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By Karen L. Grandstrand 

Barlow Research’s December 2018 First Friday Web Conference, titled “Evolving Challenges and Competition for Small Business Banking,” focused on new challengers entering the financial services market. These new challengers are more sophisticated than the early disruptors and are vested in being digital, transparent, and nimble.

The Web Conference featured Senior Analyst Joel Mueller from Barlow Research Associates, Inc.,* Dan Rosenbaum, a partner with Oliver Wyman, and me.

This article provides a summary of my comments during the Web Conference in response to questions from Dan Rosenbaum on the evolving regulatory landscape for fintechs:

At this time, fintechs essentially have three options for bank charters—the industrial loan charter, the new OCC fintech charter, and a full national bank charter. Each of these regulatory schemes has pros and cons.

The industrial loan charter (ILC) has been around since the early 1900s. Originally, it was a charter for small niche lenders that provided consumer credit to low and moderate income workers who were not able to obtain consumer loans from commercial banks. By 1980, there were 123 ILCs in the United States. As of 2016, that number had declined significantly to only 25. ILCs are very similar to banks, and many even use the term “bank” in their names, such as Toyota Financial Savings Bank, WebBank, and BMW Bank. Seven states allow ILCs by statute. Most, however, are chartered in Utah. Under Utah law, ILCs are authorized to make all kinds of commercial and consumer loans and, significantly, can accept federally-insured deposits. They have access to the Federal Reserve discount window and payment systems. Also, they are exempt from state lender licensing laws and state money service business laws, and they enjoy federal preemption of state usury laws. They are supervised by whatever state granted the charter, as well as by the FDIC. ILCs, however, are not banks for purposes of the Bank Holding Company Act; therefore, commercial companies can own ILCs. Companies that own ILCs are not subject to regulation and supervision by the Federal Reserve, and as a result, they do not have to confine their activities to those that are financial in nature or closely related to banking.

By comparison, the new OCC fintech charter is issued by the OCC and is a special purpose charter. The chartered institution may make loans and engage in payments, but cannot take deposits. Like the ILC, a fintech is not a bank, and therefore not subject to supervision by the Federal Reserve. The OCC is the sole regulator. Besides the inability to take deposits, the other limitation is uncertainty in a couple respects. Importantly, the Federal Reserve has not at this time indicated whether it will grant a master account to these nondepository financial institutions so that they can settle transactions directly with the Fed. There is also uncertainty created by pending litigation. The New York State Department of Financial Services, as well as the Conference of State Bank Supervisors, have sued the OCC contending that the OCC does not have authority under the National Bank Act to grant this type of charter. The superintendent of the New York State Department of Financial Services has called the OCC’s decision “lawless, ill-conceived and destabilizing of financial markets that are properly and most effectively regulated by New York State.” The Conference of State Bank Supervisors contends that the “OCC is playing the role of an industrial planner that picks winners and losers, makes consumers vulnerable to predatory actors who do not have to follow state consumer protections, and creates a new risk to taxpayers: failed fintechs seeking bailouts.” There are political and public policy concerns and issues raised about access of fintechs to FDIC insurance.

The third option is the full OCC charter, which is the charter type being pursued by Varo. This charter might be politically easier to obtain than the ILC charter, but again, questions remain as to whether and when the FDIC will actually grant FDIC insurance to a fintech. Varo filed for a full OCC charter, and received preliminary approval for its charter from the OCC in August 2018. Varo also had to apply to the FDIC, and has withdrawn its pending FDIC application.

In addition, Social Finance, Square, and Nelnet have applied for ILC charters, and all three companies now have withdrawn their pending FDIC applications. Square and Varo both stated that they will be enhancing their applications and ultimately refiling, but these withdrawals are really telling. It is obviously very difficult to obtain FDIC insurance for an ILC charter. The most recent Utah ILC was chartered in 2009, and in fact, there have been no ILC applications filed between 2009 and Social Finance’s application in June of 2017. If you look at the history of de novo ILC formations, they do have a number of concerns in their history and have been affected at various times by moratoria. For example, Utah placed a moratorium on new ILC charters between 1986 and 1997 after a number of ILCs experienced significant financial difficulties in the early 1980s. When Walmart and Home Depot filed for ILCs in the mid-2000s, the FDIC imposed a moratorium on granting insurance for ILCs. In 2010, Congress, with the Dodd-Frank Act, imposed a three-year moratorium.

Keep in mind that since the Great Recession, it has been very difficult to obtain approval for any kind of de novo charter, not just an ILC and not just applications filed by fintechs. Prior to the Great Recession, we would see roughly 100 new charters a year in this country. From 2009 to 2013, there were seven new charters, and only 11 new charters since then. Why so few charters? According to the FDIC, of the more than 1,000 banks that were chartered between 2000 and 2008, their failure rate was more than twice that of small established banks. According to the FDIC, de novos are susceptible to failure under adverse economic conditions, and therefore the regulators do not readily approve charters, particularly during economic downturns. Now bank conditions have improved, political winds have changed with the Trump administration, and there is increased de novo activity. Right now there are 10 applications pending with the FDIC for deposit insurance, and the new chair of the FDIC, Jelena McWilliams, has stated that she is open to new charters. Having said that, when she was asked earlier this month her thoughts about letting fintech companies like Social Finance and larger firms like Apple have access to the banking system, she said, “We need to be very careful about allowing firms that are not traditional banks or don’t look like traditional banks into the banking space.” So what other options are there?

First, fintechs are pursuing acquisitions of existing bank charters. The process is generally easier and quicker than applying for a de novo charter. The capital requirements tend to be less, and regulators favor this approach over granting approvals for de novo charters. In FDIC testimony before Congress, the FDIC noted that acquiring an existing bank has the advantage of providing a core deposit and loan base on which a new investor can build a sustainable franchise. In addition, the existing bank is more likely to have a strong, tested management team already in place. In certain parts of the country, there are few or no charters available for sale, and that indeed is where we have seen much of the de novo activity. Here in the Upper Midwest, there still are many charters for sale. In Minnesota, for example, there are roughly 220 banks, many of them small.

Another option: Fintechs can also continue to operate and expand by using their non-bank entities and continuing to obtain the required state-by-state licenses and contracting with existing banks for deposit accounts.

A post-Web Conference note: Two key developments have occurred since airing of the Web Conference. First, the FDIC announced its highly anticipated initiative to promote de novo activity. Part of this initiative includes a new review process for deposit insurance applications; the FDIC believes this will be particularly helpful for business models that have unusual or complex aspects. Second, Square has refiled its application with the FDIC seeking deposit insurance for its ILC charter.

Throughout the coming year, these developments will continue. Fintechs are focused on the banking space, and this will not change.

*Barlow Research Associates, Inc. founded in 1980, provides the Voice of the Business Customer to Banks and Financial Service Providers. A full service market research firm, Barlow offers both custom and syndicated research and unique expertise in competitive intelligence CX studies.


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