Few things terrify today’s bank CEOs more than the specter of a financial technology (“fintech”) company growing large enough to elbow them aside. And who can blame them? Fintechs are signing up customers at a much faster pace than legacy institutions.
According to CB Insights, over 20 fintech startups have crossed over the 1 million customer account mark, and twelve of them are already unicorns valued at $1 billion or more. In aggregate, those companies have added over 200 million accounts over the last 10 years, and that number doesn’t even reflect players in China and India where “super apps” like Paytm (with 350 million users) and Ant Financial (with 800 million mobile wallets) benefit from enormous populations sizes.
Fintechs are taking on all sorts of activities that were once the dominion of incumbent banks, including consumer & commercial lending, investment banking, trading, asset management, and so on.
One trend that’s eliciting attention is the growing number of payment apps and payment processors entering the banking business. Per CB Insights, one report even predicts that the 10 largest banks could lose $344 billion in deposits to smaller competitors over the next year.
In Europe, popular neobanks such as N26 from Germany and Northmill from Sweden have recently been granted banking licenses. The same is true of Revolut, Monzo, and Starling which are UK-based. Not only are these upstarts taking market share away from “High Street” banks, they are doing so with flair: Their banking tools are high-tech and intuitive, neobanks are constantly adding to their suites of tools in ways that allow customers to better manage their finances, and neobanks issue bank cards with eye-catching non-traditional designs which go a long way towards enhancing brand recognition.
Kantar, a market research firm, reports that the brands of eight of the largest banks in the UK — including HSBC and Barclays — declined by an average of 7% over the last year, adding up to a collective $2 billion in lost brand value. The decline was attributed to the rise of challenger banks like Monzo, Revolut and Starling.
US fintechs are also entering banking, specifically via lending, as a way to further grow and retain customers. What’s more, they are using their vast troves of data to determine creditworthiness and to model repayments.
Stripe, a payment processor, launched Stripe Capital this month. This arm of Stripe will offer $10,000 to $20,000 in loans to online businesses that are existing customers, as well as to merchants that sell on platforms that process payments through Stripe. Shopify’s clients, for example, would be eligible. The Loan amount offered will be based on the customer’s transaction activity on Stripe itself. Repayments will be taken out of the customers’ future sales made through Stripe’s payment platform. Stripe is also rolling out a corporate credit card for business customers.
Stripe’s ubiquitous payment platform makes it possible for e-commerce and other businesses to integrate payments into their websites or apps via an API. That service has catapulted the company from a modest startup to one that makes local currency payouts to recipients in 45 countries and over local bank networks. This has produced massive amounts of data.
Now, Stripe is building on its big data analytics and algorithms to intelligently deduce who might be ripe to take a loan, and how much that customer might be able to pay back. John Collision, Stripe’s CEO, expressed the opportunity quite simply: “We use our data to underwrite the loans. In the past you had to wait weeks or months while a loan officer reviewed an application, but we can see a customer’s historical performance on Stripe and apply our machine learning models to do the work, analysing with no human intervention.”
Square Inc. (SQ), a mobile money-transfer business founded in 2009, is also making inroads into the banking business. Best known for its white credit-card readers that plug into smartphones, allowing merchants to take credit card payments, Square has evolved from being a merchant acquirer to becoming a merchant services aggregator and commercial lender.
Customer feedback drove the idea. Small-business owners that used Square’s payments services complained they couldn’t get bank loans, either because their personal credit scores were too low or their businesses didn’t generate enough revenue. The company launched Square Capital in 2014 based on the premise that Square, as a merchant acquirer and provider, could leverage a customer’s charge card volume data to lend against. In other words, Square Capital leverages a merchant’s credit card data to underwrite loans against that business’ future receivables.
That lending business is booming. According to Square’s 2Q 2019 earnings report, Square Capital facilitated 78,000 loans totaling $528 million between April 1 and June 30, a figure that’s up 36% year-on-year. In aggregate, Square Capital has loaned more than $5 billion across 800,000 loans since its debut in 2014.
Recently, Square debuted a Mastercard-branded business debit card that allows sellers to spend the money they earn through their Square payments — a move that will service underserved and unbanked sellers so that they can start businesses without going to a bank. Square has also submitted an application for a US banking license, which, if approved, will be used to launch Square Financial Services.
Stripe and Square are just two of many US-based non-banks undertaking commercial lending activities. PayPal Holdings Inc. (PYPL) has extended more than $6 billion in small-business loans since 2013, using data it collected by processing payments for Internet retailers; independent merchants that sell goods on Amazon (AMZN) have borrowed more than $3 billion from the e-commerce giant, which approves loans based on sellers’ historical volume and other factors; Intuit Inc. (INTU) started offering loans last year to businesses that use its Quickbooks software, based in part on the data contained in their accounting statements; and First Data Corp. (FDC) now lets businesses that use payments devices from Clover, a Square competitor that it owns, take out loans based on their sales history.
By offering growth capital and bridge loans, these fintechs are taking advantage of the fact that traditional banks are reportedly lending less and less money to small businesses (Stripe claims that the amount loaned in the past decade has declined by half). Others fintechs, like Prosper, SoFi and Lending Club, focus on the consumer lending segment, and offer loans to pay off debt or make discretionary purchases.
One commonality shared by both groups (commercial and consumer lenders) is that the loan process is faster, cheaper, algorithm-driven, and highly automated, which gives them an advantage over traditional banks in terms of efficiency.
Fintechs have also benefitted from looser regulation than traditional banks, so compliance and general cost of doing business is lower for them. In some cases, they may have also profited from a lower tax rate. The city of San Francisco, for example, charges financial-services companies a tax rate between about 0.40% and 0.56% of their gross receipts. Tech companies pay between about 0.13% and 0.48%.
In the wake of fintechs entering their turf, some legacy institutions are fighting back by cherry-picking the best financial innovations that their younger competitors develop — investment robo-advisors, AI-based budgeting, and expense monitoring — and incorporating them into their services. As such, the head start and advantages Fintechs have enjoyed thus far probably won’t last forever. As the lines blur, fintechs will eventually get more regulated, which should slow them down somewhat.
The biggest banks have other advantages over the fintechs: they are well-capitalized, they have experience navigating through credit cycles, and regulations passed by the administration remove some of the constraints placed on them after the financial crisis.
While a toxic combination of tepid growth, low interest rates, trade tensions, economic uncertainty and geopolitical tensions amount to a tough macro landscape for banks at the moment, things will eventually get better. Perhaps, not so much for European banks, but certainly for American banks.
MRP suspended its Long Financials theme on March 1. Our rationale for the suspension was that several shifts in the macro and micro environment would cause financials to underperform the broad market. That turned out to be the right move. Bank stocks have gotten cheaper since then.
At this point, a steepening of the yield curve, marijuana banking deregulation, or even the long-anticipated rotation out of growth and into value stocks could send investors rushing backing into the sector. Based on the one-month performance of the SPDR S&P Bank ETF (KBE), that may be happening already. In one month, the KBE has rallied 11.2%, while the SPY and FINX have gained 6.1% and 3.8%, respectively.