“Silicon Valley is coming,” Jamie Dimon, chief executive officer at J.P. Morgan Chase & Co., famously warned his bank’s shareholders two years ago. Indeed, with the rapid proliferation of fintech companies that are creating cutting-edge products, banks are asking how they can compete with these nimble startups that are reaching unbanked populations, and making routine transactions speedier and more accessible, without the same regulatory burdens shouldered by banks. While we can’t offer a silver bullet, it appears that some banks have concluded that there is considerable wisdom in the adage “if you can’t beat them, join them.”
A bank-fintech partnership is an arrangement in which a fintech company provides marketing, administration, loan servicing or other services to a bank to enable the bank to offer tech-enabled banking products. For example, a fintech company may perform loan origination services, while the bank funds and closes the loans in its own name and later sells loans it does not want to hold in portfolio to purchasers, including the fintech company. Banks have also partnered with fintech companies to provide payments services or mobile deposits. While some partnerships offer products under the fintech company’s brand, in other cases the fintech company quietly operates in the background. Some banks enter into more limited relationships with fintech companies, for example, by purchasing loans or making equity investments.
Many banks have realized advantages of bank-fintech partnerships, including access to assets and customers. Since most community banks serve discreet markets, even a relatively simple loan purchase arrangement can unlock new customer relationships and diversify geographic concentrations of credit. Further, a fintech partnership can help a bank serve its legacy customers, for instance, by enabling the bank to offer small dollar loans to commercial customers that the bank might not otherwise be able to efficiently originate on its own.
Of course, fintech companies derive significant benefits from these partnerships as well. For Fintech companies, having a bank partner eliminates barriers of market entry. With the bank as the “true lender” or money transmitter, the fintech company spares the time and expense of obtaining state licenses. Bank partners can lend uniformly on a nationwide basis and are not subject to many of the different loan term limitations that state licensed lenders are. Of course, banks must comply with their own set of lending regulations.
Though potentially beneficial, banks must be mindful of the risks that partnerships present. Banks are expected to oversee their fintech partners in a manner commensurate with the risk, as they would any service provider, following detailed regulatory guidance on oversight of third-party relationships. In June 2017, the Office of the Comptroller of the Currency (OCC) issued a bulletin communicating enhanced expectations for oversight of third parties, including, specifically, fintech companies.
Banks must perform initial and ongoing due diligence on any fintech partner to ensure that it has the requisite expertise, resources and systems. The partnership agreement should hold the fintech company accountable for noncompliance, and enable the bank to terminate the relationship without penalty in the case of any legal violation. The parties should agree to strict information security and confidentiality standards. Banks should reserve the right to conduct audits and access records necessary to maintain oversight. Adequate oversight is essential because liability for violations or errors made by the fintech company may ultimately rest with the bank.
Banks seeking to partner with lending platforms must also structure the relationship to address true lender concerns and consider how they will sell loans or receivables on the secondary market, including to the fintech company. Unless an arrangement is properly structured, a court or a regulator may conclude that the bank was not the true lender and that the interest exceeds applicable usury limits. Similarly, as a result of a ruling by the U.S. Court of Appeals for the Second Circuit in Madden v. Midland Funding, if interest on a bank loan exceeds the rate permitted by applicable law for non-bank lenders, a non-bank purchaser may not be able to enforce the loan even if it was valid when made by the bank. Banks might address this risk by selling participation interests instead.
While competition from fintech companies may seem daunting, the proliferation of bank-Fintech partnerships suggests that banks fill a critical niche in the fintech industry. Moreover, even though some fintech companies have sought to become banks themselves and the OCC has proposed offering a special purpose bank charter to fintech companies, given the high regulatory hurdles of operating as a bank and the obstacles the OCC has encountered in advancing its proposal, it appears that bank-fintech partnerships are here to stay.