The Customer Effect
The big question: Should fintech startups buy banks?
- Fixing fintech startups' scale problem calls for an entirely new approach to core banking
- Most fintech solutions so far have been new entry points to the same old banking services
Banks buying startups isn't anything new. But for financial tech startups, looking for scale at any cost, perhaps the solution would actually be to buy a bank, according to a growing number of observers and experts in the industry. There are almost 6,000 FDIC-insured banking institutions in the U.S. as of the end of 2016 and 1,541 of them have less than $100 million in assets, including a sliver of failing banks that need saving. With average common equity around $12.5 million for a healthy bank of that size, a well-established startup could pay $25 million and get fully licensed to be deposit taking. It’s a faster route to market than other solutions, said one U.S. consultant who has banks as clients and predicts there will be more of this kind of M&A this year. The obvious damper in this situation is regulation. Buying a bank puts startups squarely in the crosshairs of being regulated like a bank. This is part of why the regulators have been developing a fintech charter for startups, a regulatory framework for companies that want to do provide certain banking functions but don't necessarily want to be regulated like a universal bank. There have been glimmers of action on this. Prepaid debit card firm Green Dot is perhaps the best example. In 2011, the company, then valued at $1.3 billion, acquired the $37 million-asset Bonneville Bank in Utah. The buy did a lot for Green Dot's growth as it began to operate with more efficiency, innovation and collect fees directly and introduce new products without waiting for the the green light from its bank. The scaling problem Part of the reason startups haven't been able to scale, at least in the retail banking world, is that so-called innovations are usually just different ways for people to interface with their banks, while core banking transactions – deposits, loans, mortgages and payments – generally remain the same on the backend. In other words, there hasn't truly been an Uber for banking, said Pascal Bouvier, a venture partner at Santander Innoventures. Most fintech startups operate at the thin outer layer of banking. “It has not happened in financial services at large because most entrepreneurs have come up with a new-ish way of doing something that is very old,” he said. “They don't really solve bigger problems.” The problem calls for a completely new approach to core banking, Bouvier said, although he did not specify how that should look. No one in the U.S. has ventured there yet and it’s not obvious who will make the first move. He suggested it might be a forward-thinking bank that finally realizes they need to “truly disrupt themselves” as opposed to striving for incremental fintech partnerships and integrations, but so far this is the least likely scenario; Bouvier said he’s seen no such indication by a bank. And he did not rule out the possibility of a Facebook, Google or Amazon like tech giant taking the first step. In February a rumor circulated that Amazon might be looking to buy Capital One – an unlikely scenario and an old concept that is often revived as moving and managing money becomes more about data and less about cash. “The opportunity is far away,” Bouvier said. “It could hold more opportunity than originally thought that far outweighs the cost of friction associated with having some kind of a bank license.” That’s often because most people on the tech side of fintech, the ones building solutions, don't know core banking like those on the finance side, Bouvier said, which would make it easier from that perspective to dilute the front end of the bank. “That’s a strategic error,” he said. “The back end is the cornerstone of success and scalability, and that's where a lot of people have failed to understand value is created in the banking world by the massive flow and integration of all different kinds of services.” Challenges There’s more evidence of fintech companies acquiring banks, but not very much, particularly in the last five or 10 years, said Jay Wilson, the lead on Mercer Capital’s financial technology team and author of the forthcoming book Creating Strategic Value through Financial Technology. The valuation gap between fintech startups and banks makes it difficult to structure a deal, he said. Banks tend to be valued more through historical earnings and the price of tangible book value, whereas fintech startups, because of their perceived high growth potential, often tend to have higher earnings multiples. “There are certainly benefits for fintechs if they acquire smaller banks,” Wilson said. “But if you bought a small bank then went out and signed partnerships with five, 10, 15 banks, you would be viewed more as a competitor.” Startups would also be competing against other banks for those deals, he added. The under-$100 million class of banks has been consolidating aggressively in the last 20 to 30 years. Plus, as soon as startups buy legacy banks they expand the number of services and products that require expertise and as a result they dramatically increase their levels of risk and exposure, said John Waupsh, author of the book Bankruption. “The idea is nothing new but there’s a reason why the majority of fintech companies or startups and are focused on a select product set," he said. "Partnerships have always been the reason and the way for fintech companies to scale. This idea of 'fintech' got relegated to just companies since 2009 but for about 50 years fintech companies have been partnering with banks."