How Young and Hungry Fintech Companies are Disrupting the Status Quo

fintech-7-30-15.pngIn 2004, Blockbuster was a vibrant company that employed 60,000 people and provided home movie and video game rental services through a network of 9,000 retail stores throughout the United States. Then everything got disrupted.

Two Blockbuster competitors—Netflix and Redbox—began experimenting with alternative forms of distribution, Netflix through the mail and Redbox through, yes, red boxes located at grocery and convenience stores. These low cost delivery systems gave Netflix and Redbox a significant competitive advantage. Blockbuster, slow to respond to the disruptive impact on its brick and mortar business model, went into a downward spiral that eventually led to bankruptcy in 2010. The company was later acquired by Dish Network Corp., which closed the last of its Blockbuster stores in 2014. Today, the brand name survives only as video streaming services to Dish customers and the general public.

Is there a lesson to be learned here for the banks? You better believe it. The digital financial services space is exploding in activity as new technology companies push their way into markets and product lines that traditionally have been the banking industry’s turf. Usually, these so-called fintech companies focus on one or two product lines, which they distribute online at a significantly lower cost than traditional banks because banks still are holding on to their expensive branch networks. And doesn’t that sound a lot like the Blockbuster scenario?

Blockbuster did try to expand its distribution channels to include mail and streaming video, but it probably waited too long to make that change. There are in fact countless examples of disruptive business trends in U.S. history (airplanes taking passengers and trucks taking freight away from trains, or mobile phone carriers supplanting traditional telephone companies), and they share a common theme: The incumbents often responded to disruption too slowly and either failed, like Blockbuster, or managed to survive but at a permanently reduced state, like the railroads.

Often the disruptors were initially dismissed by the incumbents as not posing much of a threat, and you have to wonder if we’re seeing a similar scenario playing out today in banking. “Banks look at these upstarts with a kind of, hey, they are nice little experiments but what the fintech companies are doing isn’t really relevant,” says Anand Sanwal, chief executive officer at New York-based CB Insights, which tracks investor activity in the fintech space. “The problem is, today’s nice experiments are tomorrow’s disruption.”

In a March 2015 report on the emerging fintech sector, Goldman, Sachs & Co. estimated that over $4.7 trillion in revenue at traditional financial services companies is at risk of disruption by new, technology-enabled entrants. In a report two years ago, the consulting firm Accenture saw an equally challenging future for traditional banks. “A number of emerging trends—including digital technology and rapid-fire changes in customer preferences—are threatening to weigh down those full-service banks that limit themselves to products and services that get distributed primarily through physical channels, particularly the branch,” the report said. “Given the scale of these disruptions, our analysis shows that full-service banks, as a group, could lose 35 percent of their market share by 2020.”

Disruption is not new to the banking industry. It has been occurring in the payments space where companies like PayPal, Google, Square and American Express Co. have developed alternative payments systems that threaten to chip away at the banking industry’s market share over time. But it isn’t clear whether most banks see payments as a profit center or just the necessary plumbing to facilitate transactions. However, since the financial crisis there has also been a great deal of activity by fintech companies in the lending space—which is squarely where most banks make most of their money.

The new fintech lenders fall into two general categories. One group is made up of those companies that focus on consumers and small businesses and hold some loans on their balance sheet. These are often referred to as direct lenders and examples include Kabbage and CAN Capital. (See interview with Kabbage CEO Rob Frohwein) A second broad group, often called marketplace or peer-to-peer lenders, originate consumer and small business loans and sell them to investors, and increasingly banks, instead of keeping them on their balance sheet. Companies that fall into this category include Lending Club and Prosper Marketplace Inc.

The strategy of most fintech companies is to focus on a specific activity rather than compete with traditional banks across the full spectrum of their consumer and business product lines. So while fintech companies individually might pose little, if any, threat to banks, in the aggregate—and across all their full range of activities—they are doing everything that banks do. The infographic on the facing page, provided by CB Insights, shows many of the fintech companies that offer the same products that are provided today by San Francisco-based Wells Fargo & Co.—the country’s fourth largest bank at approximately $1.7 trillion in assets—and brings to mind a modern Gulliver who is under assault by the Lilliputians. “They are being attacked on all these fronts now by companies with new technology,” says Dan Latimore, a Boston-based senior vice president in the banking practice at the consulting firm Celent.

The emergence of such a large and vibrant fintech sector is driven by a variety of factors, beginning with the widespread acceptance among borrowers of conducting financial transactions online or with their smart phones. “Consumer behavior is changing pretty rapidly,” says Halle Bennet, a managing director at the investment bank Keefe Bruyette & Woods in New York. “Technology is now involved in everyday life and financial services is part of that. People like convenience and expediency and that is almost antithetical to conventional banking.”

It’s also true that the banking industry has been distracted by a series of events during the last several years while the fintech revolution was unfolding, first by the financial crisis and Great Recession and later by tough new laws and a more vigorous regulatory environment that forced them to raise capital and focus more of their attention on compliance. The result was a pull back from some consumer and small business markets just when newly emerging fintech companies were beginning to focus on them. “It would be hard to overestimate the extent to which banks pulled back from small business and consumer lending,” says Brendan Dickinson, a principal at Canaan Partners, a New York-based venture capital firm that invests in technology companies including several in the fintech space.

There are actually two kinds of investors in the fintech companies. One category, like Canaan Partners, provides debt and equity funding to the companies themselves, where they see an opportunity to leverage advancements in technology and create a significant competitive advantage in the marketplace—especially since the banking industry has been slow to embrace the fintech revolution. “There is a lot of money going into fintech startups,” says Sanwal. “Investors see a massive industry where there has been a lot of incremental innovation but not a serious shift in how things are done. Banks are pretty terrible at innovation.” To Sanwal’s point, banks have incorporated new technologies like mobile into their distribution system, but the system itself hasn’t changed all that much. The branch is still the focal point for most banks.

A second group that has shown a great deal of interest in the fintech space is comprised of institutional investors who see consumer and small business loans as an attractive asset class in the current low interest rate environment, where the search for yield has forced them to broaden their horizons. “Fintech companies have developed a fundamentally less expensive way to originate loans while giving investors access to an asset class that they want,” says Dickinson.

It’s not surprising that fintech companies are very tough competitors in their product niches. Advances in technology have given them several very important advantages over traditional banks, including significantly lower costs, super-fast decisioning and simplicity. “At the end of the day, what the customer wants is a product they can understand at the lowest possible cost,” say Jeff Bogan, head of the institutional group at Lending Club, a marketplace lender that offers unsecured personal loans from $1,000 to $35,000 with three- or five-year terms, and more recently, unsecured business loans up to $300,000 with repayment terms between one to five years. One of the earliest fintech companies in the consumer loan sector—the San Francisco-based company launched its service in 2007—it has also been one of the most successful. Lending Club went public in 2014 and is listed on the New York Stock Exchange.

Bogan believes there are two components that have helped drive Lending Club’s success: operating cost efficiency and the customer experience. “I really think that is the core behind our growth and why we’ve been so successful,” he says. Lending Club has focused on providing a positive user experience built around its easy-to-use website, simple application process, transparency of loan terms and fees, and quick response time. Bogan contrasts Lending Club’s approach to that of most banks, which he says tend to offer “a clunky online user experience.” “That alone is a huge source of competitive advantage relative to the traditional banking system,” he adds.

Just offering a good user experience isn’t enough, and Lending Club also tries to exploit its significant cost advantage compared to most banks. One metric that the company uses to measure efficiency is operating expense as a percentage of its outstanding loan balance, which Bogan says is 2 percent and declining. Capital One Financial Corp.’s unsecured consumer loan business operates at 7 percent, according to Bogan. “The way we run our business, there’s substantial operating efficiency,” he says. “It’s really a combination of both of those elements that has driven the success of Lending Club today.”

This significant cost advantage is something that is common to the entire fintech space. “The cost of origination is a fraction of what it costs the banks,” says Ethan Teas, a managing director based in Australia at the consulting firm Novantas. “They have figured out how to keep costs super low.”

Prosper, also based in San Francisco, bills itself as the oldest peer-to-peer lender, having started operations in 2006. The company offers unsecured personal loans from $2,000 to $35,000, with repayment options of either three or five years. To date the company has made over $3 billion in loans, and derives its revenue from loan origination fees that it charges borrowers, and loan servicing fees that are paid by investors. CEO Aaron Vermut says that when banks scaled back their consumer lending during the financial crisis, it left high interest credit cards and payday lenders as the only loan options for many consumers. And one of Prosper’s goals, as Vermut puts it, was to “democratize credit.”

Like many fintech lenders, Prosper takes a broader approach to credit underwriting than most traditional banks, which tend to rely heavily on credit scores. Vermut says that Prosper uses credit scores as a “guardrail” to keep itself within certain parameters, but not to determine the final decision. The company’s underwriting process relies on over 400 data points including such factors as the applicant’s relationship with suppliers, shipping companies and credit card processors, e-commerce activity and cell phone records.

CAN Capital, a New York-based direct lender that offers up to $150,000 for business loans and merchant cash advances based on future credit card receivables, also takes other information into consideration during the underwriting process to identify those applicants that might have a lower-than-optimal credit score but have a track record of making good business decisions. “A credit score is a blunt instrument that is based more on personal credit than on business performance,” says CAN Capital CEO Daniel DeMeo.

The underwriting process at all of these fintech companies is driven by algorithms that can make quick decisions with little, if any, human intervention. CAN Capital’s approach is “faster, quicker and has a higher yes rate” than most banks, says DeMeo. “We can do our job in a day if we can get all of the information that we require.”

Given the vibrancy of the fintech sector and the vast amounts of investor funds that are pouring into it, how should traditional banks assess the competitive threat posed by the new upstarts? Unsecured credit, whether it’s to consumers or small businesses, is not a market that most banks—especially smaller community banks—are all that focused on these days. It would be difficult for them to offer a similar consumer or small business loan at a competitive price because their costs are too high. And this might explain why many banks view the fintech sector as something of a sideshow, a phenomenon that does not impact them directly since they are more interested in auto loans, first-lien home mortgages and home-equity loans—and on the business side—commercial real estate and commercial and industrial loans secured by collateral.

And yet there are two reasons why banks should pay close attention to what is happening in the fintech space. At a time when they are experiencing severe margin pressure due to low interest rates and intense competition for good commercial loans, banks should consider working with fintech lenders and see them as collaborators instead of competitors, particularly since most of them don’t have a good unsecured loan product of their own. And for their part, most of these fintech lenders—including Lending Club, Prosper and CAN Capital—would be happy to partner with banks and in effect become an outsourced loan origination platform, selling them the loan in return for a fee. The consumer and small business markets in the United States are massive and the banking industry serves only a relatively small part of it. Goldman Sachs—a high end Wall Street firm with a long roster of corporate clients throughout world—thinks so much of the opportunity that it plans to start a new online consumer lending business next year.

Some fintech lenders are already working closely with banks, including Lending Club. “You’ll find that the products that we’re very successful in are small balance loans where you need the data algorithm and significant scale to make the economics work,” explains Bogan. “So the banks that work with us today don’t have a great personal loan product because they can’t efficiently underwrite it and don’t understand it. Their approach is essentially, if you haven’t had a bankruptcy in the last few years and you have a 700 FICO score or greater, you’ll get a loan at 12.99 percent. That’s the extent of their sophistication in the personal loan business. We can bring significant value to them.” Lending Club, which doesn’t have a balance sheet, gets fees for originating and servicing the loan while the bank gets an earning asset with an attractive interest rate and quite possibly a new customer relationship.

There’s another reason why banks need to pay close attention to the fintech revolution. Technology is beginning to alter some of the basic economics of the lending business and to redefine the customer experience—and banks are being impacted by those changes. Kabbage CEO Rob Frohwein says that 95 percent of his company’s customers start and finish their loan application online with no human intervention. And Bogan says that the demographic makeup of Lending Club’s customer base is quite diverse. We tend to assume that fintech’s growth is driven by the entry of millennials into the economy as spenders and borrowers, and while there’s considerable truth behind that assumption, the acceptance of online financial services today is widespread. Bogan says that Lending Club originates loans across a broad cross section of the U.S. population. “We actually have very few 18 year olds because they don’t have the credit history necessary to get a loan,” he says. “And we probably have very few 70 year olds. If you look at our customer base, it’s really correlated with the general U.S. population.”

Even if they don’t partner with fintech companies, banks at least need to pay attention to how the technological innovations they are pioneering are changing their industry. They can’t afford to fall behind their fintech competitors in the innovation race. “Banks have processes and procedures that are very slow to change,” says Teas at Novantas. “And they look at what’s happening in financial technology and say it’s not big enough to be interesting. But when it does become big enough to be interesting, you’ve missed the boat.”

Bank Waters Will Remain Choppy

Ken Usdin is a managing director in the equity research department for Jefferies & Co. in New York, where he covers large regionals such as Fifth Third Bancorp and BB&T Corp.  In this longer version of an interview that appeared in Bank Director magazine’s third quarter issue, he talks about his predictions for the future of bank stocks, his favorite stock picks and what investors are looking for now.

We’ve seen the banking sector outperform the S&P 500 this year, but bank stocks haven’t done so well since March. Why?

There is not a lot of conviction about the macro-economy and Europe. There are concerns about the election here in the U.S. There is a slowing rate of economic growth in the U.S. I think the market for the bank stocks is going to be pretty choppy for the next several months. The fundamentals are OK but they’re not getting much better.

What are your favorite stocks?

PNC Bank is one of the high quality banks. They have a good growth trajectory—they just bought Royal Bank of Canada’s business in the U.S. so they’ll have some cost savings from that and some growth opportunities as they start to move their people and processes into a new territory for them, which is the Southeast. They have a conservative credit portfolio and [the stock] has a reasonable valuation. I’ve been of the view that you need to have high quality and low quality names. What happens is when people get fearful of the market, people tend to hold onto high quality names and sell their low quality ones. The [low quality] story we like the most is SunTrust Banks. What I like about that is they have a bunch of cost savings programs they’ve implemented. They’ve had a bigger burden relative to other banks from the credit crisis, especially from mortgages. As those costs continue to abate, they’ll have a nice pickup in earnings.

I really thought we would have a better understanding of how regulation is going to affect this sector by now. Do you think you have a better idea of how the Dodd-Frank Act is going to impact the sector than you did a year ago?

The only thing that is consistent from last year is that is going to cost a ton of money. I think the smaller banks are going to feel it bigger than the big banks. It is going to be a long, drawn out process to get compliant. We really just don’t know some of the impact. Costs are going to continue to spiral upwards as it relates to Dodd-Frank.

What are the most important performance metrics for investors and do you see that changing?

Loan growth. One thing people are really focused on is: Can banks grow loans through this tougher environment? Can banks hold up their interest margins? Those are the two most important things that I’m looking for, in terms of being able to sustain an earnings projector. 

TARP Legacy: Hidden Costs

The U.S. Treasury reported this week that taxpayers will make a $20 billion profit from the Troubled Asset Relief Program for banks, the government’s emergency support during the financial crisis.

That’s because banks have been paying dividends to the government on what was essentially borrowed capital and now 99 percent of the funds have been paid back.
The latest banks to pay back TARP, as announced this week, were Cincinnati’s Fifth Third Bancorp; Boyertown, Pa.’s National Penn Bancshares; Rapid City, South Dakota’s Stockmens Financial Corp.; San Jose, California’s Bridge Capital Holdings; and Norfolk, Virginia’s Heritage Bankshares.

Separately, the Congressional Budget Office has brought down its estimate of the total cost of TARP to taxpayers, which included investments in automobile manufacturers and insurer AIG, down to $25 billion, must less than the $356 billion the budget office previously estimated.

Winding down its work this week, the Congressional Oversight Panel for TARP released its final report on the program, saying TARP helped avert an even worse financial meltdown, which has become a pretty standard line for economists on both sides of the political aisle.

The Congressional Oversight Panel said: “The TARP does not deserve full credit for this outcome, but it provided critical support to markets at a moment of profound uncertainty. It achieved this effect in part by providing capital to banks but, more significantly, by demonstrating that the United States would take any action necessary to prevent the collapse of its financial system.”

The report goes on to criticize TARP as well, saying part of the reason the program has cost so little is because some of it didn’t work. For instance, the home affordable modification program (HAMP) was designed to lose money and benefit three to four million homeowners, but the U.S. Treasury hastily crafted it, and relied on voluntary participation from mortgage servicers.

“The program now appears on track to help only 700,000 to 800,000 homeowners,’’ the Congressional Oversight report says.

Also, TARP probably cost less than expected because of other government aid to the economy, the report says.

Plus, TARP leaves an even bigger problem on the table: the problem of moral hazard, the report says.

“By protecting very large banks from insolvency and collapse, the TARP also created moral hazard: very large financial institutions may now rationally decide to take inflated risks because they expect that, if their gamble fails, taxpayers will bear the loss. Ironically, these inflated risks may create even greater systemic risk and increase the likelihood of future crises and bailouts.”

The Congressional Oversight Panel is not the only one to bring up this problem. Many economists have been calling attention to the same issue. Whether the topic will resonate with the American public, still reeling from high unemployment, remains to be seen.

Top lobbyist to bankers: When the economy improves, the beatings will stop

Public officials will spend less time slugging bankers when the economy improves, but Dodd-Frank will stick around, changing the rules in fundamental ways, says one of the top lobbyists in Washington D.C., for the financial industry, Steve Bartlett.

Bartlett, the head of The Financial Services Roundtable, represents 100 of the nation’s largest financial companies, including Fidelity Investments and JP Morgan Chase.

Speaking to a crowd of hundreds of bankers at Bank Director’s Acquire or Be Acquired Conference in Scottsdale, Arizona two weeks ago, Bartlett said politicians have been criticizing the financial industry because the economy is hurting.


“The beatings will stop when morale improves,’’ he said. “It helps a lot for you to tell your story to members of Congress. Go to their town hall meetings and sit in the front row. They will be less inclined to beat the hell out of you the next time they make a public statement.”

Bartlett said he’s already noticed a change of tone in the Obama administration in the hiring of the president’s new economic advisor, Gene Sperling, and chief of staff Bill Daley, a veteran of JP Morgan Chase. Sperling once consulted for The Goldman Sachs Group. The Obama administration also has announced plans to review government regulations to weed out rules that seem burdensome to business and ineffective.

But the Dodd-Frank legislation passed by Congress last year is going to stick around, perhaps with only some changes here and there, Bartlett said.

He called the Durbin amendment’s limits on debit fees a “shocking” part of the legislation that will limit bank access to low and moderate income customers. (Editor’s note: Some bank analysts say more regulation is doing away with products like free checking for everyone, although free checking without a minimum balance requirement was getting dropped before Congress passed Dodd-Frank last year anyway).

But another fundamental change in Dodd-Frank is the shift away from simply requiring disclosure of the terms for financial products, Bartlett said. The new legislation requires that customers actually understand them, he said.

Dodd-Frank requires the new Consumer Financial Protection Bureau to end “abusive” practices and requires that disclosures be written in “plain language.” It goes on to say that the bureau should rely on consumer testing to figure out if those disclosures are understood. The specific language of Dodd-Frank asks the agency to consider evidence of “consumer awareness, understanding of, and responses to disclosures or communications about the risks, costs, and benefits of consumer financial products or services.”

Bartlett said Dodd-Frank will not just impact subprime loans, but other types of financial products.

“It’s no longer what you say to your customers but what your customers understand,’’ he said. “The statute says that you as a regulated entity will be held to the standard: Did the customer understand it? Not whether you said it plainly.”

Travis Plunkett, the legislative director at the Consumer Federation of America, did not attend the conference, and he disagrees with Bartlett.

“He is vastly overstating the impact,’’ Plunkett said, adding that he doesn’t believe companies will be punished just because a customer misunderstands something. He said the law is taking care of a minor gap in regulation that has allowed companies to create products that are so complex, they are designed to hide fees and charges from consumers, he said.

Elizabeth Warren, who is charged with setting up the Consumer Financial Protection Bureau, has said she wants to clean up disclosures and get rid of the “shrubbery” inside credit card disclosures. To see the interview she gave last month on the topic, read the Associated Press interview.

An adoption rate of 66%+?

mobile.jpgEarlier this week, our editor forwarded a survey recently released by Intuit Financial Services.  On the heels of our Bank Board Symposium (where retail banking-focused Q+A dominated our two-day Dallas event), some interesting analysis around the consumption habits of people utilizing online banking tools through their financial institutions.  While the percentage of online users stands at 34% today, “approximately one in five banking customers currently use mobile banking solutions to manage their finances.”

Now, I could simply laud USAA’s mobile banking app — or send you to Lincoln Financial’s dynamic and highly informative/addicting “future self” site.  Doing so will paint a broad picture of how innovative firms are winning business while retaining happy customers by marrying smart IT expenditures with savvy marketing plays.  No, I prefer to send a bigger nod to the many men and women working hard to grow AND avoid another financial crisis by incorporating new methods to increase deposits, better qualify loans and make more data-driven investments.

Having played in the high tech space for the past 5+ years, I’m of the opinion that the biggest advances in the next 24 months will come in the mobile banking space.  Think payments and remote deposits. Spurred on by our love affair with iPhones and Blackberries, mobile banking already is growing at a faster rate than online banking did during the 90s and early parts of 2000s.  So in the interest of sharing some of our company’s findings, let me juxtapose the top ten technologies that bank executives are interested in with the findings Intuits reports:

  • Mobile Banking
  • Mobile Payment
  • Peer-to-Peer Payments
  • Mobile Remote Banking
  • Social Media
  • Personal Financial Management
  • Reward Checking
  • Small Business Banking
  • Anti-Fraud + Security

Quite a few market forces — e.g. demographics, fast-changing customer demand, and a need to differentiate — are propelling advances in these technologies.  However, with the wealth of technology options and advancements being delivered by firms like Intuit, SASFiserv, etc. promises better days ahead for both the consumer and financial institutions.

The King + Queen in Today’s Financial Environment

kqcards.pngIf I’ve learned only one thing since re-joining Bank Director last month, its that capital is king, and liquidity, queen. Whether in Dallas, Chicago, New York or D.C., the messages I’ve heard from bankers, attorneys and CEOs are telling: if you’re in a leadership position, these are some of the most challenging times the U.S. banking industry has ever faced.

What buoys my confidence?  A collective optimism that opportunities for growth and new client relationships do exist.

So rather than taking a stance on asset quality issues, the absence of earnings or speculate about when lending will start again, my plan is to post something interesting I’ve recently learned that relates to growth.  Every Monday, I’ll use this blog to share what I’ve learned in my travels, provide an opinion or two, and generally contribute to our regular dialog around driving bottom line performance and enhancing shareholder value.

Whereas our editor’s writing will trend towards the director community — and VP of Digital’s will highlight our many great conferences — I’m intentionally focusing my writing efforts around the interests of the key officers running financial institutions.  As we build upon Bank Director’s 20 years of excellence in this industry, I expect this to be a fun journey and welcome ideas and suggestions for emerging areas of interest.