February 2024: Fintech can save the American banking system. Regulators should help
The amazing, consolidating American Banking system.
The American banking system is growing in assets, while the number of banks shrinks.
Over the past 40 years total US banking assets expanded > 10x, from ~$2 trillion in 1984 to >$22 trillion in late 2023.
During that same period the number of commercial banks in the US has shrunk from ~14k to ~4k. The number of active bank charters has shrunk from ~18k to around 5k over the same time period.
Multiple trends drive consolidation
This reduction in charters/active banks is primarily M&A driven. During that period, an average of ~350 banks get acquired each year. The consolidation is partly driven by the loosening of geographic restrictions on US banking institutions beginning in the late 70s.
In contrast, around 2800 banks have failed in that period, or 70 per year (~2200 of these happened between 1984 and 1994). Most bank failures occur during localized crises (like Texas in the 1980s) or more general recessions.
At the same time, fewer charters get issued each year, than the number of acquisitions and failures. Between 2010 and 2022, only 62 new FDIC insured commercial bank charters were issued to de novo banks in the US.
Consolidation applies to talent as well as just charters. I recently asked a large (top 10) retail bank leader what their biggest problem was. Their answer; ‘our business runs on systems built in a programming language so old [COBOL], there are simply too few active developers to hire’.
Another bank COO highlighted problems hiring bankers who are experienced operating a Fiserv core (I can’t truly generalize but my instinct is this is not strictly a Fiserv problem). A shrinking talent pool benefits banks with scale (as on balance talent is more expensive and better capitalized banks are more likely to be able to afford them).
SVB’s recent demise accelerated a meaningful driver of consolidation; it solidified the perception that the US banking system now has two effective tiers when it comes to deposit insurance; banks whose depositors will be made whole no matter what (too big to fail) and everyone else. Bankers see this, and are acting accordingly; Bill Demchak, CEO of PNC Bank said in a recent earnings call:
“if you just look back at what happened this year on top of kind of eight or nine years of history post the financial crisis. We've seen, [in] your words Goliath win, in terms of organic deposit share growth. That trend line has accelerated as a function of the mini crisis in March, where corporates bluntly don't necessarily trust the regulatory environment to ensure that their deposits at a bank are safe.”
So long as this perception remains true, banks will seek scale, and those left will experience more deposit and asset concentration as sophisticated, diversified depositors seek larger banks.
Without a substantial change in these trends, we’re within 2 decades of having a banking system more similar to Canada (80 banks), Australia (95 banks), or Brazil (191 banks). This isn’t meant as a criticism of those banking systems; Australia and Canada’s banks probably don’t envy America’s banks. All that being said, we’re drifting into an eventual financial system that appears unintentional (as in, literally no participant openly describes a financial system with 80 banks as a goal, yet that’s where we’re headed), and simultaneously doesn’t address many of the actual complaints that American banks, regulators and customers have about the banking system (money movement is slow, fees are too high, many Americans are unbanked, operational overhead etc).
Pros and Cons
Personally I don’t know the “right” structure of the American banking system. Any structure we choose comes with different benefits and drawbacks, and different structures can be more optimal for different economic environments. From what I can tell, the benefits of the current shape and structure (thousands of banks with local, regional, or sector footprints) are
A community bank (or any bank that’s focused on a region or sector) can probably offer credit in much more nuanced and customized ways, and more cheaply to smaller borrowers than a large national one [1]. Larger banks are just less interested in servicing smaller businesses.
An extremely diverse banking system likely enables more experimentation than a more consolidated or centralized one. For instance, the Durbin amendment expanded the opportunity for interchange-based consumer fintechs. However, the explosive growth was surely aided by a wide variety of banks willing to launch products with startups that at launch wouldn’t have had sufficient scale to be interesting to Wells Fargo’s of the world (even if they had the interchange structure to support it). At Cash App we iterated through 6 banking relationships prior to launch. My guess is many fintechs from the pre 2015 era have a similar story when seeking bank partners.
A more diversified banking sector is likely more resilient; the relative cost of failure of any one institution is lower and more contained (because they’re smaller and touch fewer people) and more easily borne by the industry itself (rather than the backstop being blown through and covered by taxpayers)
The downside of the current shape:
Financial services companies benefit from extreme economies of scale, and being subscale means lower returns; high startup costs, high system operating costs (the most widely used banking cores are fairly expensive), higher talent costs on a unit basis, and material regulatory overhead. Evidence of this regulatory overhead issue; many fintechs run their financial activity through small traditional banks that manage the regulatory complexity on their behalf (rather than applying for a charter themselves). However, the small banks are often less technically and financially sophisticated than the fintechs themselves.
small traditional banks and de-novo banks both suffer from a concentration [2] problem; community banks often have asset and deposit concentration in a region, and de novo banks have asset and deposit concentration in an industry or sector. This concentration makes them more vulnerable to a contraction in that region (for small community banks) or sector (for de novo banks) than a bank with a large, diversified balance sheet. SVB is an example of a bank with asset and deposit concentration in the technology sector.
Building nuanced, high quality, real time consumer and SMB experiences requires a meaningful technology investment, that the long tail of banks simply cannot afford (which is why many banks buy off the shelf web and mobile app technology to offer to their customers, rather than hiring giant developer teams)
The future shape of the American banking sector is fewer banks (probably sub 1k in total). The upside:
Bigger, more diversified balance sheets in fewer hands. This means the banks left standing will be less susceptible to failure due to a regional or sector contractions
Larger banks with more capital can more easily invest in technology and banking platforms that are more modern, more real time [3], and thus more capable of bringing bank operations in line with customer expectations.
(at least from a regulatory perspective) fewer banks are probably more straightforward to control or influence
The downsides of fewer banks are often discussed:
Many more banks will be “too big to fail” (whether or not they actually get classified as GSIBs is a separate question. Giant banks are insanely complex beasts. Bank failures will be be far more painful when they happen (because each entity is just larger and touches more people, businesses and regions)
Fewer banks probably means less consumer choice. This typically drives increases in fees and the cost of credit, which can reduce access to credit.
Local neighborhoods or less metropolitan regions will get less customized support (local banking as we know it probably goes away to some extent)
It will be harder to be a small business (simply because larger businesses are easier to underwrite by larger banks)
My overall point is this; any structure of the banking system will have its own advantages and disadvantages. The question is; does the structure we’re headed towards have advantages we prefer over the structure we currently have?
Charters are picking up, but it won’t be enough
On the positive side, you can see the number of charters picking up since 2017. Some of the “issue” is supply; getting a charter has an explicit subjective step [4]. In order to launch a de-novo bank, you need a combination of a large amount of equity capital, the ability to raise more pretty much on demand, and fairly senior, seasoned (and by extension expensive) talent. And after all that, you can still get denied (or just have your application process dragged out long enough that you can no longer finance your application/maintain your talent density and you have to withdraw it).
The reason charter supply matters is that without it, the only innovations in our banking system will come from existing banks adopting and migrating to new tools and systems (which is the literal slowest way to do this). In contrast; in basically every other industry, a meaningful amount of innovation comes from new companies being formed, that build their business in a whole new way with different assumptions and new technologies at their core.
My observation over the last few years is that the development of fintech has served this purpose (of new firms innovating with new technology). It has both elevated the level of competition and forced traditional financial institutions of all sizes to level up their game. Overall this has driven advanced and interesting customer experiences in financial services. The largest fintechs (Stripe, Square, Affirm, Chime, Robinhood, Coinbase etc) have also basically funded a new generation of infrastructure providers (by becoming customers of companies like Modern Treasury, Marqeta, Lithic etc) that are only just beginning to penetrate the traditional banking sector.
So this means the largest and most successful financial services providers of the past decade touch a large number of Americans, are built on a modern stack, and are mostly not banks. And most banks are built on a legacy stack that will take ages to migrate, and in that period pay more for doing essentially the same sorts of operations.
In the future, every bank might become “too big to fail”
After the next couple of decades of consolidation, most of the banks left standing will effectively become too big to fail. This reflects something banks have known and fintechs are discovering; it is exceedingly hard to generate outsize returns while being a subscale player in financial services, regardless of whether you’re focused on payments, extending credit, gathering deposits, or anything else.
As a consequence, banks have to grow. In a world where you’re competing with behemoths like Chase for customers, inorganic growth is far easier than organic[5]. This is basically because the GSIBs in the US are simultaneously better at monetizing their target customers than anyone else (show me a fintech that has developed the equivalent of the Chase Sapphire Card), and simultaneously are effectively barred from acquiring new banks in peacetime (in times of crisis they’re basically the acquirer-of-last-resort).
The Durbin Amendment created a similar dynamic, which ultimately accelerated the creation of the large consumer neo-banks like Chime and Cash App. With non-Durbin-exempt interchange capped at $0.22 and 5bps, large banks like Chase, Wells, and BofA could no longer profitably service consumers who primarily monetized via spend (and by extension interchange) vs via net interest margin. This created 2 effects; first they stopped competing for these consumers in most customer acquisition channels, effectively cratering customer acquisition costs for Durbin exempt competitors. Second, because of their high core banking costs (if I remember correctly FIS/Fiserv charged banks something like $3/month per account for their core banking system, regardless of whether the accounts were active or not) they began churning these customers either by charging overdrafts, closing accounts, raising minimums, or other tactics, which made lower income customers far more open to new banking solutions.
Similarly, because GSIBs are effectively barred from growing via acquisition, a large pool of capital basically no longer competes for bank acquisitions, opening the playing field for regionals and super regionals to acquire at attractive multiples, and build sufficient scale that enables them to become effectively GSIBs themselves (this is one of the forces driving consolidation)
Embers of change
I contend that two of three things must happen for the American banking system to have a shot at not becoming Canada/Brazil/Australia (with no offense to any of those countries). Either
The regulatory framework for de-novo banking must become far more straightforward and predictable (resulting in higher return on capital opportunity for investors, or lower startup costs). This can drive more investor demand for the creation of new banks. This doesn’t have to look like the banking system of the past; countries like the UK have paved the way with concepts like the e-money license, that give fintechs a direct interface to regulators and a way to provide banking or banking adjacent services without launching a bank;
The breadth of talent, practices, infrastructure and tools that have blossomed in fintech over the last decade must begin to migrate into the traditional financial system. This can be driven by traditional banks adopting the new technology, or new banks being built around them
The underlying infrastructure on which our banking system runs must modernize; tools for real time money movement, real time exception detection, continuous compliance & reporting, synchronous front office and back office communication, and rules updated for modern life.
You can already see the embers of #2 happening; Lead Bank (and Column and others) are early examples. I’m most familiar with Lead [6] ; the talent density Jackie has assembled is simply insane - they’ve done this before, felt the pain as bankers, customers and partners, and are focused on creating a world class experience and infrastructure to match. Lead Bank brings a ton of talent from Square, and Column from Plaid. I imagine over time these teams will bring a lot of practices (like operational systems that work in real time rather than on a batch basis etc) and tools that are native to fintech, to the banks. Theoretically this should lower costs, reduce compliance and regulatory errors and drive margins and returns. But even if this worked perfectly it would still only be for a handful of banks.
The problem is you need them all. There are just not that many Jackie’s. Without #1 only the absolutely most seasoned and well capitalized entrepreneurs will attempt to launch banks, which will mean very few de novo bank charters are filed each year, even though many banking services can be provided in capital-light ways. To do this well you both need to reduce the cost of starting up a bank and the impact of failure. This is easy for me to say as I’m not a regulator, but as long as the impact of failure remains super high our tolerance for experimentation as a society will remain low. And the impact of failure only gets higher the more consolidated our banking system gets. And the legislative security on regulators intensifies with each failure.
Without #3 the long tail of banks will shrink as Americans gravitate towards the best experiences. and the small banks left will have more and more concentrated assets and deposits, as the customers who remain will maintain deposit relationships primarily to support their borrowing relationship.
Generals are always prepared to fight the last war
A couple years back, I asked a bank COO with a large banking as a service business, and a large local lending portfolio what regulators thought about their fintech portfolio. Their response; “they don’t care if it disappears. All that matters is that it doesn’t interfere with our traditional banking business in the region.”
Banking regulators care deeply about the safety and soundness of the banking system. And from what I can tell, they don’t care (much) about fintech - or they care about it only insofar as it impacts the safety and soundness of the banking system in a traditional way. I don’t mean this perjoratively - its not malice. The statement above is verbal confirmation of an effect that many folks working at large fintechs today are familiar with (and probably appreciate) but might find strange; there are multiple large technology companies with large national consumer footprints that serve tens of millions of Americans, often through a regional banking relationship, with with a regulatory interface directed through a bank. A weird consequence of this is; multiple fintechs operate through a bank for years, one of those fintechs breaks some rules, the bank gets a consent order (like Evolve, Lineage, Choice & Green Dot all have in Q1 2024 alone) , and a bunch of the other fintechs are affected and have to find a new bank to partner with.
Said plainly, our existing regulatory regime looks through to the fintech and aggregates up risk at the bank level, rather than the fintech level. We have massive fintech companies whose financial products reach (and by definition are building products that benefit) hundreds of millions of American consumers. This means that the banking partners these companies choose to manage their relationships has significant meaning as it is the lens through which they are regulated (in contrast to somewhere like the UK where e-money licenses make it possible for fintechs to have a direct regulatory interface of their own).
The point here isn’t that we should adopt the financial system of another country. It’s that our financial system today isn’t the way it is as a law of physics; it’s the way it is as a result of choices. We can just choose a different structure, with straightforward rules for new banks coming to life, and direct regulatory interfaces for them as well. Without making different choices, we’re careening towards a banking system that only has banks that are too big to fail, which means either they’re effectively regulated and essentially barred from taking risk, or they’re ineffectively regulated and the public foots an ever larger bill.
My instinct is that because the regulatory scars of the last couple decades have come from the traditional banking sector (with lots of banks disappearing during the S&L crisis in the 90s and in 07/08), many regulatory leaders who grew up in that environment view systemic risk exclusively through the traditional banking lens. But ask yourself this - which would be more impactful, and cause more harm to consumers if it happened tomorrow; bank #101 disappearing, or Chime disappearing?
Thanks to Jim Esposito, Aaron Frank, Jackie Reses, Saira Rahman, Justin Overdorff and Amias Gerety for reading & editing this in draft form.
[1] From what I can tell, to date, reductions in lending capacity associated with M&A are mostly mitigated by the reactions of other local banks in the affected region(s)#. There might be a tipping point to this (at which consolidation truly causes reductions in local lending after a bank acquisition), but from what I can tell to date, there’s little to know impact: https://www.sciencedirect.com/science/article/pii/S0304405X98000361#:~:text=Peek%20and%20Rosengren%20and%20Strahan,effect%20on%20small%20business%20lending.)
[2] Outsize returns often stem from rapid growth, and new banks often grow quickly by catering to a fast growing region or industry, which results in asset and deposit concentration. Asset and deposit concentration increases the risk of bank failure, because a headwind in the bank’s geography or sector could cause the bank’s balance sheet to deteriorate rapidly (again, one of many reasons contributing to SVB’s ultimate demise). SVB and FRB grew rapidly over the last 40 years in large part by offering highly customized financial products to the technology industry, and the end of the ZIRP era combined with a contraction in the technology industry contributed to it’s demise (this is an example of contraction in a sector causing a bank failure). An example of regional contraction is the Texas banking crisis of the 1980s which was exacerbated by oil price volatility (https://www.fdic.gov/bank/historical/history/291_336.pdf) All this matters because banks are ultimately insured by American taxpayers, and the only time the FDIC gets called before Congress is when banks fail. So there’s an underlying incentive to prevent banks from failing. And one way to achieve this objective is to only allow banks to exist that have no chance of failing. This limits downside, which is admirable, but it also inherently disadvantages anything that is new.
[3] There’s currently a large mismatch between what consumers and businesses expect of their money (which is almost everything is instant or real time) and how bank systems actually work (many operations are still batch based or require a human in the loop to complete). This mismatch at least partially contributed to SVBs demise (https://writing.kunle.app/p/jpmorgan-chase-doesnt-care-about) and continues to cause funding problems today.
[4] An example of a different way to do this is the UK e-money license. Many UK and European fintechs were able to launch banking services without explicitly having to partner withIn the UK, you can kind of apply for an e-money license (again not a bank, but an explicitly licensed entity that allows you to take deposits) and mostly just get it barring character/reputational issues.
My impression in the US is you can have all the technical requirements met and still regulators can make a subjective decision to deny you a charter (and there's nothing like an e-money license thats essentially deterministic)
[5] No regional bank is going to beat Chase at Adwords. Or incentives.
[6] For disclosure I’m on the Lead Bank board