of consumers’ changing behavior and attachment to smartphones.

Some banks took it as an opportunity for their own “revival,” Mills said.

Evolve Bank & Trust was among them. The bank formed in 1925 as First State Bank to lend to local farmers in Cross County, Arkansas, about an hour’s drive from the Tennessee border. It became a member of the Federal Deposit Insurance Corporation in 1934, when President Franklin D. Roosevelt was president. In 2005, new owners bought it and renamed it.

Luckily for the new owners, the bank was “small and clean” and had none of the mortgage-backed security issues that brought down some of its peers in 2008, its chairman said.

“We saw fintech coming down the pipeline, and really embraced it as another avenue for us to get deposits,” Evolve Bank chairman Scot Lenoir said in a recent interview. “We decided from a strategic standpoint why not embrace that and collaborate with them?”

Global financing for the fintech industry hit a new record in 2018, according to a recent report from CB Insights. The amount of venture capital money pouring into fintech climbed to $39 billion, more than double what it was a year earlier, according to the report. There are now 39 fintech “unicorns,” or private companies valued at more than $1 billion, across the globe.

Hummingbird’s Barefoot pointed out the struggles smaller banks have keeping up in a changing industry: They use older technology; their physical branches are proving less necessary as consumers go mobile; and they are highly regulated.

But they also have natural advantages that make them attractive for fintech start-ups. The banks already have customers, their ability to take deposits gives them a ready pile of low-cost funds, and they already have permission from regulators to conduct banking business.

Evolve’s fintech-related business is its fastest-growing by far, with more than 200 percent deposit growth month over month and almost no advertising spending. “We’re not Citi, we’re not Wells Fargo — we’re not spending that money to be a brand, which is a long expensive road,” Lenoir said.

Another advantage a small bank has is ability to move quickly, said Cross River Bank CEO Gilles Gade, a former investment banker at Barclays Capital and Bear Stearns. A meeting with a big Wall Street bank can take months to set up, he said, and getting regulatory approval for a bank charter takes even longer.

Cross River, which works with fintechs such as Coinbase and RocketLoans, started around the same time as Evolve. As a bank with responsibility for abiding regulatory rules on anti-money laundering and internal accounting controls, Cross River has a role in how the fintech industry is taking shape.

Banking regulators expect them to be the ones checking that the fintech start-ups are following the rules, which often means turning away business. Last year, Cross River signed 250 nondisclosure agreements for multipurpose loans and ended up signing only 14 new fintech partners. The process can be self-selecting, he said.

“The platforms get weeded out by the process because of the amount of compliance that we require them to implement — others disappear just because they were denied funding or didn’t have adequate controls,” said Gade.

Breaking into banking

In order to take customer deposits in the United States, a company needs federal deposit insurance. It’s an elite club that is not eagerly looking for members.

“It’s very difficult, if not impossible for a nonbank to get an account with the Fed,” said Amias Gerety, partner at QED Investors and a former acting assistant secretary at the U.S. Department of the Treasury. “Through that you can get access to the payment system the Fed controls.”

That gives the community banks that work with fintechs some breathing room for now, but competition looms. The Office of the Comptroller of the Currency is accepting applications for a national fintech charter, which would give the agency more direct oversight instead of regulating their partner banks.

“It’s awkward to regulate these fintech companies indirectly, so the thought is, if we give them a charter we can regulate them directly with a bit more clarity,” Gerety said.

Companies can also apply to be an industrial loan company, or ILC, which allows nonbanks to lend money, issue consumer and commercial loans, and accept federally insured deposits. Wal-Mart fought hard for the designation in the early 2000’s but dropped its application following a backlash from banking officials, watchdog groups and lawmakers.

More recently, fintech payments company Square refiledwith the FDIC for a special ILC license that among other things would allow it to accept government-insured deposits. It pulled its first application in July, but the company was clear back then that it intended to refile after it could “amend and strengthen” the application.

Square, run by Twitter founder Jack Dorsey, already has a small-business lending arm through Square Capital, which operates through Celtic Bank in Salt Lake City, Utah.

Varo Money, a mobile-only banking start-up, made history as the first fintech to receive preliminary approval for a national bank charter from the OCC. They still need full approval from the agency, as well as FDIC approval, according to the CEO.

Varo’s co-founder and CEO Colin Walsh led Europe’s largest consumer credit and charge card business at American Express. He said he knew the process wasn’t going to be easy, and it still relies on its bank partnership until the approvals are completed. But it wanted to go out on its own.

“With a partnership, you’re beholden to the success of the bank, anything that they could do right or wrong that could limit your success,” said Walsh, who was also a managing director at Lloyd’s Banking Group in London. “I think that’s the No. 1 thing here, is to control your own destiny — we wanted a broader set of permissions.”

Other fintechs are less eager to leave their banking relationships. Chime, an online-only bank, said it may consider going the banking route eventually. But for now, CEO Chris Britt said it can focus on building the platform and customer experience.

“Becoming a bank right now hasn’t been a top priority for us,” said Britt, a former executive at Green Dot and Visa before co-founding Chime. “I could imagine over time it’s something we might want to explore and we’re seeing other companies exploring that notion.”

This is completely new territory for most regulators. With the financial crisis fresh in the mind of most Americans, they are careful not to open the floodgates too quickly. The bar is especially high in the U.S., and fintechs that want to become a bank need to prove they can provide the safety and soundness.

“Regulators are going to take a long look at this and ask, ‘Who’s running this thing?'” said Donald Powell, a former FDIC chairman. “You need to go in the front door, and not the back door or the side door.”

The United Kingdom is more open to “challenger banks.” The Competition and Markets Authority, or CMA, made it easier for these start-ups to enter the retail banking market after 2008, allowing firms such as Revolut to pass the billion-dollar valuation mark. The mobile-based bank said earlier this year it plans to expand into the United States and Canada.

Risks to the model

Banks, fintech companies and regulators all seem to be aware of certain downsides. Cross River’s Gade said that like in any economic cycle, “there will be a crisis at some point.” The risk in that is any “contagion” and “risk of stigma” becomes a focus for regulators.

“There are good actors and there are bad actors — there’s a tendency to basket these all together,” Gade said. “We just want to make sure regulators don’t suddenly pull the rug from under everybody and prevent access to credit, because that’s the worst thing that can happen.”

Cross River makes loans, holds them on its books for a few days and then sells them on Wall Street. It’s a similar originate-to-sell model that tripped up the financial industry a decade ago. But while any failure along the chain would affect the parties involved, it wouldn’t be overly complicated to unwind.

The bigger risk is that many of these fintech companies haven’t existed through a downward economic cycle. These start-ups in many cases have reached for customers further down the credit curve and have found an eager pool of willing borrowers and investors.

For the industry, personal loan balances have ballooned in recent years. The total jumped 72 percent from 2005 to 2018, according to data from TransUnion. Balances were roughly $69.4 billion in 2005, and hit $119.9 billion last year.

Fintechs are quickly making up a bigger portion of that total.

In 2017, fintechs originated 36.2 percent of the unsecured personal loan balances, up from less than 1 percent in 2010, according to data from TransUnion. Banks have gone the opposite direction. Nine years ago they originated 34.1 percent of such loans, but by 2017, they handled 26.4 percent.

Even barring some economic disaster, demand for these higher-yielding loans could dry up. “It’s a game of musical chairs, but if the music stops who is left holding the loan?” said Alan Lane, CEO of San Diego-based Silvergate Bank. “Whoever is holding these consumer loans has to be prepared to be stuck with loans because the process could eventually stop.”

Mark Palmer, an analyst at BTIG, said rising interest rates could make institutional investors turn to other higher-yielding debt instead of fintech loans. BTIG has a sell rating on Square because of that potential exposure to credit markets, he said. Any “hiccups” in the credit market would cause a slowdown in Square Capital.

“It’s broadly accepted we are in a late stage of the credit cycle and that many investors are more cautious about lending in general and lending to small businesses in particular,” Palmer said.

Cutting your own hair

While eventual acceptance of these fintechs into banking could mean fewer opportunities for community banks, Nick Rosenberg, Metropolitan Commercial Bank’s executive vice president and head of the global payments group, says he isn’t worried. He likened it to going to a barber.

“At the end of the day, you can cut your own hair, but nobody would stop seeing the barber, because they want it done properly,” Rosenberg said. “Banking is a heavily regulated market, and most people realize it takes a partner with experience.”

The bank works with cryptocurrency companies such as Coinbase, which Rosenberg said they never could have imagined 10 years ago.

“We’re just going to keep innovating and working with our fintech clients,” Rosenberg said. “Certainly if the competition increases we’ll have to find the next big thing.”

Green Dot, the biggest seller of prepaid debit cards, has its own bank charter and does back-end banking for Uber, Stash and others. Seth Ross, head of business development, highlighted just how complex the financial side of fintech is. Many start-ups don’t have the time or cash flow to figure it out.

“People underestimate our financial system — it’s relatively complex,” said Ross, a former vice president of business development at American Express. “There are a lot of regulatory regimes, and I do think that there is significant risk that can be solved by working with a partner bank.”

What fintechs say they are doing is luring customers from Wall Street’s biggest banks. Chime works with The Bancorp Bank to offer savings and debit cards with no fees. Its CEO said many of their customers move over from traditional banks.

“We don’t really look to them as partners, and we haven’t explored those sort of relationships,” Chime CEO Chris Britt said. “We’re taking business from the big banks that charge $5 for a savings account or $40 for overdraft fees.”

And Wall Street has other worries on the horizon. If tech giants such as Amazon and Apple continue moving into the market, the banks may have a whole new fleet of competitors.

“We’re nimble enough to win that race,” Cross River’s Gade said.