Should Fintechs Buy or Build Their Way into Banking Today?

Obtaining approval to build a bank from scratch has become next to impossible in Washington under the current administration and regulators. Receiving approval to acquire a bank and obtain a bank charter in that way has grown tougher, but it is still a practical strategy. Veteran federal banking lawyer Michele Alt weighs issues that will impact banks as much as fintechs as banks compete with fintechs or seek to be acquired by them.

Preparing a bank charter application requires a multi-disciplinary team and many months to complete and submit to regulators. It’s a big deal. But since 2017, more than half of the fintechs that put in that effort later withdrew the de novo bank charter applications they filed with the Office of the Comptroller of the Currency. Most of these withdrawals came after a lengthy review period.

Why would an applicant pull the plug after so much effort and so much time?

Because the applicant learned one or more of four important lessons while waiting for the OCC to act:

  • The advantages of a bank charter would be outweighed by the costs.
  • The fintech didn’t really need a bank charter to succeed.
  • The OCC was unlikely to welcome the fintech into the regulatory fold.
  • The fintech was more likely to obtain a bank charter by acquiring an existing bank.

Going forward, will fintechs choose to “build” their way into the banking business or will they choose to “buy” their way in?

The answer to this question is not only of interest to fintechs, but also to banks. Banks can play several roles with fintechs, including competitor, acquisition target or provider of banking as a service at some point in the fintech’s lifecycle. That last role may prove somewhat more difficult than in the past, but we’ll get to that.

OCC Fintech Application Outcomes Since 2017

*Approval later expired Source: Office of the Comptroller of the Currency

Notably, the fintechs that filed de novo applications with the Federal Deposit Insurance Corp. in the same time period as the OCC filers in the table above were mostly seeking industrial loan company charters. Their experience was similar to those seeking national bank charters from the OCC. While the applications of Square Financial Services and NelNet were approved by the FDIC, SoFi, Brex and Rakuten withdrew their applications to become industrial loan companies. (ILCs are also called industrial banks.)

Let’s break down the big question — build or buy — into four sub questions.

Question 1. What are the Advantages and Costs of a Bank Charter?

A bank charter provides significant advantages over most nonbank business models. A bank charter provides stable, low-cost funding in the form of insured deposits. That advantage is increasingly attractive as capital markets funding becomes less reliable and more expensive in a volatile, higher interest rate environment. (Even though deposit funding has become more expensive, deposits remain comparatively cheaper than funding supplied via the capital markets.)

In addition, having a charter liberates a fintech from relying on a bank partner, thus improving its economics and allowing it to move more nimbly and control its own destiny to a much greater degree. In addition, most banks are eligible for a Federal Reserve Master Account and direct access to payment card networks. Without such access, state-licensed money transmitters and nonbank lenders must rely on a bank intermediary to access critical payments systems and related services.

Moreover, a bank charter offers regulatory efficiency. Without a bank charter, a fintech with a large footprint must rely on a complex patchwork of licenses and submit to dozens of examinations by state agencies each year. This can hinder fintechs’ ability to scale their products across state lines and also increase the surface area of regulatory risk.

Typically, fintechs also have to manage the regulatory risks of their bank partners — and without a seat at the table. Fintechs will bear the brunt of regulatory outcomes at their partner banks but have very limited ability to influence those outcomes.

Another advantage to having a charter is that a national or state bank can “export” the interest rates permitted in its home state when making loans in other states, regardless of the other states’ usury laws. Without a bank charter, a nonbank lender is bound by the usury laws in each state where it offers loans.

National banks also enjoy the benefits of being chartered under federal law, which preempts the application of many state laws that conflict with the bank’s ability to exercise its powers. This allows the bank to offer a cohesive set of products and services nationwide subject to the requirements of a single regulator, reducing its legal and regulatory cost, complexity and risk.

Bank Charter Advantages

Source: Klaros Group

Of course, these advantages don’t come cheaply. Regulators typically require de novo banks — fintech or otherwise — to hold substantially greater amounts of capital than required to meet the regulatory standards for “well-capitalized” status. For de novos approved since 2015, this translates to a median total capital requirement of $55 million.

De Novo Capital vs. Well-Capitalized Standards

1FDIC requires 8.0% for a de novo bank during its initial three years of operation. Source: Federal regulatory capital standards

A fintech must also consider the cost of building and maintaining enterprise and compliance risk management programs that meet bank regulators’ standards. To do so, a fintech bank charter applicant must invest considerable resources to build and maintain robust risk management governance and processes, generally centered on a “three lines of defense” model federal agencies favor, and supported by detailed policies, procedures and internal controls. Fintechs seeking to charter a bank will also need to “in-house” many of the backend services they have historically received from bank partners (e.g., loan origination and credit administration, asset-liability risk management, regulatory reporting and much more).

Read more: How Banks and Fintechs Can Get the Best Results from Their Partnerships

An Aside About the Role of Bank Valuations

These capital requirements and costs are all the more daunting in the light of bank valuations.

In explaining why Figure decided to withdraw its national bank charter application, Mike Cagney, the chief executive, noted in an op-ed for Fortune that banks typically trade on multiples of book value below 2x, suggesting that banks’ need to hold capital limits their capacity for growth. A fintech, on the other hand, “trades on earnings and can increase market capitalization through revenue growth and/or margin improvement.”

But it’s important to put bank capital requirements and risk management costs in context.

A bank’s valuation depends on the growth cycle. During most of this cycle, banks are typically valued at price per earnings. Bank multiples are highly correlated with loan growth, as reflected by forward earnings expectations. When loan growth slows, as in the current environment, analysts and investors focus on book value because they have less visibility into future earnings.

Bank book value to fintech trading multiples isn’t an apples-to-apples comparison. That’s because most fintechs aren’t really trading on multiples of earnings, given that they don’t have “earnings” under generally accepted accounting principles. As growth companies, fintechs invest heavily in driving top-line growth, which often leads to earnings losses on a GAAP basis. Prior to 2022, fintechs enjoyed valuations that reflected the premium investors were placing on that revenue. The decline in fintech valuations reflects an important shift in investor sentiment — higher interest rates would stem access to “cheap” funding and slow the economy, which would likely crimp fintech top-line growth.

In periods of slower growth, both fintechs and banks can protect their margins by cutting spending. However, that’s not ideal. Banks must continue to spend on risk management and compliance to meet regulatory expectations. While a fintech may decide not to invest in these areas, that decision makes them vulnerable. They face adverse consequences in a period of increasing regulatory scrutiny of the third-party risks involved in fintech-bank partnerships.

Read more:

Question 2. Is a Bank Charter Really Necessary?

Not all fintechs need, or should seek, a bank charter. A bank charter may be critical, however, to the survival of some nonbank lenders and scaled fintechs currently relying on bank partners for critical backend services.

Many nonbank lenders rely on capital markets funding. Until recently, these lenders enjoyed a favorable securitization market for loan originations. These good times made deposit funding less important to many fintech lenders. But a weaker economy and rising interest rates result in a less reliable capital market environment. Moreover, fintechs rely on venture capital to fund their operations and growth. Venture funding of fintech startups plunged globally by 49% year-over-year to $23 billion in the first half of 2023, according to S&P Global Market Intelligence.

Fintechs that deliver their products and services through a bank partner are vulnerable to the banks’ regulatory risks. In addition to public enforcement actions, such as the orders involving Cross River Bank and Blue Ridge Bank, rumors suggest that several partner banks are now under informal orders.

Are BaaS Banks Tightening Up?:

As a result of increased regulatory attention, some partner banks have quietly 'offboarded' fintech partners while others have stopped taking on new fintech partners or started saying 'no' to their partners' requests to launch new products.

These adverse actions can pose severe, even existential, threats to the fintechs on the receiving end.

What’s worse, these actions often occur with no advance warning to the fintechs affected, because banks are specifically forbidden to share confidential supervisory information.

For larger fintechs that are deeply concerned about their vulnerability to the whims of the capital markets or to disruption in their bank partnerships, a bank charter remains the best solution.

Read more: What Banks & Fintechs Must Know About Washington’s Guidance on Partnerships

Question 3. Is the Comptroller’s Office Actually Even Open for Fintech Business?

Figure’s CEO explained in his op-ed that “the primary reason” the fintech withdrew its application was “the U.S. bank regulator’s view on public blockchains.” This sentiment is likely shared by the other three blockchain-oriented applicants identified in the first table in this article, none of which succeeded in opening a national bank.

Figure, Bitpay and Paxos filed their applications during the tenure of Acting Comptroller Brian Brooks, a Coinbase alumnus and an outspoken proponent of digital assets and distributed ledger technology. First Blockchain Bank filed its application shortly after Brooks’ departure but before Federal Reserve alumnus Michael Hsu took over the helm at OCC as Acting Comptroller.

Given the change in administration and the ensuing meltdown in the crypto sector, OCC’s current wariness of blockchain applicants is unsurprising (even if an unfortunate example of tarring with the same brush).

Since Acting Comptroller Hsu took over, however, the OCC hasn’t approved any de novo bank charter application filed by a fintech. If the OCC is open for fintech de novo application business, the agency has a funny way of showing it. (Note that during Hsu’s tenure, OCC has approved four trust companies and one digital bank. At FDIC, no fintech applications have been approved since Marty Gruenberg replaced Jelena McWilliams as the agency’s chair.)

Read more about fintechs:

Question 4. Is a Bank Acquisition a Better Option?

In 2020, OCC conditionally approved SoFi for a de novo national bank charter. In 2021, LendingClub entered banking through the acquisition of Radius Bank. Instead of opening a de novo bank, as it might have, SoFi acquired Golden Pacific Bancorp in 2022. Plaid co-founder William Hockey and his wife, Annie Hockey, also succeeded in buying Northern California Bank in 2022, now operating as Column Bank. Many fintechs and investors have been inspired by these successes and filed applications to pursue acquisitions of their own.

There are currently 11 acquisition applications pending with the federal regulators. Ten of these are for state-chartered banks. This should not be seen as a move away from the OCC, however chilly the agency has been to fintech applicants. More likely it is just that most of these applicants are looking for small, affordable banks to acquire, and those are more likely to be state-chartered community banks.

Pending Bank Acquisition Applications

Source: Comptroller of the Currency and FDIC

Regardless of the regulator, application processing times have been prolonged.

Read more: What Banks Can’t Afford to Miss In the Next Phase of the BaaS Revolution

Some Perspective on the Bank Acquisition Option for Fintechs

Any would-be acquirer should understand that acquisition is not a banking side door to open when the de novo front door appears closed.

Any application that involves a significant change to a bank’s business model will be given the same degree of regulatory scrutiny as regulators give to a de novo bank. Like any de novo applicant, an acquisition applicant who seeks to alter the target bank’s existing business must have:

  • The necessary financial resources.
  • A strong business plan.
  • A management team that can safely execute that business plan.
  • The patience to pursue an arduous regulatory licensing process that includes months of preparation before filing an application, and a lengthy review process that can take more than a year.

An acquisition applicant must also demonstrate its commitment to the community served by the bank it seeks to acquire. This requires more than just carrying forward the bank’s original CRA plan. Regulators worry about acquisitions that would result in “charter strips” — a significant repurposing of a bank to the detriment of its existing community and customers — even as they acknowledge the challenges many community banks have in remaining competitive in a market increasingly dominated by large banks.

To overcome charter stripping concerns, a would-be acquirer should start by selecting a target bank with a business strategy and management culture that aligns with its own. Doing so will minimize any required changes to the bank’s existing services and leadership. An acquirer should then make the case that its financial and technological capabilities, coupled with the bank’s existing management expertise and core business competencies, will improve the bank’s growth prospects and better meet the convenience and needs of the bank’s customers and community.

Approval Is Only The Beginning:

Would-be acquirers must remember that regulatory approval is only the starting line. Once approved, the acquirer must deliver on its promises to regulators and satisfy their risk management expectations.

The first few years are critical. It is prudent to operate with training wheels on during that period to establish a track record and build trust with your regulators, lest they make your life difficult. Within months of OCC’s approval of the Hockeys’ acquisition, for example, Column Bank was rumored to have been forced by the agency to offboard some of its fintech partners. William Hockey has denied those rumors, although there have been reports that some of Column’s initial fintech customers are now getting their banking services elsewhere.

It has been a trying time for fintechs seeking to enter banking. I remain stubbornly optimistic, however, that with the right approach fintech applicants can push through the regulatory wickets. For the time being, the best route in most cases seems to be through acquisition, but with time I am hopeful that the door will also open for de novo charters as well — at least for applicants who do their homework and bring their “A” games.

About the author:

Michele Alt is a partner at Klaros Group. She served for more than two decades in the law department of the Office of the Comptroller of the Currency. Her colleagues Patrick Haggerty, Vincent Curotto and Simon Gilbert also contributed materially to this article.

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