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Charter or not, fintechs are already ‘banking’

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Two completely contradictory things are true about fintech banking regulation in the U.S.

The first is that nobody can be a fintech bank. The second is that anybody can be a fintech bank.

It’s a paradoxical situation which, as any physicist or philosopher will say, is fundamentally unstable. A regulatory scheme that contradicts itself is a failure by definition that confuses participants, creates inefficient arbitrage and ceases to serve the public good.

This makes it all the more important to chart a new course for fintech banking regulation.

Without change, the current system will continue to drive innovative companies into unproductive operating structures defined by outdated regulatory approaches. The best course for change is to bring fintech banking inside the regulated banking system rather than keeping it outside, looking in.

The reason no one can create a fintech bank today is because the U.S. bank regulation structure makes concentrated ownership — a feature of venture-funded innovation — an insurmountable barrier for most would-be banks.

Even where that’s not an issue, it’s nearly impossible for fintechs to convince regulators to approve their de novo banking applications. This is because digital banks, by definition, don’t look like the Main Street startup banks around which regulatory approaches were built.

The applications that are accepted are processed with painful slowness if it shows any hint of an innovative approach. Just ask Varo Money, which is still waiting on final regulatory approvals for a banking charter first filed in July 2017.

This is a stark contrast to Europe, in particular the U.K., where “challenger” banks are common.

While the U.S. regulatory process is stuck, politicians like Sen. John Kennedy, R-La., are introducing one-off bills to further limit industrial loan company applicants. Meanwhile, state financial regulators are suing (and so far, succeeding) the Office of the Comptroller of the Currency over its new special-purpose bank charter for fintechs.

It’s not a hopeful picture for those who think inviting fintech, along with other types of parallel and shadow banking entities, into the regulated banking system — rather than pushing them away — is the right policy outcome to manage systemic risks.

Despite these challenges, many fintechs (Varo Money, LendingClub, OnDeck, Robinhood, Square and Revolut, among others) are actively trying to become some type of a bank.

The reasons they want to be a “real” bank are obvious. Licensed banks in the U.S. get extremely valuable privileges, including direct access to the payments system, low-cost deposits, stable funding and a national platform to preempt conflicting state laws. This would be especially valuable for fintech lenders and payments innovators. But no one has made it to the goal line yet.

What about the contradictory proposition that, today, anyone can be a fintech bank? Just look around.

So many fintech and big tech companies have created so-called synthetic banks. These are companies that provide insured checking and savings accounts, payment cards and most of the capabilities of a traditional consumer bank without actually being a licensed bank.

From their customers’ point of view, companies like Aspiration, Chime, Varo, N26, MoneyLion and Betterment (not to mention Apple, Google and a few old-timers like Fidelity) are banks for all practical purposes.

Synthetic banks combine a customer-friendly user experience and interface with access to necessary parts of the regulated financial system through contracts with existing banking players. Experienced, specialized service providers like Cambr and Promontory make synthetic banking’s complex interactions with the banking rails close to a plug-and-play. As a result, just about anyone can start offering banking services to consumers within a few months of deciding it’s a good idea.

But there’s a big downside: Synthetic banks pay a heavy financial toll to gain access to the financial rails controlled by the incumbent banking oligopoly. Traditional banks are fighting hard to hold onto the economic rents they receive from exclusive access to deposit funding and the payments system, with policy inertia as their powerful ally.

Entrepreneurs must decide whether to challenge the current system for maximum future value, or try to fit within operational and financial limitations which limit the chance for business and financial success. It’s a mess.

Regulators have the legal authority and tools to resolve the paradox, even if they sometimes appear to think they don’t have such authority. All it takes is regulatory will.

There’s nothing that prevents regulators from licensing all types of fintech specialty banks, which would then become subject to the full scope of current banking regulations. It’s working fine in Europe where newly chartered fintech banks take deposits, do transactions and payments that, in collaboration with regulators, broadens banking services to consumers without creating excessive risk.

There’s also nothing to prevent regulators from imposing higher levels of supervisory oversight as well as bespoke capital, liquidity and activities limitations on fintechs as a way of making sure that only appropriate risks are taken.

Legislators and regulators could also help by easing the limits on bank holding companies and the Volcker Rule that pertain to “controlling” investor stakes; and resolving (one way or the other) questions around forming an industrial loan company or getting a fintech charter.

Nature abhors an unresolved paradox. So does regulation. It’s time for regulators to use the tools they already have to invite fintechs into the banking club.

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