Upstart's first step in testing fraud product: Buy a bank

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A big rule in business is to find a need and then meet it.

The founders of Nano Financial Holdings in Irvine, Calif., believe there is a need to address fraud from wire transfers. So they are developing technology to make transfers easier and more secure.

Nano, to advance its strategy, recently agreed to buy Commerce Bank of Temecula Valley in Murrieta, Calif. Once the deal closes, Nano will offer its technology to its commercial clients as it considers ways to offer the service to other financial institutions.

“If you really do a deep dive you'll find [wire fraud] is a very serious issue,” said Mark Troncale, Nano's co-founder and president. “Wire fraud is not getting any better.”
Nano’s ambitions hit on several trends in the industry — the growing threat of cybercrime, the rise of fintech and the decision of opening a bank or buying one.

Wire transfers are ripe for potential human error and fraud, industry experts said.

A common scam involves business email compromise, the FBI said in May. The scam occurs when a criminal infiltrates a company’s email, then targets people responsible for the protocols necessary for a wire transfer.

Wire transfers were the second most targeted payment method for fraud in 2016, according to a study released last year by the Association for Financial Professionals. The percentage of finance professionals who reported wire fraud jumped from 5% in 2009 to 48% in 2015, the study found.

Despite the risk, the exposure often goes overlooked, said Gilles Ubaghs, a senior analyst with Aite Group’s wholesale banking and payments practice.

“Wire transfer fraud isn't that different from classic phishing scams," Ubaghs added. "These fraud networks are kind of ingenious.”

Wire fraud can be costly for banks and their clients, with domestic and international wire fraud losses totaling $5.3 billion in 2016, Troncale said. In some cases, banks will not cover a client's loss, which could lead to litigation and damage to an institution's reputation.

Nano is working with three outside firms to build the technology, which will use a multilayered authentication process to ensure security, Troncale said. The platform will replace passwords, which are easy for customers to forget, with other methods, such as biometrics.

Nano may eventually license or sell the technology to other banks, said Troncale, who declined to fully describe the technology since it was still being developed.

There are instances of banks licensing platforms to other financial institutions. Live Oak Bancshares in Wilmington, N.C., created and then spun off lending platform nCino. Citizens Bank of Edmond in Oklahoma partnered with a technology firm to develop video ATMs that other financial institutions now use.

Licensing can allow a community bank to differentiate from the competition, said Paul Schaus, president and CEO of the consulting firm CCG Catalyst. Smaller banks lack the resources that bigger banks have to pour into numerous technology projects.

JPMorgan Chase, for instance, said last year that it was spending $9.5 billion on technology.

“How do you even compete against that?” Schaus said. “Community banks can’t be everything to everyone. … Community banks need to be smarter and more focused and look into differentiation.”

Executives at Nano also decided to buy a bank rather than apply for a charter because doing so will give them an immediate foundation to start from, Troncale said.

While the number of de novos being approved is rising, it remains far below pre-crisis levels. Southern California has seen at least four de novo applications in recent years.

In many instances, it still makes sense to buy a charter, said Ruth Razook, founder and CEO of RLR Management Consulting, who discussed the de novo application process with Nano. The application process takes longer and requires more capital than it used to, she said.

“It will be interesting to wait and see how Nano Financial and its bank play out,” Razook said. “It is the first one I'm aware of that's a borderline fintech bank.”

Nano’s wire transfer technology really wasn’t a factor behind the $77 million-asset Commerce's decision to sell, said Scott Andrews, the bank's president and CEO. Instead, the deal’s price of 1.7 times tangible book value and Nano’s ability to raise $60 million in 10 weeks made the difference.

Commerce had previously agreed to be sold to AltaPacific Bancorp, but that deal was terminated after its shareholders rejected the sale.

“Certainly the pricing got our attention,” Andrews said. “When we got to know the Nano management team, looked at their board and their investors, our board was favorably impressed with all of those things.”

Despite Nano's fintech elements, Troncale said, members of the management team think of themselves as commercial bankers "through and through." The technology component was a way to better serve the businesses they will target. Troncale said community banks often overlook the technological element.

"We service high-net-worth individuals and businesses that are successful," he said, "so we had to be out in front of the cyber threat."

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Community banking M&A Consolidations Payment fraud Fintech California