Smaller institutions should think of financial technology firms as friends, not foes, as they compete with the biggest banks.
These companies, often called fintechs, pose real challenges to the biggest banks because they offer smaller firms a way to tailor and grow their offerings. Dozens of the biggest players are set to reach a $1 billion valuation this year—and it’s not hard to see why. They’ve found a niche serving groups that large banks have inadvertently missed. In this way, they’re not unlike community banks and credit unions, whose people-first philosophy is akin to these emerging tech giants.
Ironically, savvy fintechs are now smartly capitalizing on their popularity to become more like big banks. These companies have users that are already highly engaged; they could continue to see a huge chunk of assets move from traditional institutions in the coming year. After all, what user wouldn’t want to consolidate to a platform they actually like using?
The growth and popularity of fintechs is an opportunity for community banks and credit unions. As customers indicate increasing openness to alternative financial solutions, these institutions have an opportunity to grab a piece of the pie if they consider focusing on two major areas: global trading and digital capabilities.
Since their creation, community banks and member-owned organizations have offered many of the same services as their competitors. However, unlike fintechs, these financial institutions have already proved their resilience in weathering the financial crisis. Community banks can smartly position themselves as behind-the-scenes partners for burgeoning fintechs.
It may seem like the typical credit union or community banking customer would have little to do with international transactions. But across the world, foreign payments are incredibly common—and growing. Global trading is an inescapable part of everyday consumer life, with cross-border shopping, travel and investments conducted daily with ease. Small businesses are just as likely to sell to a neighbor as they are to a stranger halfway around the globe. Even staunchly conservative portfolios may incorporate some foreign holdings.
Enabling global trades on a seamless digital scale is one of the best avenues for both community banks and credit unions to expand their value and ensure their continued relevance. But the long list of requirements needed to facilitate international transactions has limited these transactions to the biggest banks. Tackling complex regulatory environments and infrastructure can be not only intimidating, but downright impossible for firms without an endless supply of capital earmarked for these such investments.
That means that while customers prefer community banks and credit unions for their personalization and customer service, they flock to big banks for their digital capabilities. This makes it all the more urgent for smaller operations to expand while they have a small edge.
Even as big banks pour billions of dollars into digital upgrades, an easy path forward for smaller organizations can be to partner with an established service that offers competitive global banking functions. Not only does this approach help them save money, but it also allows them to launch new services faster and recapture customers who may be performing these transactions elsewhere.
As fintechs continue to expand their influence and offerings, innovation is not just a path to success—it’s a survival mechanism.
Every bank director has heard it: You can outsource a service, but you cannot outsource the responsibility.
That sounds clear enough, but how does a board know what its role should be when an opportunity to partner with a financial technology firm, or fintech, arises? The board’s role is oversight and guidance, not day-to-day management. But oversight is not passive. So what does board oversight look like in the evolving world of bank and fintech relationships?
Consider a bank that is reviewing a proposal from a fintech. Management believes that this is a great opportunity for the institution, and presents it to the board for approval. What is the board’s role here? The board’s involvement must be flexible enough that it can react to these situations, but it should also consider some essential inquiries, such as:
Does the proposal match up with the bank’s strategic plan? The board is responsible for the strategic direction of the bank. Directors should consider if the proposal is an appropriate project for the size, resources and initiatives of the bank. They must also think about whether the proposal aligns with the bank’s strategic plan. If the proposal does not match up with the strategic plan, they may also want to consider if it is material enough that the strategic plan should be amended.
What are the risks? The board is responsible for ensuring that an effective risk management program is in place at the bank, which includes the ability to fully assess risks and establish controls and oversight to mitigate those risks. It should assess the fintech proposal through its risk management process
Management should provide the board with a comprehensive risk assessment of the proposed relationship that thoroughly outlines how each identified risk will be mitigated. The board should look at that assessment critically. Was it prepared by competent and experienced personnel? Does it appear to be thorough? Does it focus on IT risks or other narrow issues, or take into account all of the compliance issues? Does it include state laws, which is especially important if the bank is state-chartered? How does the assessment address concerns about privacy and cybersecurity? What does it say about reputation risk?
Is there a negotiated contract that addresses all of the risks? The board is responsible for ensuring that all third-party relationships are documented in negotiated contracts that protect the interests of the bank. The board needs to ensure that appropriate legal counsel is engaged to negotiate the arrangement, depending on the riskiness of a proposed fintech relationship. Counsel should have a thorough understanding of the legal issues involved in the proposed program and the applicable regulatory guidelines for third-party contracts.
The actual contract negotiation should be done by management. However, the board could consider requiring a summary of the important contract provisions or a presentation by management or legal counsel about the terms, depending on the level of risk involved and materiality to the bank.
How will the board know if the program is performing? The board should receive ongoing reports relating to monitoring of the program and the fintech. These reports should be sufficient for the board to establish that the program is compliant with law, operates in accordance with the contract and meets the strategic objectives of the bank. If the program is not performing, the board should know whether appropriate action is underway to either facilitate performance or terminate the program.
A bank’s board cannot outsource its responsibility for outsourced services, even if a fintech partner seems to have a fantastic product. The board must ask enough questions to be certain that management has engaged in appropriate due diligence, identified the risks and determined how to mitigate those risks through the contract and oversight. The implementation of all of those steps is up to management. But one role in particular rests with the board: ensuring that the relationship with the fintech partner furthers the strategic goals of the bank.
To understand the seismic shifts underway in the banking industry today, it’s helpful to look back at what a different industry went through in the 1980s—the industry for computer memory chips.
The story of Intel Corp. through that period is particularly insightful.
Intel was founded in 1968.
Within four years, it emerged as one of the leading manufacturers of semiconductor memory chips in the world.
Then something changed.
Heightened competition from Japanese chip manufacturers dramatically shrank the profits Intel earned from producing memory chips.
The competition was so intense that Intel effectively abandoned its bread-and-butter memory chip business in favor of the relatively new field of microprocessors.
It’s like McDonald’s switching from hamburgers to tacos.
In the words of Intel’s CEO at the time, Andy Grove, the industry had reached a strategic inflection point.
“[A] strategic inflection point is a time in the life of a business when its fundamentals are about to change,” Grove later wrote his book, “Only the Paranoid Survive.”
“That change can mean an opportunity to rise to new heights,” Grove continued. “But it may just as likely signal the beginning of the end.”
The parallels to the banking industry today are obvious.
Over the past decade, as attention has been focused on the recovery from the financial crisis, there’s been a fundamental shift in the way banks operate.
To make a deposit a decade ago, a customer had to visit an ATM or walk into a branch. Nowadays, three quarters of deposit transactions at Bank of America, one of the biggest retail banks in the country, are completed digitally.
The implications of this are huge.
Convenience and service quality are no longer defined by the number and location of branches. Now, they’re a function of the design and functionality of a bank’s website and mobile app.
This shift is reflected in J.D. Power’s 2019 Retail Banking Advice Study, a survey of customer satisfaction with advice and account-opening processes at regional and national banks.
Overall customer satisfaction with advice provided by banks increased in the survey compared to the prior year. Yet, advice delivered digitally (via website or mobile app) had the largest satisfaction point gain over the prior year, with the most profound improvement among consumers under 40 years old.
It’s this change in customers’ definition of convenience and service quality that has enabled the biggest banks over the past few years to begin growing deposits organically, as opposed to through acquisitions, for the first time since the consolidation cycle began in earnest nearly four decades ago.
And as we discussed in our latest issue of Bank Director magazine, the new definition of convenience has also altered the growth strategy of these same big banks.
If they want to expand into a new geographic market today, they don’t do so by buying a bunch of branches. They do so, instead, by opening up a few de novo locations and then supplementing those branches with aggressive marketing campaigns tied to their digital banking offerings.
It’s a massive shift. But is it a strategic inflection point along the same lines as that faced by Intel in the 1980s?
Put another way, has the debut and adoption of digital banking changed the fundamental competitive dynamics of banking? Or is digital banking just another distribution channel, along the lines of phone banking, drive-through windows or ATMs?
There’s no way to know for sure, says Don MacDonald, the former chief marketing officer of Intel, who currently holds the same position at MX, a fintech company helping banks, credit unions, and developers better leverage their customer data.
In MacDonald’s estimation, true strategic inflection points are caused by changes on multiple fronts.
In the banking industry, for instance, the fronts would include regulation, technology, customer expectations and competition.
Viewed through this lens, it seems reasonable to think that banking has indeed passed such a threshold.
On the regulatory front, for the first time ever, a handful of banks don’t have a choice but to focus on organic deposit growth—once the exclusive province of community and regional banks—as the three largest retail banks each hold more than 10 percent of domestic deposits and are thus prohibited from growing through acquisition.
Furthermore, regulators are making it easier for firms outside the industry—namely, fintechs—to compete directly against banks, with the Office of the Comptroller of the Currency’s fintech charter being the most obvious example.
Technology has changed, too, with customers now using their computers and smartphones to complete deposits and apply for mortgages, negating the need to walk into a branch.
And customer expectations have been radically transformed, as evidenced by the latest J.D. Power survey revealing a preference toward digital banking advice over personal advice.
To be clear, whether a true strategic inflection point is here or not doesn’t absolve banks of their traditional duty to make good loans and provide excellent customer service. But it does mean the rules of the game have changed.
Ten years ago a technology session at a banking conference wouldn’t have drawn a standing-room only crowd of experienced community bankers, but in 2019 you’ll see a much different scene.
Many of the 800-plus bankers attending Bank Director’s Acquire or Be Acquired Conference at the JW Marriott Phoenix Desert Ridge resort in Phoenix, Arizona were eager to soak up knowledge about technology—which many experts see as the answer to both the competitive pressure being applied by fintech companies from outside the industry, and from customers who want digital alternatives to the industry’s traditional distribution channels.
The shift in attention to tech-focused content is a clear indication that bankers are taking technology more seriously than they ever have—and for good reason.
“We’re entering a time where outside forces feed on the unprepared—maybe not directly but I think they create conditions that will make it very hard for unprepared institutions to survive,” said Mike Carter, executive vice president at the consulting firm SRM Corp., who made a presentation Monday on the threats posed by nonbank payments companies.
The good news, Carter said, is community banks can now more easily compete up-market despite the wide gap in deposit share compared to the country’s biggest money center banks that invest as much as $11 billion per year on technology. It no longer requires millions in up-front investment, Carter said, as many fintech firms now sell their technology through licensing fees.
The catch is that some banks will have to recalibrate their strategies and think of it as “banking in reverse,” said Frank Sorrentino, chief executive officer of $5.6 billion asset ConnectOne Bancorp, based in Englewood Cliffs, New Jersey.
Sorrentino, who participated in a panel discussion Sunday outlining strategies for growth, said ConnectOne has operated from its formation as a de novo in 2005 with the customer’s needs foremost in mind. Instead of thinking about what products would sell best, they thought about what the customer wanted and how they could provide that—and that has contributed to the rapid growth that ConnectOne has experienced.
“Technology gets you on the road to (grow),” Sorrentino said.
Before he became a banker, Sorrentino was a home builder who had become frustrated with the service he received from his bank—so he decided to start his own bank with a customer-first strategy.
Sorrentino’s philosophy is one that is becoming increasingly common among executives, said Pierre Naudé, CEO of nCino, which markets a cloud-based bank operating system to banks.
“I think it’s a new breed of C-suite people that’s coming up that’s actually adept and used to technology and very comfortable talking about it,” Naudé said.
That philosophical shift among bank executives has been a transition, Naudé said, which began with the initial wave of fintech firms that caused disruption in the industry through their technical innovation.
This disruptive dynamic has been exacerbated by the growth in market share by the country’s largest institutions.
Since 1992, deposits held in the country’s 100 largest banks have increased more than 700 percent compared to a mere 18 percent in the smallest institutions, according to data presented Monday by Don MacDonald, chief marketing officer for MX, a Utah-based fintech firm.
MacDonald made the case that the industry is entering a fifth age—the so-called “data age”—that emphasizes the use and leverage of various levels of information to reduce cost, increase revenue and deliver an exceptional customer experience, regardless of asset size.
“What’s amazing about it is the role of the consumer,” MacDonald said.
That role was a common thread in technology-focused presentations and conversations at the conference, where most agree that the focus should become what the consumer wants, not what banks can deliver that will appease them.
It’s a reversal in the traditional relationship between banks and customers.
“We as consumers have more choice than we’ve ever had in our lives, and perhaps more important is the friction to change is virtually nil,” MacDonald said.
“So if I don’t like you I can move from you at the click of a button, or from my current provider I can move to you at the click of a button.”
That precipitates a shift in perspective about how banks will think about growth, and in what terms that’s defined.
“Size isn’t a number,” Sorrentino said. “Size is your capability.”
Most people assume that fintech companies are out to take business away from banks, but what if the opposite is true?
What if, instead of being a threat, fintech companies actually open up new opportunities for banks?
That’s what a handful of banks are exploring right now. They’re doing so by essentially white-labeling deposit insurance, regulatory expertise and access to credit platforms.
You can think of it as a partnership that leverages a fintech company’s strengths on the front end of the customer experience, with attractive and refined digital interfaces, as well as a bank’s strength on the backend, by providing access to safe and secure financial products.
It’s a classic win-win situation.
One bank pursuing this course is TAB Bank, an online bank based in Ogden, Utah, with $711 million in assets.
“We came to the conclusion that we would build our strategy around how we think the market will look in two to five years, not how it behaves today,” says Curt Queyrouze, president of TAB. “What we determined was that once consumers try a digital interaction, they stay in that lane.”
Queyrouze has been cultivating this model for years.
The 20-year-old online bank has “sponsored” non-banks before who wanted access to the Visa and MasterCard credit platforms, says Queyrouze. Then TAB began working with marketplace lenders and offering traditional transaction accounts—in other words, white-labeling banking services to its partners.
“To the extent we can be the infrastructure for that cash account that attaches to whatever payment systems are out there, yeah, there’s a lot of benefit to that,” says Queyrouze. “As traditional banks we can hold that money, we can insure it and then we can take that money and turn around as the traditional banking model has always been and lend out that money, (or) use it in other ways to create profitable margin.”
The Bancorp Bank is pursuing a similar course. The $4.4 billion online bank headquartered in Delaware makes it clear what their model is all about: enabling non-bank companies to offer bank-like products.
“Take a close look behind some of the world’s most successful companies: that’s where you’ll find The Bancorp,” the company boasts.
The Bancorp backs Varo Money, for example, a mobile app offering users insured deposits, fee-free ATM withdrawals, interest-bearing savings accounts and personal loans in 21 states. (Varo Money was among the first fintechs to apply for the new national charter offered by the Office of the Comptroller of the Currency last year.)
Yet another bank pursuing a similar strategy is Cross River Bank, a New Jersey-based bank with $1.2 billion in assets.
Getting back to TAB, another epiphany came to Queyrouze in late 2018 at one of the biggest financial services conferences of the year.
Queyrouze thought about all the money being spent to lure new customers by both banks and non-banks.
As Queyrouze saw it, this gave TAB two potential paths to follow.
One would require a massive marketing budget to compete against bigger banks and fintech companies in the competition to acquire customers. The other was to stick to what it knew on the backend—namely, banking—while leveraging the strength of fintech companies on the frontend.
“While we do have the option to market against this tide, we also have the opportunity to build a banking infrastructure to align with the fintech world and provide banking services to support their client base,” says Queyrouze.
In short, small banks like TAB don’t have the resources to compete in the digital realm against larger peers. Nor can they pump money into a national marketing blitz to grow their customer base.
But they can stick to what they do just as well as any bank regardless of size—banking—and let fintech partners handle the rest.
There are three ways to consider expanding into new lines of business, improving operational capabilities, or tapping new markets. Should you build, buy, or partner?
Technology is disruptive, and established companies struggle with the best way to adapt to the changing trends.
Fortunately, there are options. Fintech partners, big and small, offer a variety of financial products and services utilizing the latest technology that can be white-labeled or simply acquired.
In addition, the talent pool of technologists is expanding, giving financial institutions access to the necessary skills should they choose to build internally. When determining whether to build, buy, or partner, these institutions must consider their core competencies and competitive advantages, as well as their culture, structure, and access to capital.
While there is no one-size-fits-all approach for financial institutions, partnering with fintechs can be most beneficial and provide needed flexibility for the long term.
Consider the choice to build. First, an institution must recruit and fill a team of product managers, engineers, and other highly skilled positions that demand significant compensation. An up-front investment must be made to support software development, testing, security and maintenance. The speed to market is typically slower if an institution chooses to build, elevating the risk the product or service will be out-positioned by the time of launch.
While true that some of the largest financial institutions have managed to develop popular new digital products and applications internally, they are the exception. Those banks also typically had the surplus capital to put to work.
The “buy” option presents challenges as well. Few credit unions and community banks have the financial clout to acquire a fintech company. Those that do will face numerous hurdles integrating the acquisition into their existing operations, technology stack and company culture.
There are certainly examples of successful fintech acquisitions by financial institutions, but unless the acquirer is prepared for a lengthy and resource-consuming process, this may not be the most viable option.
Partnering can often be the most cost-effective and efficient alternative. There is no shortage of turnkey solutions that allow community banks to automate products and services, enabling them to provide the kind of digital experience consumers have come to expect.
Partnering with a fintech also provides the financial institutions with an option to test before investing in a build or buy strategy later. For institutions seeking a stopgap solution, partnering can meet current needs and buy time to consider long term alternatives.
It’s not hyperbole to suggest the technological challenges and threats facing banks are existential. Those that do not adapt quickly face the risk of becoming irrelevant. Fortunately, whether it is build, buy, or partner, there are myriad solutions that allow institutions to provide an attractive digital experience without relinquishing their core competencies and competitive advantages.
As a microcosm of the banking sector and the broader economy, North Carolina provides an interesting glimpse at some of the trends and issues impacting banks nationwide.
“North Carolina’s banks are strong and benefiting from a robust economy,” says Ray Grace, who has served as the North Carolina Commissioner of Banks since 2013. “A sign of the good times for banking here is the interest we’ve seen in this cycle from out-of-state banks buying their way into North Carolina markets.”
Out-of-state banks making recent acquisitions in North Carolina include Columbia, South Carolina-based South State Corp., Pittsburgh, Pennsylvania-based F.N.B. Corp., and two Tennessee banks: Pinnacle Financial Partners, in Nashville, and First Horizon National Corp., in Memphis.
As the state’s banks consolidate, there is interest in opening new banks—the first since the financial crisis.
North Carolina also boasts a burgeoning technology sector, including the bank operating system nCino, based in Wilmington, and payment solutions provider AvidXchange, digital banking provider Zenmonics and IT consulting firm Levvel—all based in Charlotte.
In this interview, which has been edited for length and clarity, Grace explains why he’s seeing more interest in opening de novo banks in the state, shares his advice for banks exploring fintech partnerships and weighs in on prospective challenges for the industry.
BD: North Carolina just chartered its first de novo bank in a decade, with American Bank & Trust in Monroe, North Carolina. The Charlotte Observer reported you believe there’s more interest in opening new banks in your state. What’s driving that interest, and do you expect more activity to result from that interest?
RG: During the so-called Great Recession, the traditional economic drivers for bank formations disappeared. The economic downturn increased credit risks from borrowers, monetary policy wrung the margins out of lending, and the predictable tightening of the regulatory screws increased both the cost and the complexity of banking. Normally, we would have seen a faster return of de novo activity, but this was of course no normal recession, and fittingly, it was no normal recovery. Rather than the “V-shaped” recovery we had seen following previous downturns, this was the dreaded “L-shaped” variety, prolonging the drought.
On the heels of an epic consolidation trend, many North Carolina markets, including some that had been historically very supportive of community banks, lost those banks. As with previous consolidation episodes, this has left voids in these markets, particularly in rural areas. At the same time, we have seen a strong, decisive uptick in the economy through much of the state, a gradual return to normalizing interest rates, and, mirabile dictu, the beginnings of a swing of the regulatory pendulum toward a somewhat less restrictive environment. All these factors have contributed to the return of industry profitability and made the banking model attractive once again.
BD: Banks have been increasingly working with fintech firms to better expand and improve their own products and services, but properly vetting younger tech companies can be tricky. Do you have any advice for banks exploring fintech partnerships?
RG: Banks will need to embrace new technologies if they are to remain viable. That said, they need to focus on being cutting edge, but not bleeding edge. There is a dizzying array of gee-whiz products being introduced now, and it’s important to be careful in what you choose to implement.
Like a lot of advice, mine is more easily given than followed, but start with the fundamentals. What [or] who are your markets? What are you offering those markets and customers in the way of products and services, and why? What is trending, and in what directions? How does all this fit in with your business plan? Does your business plan still make sense? If not, change it.
In light of the foregoing, is your management team and board adequate to your bank’s current and future needs? For example, do you have a chief technology officer? A tech-savvy director or two?
Know what is available, [and] study and carefully assess the alternatives that fit the needs of your business plan. Discard applications or products that do not enhance customer value and the quality of their experience—while not breaking the bank.
What existing bank systems must be accessed by the new application? What firewalls or other protections are provided for access, data and systems security?
What is the financial strength of the company you are contracting with? What is their capacity to support the application? Do they have a track record with other banks? What would be the consequences to your operations in the event of failure of the vendor? Who owns the code in that event, and who could take over support?
Not long ago, there were any number of fintech startups with interesting offerings but limited resources and infrastructure, which made them risky to engage with. The good news is that’s changing, and clearly it is better to deal with companies that have some legs, financially and organizationally.
BD: Is there anything else you think is important that boards be aware of heading into 2019?
RG: Change, or the failure to meet its challenges, is the single greatest existential risk to banking as we know it. However, boards cannot afford to lose focus on more traditional risks. There is an old banking axiom that the worst of loans are made in the best of times. These are some pretty good times, and we are beginning to see some troubling signs that memories are short. Among those I would cite are the rising prevalence of “covenant light” loans and other structural concessions on the commercial side, and 100 percent financing in both the commercial and mortgage lending spaces. Some in Washington are again talking about the need to increase access to affordable housing. Déjà vu all over again?
Interest rates are likely to continue to rise, albeit at a modest rate. I think this is a good thing for the industry and the economy, but it will require an increased emphasis on sound funds management policies and practices on both sides of the balance sheet.
Our banking industry has always faced challenges: the Great Depression, disintermediation and the thrift crisis of the 80s, the repeal of Regulation Q, the Great Recession and resultant Dodd Frank Act, and a host of others. Yet, the industry has survived and reinvented itself time and again. Unfortunately, banks have also been the target of damaging criticism from Washington, sometimes for good reason but too often for political motivation. Restoring the public trust tarnished by this criticism will play a critical role in ensuring the industry’s future. We need to be reminded that banks are special. That they are the only industry that “creates” money. And that they are the place where people have traditionally gone when they wanted to buy a home or a car, or start a business. In a very real sense, banks are where people go to make their dreams come true. That’s a powerful story. It’s up to banks to tell it and to make it so.
More banks are exploring relationships with technology companies, but there are distinct differences between a vendor and a true partner. Steve Brennan, the senior vice president of lending technology at Validis, explains what banks should seek in a partner and in turn, shares how banks can be good partners.
Ultimately, partners should work toward being successful together. This video outlines how a bank can ensure a good outcome results from these relationships.
Should you acquire or be acquired? Some community banks are electing to do neither, and instead are attempting to forge a different path – pursuing niche business models. Each of these business models comes with its own execution and business risks. All of them, however, come with the same regulatory risk – whether the bank’s regulators will challenge or be supportive of the changes in the business model.
Some community banks are developing partnerships with non-bank financial services, orfintech, companies – companies that may have created an innovative financial product or delivery method but need a bank partner to avoid spending millions of dollars and years of time to comply with state licensing requirements. These partnerships not only drive revenue for the bank, but can also – if properly structured – drive customers as well. WebBank is a prime example of the change this model can bring. As of the close of 2007, WebBank had only $23 million in assets and $1 million in annual net income. Ten years later, WebBank had grown to $628 million in assets and $27.5 million in annual net income, a 39 percent annualized growth in both metrics.
Following the recession, bank regulators have generally been supportive of community banks developing new business models, either on their own or through the use of third party technology. As the OCC notes, technological changes and rapidly evolving consumer preferences are reshaping the financial services industry at an unprecedented rate, creating new opportunities to provide customers with more access to new product options and services. The OCC has outlined the principles to prudently manage risks associated with offering new products and services, noting that banks are motivated to implement operational efficiencies and pursue innovations to grow income.
Even though the new business model may not involve an acquisition, the opening of a new branch, a change in control, or another action that requires formal regulatory approval, a bank should never forge ahead without consulting with its regulators well before launching, or even announcing, its plan. The last thing your board will want is a lawsuit from unhappy investors if regulators shut down or curb the projected growth contemplated by a new business model.
Before introducing new activities, management and the board need to understand the risks and costs and should establish policies, procedures and controls for mitigating these risks. They should address matters such as adequate protection of customer data and compliance with consumer protection, Bank Secrecy Act, and anti-money laundering laws. Unique risks exist when a bank engages in new activities through third-party relationships, and these risks may be elevated when using turnkey and white-label products or services designed for minimal involvement by the bank in administering the new activities.
The bank should implement “speed bumps” – early warning indicators to alert the board to issues before they become problems. These speed bumps – whether voluntary by the bank or involuntary at the prompting of regulators – may slow the bank’s growth. If the new business model requires additional capital, the bank should pay close attention to whether the projected growth necessary to attract the new investors can still be achieved with these speed bumps.
Bank management should never tell their examiners that they don’t understand the bank’s new business model. Regardless of how innovative the new business model may be, the FDIC and other bank regulators will still review the bank’s performance under their standard examination methods and metrics. The FDIC has noted that modifying these standards to account for a bank’s “unique” business plan would undermine supervisory consistency, concluding that if a bank effectively manages the strategic risks, the FDIC’s standard examination methods and metrics will properly reflect that result.
Banks also need to be particularly wary of using third-party products or services that have the effect of helping the bank to generate deposits. Even if the deposits are stable and low-cost, and even if the bank does not pay fees tied to the generation of the deposits, the FDIC may say they are brokered deposits. Although the FDIC plans to review its brokered deposit regulations, it interprets the current regulations very broadly. Under the current regulations, even minor actions taken by a third party that help connect customers to a bank which offers a product the customer wants can cause any deposits generated through that product to be deemed brokered deposits.
Community banks definitely can be successful without acquiring or being acquired. However, before choosing an innovative path a bank should know how its regulators will react, and the board should recognize that although regulators may generally be supportive, they do not like to be surprised.
Strategic planning is one of the most important roles of a financial institution’s board of directors. Since the 2008 financial crisis, financial institution boards have dealt with the emergence of fintechs as a primary consideration in developing their strategic plans. A few large financial institutions have opted to build fintech capabilities, but the majority of financial institutions have determined that the best strategy is either to invest in or partner with a fintech firm through an outsourcing process.
On July 31, 2018, the Office of the Comptroller of the Currency announced it would begin accepting applications filed by fintech firms for “special purpose” federal bank charters. While not unexpected given the conversations around this topic in recent years, the announcement garnered immediate and passionate responses from the interested constituents. Whichever strategy has been adopted and implemented in their firm, financial institution boards should consider the impact a “special purpose national bank charter” may have on their relationship with a fintech firm, or how newly chartered fintechs may change their strategic plan.
First: Re-evaluate Your Strategy Financial institution boards should first consider if their strategy should change based on an assumption that fintech firms would become chartered special purpose banks. Applying the standard SWOT (strengths, weaknesses, opportunities, threats) approach to their strategic planning, the board might determine that what once was a strength for a financial institution (direct access to customers, ability to accept deposits) could become a threat as chartered fintechs obtain bank powers, while weaknesses (stricter regulatory oversight and related infrastructure expense) become strengths or opportunities. This shift in the playing field for fintech and financial firms should become a basis for deciding if the build, invest or partner strategy is still the best fit for the financial institution.
Second: Evaluate Your Options Whether the board determines that their current strategy is appropriate or needs to be reconsidered, their decision will be influenced by the ability to and cost of change. The board should review the existing relationships that are in place and determine the feasibility of changing strategy. While building may be the best answer, the cost of building fintech expertise may not be a valid strategic option, given the expertise required and the size of investment. Likewise, finding a new vendor or outsourcing partner may be relatively easy, but exiting a current contract may be difficult or costly if there isn’t a valid contractual reason for termination.
Third: Focus on Execution In their review of options the board should have been exposed to any shortcomings or important factors in executing the adopted strategy. Once the strategic approach has been decided, the basis of that decision must be taken into account in the execution. The possibility of a fintech firm obtaining a bank charter should be the cornerstone of execution. Directors should ask themselves whether getting a bank charter should be a basis for terminating a financial institution’s relationship with a fintech firm. If so, the terms should be clearly stated including financial outcomes and operational details. For example, any fintech investments or contracts should make it clear the financial institution will maintain the customer relationships and the related data. In addition, the arrangement should have appropriate non-solicitation and non-competition clauses to protect the financial institution in the event the fintech becomes a competitor. If the fintech firm can terminate the relationship, the financial institution should ensure there is an adequate conversion process that will allow it to pursue a different strategy or to migrate to a new strategic partner with minimal interruption to its customers.
It is not expected that fintech firms will rush to obtain charters or that charters will be granted to fintech firms in the near future. Significant barriers still remain for fintech firms to obtain charters. The application, review and examination process for obtaining a new (or de novo) charter is arduous and time consuming. In addition, newly chartered special purpose banks would need to build extensive regulatory infrastructure and would be subject to additional oversight and supervision during their early existence. Nevertheless, the OCC’s announcement will provide fintech firms with additional strategic options and a foothold for bringing further disruption to the financial services industry. Financial institution boards should be prepared to strategically respond to that challenge.