Financial institutions face competitive pressures from a variety of challengers both within and outside the banking industry. In this interview with Promontory Interfinancial Network’s Barbara Rehm, Frank Sorrentino, chairman and chief executive officer of $5 billion asset ConnectOne Bancorp, reveals his thoughts on today’s competitive threats, and explains why the network effect is something that should give community banks pause as big banks continue to enhance their product offerings.
As if banks couldn’t be more nervous about the cybersecurity threats facing the industry, 2018 opens up with a new method of attack: jackpotting, in which criminals install malware to take control of ATMs to gain vast amounts of cash. It’s no wonder that Robin Wiessmann, the secretary of the Pennsylvania Department of Banking and Securities, says that cybersecurity is the top issue for her department, and that she was one of the first state regulators to create a task force to focus on the issue. In this interview, which has been edited for length and clarity, she shares her thoughts on this top risk, as well as her views on safe and sound partnerships between banks and fintech firms.
BD: As your state’s banking regulator, what are the top issues you’re looking at relative to the banking industry right now? RW: I think the overarching goal of the department is to ensure that the industry is healthy, and viable, and competitive. Specifically, as relates to the top issues, I think the overall challenge for community banks and banks of all types is adaptation to the new banking models, and that’s driven by a number of things. One [are the changes] in technology and the way the delivery of services [is] provided, as well as banks choosing what services they want to provide to their particular marketplaces. That is a fundamental question or challenge for banks right now. Technology is changing the business models, but they also have to make a decision about how they’re actually going to utilize fintech. I don’t think it’s a question of whether or not they should or not. It’s hard to not do it.
And then the other overarching challenge is that of cybersecurity—making sure that there is confidence in our banking and our financial services sector.
So those are the three major elements: adaptation to the new banking models, changing the choice of services and the delivery of services—how they’re going to apply fintech—and how they’re going to deal with the necessity for cybersecurity.
BD: You wrote recently that cybersecurity is the word of the year for your agency. Why is this the issue for 2018 for the entities that the agency regulates? RW: I think our role is to provide a focus on the most pressing matters of the day, as well as the long-term viability and the vitality of [the] commercial banking marketplace. And I don’t think there’s any other challenge greater at this point in time than cybersecurity. This is not obscure; it’s not theoretical any longer—it’s got real practical implications and if we can’t manage that—we know we can’t prevent it all but if we don’t manage it properly, we will not only lose the confidence of the marketplace, we can potentially lose the ability to function in our marketplace through hacking. The risk of security breaches grows exponentially every day, and it’s not only disruptive in terms of our personal information but also the very framework of our business and our economy. That’s why it’s at the top of the list.
BD: What are your expectations for bank boards around cybersecurity? RW: I’ve been on boards previously…and I’ve seen the evolution to more focus on the audit committee which has historically been [the] bottom line of defense in terms of the reporting out of operations and actual operations. But [the audit committee has] now evolved into a broader risk management, and that’s for the business model—how economically viable it is—as well as the operations. So, I would expect that the boards today are dealing with the classification of risk management—either inside the audit committee or as a stand-alone committee, because risk management encompasses a lot.
The companies that do pay attention to this existential risk will do well, and those who don’t provide that particular focus leave themselves to be very vulnerable. We know the responsibilities [of] corporate board directors have increased and bank directors, of course, perhaps even more so. Any organization that does not recognize the threat really does risk the loss of their customer base, their partners, their vendors. So, it requires a particular focus, a separate monitoring if you will, by the board of directors.
BD: We’re seeing more partnerships between banks and fintech firms. As a regulator, what do you want to see occur to ensure that those are safe and sound relationships? RW: What we have observed in terms of fintech companies is, they’re financial services [firms] that are driven by technology—that’s the way I think about it—but many of these fintech firms think of themselves as technology companies, so they may not be aware of how they actually are regulated in terms of whether or not they’re money transmitters, if that’s what they’re doing, or if they’re lenders, or they’re investing or any combination thereof. So fundamentally, we want to make sure that there’s knowledge and awareness of their responsibilities under the law. For the fintech firms.
Now obviously the partnerships between banks and fintech firms, they have to figure out where that balance lies. Are there requirements for separate registrations? If they’re partnering with a company—a lot of them are going to [ask], do we buy, do we build or do we partner? And each one of [those options] has a different implication, obviously. Building the technology internally is clearer from a regulatory standpoint, but it may take longer, and there may be things in the marketplace that suit their interests. I think we’re going to see a lot of buying of these technologies, because I think that’s part of the goal of some of these technologies, is to be acquired at a premium price.
But I do think there may be many, maybe most, situations where there’s real partnering, and the responsibility will ultimately rest with the bank to make sure their partners are complying with whatever laws they need to, because the partners may be doing business in 50 different states, and there are different laws and regulations applying to them.
So, it’s about due diligence, it’s about thinking through very carefully and figuring out literally where the buck stops. Because if you put the overlay of cybersecurity on top of these partnerships, then you really appreciate that if you’re partnering with someone, you want to be sure that your clients’ information is safe, so how do you create a firewall? How do you manage that information sharing while protecting the privacy of the data? And where are vulnerabilities, and under what circumstances, if there was something that happened to your partner—and we’ve seen this recently in a number of corporate situations as it relates to identifying information—if there’s something that happens to your partner, what do they have in place to handle it? Do they have policies and procedures in place, and what are their responsibilities to you as an entity, in terms of not just informing but managing the situation?
There’s great upside for business models, but there’s also great [exposure] for security and operational risk, and you just have to deal with that.
Several factors will drive M&A in 2018, but shareholder lawsuits will remain a fact of life for the banking industry. In this video, Josh McNulty of Bracewell LLP explains how market stability and more de novo activity could drive more deals. He also addresses how boards can minimize the risk of shareholder lawsuits.
Tax reform could be a net positive for the banking industry, with an expected long-term boost to profits due to a significant cut in the corporate tax rate, from 35 percent to 21 percent. Its proponents believe that it will fuel the broader economy as well.
But despite the anticipated net gains, boards and management teams need to look at how tax reform will impact their organizations. Certain areas will be negatively impacted or warrant discussion to ensure the bank’s making the most of these changes. With that in mind, here are some of the topics your board should tackle in light of tax reform, and how it could affect your bank.
Initial Tax Hit Tax reform just passed in late December, but many banks are already aware of its short-term downside, as the deferred tax assets on bank balance sheets, calculated based on a higher tax rate, have resulted in write downs on fourth quarter 2017 earnings. (Some banks have deferred tax liabilities on their balance sheets, which will positively impact earnings.)
These losses are expected to be recouped rather quickly. Kristine Hoeflin, a partner at Moss Adams LLP, recommends that banks quickly communicate this to shareholders and other stakeholders, so they understand that this is a one-time loss.
Impact on Compensation Plans Under the new tax law, companies can no longer deduct executive pay above $1 million—a shift from the old law, which allowed companies to deduct performance-based pay in excess of $1 million. In another change, companies can’t deduct compensation surpassing $1 million for a departed named executive—the CEO, chief financial officer and three highest paid officers. “You can’t beat it by paying it out after they step down,” says Doug Faucette, a partner with the law firm Locke Lord LLP.
Banks still need to provide their executives with competitive compensation, so for most entities this will likely become just another cost of doing business—and with a lower tax rate, the scales still tip in the industry’s favor. However, a review of compensation plans is still warranted, and acquisitive banks will also want to determine the potential impact in a deal.
Another note: Banks are expected to earn more in 2018 as a result of the new tax code. Make sure the bank is truly rewarding the executive’s performance, not improved metrics that resulted from the tax cut.
Impact on Organizational Structures Banks should also look at their own organizational structures following tax reform, particularly if the bank is a Subchapter S corporation, which has 100 or fewer shareholders and is taxed as a partnership while enjoying the benefits of being a corporation. Management should make a presentation to the board outlining the impact of tax reform on the bank, along with an analysis of how the bank would be affected in a conversion from a Sub S to a C Corporation and management’s recommendation on the best choice for the organization, says Robert Klingler, a partner at the law firm Bryan Cave.
How the bank wants to deploy its profits will factor into this decision, says Hoeflin. For banks that prefer to continually reinvest profits into the company, “the C Corp set-up, with this low tax rate, would present some favorable circumstances,” she explains. For banks that want to share those profits directly with shareholders, the Sub S structure will continue to make more sense, as Sub S shareholders avoid the double taxation that occurs with a C Corporation.
Shareholder agreements should be reviewed regularly, and will outline how the board can proceed if it wants to change the bank’s structure. “Many times it will involve the consent of the holders of two-thirds of your shares,” says Jonathan Hightower, a Bryan Cave partner, but that threshold differs with each bank. Sometimes the board has the discretion to change the structure without shareholder approval.
Subchapter S banks will still benefit from tax reform—but your bank could benefit even more as a C Corporation, depending on its strategic goals. A current analysis will make that clear to the board.
Another item to note: Banks below $10 billion assets will still qualify for the same deduction for premiums paid to the Federal Deposit Corp. that they have been receiving, but banks between $10 billion and $50 billion will qualify for a partial deduction for these premiums, and banks above $50 billion will no longer qualify for any deduction.
Impact on Local Markets The mortgage interest deduction is now capped at a principal balance of $750,000, down from $1 million. “That could reduce demand for new home purchase mortgages if folks decide not to move because of the inability to deduct their interest going forward,” says Michael Giammalvo, a partner at Crowe Horwath LLP. Demand could dampen in certain markets more than others. For example, the average home price in California is $697,539, according to Trulia, compared to an average $230,000 for a home in Nebraska.
If your bank has a significant market presence in a state with higher real estate taxes, the cap on itemized deductions at $10,000 for state and local income and property taxes could throw additional cold water on the decision to purchase a new home. “It’s not as tax-advantaged as it used to be, to be a homeowner in an expensive market, says Giammalvo.
Interest is also no longer deductible for home equity lines of credit, so demand could be diminished there as well, adds Giammalvo.
Companies can no longer deduct entertainment expenses—taking a client out for dinner, for example—that were previously deductible at 50 percent of the money spent. That’s a potential pain point for commercial lenders. “I’m hearing from a lot of banks that the inability to deduct entertainment expenses going forward is a problem,” says Giammalvo.
Banks serving businesses with average gross receipts over $25 million should understand that interest expense deductions are now limited for these businesses. “Would we start to see in the banking industry a decrease in demand for lending, because [companies] would find equity for the financing rather than debt sources?” asks Hoeflin.
Take care not to overestimate the positive impact of tax reform on loan demand. While many in the industry expect a wave of commercial loans as companies earn more money, Bill Demchak, CEO of PNC Financial Services Group, has expressed skepticism on this front, as reported in The Wall Street Journal. He believes that companies with more money in their pockets as a result of tax reform will have less need to borrow from banks, dampening rather than fueling demand.
Since each bank’s markets and competitive niches will differ, a strategic discussion around how the impact will be felt will benefit the board and management. “A tailored and careful conversation for each bank, particularly for smaller community banks, makes sense,” says Hightower.
Making the Most of Earnings Gains Perhaps the biggest question for boards to consider is how to invest the gains derived from a lower rate. Many banks have already announced that they’re spreading the wealth to employees and communities, through one-time donations to a community fund, for example, and hourly wage increases and bonuses for employees.
This a good public relations move for the industry, as the tax cuts were seen by some Americans as a favor to corporate America. “Banks need to make sure that the benefit they’re getting from tax reform really works for the country at large,” says Hightower.
Further, investors will be expecting banks to deploy excess capital to fuel improvements and growth. For banks slow to use that capital for M&A, or to provide share repurchases or dividends to shareholders, “we may actually see activist pressure accelerate and those [banks] may become potential targets,” says Sharon Dogonniuck, senior managing director at Ernst & Young Capital Advisors LLC. Investment in technology is another way to deploy that capital, and could provide a much needed-boost to banks that have struggled with the financial industry’s digital evolution. Smart investment in technology will define community banking’s winners and losers, says Dogonniuk. “Technology costs money, and [banks] need technological scale.”
The discussions occurring now in boardrooms spurred by tax reform could be a once in a lifetime occurrence for the banking industry and businesses at large. “I’ve doing this for 24 years, and we’ve never seen anything like this, where there’s such a transformation in the business tax world,” says Giammalvo.
There is perhaps no other area of the federal government where personnel have a greater influence on policy than bank regulation. By picking the right regulators, the president can have a meaningful impact on the banking sector and the economy at large.
Banking has long been a bastion of static thinking on the regulatory front, and it needs a shot of dynamism. With recent confirmations at the Federal Reserve and the Office of the Comptroller of the Currency, and the nomination of a new chair of the Federal Deposit Insurance Corp., the administration is on the cusp of an overhaul of regulators that will have potentially far-reaching consequences. A new director—and new thinking—at the Consumer Financial Protection Bureau would also have a positive impact on the regulatory culture under which banks are operating.
The president’s new team of regulators can make an impact without any changes in the law or regulation in three key areas.
First, these regulators can approve new banks. Only six new banks have been chartered since 2010, and more than 2,000 have gone away. The attendant lack of dynamism and entrepreneurial disruption is palpable. Community banks are losing critical funding and payment market share to large banks and fintech companies. Traditional banks are crowding around discrete areas of the American wallet: middle-market commercial loans, owner-occupied commercial real estate and small business lending. Mortgage and consumer lending are increasingly offered by big companies that can afford to comply with costly rules. Customer contact and loan pricing is increasingly automated and regulated. New bank founders need the flexibility to build diversified portfolios, certainty around the capital required to implement a given business plan and certainty around the timeliness of the approval process. Greater transparency in these areas would contribute far more to stimulating new charter development than revising handbooks and holding conferences. Agency leaders can give that clarity right now, and they should.
Second, the burden of onsite bank exams is a continual concern. Most of these complaints are from banks so small that if any 200 of them were to fail tomorrow, it would hardly make a dent in the FDIC’s reserves. Banks divulge massive amounts of information to regulators on a quarterly basis. Couldn’t regulators perform remote exams of these small banks, with onsite spot checks as needed? Further, the rigid application of compliance regulations are eliminating small dollar lending programs at many community banks—to the detriment of the very customers these rules are supposed to be protecting. Wouldn’t community banks be better off if they could diversify their loan portfolios by offering products needed by their communities? Wouldn’t the industry be better served if examiners’ efforts were focused on large banks, where the customer experience needs improvement, and the consequences of failure are more severe?
A final element of dynamism relates to the ability to exit. Banking is one of the few industries where the government approves the sale of the company—and takes months, if not years, to do so. Even the smallest transactions are subject to geographic competition tests normally seen when titans merge and make no sense in this age of digital banking. The list of incentives for regulators to say “no” is long and getting longer. Third-party protest groups have no direct skin in the game, yet have great influence over the process. Meanwhile, stakeholders, customers, employees and communities are all in limbo. Regulators could address these concerns by setting deadlines, actively brokering conversations between all parties and holding public hearings in a matter of days, not months. Restoring a timely process could make a big difference in resolving these issues.
None of these efforts require changing a law or a regulation. All of them would improve the transparency and timeliness of regulation. Unfortunately, few of the beltway types that frequently occupy regulatory chairs have a business executive’s skill and experience in gathering information and making timely decisions. These skills are badly needed now in the regulatory arena. As the new administration gets its team in place, the president should know he can make a significant difference in banking just by choosing the right people to occupy the regulatory chairs—and then letting them do their work.
Driven in part by expectations for modest growth in the U.S. economy, almost half of the bank executives and directors participating in the 2018 Bank M&A Survey believe that the current environment for bank M&A is more favorable for deals, and 54 percent say their institution is likely to purchase another bank by the close of 2018. U.S. banks announced 191 deals through October 27, 2017, according to S&P Global Market Intelligence, and is on track to close the year on par with 2016, which closed with 241 deals. With that in mind, it’s perhaps no surprise that 40 percent expect a stagnant deal environment.
The 2018 Bank M&A Survey, conducted through September and in early October of 2017, is sponsored by Crowe Horwath LLP. It features the views of 189 chief executive officers, directors and senior executives of U.S. banks on the U.S. economy, the bank M&A environment and their own M&A strategies.
The unfettered optimism felt by the banking industry in the wake of the election of expected deregulator-in-chief Donald Trump has been tempered with the reality that regulatory relief largely hinges on the actions of the U.S. Congress. One-third of bank executives and board members lack confidence that the Republican majority will be able to push through regulatory relief for the banking industry by the end of 2018. But hope springs eternal for most bank leaders. Fifty-nine percent expect modest relief for the industry.
Where President Trump and his administration can best impact the nation’s banks is through his appointment of regulators. Fifty-eight percent believe that Donald Trump has had a positive impact on the banking industry. As of November 30, 2017, Trump has appointed Randy Quarles, who’s viewed as a moderate deregulator, as vice chairman of supervision for the Federal Reserve, and former OneWest CEO Joseph Otting as Comptroller of the Currency. Janet Yellen will leave the Fed when she is replaced as chairman by current Fed board member Jerome Powell in February 2018. Trump has nominated economist Marvin Goodfriend to fill an open seat on the Fed Board of Governors, and announced he will nominate Fifth Third Bancorp Chief Legal Officer Jelena McWilliams to chair the Federal Deposit Insurance Corp. The permanent leadership of the Consumer Financial Protection Bureau—not addressed in the survey—is also in flux. Ninety-seven percent of respondents believe that these regulatory appointees will be more sympathetic to the banking industry.
Forty-four percent indicate that rising bank valuations have made it more difficult for their bank to compete for or attract suitable acquisition targets.
When asked about the kinds of acquisitions the bank is willing to make, 83 percent say their board and management team would consider a market extension, and 78 percent an in-market deal. Twenty-eight percent would consider an out-of-market deal.
Few—just 7 percent—are likely to acquire a fintech company by the end of 2018.
To view the full results to the survey, click here.
The Wall Street Journal recently ran a column under the headline, “Why Would Anyone Sane Be a Bank Director?” It was written by Thomas P. Vartanian, a partner at the law firm Dechert LLP and a former general counsel of the old Federal Home Loan Bank Board, a former thrift regulatory agency that was superseded by the Office of Thrift Supervision. Vartanian pointed out that after every financial crisis over the last four decades, Congress and the bank regulatory agencies have piled a new layer of regulation on the banking industry, which has given bank directors an increasingly difficult governance task, while also raising their legal liability. I found little to argue with in that statement, and in fact, the increasing regulatory burden was the subject of a Bank Director magazine cover story in the second quarter 2016 issue.
So, to his question, why would anyone want to be a bank director? Certainly, it’s a challenging job which rarely offers a level of compensation commensurate with the time demands and liability risk. And operating in a thicket of regulations isn’t the only problem facing bank directors today. Emerging threats like cybersecurity, a challenging interest rate environment and the impact that digital commerce and fintech disruptors from outside the industry is having on the traditional bank business model are also bedeviling bank boards today. I think many bank directors serve because they are interested in banking and still see prestige in such an appointment, and because it provides an opportunity to give something back to their community.
On September 25-26, Bank Director will host the 2017 Bank Board Training Forum at the Ritz-Carlton Buckhead, in the northern edge of Atlanta. This will be the fourth year for this event (the first two years were in our hometown of Nashville, and last year we were in Chicago), and it is designed to provide bank directors with a broad perspective on many of the issues that bank boards must deal with today, including risk, compensation, governance and technology.
In his article, Vartanian pointed to a recent proposal made by the Federal Reserve Board that, among other things, would provide updated guidance on the supervisory expectations for the boards of banks and thrifts. The Fed would more clearly define the roles of the board and ensure that most supervisory findings make their way to the right hands—management teams, rather than the board. For supervisory purposes, boards of bank and thrift holding companies with more than $50 billion in assets would have several responsibilities. Here they are:
Set clear, aligned and consistent direction regarding the firm’s strategy and risk tolerance.
Actively manage information flow and board discussions.
Hold senior management accountable.
Support the independence and stature of independent risk management and internal audit.
Maintain a capable board composition and governance structure.
To me, those are principles of good corporate governance in a banking context that every board should internalize as their modus operandi. And it’s the kind of governance that the Bank Board Training Forum was designed to support.
I’ve seen enough to believe there are no barriers to innovation in banking. Certainly, there are speed bumps, gate crossings and rumble strips that banks will encounter on the road to innovation, but nothing that flat out prevents you from getting there. Indeed, there are a growing number of banks, including community banks, that have made important achievements that serve as good examples of innovation. (For a great list, see the Best of FinXTech Award Winners announced at Nasdaq this week.) Some innovation projects have been quite ambitious, others more modest, but they all spring from the same source—a recognition that banks need to begin simplifying and speeding up various aspects of their businesses to keep pace with (or at least, not fall too far behind) where the customer is heading.
Where is the pressure to innovate coming from? The popular boogeymen are fintech companies that compete with banks in payments, lending and personal financial management. But companies in that space are simply reacting to a much deeper trend, which is the profound way that technology is changing our lives. Banks must do the same, and a growing number of you seem to realize it.
On April 26, Bank Director hosted the FinXTech Annual Summit at the Nasdaq MarketSite in New York. The event brought together 200-plus bank executives, directors and fintech executives to explore how technology is changing the industry. Underlying themes were innovation, the opportunities for partnership between banks and fintech companies, and how banks can move forward.
I believe that most bankers understand the imperative to innovate around key aspects of their business, whether it’s payments, mobile in all its many permutations, lending, new account onboarding or data. What many of you lack is a roadmap for how to innovate. Actually, a “roadmap” is probably the wrong metaphor to describe what you need because innovation is really a process rather than a destination—something you do rather than a place that you go. So maybe you need something like a yoga chant (Om!) to help focus your energy as you practice innovation.
There are several issues that need to be dealt with, starting with a vision of what projects to undertake. You can’t change everything at once, so where do you start? What are the greatest friction points within your most important businesses? Where are you seeing the greatest competition, and how would digitalization tilt the competitive balance more in your favor? What has the greatest potential to positively impact your profitability?
Innovation costs money, so you will have to budget for it. Based on my conversations with bankers that have begun to automate key parts of their operations, expect your innovation projects to cost more and take longer than their original estimate. Innovation can be messy, so perseverance and patience are important. You also have to make sure that your bank’s culture will embrace change. When I say “culture,” I really mean people. You must ensure that your employees are open to new ways of doing things, because innovation will change job descriptions, processes and work habits, and many of your staff will feel threatened by this. It’s not enough that your executive management team and board commit to a large project like a new automated underwriting platform for small business lending and allocate the necessary resources to make that happen. You will also have to sell this change to people in your organization whose buy-in is critical.
For most banks—and particularly community banks with a finite amount of money to spend—innovation isn’t something they can do by themselves, so you will have to work in partnership with a fintech company that can help you achieve your objective. This is more complicated than it sounds, because banks and fintech companies have very different perspectives when it comes to how they do business. Banking is a highly regulated industry, so you need a partner who knows how to work within a prescriptive environment that has lots of rules. Fintech companies that have experience working with banks understand this and have learned how to manage change in an ecosystem that tends to discourage it.
The innovation imperative is real, and banks must act upon it. Your world is changing faster than you think, and the longer you wait to embrace that change, the further behind you will fall.
I’ve seen enough to believe there are no barriers to innovation in banking. Certainly, there are speed bumps, gate crossings and rumble strips that banks will encounter on the road to innovation, but nothing that flat out prevents them from getting there. Indeed, there are a growing number of banks, including community banks, that have made important achievements that serve as good examples of innovation. (For a great list, see the Best of FinXTech Award Winners announced at Nasdaq this week.) Some innovation projects have been quite ambitious, others more modest, but they all spring from the same source—a recognition that banks need to begin simplifying and speeding up various aspects of their businesses to keep pace with (or at least, not fall too far behind) where the customer is heading.
Where is the pressure to innovate coming from? The popular boogeymen are fintech companies that compete with banks in payments, lending and personal financial management. But companies in that space are simply reacting to a much deeper trend, which is the profound way that technology is changing our lives. Banks must do the same, and a growing number of them seem to realize it.
On April 26, Bank Director hosted the FinXTech Annual Summit at the Nasdaq MarketSite in New York. The event brought together 200-plus bank executives, directors and fintech executives to explore how technology is changing the industry. Underlying themes were innovation, the opportunities for partnership between banks and fintech companies, and how banks can move forward.
I believe that most bankers understand the imperative to innovate around key aspects of their business, whether it’s payments, mobile in all its many permutations, lending, new account onboarding or data. What many of them lack is a roadmap for how to innovate. Actually, a “roadmap” is probably the wrong metaphor to describe what they need because innovation is really a process rather than a destination—something you do rather than a place that you go. So maybe bankers need something like a yoga chant (Om!) to help focus their energy as they stretch to innovate.
There are several issues that need to be dealt with, starting with a vision of what projects to undertake. They can’t change everything at once, so where should they start? Here are a couple of questions they should ask. What are the greatest friction points within their most important businesses? Where are they seeing the greatest competition, and how would digitalization tilt the competitive balance more in their favor? What has the greatest potential to positively impact their profitability?
Innovation costs money, so they will have to budget for it. Based on my conversations with bankers that have begun to automate key parts of their operations, they should expect their innovation projects to cost more and take longer than originally estimated. Innovation can be messy, so perseverance and patience are important. They also have to make sure that their bank’s culture will embrace change. When I say “culture,” I really mean people. Banks must ensure that their employees are open to new ways of doing things, because innovation will change job descriptions, processes and work habits, and many of their staff will feel threatened by this. It’s not enough that executive management teams and boards commit to a large project like a new automated underwriting platform for small business lending and allocate the necessary resources to make that happen. They will also have to sell this change to people in their organization whose buy-in is critical.
For most banks—and particularly community banks with a finite amount of money to spend—innovation isn’t something they can do by themselves, so banks will have to work in partnership with fintech companies that can help achieve their objectives. This is more complicated than it sounds, because banks and fintech companies have very different perspectives when it comes to how they do business. Banking is a highly regulated industry, so they need a partner who knows how to work within a prescriptive environment that has lots of rules. Fintech companies that have experience working with banks understand this and have learned how to manage change in an ecosystem that tends to discourage it.
The innovation imperative is real, and banks must act upon it. Their world is changing faster than they realize, and the longer they wait to embrace that change, the further behind they will fall.
Don’t expect an onslaught of fintech companies rushing to become banks. The recent announcement that the Office of the Comptroller of the Currency would begin accepting applications for special purpose national bank charters from fintech companies was met with gloom from some in the banking industry, and optimistic rejoicing from others.
The OCC is offering fintech companies the same charter many credit card companies and trust companies have. Basically, the institution has to become a member of the Federal Reserve, and is regulated as a national bank with the same capital standards and liquidity requirements as others. The company has to provide a detailed plan of what products and services it intends to offer, a potential hurdle for a nimble start-up culture more accustomed to experimentation than regulation. “They will have a high bar to meet and they might not be able to meet those requirements,” Stanford says.
However, if the special purpose bank doesn’t accept deposits, it won’t need to comply with the same regulations as banks insured by the Federal Deposit Insurance Corp., which means it is exempt from the Community Reinvestment Act (CRA). Although nondepository institutions would not have to comply with the CRA, the OCC described requirements to make sure the fintech companies follow a plan of inclusion, basically making sure they don’t discriminate, and promote their products to the underserved or small businesses. This has caused some consternation among community banks.
“Why should a tiny bank have to comply with CRA and a big national bank across America does not have to comply?’’ says C.R. “Rusty” Cloutier, the CEO of MidSouth Bancorp, a $1.9 billion asset bank holding company in Lafayette, Louisiana. “If they want a bank charter, that’s fine. Let’s just make sure they play by the same rules.”
The Independent Community Bankers of America, a trade group, put out a press release saying it had “grave” concerns about what it called a “limited” bank charter. “We don’t want a charter that disadvantages one set of financial institutions,’’ says Paul Merski, an executive vice president at the ICBA. “We aren’t against innovation. But we want to make sure some institutions aren’t put at a disadvantage.”
Richard Fischer, an attorney in Washington, D.C., who represents banks, says he doesn’t think a fintech charter is a threat to banks. The Wal-Marts and Apples of the world will do what they want to do, whether or not they have a bank charter. Wal-Mart, which abandoned attempts to get a special purpose banking charter in 2007, already has a sizeable set of financial services, although it partners with banks that do have a charter, such as Green Dot Corp. in Pasadena, California.
Could a new fintech charter lead to fewer bank partnerships with fintech companies, as the fintech companies can cut out the need for a bank? Possibly. But it could also lead to more bank partnerships, as some banks, especially small or midsized banks, become more comfortable with the risk involved in doing business with a fintech company that has a national banking charter.
Jimmy Lenz, the director of technology risk at Wells Fargo Wealth and Investment Management, a division of Wells Fargo & Co., says he’s optimistic that a charter could create more products and services.
“I don’t see this cutting the pie into smaller slices,’’ he says. “I think they will be cutting a bigger pie. I don’t see the banks coming out on the short end of this.” Others said that the competition to banks coming from fintech companies already exists, and won’t go away if you don’t offer a federal charter for fintech companies. “The competition is already there,’’ Stanford says.