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Why is it so hard for a fintech to become a bank?

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Below is an edited transcript of the podcast:

CALIFORNIA BANKERS ASSOCIATION PSA: Well, maybe I better start with some background on me and banking.

BRENDAN PEDERSEN: You’re listening to a PSA on banking careers circa 1967 from the California Bankers Association.

PSA: Now, like most of us, I’ve done some reading about banking, and I’ve been inside quite a few banks. But from all I’d seen up to this point, I had the impression that everyone in banks worked out front with the customers — either taking in money or handing it out, either paying interest or charging it. This, plus checking accounts, seemed to be it. Which meant that all that anybody in a bank did was add, subtract, multiply and divide.

PEDERSEN: Alright, so: why am I making you listen to this very, very corny audio? Well, for most people, and for most of American history, this is how we’ve thought about banking. Sometimes you put money in the bank, sometimes the bank gives you money, sometimes you have to re-do your deposit slip because your fours look like nines. As a listener of this podcast, you probably know that ‘adding, subtracting and dividing’ is not the fullest encapsulation of banking, then or now. But that leaves us with the question: What, actually, is banking? And more importantly, whatshould banking be?

It turns out, that’s a question folks were asking back in 1967. See, that PSA wasn’t just trying to recruit kids with degrees in finance or accounting: it was also trying to entice grads from the newfangled field of computer science. Here’s the narrator of that PSA describing the wonders of electronic information processing inside a neighborhood bank and the cutting-edge IBM System 360 Operator Console.

PSA: The whole operation is one of many known as electronic data processing, known as E.D.P. Much more complex is this computer, and although these electronic marvels help guide astronauts to the moon, they also help banks solve down-to-earth problems. Computers are mathematical wizards, yet they’re just machines, which need someone to tell them what to do.

PEDERSEN: Technology has always been a critical factor in how banking changes over time, and that has become especially true in the last several decades as computers and the internet have become more central to every waking moment. But it has also given rise to a new kind of company: financial technology firms, or fintechs as they are known in the biz. Many fintechs offer the kinds of services that used to be performed exclusively by banks, but without the constraints — or supervision — endemic to banks. And that’s creating something of an existential question for the banking industry and its regulators: namely, what makes a bank a bank? And how do you decide which kinds of companies require a banking charter?
From American Banker, I’m Brendan Pedersen, and this is Bankshot, a podcast about banks, finance and the world we live in.

PEDERSEN: When we talk about what banks are, who can own them or launch them, and what they can actually do, what we’re really talking about are bank charters. A bank charter is the legal document that declares a bank is a bank, giving the institution all the rights and responsibilities therein. In the U.S., there are two kinds: state charters, which are granted by state banking authorities like the Utah Department of Financial Institutions, and national charters, which are granted by the Office of the Comptroller of the Currency. But getting a bank charter isn’t as simple as applying for a business license of even a loan — not by a longshot.

SAULE OMAROVA: Charting banks is a fundamentally political act.

PEDERSEN: That’s Saule Omarova.

OMAROVA: Saule Omarova. I'm a professor of law at Cornell University.

PEDERSEN: And she says you can’t really understand the fundamentals of the American economy without starting with the historic role that bank charters have played in creating it.

OMAROVA: People tend to forget how important the chartering process is, especially for banks, because banks are monetary institutions, right? Banks have historically been the institutions whose business involved creation of certain public goods that otherwise would not be created on the scale and of the quality that is necessary for the economy to function. And that public good is money.

PEDERSEN: If that sounds lofty, well, that’s because it is. The U.S. has always had banks, and in the beginning the federal government took a hands-off approach to regulating them. In fact, for a long time — really until the civil war — banks would print their own money as a kind of deposit slip, and those bank notes would trade at different rates. Keeping track of those rates was a lucrative enough business that financier John Thompson founded a newspaper in 1836 called Thompson’s Bank Note Reporter to keep track of those exchange rates — a newspaper that lives on today as American Banker. But even back in those days banks had charters, and those charters served as the government’s check on the safety and soundness of a banking enterprise.

OMAROVA: How do you make sure that privately issued liabilities of banks, for example, like deposits, right, actually circulate within the economy on the same level as if they were issued by the U.S. government? And the question of chartering — who is allowed to enter into this market of issuing money? And that's the centuries-old question, right? Who issues money? This is an act of the government: the sovereign deciding who is allowed to issue this instrument that has the full backing of the sovereign.

PEDERSEN: When you put it like that, banks begin to sound almost sacrosanct. But a lot has changed in our financial system over the past two centuries, and banking isn’t exactly the only game in town anymore.

OMAROVA: Banks are conceived as institutions that provide two main services, right? Deposit-taking, payments, and the other one is lending. So in the kind of everyday sense of the word, that's what a bank is supposed to be doing. But at the same time, we also know that not only banks, but other institutions, other businesses, other firms provide these same services in different ways without actually being a bank. For example, you can borrow money from a mortgage company that is not actually regulated as a bank. And to you, as a consumer, that wouldn’t mean anything.

PEDERSEN: It’s true that, since the 1980s, non-bank financial services have grown by a lot. If you use Venmo to split your takeout order, you’re using a non-bank service. If you’ve tried getting “Rocket Mortgage” from Quicken, that’s another non-bank — and the largest mortgage lender by volume in 2019. In theory, you as a consumer today can live the entirety of your financial life — whether that’s paying for groceries, getting a credit card, taking out a mortgage, getting a business loan — without ever interacting directly with a bank. And those nonbanks, for the most part, were happy to stay nonbanks. But that’s starting to change.

CNBC: Hey Kelly, digital bank Varo Money was approved this morning by regulators to become a full service bank. It’s a landmark case, and it could pave the way for other tech-focused finance companies to do the same.

PEDERSEN: In July, Varo Money became the first fintech firm to receive approval from the Office of the Comptroller of the Currency and own a national bank. That same month, SoFi applied for the same thing, and in October, the OCC gave them the thumbs up too.

OMAROVA: And that's sort of what takes us to the fundamental question, right, what makes banks special?

PEDERSEN: What makes banks special — and why would a nonbank want to take on the special privileges and responsibilities of a bank charter? Let’s start by talking about what those special privileges are. A big one is federal deposit insurance — today, the government guarantees FDIC-insured deposits up to $250,000. We sort of take this for granted today, but when this idea was introduced in the U.S. in the 1930s or so, it was a big deal. When the federal government backs deposits, consumers know their savings won’t vanish no matter what happens to the bank itself. The effect has been the near-disappearance of bank runs, which means people keep their deposits in banks. And deposits are cheap and reliable way to generate the capital that banks use to make loans.

FDIC insurance come with strings, however. Banks are heavily, heavily regulated and supervised by the government, which can be seen as both a constraint and a benefit. A lot of fintechs will tell you that their dynamism and innovation is thanks to the absence of bank-like rules and regulations. But at the same time, government regulation also serves as a kind of ongoing vote of confidence: bank examiners exist to poke the insides of highly complicated institutions to make sure everything is working, everything is profitable, and that consumers won’t be harmed.

In fact, one of the biggest hurdles for a company applying for a bank charter is getting their business model and strategy approved by their regulator. You have to convince them that what you’re going to do is going to work long before you actually become a bank. But if you can survive that kind of scrutiny, that little piece of paper that says “bank charter” on it suddenly becomes pretty powerful.

CLIFF STANFORD: I've had a number of those discussions over the last five to 10 years as fintech has emerged, and there's been real money in fintech. And so there's been some real hunger to get bank charters.

PEDERSEN: That’s Cliff Stanford, a partner at the law firm Alston & Bird in Atlanta, Georgia, and a former assistant general counsel with the Atlanta Fed, where he worked with banks seeking charters. He says he’s fielded a lot of questions over the years about what fintechs’ options are when it comes to becoming a bank. The conversation usually starts with a reality check.

STANFORD: The first question I ask is, do you really want it? And then they'll say, well, yeah, sure. We really want it. And I'll say, do you really, really want it?

PEDERSEN: Because, in case you didn’t know, becoming a bank istough.

STANFORD: It's a long road to hoe, it's going to take some time, it's going to take a lot of diligence, it's going to take a lot of discussion with regulators, it's going to take some fundamental sort of thinking about your strategy as to whether or not you want to be regulated and seen by the market as a banking firm. And there's a whole slew of questions that come with that, but that sort of the threshold question as to whether or not you really want to wade into this.

PEDERSEN: And for a long time, that reality was enough to discourage most fintechs from pursuing a bank charter. It wasn’t that companies didn’t try — American Banker reported in 2019 that both Google and PayPal had considered applying for a national bank charter. But Stanford says the bank chartering landscape for fintech firms has changed considerably in the last few years.

STANFORD: I would say that the odds are noticeably better today than they were several years ago. And part of the reason for that is there's been more sort of regulatory acceptance of this model. There's also been some trailblazers who have blazed that trail for others that go behind them, so to speak.

PEDERSEN: Before we talk about those trailblazers, though, we need to talk about the options available to fintechs who are bank-curious. The first one is the partnership model. That’s the path most fintechs have fallen into over the last several years, and the way it works is a small firm goes to a bank and says, ‘Hey, we’ve got this proprietary model that’s way better than yours at alternative credit modeling, but we can’t do all the things a bank can. Wanna team up?’ And the bank says, ‘Sure.’ That approach has been appealing to start-up-minded fintechs, because it brings in revenue and scale with limited regulatory scrutiny. But it can also be limiting, which brings us to the second option: becoming a full-service bank. That might sound crazy, but some firms simply realize that they’re better off being their own banking partner. And then there’s a third option: something else. We’ll talk about that after this short break.

THOMAS CURRY: The fintech charter was really an outgrowth of a much larger project that I initiated at the OCC.

PEDERSEN: That’s Tom Curry.

CURRY: Hi, I'm Tom Curry. I'm a partner in the banking practice at Nutter McLennen & Fish in Boston, Massachusetts. I formerly served as Comptroller of the Currency from 2012 to 2017.

PEDERSEN: And in 2015, while he was running the OCC during the Obama Administration, his team came up with what became known as the special purpose national charter for fintech companies — or, more simply, as the national fintech charter.

CURRY: And the outgrowth really was a paper, a white paper, on financial technology, recognizing that financial technology could provide faster, better services to customers of banks, would foster financial inclusion, potentially bringing in people that were left outside the mainstream of traditional banking.

PEDERSEN: The idea behind a bank charter designed for fintechs is relatively simple. Like we mentioned earlier, people tend to break banking down into roughly three kinds of activity — taking deposits, facilitating payments, and making loans. Together, this is known in policy circles as the, quote, “business of banking.”

But here’s the thing: if you’re a fintech, you might not actually be interested in all three of those kinds of activities. Maybe you’re JUST in the business of lending and have no interest in payments, or maybe you’re a payments company that doesn’t really want deposits. The innovation behind Comptroller Curry’s special purpose fintech charter was that companies could have their bank regulation fit whatever their business model actually is, rather than evaluating prospective applicants based on their approach to certain services they don’t actually plan to provide.

There’s a big regulatory upside to that approach: Don’t need deposit insurance? Well, if you’re a national bank, that means the FDIC won’t be one of your regulators. Don’t have a payments business? You might not have to worry about the Federal Reserve, either! If you’re a fintech, and you can potentially drop the number of federal regulatory agencies you need to deal with from three to one, suddenly, a bank charter can seem a lot more feasible.

CURRY: We really need to look at the business of banking in a much broader sense. I think it is counterproductive to look at what banking consisted of, or what banking practices were in 1863, when the National Bank Act came into being. It is an evolutionary business, the regulatory framework around that needs to adapt. And I think that's really a point that gets lost in some of the subsidiary debates that have gone on.

PEDERSEN: It turns out that not everyone loves the idea of reshuffling the activities and supervision that have defined banking for the last century or so. The OCC has been sued several times over the existence of its fintech charter, most notably by the New York Department of Financial Services and the Conference of State Bank Supervisors, an advocacy group that represents state bank regulators. Bear in mind that, to date, no company has received or even officially applied for the fintech charter, and because of that, most of the suits have been thrown out. But in one case, a federal judge in New York actually ruled against the OCC, saying that the agency didn’t have the legal authority to offer that kind of charter. The case is being appealed, but Curry said the point of a fintech charter wasn’t to expand the OCC’s power.

CURRY: I don't think the underlying concept really was that radical. There's a history of having special limited purpose national banks, whether they are trust companies or credit card banks. This was really, I think, an attempt to adapt the existing regulatory structure in order to assist in the development of the responsible fintech segment of the industry.

PEDERSEN: Radical or not, the shadow of litigation hangs heavy over the OCC’s fintech charter, and it probably will for some time. Here’s Cliff Stanford again, describing what happens when a client asks about the fintech charter amid all these state lawsuits:

STANFORD: One of the sort of early points that I would make to the fintech would be, you know, essentially, do you want to be Exhibit A in the litigation that is currently brewing? And it's going to continue likely for some time before it's resolved. And, you know, typically there's a scratching of heads and saying, Well, I'm not so sure I want to take that on. While the OCC has been sort of inviting applicants for a number of years now, going back to the Obama administration, we haven't seen one.

PEDERSEN: The idea of adapting the existing banking charter apparatus to today’s bank charter problems hasn’t ended with Curry, either. There’s a relatively new pitch from the current acting comptroller of the currency, Brian Brooks, for something he calls a payments charter.

It’s more or less the same idea as Curry’s special purpose fintech charter: a charter that authorizes a company to do one of the three core banking activities, rather than all three at once. In the payments space, the idea of some kind of national charter is ahuge deal. Today, if you’re a non-bank payments company that wants to launch a national business, you’ll need to be approved for, and maintain, a money transmitter license from every single state. It’s a massive compliance burden, and that’s where Brooks and the OCC come in:

BRIAN BROOKS: I'll give you a provocative soundbite here, which is, I actually think that Congress did create a national money transmission license: it's called the national bank charter.

PEDERSEN: At a virtual event hosted by the Brookings Institution over the summer, acting comptroller Brooks made the argument that payments are inherently and historically a bank activity, even as non-bank payments companies have taken a large market share from banks in recent years. If regulators allow for a bit more flexibility in how they define banks, Brooks has said, they can cut down on compliance burdens for fintechs and improve national oversight of these payment giants at the same time.

BROOKS: All these money transmitters are is, they're doing an activity that used to be done exclusively inside of banking, except they're doing it on a state platform, and the only thing states have to offer them is a money transmission license, but the activity is not different, whether you think of it as prepaid cards or traveler's checks or, you know, electronic money transmission. All of those things can be done in one of two places: either a state money transmitter or a national bank.

PEDERSEN: Is the payments charter going anywhere? We don’t know. With the courts still weighing whether the OCC can parse apart banking charters, it’s likely going to be a while before we really know whether that approach is viable long-term. But there’s another, less litigious option that has been sitting around this whole time — and it’s one that’s actually seen some success.

PEDERSEN: Let's start with the big question — the one that brings us together: Why’d you buy the bank?

STEPHANE LINTNER: [laughs] Yes, it's a question that we get a lot.

PEDERSEN: That’s Stephane Lintner.

LINTNER: Stephane Lintner. I'm the CEO and one of the cofounders of Jiko.

PEDERSEN: And in September, Jiko became the first fintech company to buy a national bank — namely Mid-Central Federal Savings Bank in Wadena, Minn. I wanted to talk to Lintner because, on paper, a fintech with fewer than two dozen employees buying a bank sounds kind of ridiculous. But from his perspective, given the company’s model, there just wasn’t another way. The company’s core product is a kind of spendable Treasury bill, where customers’ deposits are automatically swept into a brokerage account and converted into treasuries which, in theory, can deliver a higher return than typical bank interest.

LINTNER: I left my job in 2016. And even then, when we looked at it, it was clear that if you wanted to really be able to bring innovation, and really slashed the costs and bring the true value of what fintechs usually want to do, which is make things more efficient and scale. Having an operating our own license was a requirement. Otherwise you partner with a third party and not a bank, which has its own technology, its own cycles, its own prioritizations and its own capital structure. And you will have scaling issues down the road. If you want to change, if you want to evolve things, you have to be at the core of it.

PEDERSEN: That’s easier said than done, even if it doesn’t sound particularly easy in the first place. It took four years for Jiko to get that bank charter, including two years of back-and-forth with regulators.

LINTNER: The official-official process — meaning us starting to file with regulators — that took about two years, but there's a lot of preparation going into it to maximize we didn't want to file and then have, you know, a rejection. So we prepared, we worked with the Federal Reserve, we worked with the OCC, we worked to FINRA to get our broker-dealer approved. The biggest thing is, you turn from a startup into a bank holding company. And what the regulators’ really wanted to make sure of is that we operate as a bank holding company, day one.

PEDERSEN: Lintner says that Jiko’s approach of communicating with regulators early and often was essential to their getting approval.

LINTER: You shouldn't be afraid of approaching the regulators very early on to let them know that you exist. They actually have fintech arms — the Fed and the OCC have innovation offices, they're always looking to hear about the latest thing. And they can help — there are people there who are really keen on helping people figure out, “Do you really need a license? What are you doing?” Where does it fit in your roadmap and help you navigate a little bit. So dialogue is critical when what regulators don't like, for good reasons, is surprises.

PEDERSEN: There’s one last semi-innovative option for bank chartering, and that is the industrial loan charter, or ILC charter, offered by the FDIC. The industrial bank has a similar appeal as the fintech charter at the OCC — it limits the number of bank supervisors a fintech needs to contend with, because industrial banks are a type of charter that can be owned and operated by commercial companies, rather than just a bank holding company. If you’re not a bank holding company, that means you may not need to be regulated by the Federal Reserve the way most banks are.

And the ILC charter is a viable path for fintech firms. In March, the FDIC approved two industrial banks for the first time in over a decade. One went to Square, the financial services company owned by Twitter CEO Jack Dorsey, and the other to Nelnet, a student loan servicer. On paper, that’s success. But if you’re a fintech company actually listening to how FDIC Chairman Jelena McWilliams talks about industrial banks, you may not get fired up. Here she is speaking at George Mason University in early October, explaining how her agency has approached industrial banks over her tenure.

JELENA MCWILLIAMS: For a long, long time, as you know, there have not been new ILC deposit insurance obligations granted, partly because the economy was not doing so well, you know, from the 2008 crisis, partly because I think there was a little bit of misunderstanding what type of applications we accept, and whether or not the same requirements apply, and how do we interpret this? And we wanted to clarify that by basically following the rule of law. And I think that it's, it becomes a little bit messy when regulators make the laws as they go along. And I tell people this all the time: It doesn't matter if I love them, or I hate them. I have to abide by the law that Congress gave us, and my job as a regulator is to implement that law.

PEDERSEN: Explaining your rationale for granting an unusual bank charter to a financial tech company as “abiding by the law” isn’t exactly a ringing endorsement of the approach. In the meantime, the FDIC is trying to finalize a rulemaking that would codify certain updates to the process of applying for an industrial bank, including the kind of capital requirements parent companies can expect. At the same time, Square and Nelnet’s ILC approvals haven’t ushered in a wave of similar applications in the eight months since. That may be because it’s hard to get approval. In Square’s case, the company had to apply twice over the course of two and a half years before securing the charter. Another company, a Japanese e-commerce conglomerate called Rakuten, filed for an ILC charter last October, then withdrew, re-applied, and withdrew again in the span of just four months. It’s unclear if and when they’ll apply again.

The simple truth is that, for all of these possible pathways and options that we’ve been discussing, there is no straightforward way to bring fintechs into the banking regulatory perimeter. If there was, more of them would probably be there. Congress, of course, could change the National Bank Act to make the definition of “banking” more flexible or start from scratch with something else. But don’t bet on it.

OMAROVA: Congress doesn't really weigh all that often into what exactly banks can or cannot do.

PEDERSEN: That’s Professor Omarova again.

OMAROVA: Everybody understands that banks are so fundamental, so critical to the functioning of the economy, and have such an important role in, in sort of, you know, affecting the ultimate distribution of economic and political resources in in the society, that fighting over some kind of a formalized legislative pronouncement with respect to how far banks can go in conducting their business, or how restricted they become — it is an inherently very difficult process. And so Congress has weighed into that only very few times.

PEDERSEN: More often than not, it’s been the courts that decide what banking is and isn’t. That’s exactly what’s happening today in the legal battle between the OCC and New York Department of Financial Services over the fate of the fintech charter.

OMAROVA: History is incredibly rich, with respect to comptrollers at different times, sort of either kind of giving their blessing to what a national banks have kind of started doing as a practical matter, by pushing a little bit the boundaries of what has already been established as permissible for banks, right? Well, if we can do X, can we do X plus? Can we do X plus, plus? How about X squared? How about Y?

PEDERSEN: If you’re a historian, of course, it’s pretty cool to watch history unfold in real-time through the courts. If you’re a fintech with investors to keep happy and limited cash to burn, it’s a different story. But the fact remains that the discussions bankers and policymakers and tech gurus are having about the future of finance today — this fundamental question of who and what a bank can be — the answers we find will have massive implications for the future.

OMAROVA: This is to me, intellectually, a kind of a fascinating moment, because it opens an opportunity for us to assess the systemic importance of not just chartering banks, but the systemic importance of regulating banks and understanding what it is that banks do, and what it is that now non-banking firms are beginning to do or trying to do, and to what extent those new functions that are being replicated outside of the regulated banking sector really need to be either subject to the existing regulatory oversight, or perhaps, we need to rethink the entire approach to how those how those functions are provided. Perhaps there is a moment for rethinking the structure of the financial sector in a deeper way.

Fintech ILCs Digital payments