An industrial bank, also known as an industrial loan company, is essentially a bank that is not overseen by a federal regulatory body like the Federal Reserve.
Industrial banking charters are offered in only a few states and have stirred up controversy amongst bankers who say the license is more or less a loophole that allows non-financial companies to offer banking services. The application is the first of its kind to get approved in the last 10 years and could mark the launch of a significant challenge for incumbent banks’ market share.
Square gets approval from FDIC for banking license
According to Square, the core business of the bank will be servicing the small business market. The expansion into small business banking is a reasonable one, as Square’s primary business was built with small businesses. This news comes hot on the heels of the FDIC’s February approval of Varo Money’s banking charter application. Both charters signal the arrival of fintech as viable threats to traditional banks as chartered fintech companies now have the ability to accept deposits and bank their clients’ money.
The advent of fintech originally brought about predictions of the demise of traditional financial services. Financial services professionals were worried that innovative, nimble fintech businesses would circumvent the financial system and take over incumbents’ market share. After the initial wave of fintech and the fear that accompanied it, fintech companies and traditional financial services institutions engaged via partnerships and vendor-client relationships. Now, they are looking to directly challenge both incumbents and neobanks by offering banking products.
One of the prime opportunities for fintech companies breaking into the banking side of the financial services industry lies in servicing small businesses. Historically, banks have not focused heavily on servicing the small business market because of the risk inherent in extending loans to businesses that often hover on the edge of survival. Large banks’ reticence to offer small business loans is evident in their approval rate of small business loan applications, which sits around 27.5 percent. For Square, their focus on small business banking services is a natural extension of their existing client base, which is made up heavily of small businesses. Small businesses need capital and they will turn to fintech-turned-banks like Square that will offer them the funds they seek.
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Fintech companies gradually breaking into the banking game
LendingClub went the acquisition route, buying digital bankーRadius Bank in February. The acquisition was a shrewd entry into banking, as LendingClub bypassed the entire banking charter application process, which tends to be lengthy and expensive. As an example: Varo Money’s banking application took three years to be approved. Both Varo Money and LendingClub are looking to focus more on capturing market share amongst individual consumers rather than small businesses, in contrast to Square’s approach. Grasshopper, a commercial banking adjacent startup, was also approved for a banking charter back in May of 2019. All four began as fintech companies and now operate (or will operate) banking arms, leading the charge for fintech businesses looking to expand their services.
What is the big deal with becoming a bank?
Why would fintech companies go through the trouble of a years-long, multi-round intrusive application process to secure a bank charter? Until now, fintech companies have been banking adjacent, typically partnering with community banks to fill their banking needs. Those banks would handle customer deposits while their fintech partners would manage the customer facing applications and experiences. Fintech businesses that become legally chartered banks would be able to be in charge of customer deposits, allowing them to become the go-to provider of customers’ financial services.
Fintech companies’ elimination of banking partnerships means larger margins and a wider array of financial product possibilities. Acquiring a banking charter is equivalent to cutting out the middleman (the bank) and possibly securing delivery of 100% of a customers’ financial services needs. Fintech companies with a banking license get direct access to payment rails and deposit funding, which traditional banks have long kept a stranglehold on, making it much cheaper and easier to deliver their products at competitive rates.
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The future of fintech companies in banking
Banking charters granted to two (three if you count Grasshopper) fintech companies may not seem like a lot, but the number represents a positive flood when compared to the previous 10 years. In the last decade, no such business was granted banking charters and there were only nine banking charters granted to any applicant nationwide since 2008. However, that doesn’t mean we’ll see a host of fintech companies rush to apply for banking charters. The process is long and arduous, and fraught with hurdles to success, as Robinhood found out this past fall when it pulled its own application for a national bank charter.
I expect to see a few larger fintech companies follow in Square’s footsteps to tackle the small business banking market, which has been underserved by traditional banks looking for either more scale or higher margins. There are undoubtedly difficulties in achieving licensure as a bank but the potential rewards are significant. Fintech businesses that secure banking licenses gain access to existing payment rails like Automated Clearing House (ACH) at bank rates, the ability to operate nationwide and limit state interference with operations, and lower cost FDIC insured deposits. Additionally, a banking charter legitimizes a fintech business in the eyes of the financial services industry. We know that fintech companies cannot operate outside the scope of the existing financial services landscape because of the power of financial regulatory bodies.
Techfin, the term given to big tech companies that launch financial products, are another example of nontraditional companies getting into the banking game. The arrival of both fintech and techfin, as not just bank-adjacent technology providers, but banks themselves, presents incumbent banks with a significant threat to market share that they will need to address.
Fintech companies may fight to expand and evolve the solutions available to businesses and consumers, but they do it within the financial services space as it stands, altering the shape of the industry but not its core. Banking and government-issued charters approving banking activities remain the backbone of the financial infrastructure, and the surge of fintech companies entering the banking business proves that.