By Charles W. Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University and former Chief Economist, Office of the Comptroller of the Currency
Financial-technology (fintech) firms that provide banking services look very different from traditional banks. They tend to specialize either in payments or credit (a phenomenon known as “unbundling”), and they often fund themselves using off-balance-sheet mechanisms. The flexibility these new banks enjoy, the relative absence of burdensome regulation and their business models’ focus on efficient, new technologies within the niches in which they compete make them more profitable than existing banks. Their new technologies—both for credit intermediation and payment services—also permit them to break new ground on financial inclusion for underserved customers, including the poor and members of minority groups.
Unbundled, novel fintech banks specialize in one activity—a lending niche, payment niche or trust niche—but do not operate as universal banks. This represents something of a reversal of thinking about what is the most efficient way to organize banks. In the 1980s and 1990s, the United States moved to a system dominated by nationwide universal banks. By 2000, a handful of large banks operating throughout the country provided an unprecedentedly wide range of services. The universal-banking structure seemed to make sense as a means of achieving greater portfolio diversification through geographic integration across banking locations, reusing customer-relationship information, and maximizing advertising and marketing economies of scale.
But only 20 years (and one major financial crisis) later, the bloom of efficiency and stability is off the rose of nationwide universal banking. We experienced one of the worst financial crises in history in 2007-09. Since then, the traditional chartered banking system has wallowed in a state of unprofitability and inefficiency. For the first time in history, new entries into chartered banking have been virtually nonexistent for more than a decade. Banks’ services remain expensive (and some have become more expensive since 2009), and more than 60 million Americans are still described as “unbanked” or “underbanked”.
Shadow banks, however, have been bright spots on the competitive landscape, with dramatic changes happening over several years during the mid-2010s. According to Statista, the chartered banks’ share of personal loans fell from 40 percent in 2013 to 28 percent in 2018, while fintech banks’ personal loans rose from a 5-percent market share in 2013 to 38 percent in 2018. Interestingly, these new competitors have been structured very differently from traditional banks. They have focused on one or two lines of business and have typically provided either loan or payment services, but not both. Over the past several years, they have dramatically gained market share on both the payment and lending sides, out-competed traditional banks for talent and attracted huge amounts of new investor capital owing to their extremely high profit rates. What is driving the new unbundling trend?
In any business, absent a strong advantage to bundling, there are good managerial reasons to avoid it. Businesses that combine multiple lines of business suffer from a lack of strategic managerial focus. And large, multi-line organizations can be too tolerant of poor performance; under-performing business segments sometimes avoid making hard but necessary changes because they ride on the coattails of successful business segments.
In theory, the bundling of payments, lending and other bank business lines partly reflects the informational advantages of combining them within the same intermediary. Tracking a borrower’s payment history may provide timely information to the lender about how his or her business is doing. Or a bank engaged in opaque lending may find it advantageous to fund itself with demand deposits because of the discipline that comes from exposing itself to withdrawal risks. Such discipline may ensure that the bank behaves honestly and manages credit risks more efficiently. In both theories, the informational challenges of screening and monitoring bank borrowers underlie the advantages of bundling deposit-taking and lending.
Such bundling advantages have become less relevant as new screening and monitoring technologies provide alternative approaches to reducing the information costs associated with lending. Banks have new data resources they can use to screen and monitor borrowers, making the need to bundle a borrower’s deposits and loans less urgent. And those same informational improvements may allow banks to convey information about their own lending practices, thus reducing the need to use the discipline of deposit-withdrawal risk to reduce their funding costs.
Consider, for example, the information services provided by OakNorth, which collects information about small and medium-sized businesses and packages it for lenders. OakNorth developed its system in the United Kingdom, where it also used the system as a lender. In the United States, OakNorth provides informational services to other lenders. It draws real-time information about borrowers from thousands of databases and makes that information conveniently accessible to lenders. Not only do these data sets assist lenders in screening borrowers, but they also flag potential problems with loans early, often before there are any delays in payments or other traditional indicators of potential loan losses. These sophisticated monitoring procedures have made many of the traditional screening and monitoring procedures used in the past less important, including the need to gather information from observing borrowers’ checking accounts.
Unbundled fintech enterprises that can customize loan portfolios to meet the specific preferences of loan funders and take advantage of state-of-the-art information processing when screening and monitoring borrowers while avoiding the physical costs of maintaining branch networks will increasingly win the competitive struggle to serve customers.
Not only are new, unbundled fintech providers more profitable and efficient than traditional banks, but their technologies are proving to be very promising for improving access to financial services for many people who have not been served well by traditional banks, especially lower-income people. The US banking system serves about 80 percent of American families’ needs to make payments, save and borrow. But what about the other 20 percent, the so-called “unbanked” and “underbanked”?
Historically, the barriers that have kept the unbanked and underbanked from becoming fully integrated into the formal financial sector consist of several supply-side and demand-side factors. On the supply side, these include the challenges lenders face in differentiating borrowers’ risks, high transaction costs of serving small-dollar customers and costs of regulatory uncertainty (which are often defined on a per-customer basis and, therefore, disproportionately disadvantage small-dollar customers). On the demand side, factors such as the limited financial resources of low-income customers, their minimal experiences with financial-services providers and their preferences for particular kinds of products can restrict access. New fintech banks have developed customized and flexible business models that specifically address one or more of these frictions.
Most of these innovative intermediaries operate as so-called “shadow banks”, meaning they function as finance companies (licensed by the states) without official bank charters. Interestingly, chartering authorities—especially the Office of the Comptroller of the Currency (OCC), which regulates US national banks—have argued for many years in favor of encouraging these new types of intermediaries to apply for charters, and substantial progress in this direction was made in 2019-20. The benefits for shadow banks of obtaining national bank charters are several: (1) gains in their reputations from submitting themselves to regular examination by a credible authority, (2) the ability to use a single national bank platform to engage in business throughout the country and (3) access to Federal Reserve accounts to manage their transactions.
The chartering of these innovative banks as national banks (on a purely voluntary basis, not by mandating that they join the national system, I hasten to add) would offer advantages to the banking system, not just to the newly chartered banks. Regulation of these novel banks would reduce systemic risk by familiarizing regulators more with these banks’ operations, ensuring their capital and liquidity adequacy, and making liquidity-management tools (for example, the Federal Reserve’s discount window) available to them.
The next generation of fintech intermediaries could prove even more effective at delivering beneficial services, unless the self-interested defenders of the status quo (who correctly see progress as a threat to their own entrenched interests) succeed in killing off new intermediaries with prohibitive regulations. For example, stablecoin-issuing banks are a particularly interesting example of a way to improve payment services to customers while also fostering greater stability in the payment system. As I have explained at length elsewhere (“Chartering the FinTech Future,” The Cato Journal, Spring/Summer 2021), the stablecoin banks of the future will likely offer revolutionary improvements in the payment system.
First, their low overhead costs will allow them to offer higher interest rates on coins than depository banks can offer on deposits, which are similarly riskless. Second, coins are more useful than deposits. A payment via a blockchain network will soon be made with instant finality and can be accompanied by a message that assists in executing the transaction—for example, if the purchaser wishes to convey selective information about himself during a transaction that can be done credibly by using verification procedures through the blockchain. A purchaser may wish to convey that he is older than 18 years so that he can engage in gambling online or may want to reveal his state of residence so that he can pay sales taxes on the transaction.
Furthermore, the coin-holders gain from the fact that a blockchain payment network is much less vulnerable to cyber-attacks or hacking than the existing centralized payments network operated by the Federal Reserve (the Fed). That advantage also has positive systemic-risk consequences. A cyber-attack on a member of the existing centralized network will disrupt payments throughout the network, with large spillover effects on other banks and their customers. But because blockchain clearing through a decentralized network offers an environment that is much more secure from hacking, coin-holders throughout the blockchain-based network bear less risk from hacking or cyber-attacks.
So far, I have shown that unbundled, novel fintech banks offer major advantages of efficiency and inclusion and that these advantages will grow over time—for example, as new blockchain payment networks develop. I have also shown that it is possible and desirable—both for the functioning of the banking system and the novel banks themselves—to allow novel shadow banks to become chartered banks. What stands in the way of this banking modernization?
In a word, politics. Not everyone welcomes a future in which unbundled fintech banks join chartered national and state banking systems. The idea that today’s unbundled fintech banks and possibly tomorrow’s stable-value-coin banks should become chartered banks is anathema to the special interests that profit from keeping progressive financial intermediaries in the shadows. And some powerful entities may be especially threatened by the idea that a banking system could arise to accomplish payment transfers without needing to maintain liabilities in the form of deposits. After all, powerful special interests possess huge economic rents conferred on them as a consequence of preserving the status quo. Who are those special interests, and how likely are they to be successful in preventing a chartered fintech future?
State authorities that license shadow banks are one special interest group that has already identified itself as hostile to the chartering of fintech banks. The State of New York is suing to prevent the OCC from chartering non-depository fintech banks (Lacewell v. OCC). In 2019 alone, New York State earned more than $100 million in licensing fees. Not only would chartering fintechs move fees out of the state coffers for the banks that migrate to the national system, but the state-licensing authorities would likely lose from the consequent decline in the fortunes of other financial-services firms they license because those firms may find themselves in less competitive positions. For example, payday lenders are entirely state-licensed and regulated. Chartering fintech banks as national banks (including those with the financial-inclusion strategies discussed above) could substantially reduce the market share of payday lenders. That would benefit consumers throughout the country by reducing the costs of small-dollar loans, but state-licensing fees from payday lenders would likely fall.
Traditional banks, especially the least efficient among them, should and do see chartered fintechs as a threat that would likely accelerate their declining market shares and profits. Traditional banks are struggling. With few exceptions, their business models are antiquated. Net interest margins (NIMs) for traditional banks today are at historic lows, and branch networks have become highly unprofitable owing to the low-interest-rate environment that has prevailed since 2009. With the wholesale interest rate near zero, the interest savings from attracting core deposits (the primary purpose of bank branches) are also near zero, meaning noninterest expenses associated with operating branches are a source of value destruction for the banking enterprise. This effect is visible in the declining values of core deposits to banks’ enterprise values.
The bundled, universal, too-big-to-fail banks are already waging a battle to discredit progressive fintech banks. They wage this battle mainly through their policy-advocacy arm, the Bank Policy Institute (BPI). Articles published by BPI economists either stoke fear that new technologies will be destabilizing or argue that it is unfair to allow unbundled banks to provide services to consumers with lower regulatory costs than the too-big-to-fail banks are forced to bear.
There are other potential losers from the chartering of fintech banks that may also join the buggy-whip coalition. The Federal Reserve is a powerful organization that stands to lose its monopoly over the payment system as blockchain-based networks develop. The Fed’s political power is closely linked to the centralized payment system it controls, and it has always been mindful of expanding and preserving its power. Furthermore, some fintech firms are choosing to structure their chartered banks in ways that will not require Federal Reserve Board oversight of their holding companies, implying another potential decline in the Fed’s power. Finally, many economists are discussing the possibility of a Federal Reserve digital currency. Advocates of a Fed cyber-dollar see its creation (alongside the abolition or restriction of the use of paper dollars) as a means of empowering the Fed. A cyber-dollar could pay negative interest, thereby removing the zero lower bound on interest rates as an obstacle to the Fed’s ability to pursue expansionary policy. Fintech banks, especially the stable-value crypto-coin producers operating via the blockchain of the future, are important prospective sources of competition that could limit the Fed’s ability to impose negative interest rates on consumers and firms.
What about community organizations, such as the National Community Reinvestment Coalition (NCRC)? One would hope that these organizations, which have given themselves the mission of helping to advance the lives of America’s poor and underprivileged, would see the advantages for financial inclusion of chartering fintech banks. On the other hand, the heads of these organizations make large salaries and have gained substantial power by serving as poverty intermediaries. As agents of the poor, they (like all agents) can be conflicted. In particular, NCRC members have gained a great deal personally (in salaries and power) from the regulation of traditional depository banks under the Community Reinvestment Act, which entailed transfers of trillions of dollars (either in the form of grants or targeted lending) to their organizations.
I conclude that, although the chartering of fintech banks as national banks would promote efficiency and inclusion, there are powerful vested interests that either have already expressed hostility to the idea (the too-big-to-fail banks and state-licensing authorities) or may do so in the near future (the Federal Reserve and NCRC members). These are all powerful players in what Stephen Haber and I call the political Game of Bank Bargains, and it would be naïve to think that the chartering of fintech banks is a foregone conclusion as a result of its compelling economic logic. Politics has its own logic, and it isn’t always pretty.