As digital banks proliferate, so do risks

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Facing intense deposit competition from online-only banks such as Ally Financial and Goldman Sachs’ Marcus, many traditional banks are looking to turbocharge their deposit gathering by launching — or considering launching — digital banks of their own.

PNC Financial Services Group is the latest big bank to join the fray, recently rolling out a digital-only bank in markets where it lacks a brick-and-mortar presence. Like JPMorgan Chase, Citizens Financial Group and a number of other regional and community banks, PNC is counting on its digital bank to attract low-cost deposits to fuel loan growth while also helping it reach new demographic groups.

Early results have been promising — PNC CEO William Demchak said Friday that he’s been “pleasantly surprised” by the response in the Kansas City, Mo., market — but with the space becoming so crowded, industry watchers are beginning to question if the U.S. marketplace can reasonably support so many new digital banks.

They caution, too, that any bank looking to establish an online-only affiliate better be prepared for some extra layers of regulatory scrutiny.

“Every bank should at least have a board-level meeting discussing about whether to do this,” said Joshua Siegel, CEO at StoneCastle Partners, a provider of deposit services to community banks. “Running a digital bank is different from running a good mobile banking app.”

Online banks come in many variations. Ally, Synchrony Financial and USAA hold their own charters. Others such as JPMorgan Chase’s Finn, are separately named affiliates of well of well-known brands.

Some digital banks with no physical branches, like Moven, Simple and Varo Money, operate through other institutions’ charters.

And plenty of smaller banks have also launched digital-only banks. These include MemoryBank from the $5.3 billion-asset Republic Bank & Trust in Louisville, Ky., and Vio Bank, operated by the $15.4 billion-asset MidFirst Bank in Oklahoma City.

If a community, midsize or even regional bank wants to stand out in the crowd, the best way is to offer the market’s highest rate on a specific deposit product, Siegel said. But that’s going to be costly. Goldman Sachs’ Marcus pays 2.55% on a one-year CD, according to Bankrate.com, one of the highest rates in the category. One reason frequently cited for introducing a digital-only bank is that it’s a cheaper way to gather deposits in new regions. But paying market-leading rates can erase that benefit, Siegel said.

“How are you going to set your pricing and how are you going to get noticed?” Siegel said. “If you are paying top-dollar rates, is it still cheaper than opening a new branch?”

Offering high rates can also trigger unwelcome attention from regulators. Some regulators have told community banks that the deposits they collect through a digital-only bank won’t get classified as core deposits, said Chris DeCresce, a banking attorney at Covington & Burling. That means those deposits won’t provide as much benefit to a bank’s capital ratios.

“Regulators are concerned that if you price these high enough, and then JPMorgan or [Citigroup] raise their rates high enough, the community bank is going to lose all their digital deposits,” DeCresce said.

Regulators may also be concerned that a community bank that has suddenly expanded to a national platform has not implemented the necessary know-your-customer requirements, said Cliff Stanford, a banking attorney at Alston & Bird.

“There is at least a question around, do you know the source of these deposits?” Stanford said.

Other regulatory considerations come into play. Digital-only banks must follow the same fair-lending standards as a physical branch. But an online or mobile channel can introduce unintended consequences, Stanford said.

“You need to be careful in thinking about your credit models and who has access to the digital banking product,” Stanford said.

Some vendors’ technology products address those concerns. Fiserv’s OpenNow/FundNow product includes tools to comply with KYC and anti-money-laundering regulations, said Whitney Stewart, senior vice president of e-payments product management.

“It helps you do background checks and it also helps the customer digitally fund their account,” she said.

But regulators may also take notice if an increasing number of banks introduce digital-only products due to systemic risk concerns, Stanford said. Regulators may pursue the same thinking as when the Financial Stability Oversight Council in 2016 said marketplace lending and distributed ledger technology were new sources of risk to the financial system.

“The more that banks pile into this space [of digital-only banking], the more the profile rises in terms of systemic concerns,” Stanford said. “It’s just like the run-up to the financial crisis, where everyone’s business model was the same and everyone was chasing the same thing.”

Even with all of these concerns, many community banks are seriously exploring digital-only banks and most should be able to operate them successfully, Stewart said. They just need to think about how they’ll handle the new issues that are raised by digital-only businesses.

“There are nuances that have to be thought through,” she said. “The nice thing about having branches is that they’re always your safety net. When a customer has problems, they can always go to a branch. What happens if your digital client gets stuck and they don’t have a branch to go to?”

Stacey Zengel, the president of the banking division at Jack Henry & Associates, said he thinks it’s possible for these institutions to succeed even in a crowded field.

“I believe there are ways to get noticed other than rate,” Zengel said. “You can bundle other products into their account structure, for example. Yes, it’s a supply and demand issue. But it’s really a choice about who you want to do business with.”

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