U.S. Challenger Banks Turn Up the Heat on Incumbents

via The Financial Brand

Colin Walsh’s three-year slog to get a national bank charter for his fintech mobile bank is looking savvier and less quixotic than ever. The CEO of Varo Money is just one final pre-opening exam away from becoming the first ever fintech granted a banking license.

But success spawns imitators and now one of Varo’s fintech competitors, SoFi, in July filed for an application for a national charter, stating in its application that it needed to reduce complexity in its business model and bring down its funding costs. “A national bank charter could allow SoFi to have more competitive pricing and offer more products, specifically in regard to deposits,” according to Business Insider, which first reported the application.

SoFi initially concentrated on refinancing student loans, but has since broadened into investments, mortgage lending, checking accounts (through Bancorp Bank and Stride Bank) and payments (via its Galileo acquisition). SoFi’s first request for a charter (a Utah state charter) was withdrawn in 2017 after a shakeup of its management team.

The current SoFi application comes on the heels of FDIC’s approval in March 2020 of Square’s deposit insurance application for an industrial loan company charter in Utah. Square, which has been pursuing the ILC charter strategy for more than two years, said Square Financial Services will launch in 2021 and, according to the Wall Street Journal, will offer small-business loans to merchants that use Square devices to process their payments.

In addition, Monzo, one of the top U.K.-based challenger banks, with 4 million customers, filed an application for a de novo national banking charter in April 2020. Monzo began testing its mobile banking app in the U.S. in August of 2019 through a partnership with Sutton Bank, The Dive reports. A banking license would allow the challenger to offer FDIC-insured deposit accounts directly.

Has the Challenger Bank Storyline Changed?

Not long ago media coverage, including in The Financial Brand, painted a picture of fintechs hit hard by the coronavirus pandemic. Funding appeared to be drying up and consumers were seeking safety in traditional financial institutions.

True, there were several notable funding pullbacks during the first half. But since then there have also been major funding rounds completed and acquisitions pulled off 2020. Cornerstone Advisor’s Senior Director, Sam Kilmer, who lists 12 notable examples in a Gonzo Banker article, observes that, “In the midst of unprecedented market volatility, recent deals and back-channel chatter illustrate that fintech demand remains high.”

Yet some observers have questioned the viability of challenger banks that rely heavily on payments-driven fee income. For example, before the pandemic hit, Accenture’s Global Banking Head Alan McIntyre stated that such models will struggle to be profitable unless they build huge scale or, alternatively, build more of a traditional balance sheet model where they earn spread income. He continues to believe that new entrants, including even Monzo, will continue to struggle.

Varo Money’s three-year odyssey to obtain a national bank charter was driven in part by that reality. While you don’t need a bank charter to lend money, the ability to offer deposits is a big advantage to be able to lend at affordable rates on a sustainable basis.

What will be interesting to watch is whether the charter floodgates have actually opened, or will remain the exception for fintechs,

If the views of Acting Comptroller of the Currency Brian Brooks are any indication, then fintechs with charters of some sort will become more common. Brooks, in an interview with The Financial Brand states that he expects to see applications for the OCC’s fintech charter, still very much alive, in the near future.

Impact of Square and SoFi Charter Moves

Square’s ILC license and SoFi’s application for a national bank charter are definitely significant developments within banking, says Sarah Kocianski, Head of Analysis and Research Manager at 11:FS. That’s because they will allow both enterprises to build on the considerable success they’ve already achieved. Monzo’s charter application makes sense too, she feels, but at present it has practically no base of customers in the U.S.

Further, all the observers contacted felt that overall, the impact from Square’s ILC approval is the most significant recent fintech development for incumbent financial institutions.

Sheer size is part of the reason. Square’s client base and market valuation are multiple times SoFi’s. And as of mid-July, Square is now worth more than all but four of the biggest financial service firms in the U.S. by market capitalization, according to the Fintech in Five newsletter from 11:FS.

“So much attention has been focused on whether GAFA would be the ones to change financial services, Square has been winning hearts, minds and wallet share,” the newsletter states. (GAFA stands for “Google, Apple, Facebook, and Amazon”).

The ILC charter will allow Square to diversify their business, Alan McIntyre observes. “Up to this point, Square has been a flow business model — moving money from account to account and taking a fee for that intermediation. Having an ILC will allow them to build both assets and liabilities that remain with Square,” say McIntyre. That will enable them to build out a more comprehensive banking proposition for retailers, he adds.

Because Square deals in the business banking/commerce landscape that is the earnings backbone of so many commercial banks especially community banks, it will have much more near-term impact than SoFi, which is much more focused on younger consumer lending, Sam Kilmer points out. On the other hand, the typical credit union might be more impacted by SoFI, he states.

Both fintechs have a large customer base who are happy with them, observes Sam Maule, Managing Director, North America, for 11:FS. “Customer acquisition is always the biggest hurdle for [new] companies to overcome from a capital investment and marketing standpoint.” Neither Sofi nor Square will need to start from scratch.