Rethinking
Compliance in Crypto, Fintech, Banking
as a Service World- A Multi-Part Series
Community banks and credit unions have been a key part of
the American economy since its beginning.
These are the lending institutions that make loans to small sole
proprietors, first time home buyers and dreamers of all kinds. Over the years, the business model for these
institutions has hardly varied. A
review of the loan portfolios of community banks across the country will include
three similar components:
- CRE- Commercial real estate loans have been one of the
mainstays of the community banking business. These loans provide a viable,
recognizable and reliable (usually) source of income. The drawback for this type of lending is
that it ties up a large portion of the capital of a bank and the return on
investment takes a significant amount of time develop. A loss from one of these loans has the
potential to threaten the existence of a small financial institution
- CNI – Commercial and Industrial loans have been the
beating heart for community banks many years. Very much like CRE loans, the income
from these loans is recognizable and except for a few notable exceptions,
reliable. Not only do these loans
have the same concerns as CRE, but the competition for these loans is also
fierce and smaller institutions
often finds themselves left with the borrowers who present the highest
level of risk.
- Consumer products - In the past 15 years, consumer
loans have also proven to be a good source of earnings. Interest rates for consumer products
have remained well above the prime rate and for a financial institution
that is properly equipped, consumer products can provide a strong stream
of income. Consumer products also
tend to be for smaller amounts, have higher rates of losses and are
heavily regulated.
This three-pronged approach to earning income has been a
steady, tried and true method for earnings at small financial institutions, However, there are several factors that are coming
together that have threatened this business model.
- Fintech – Financial technology (“Fintech”) companies
are those companies that use software to deliver financial products. Today one of the most recognizable
fintech companies is PayPal. Using
just a smart phone, PayPal gives its users the ability to make payments,
pay bills, deliver gift cards and conduct financial transactions with
people throughout the country. For
community banks, the knowledge of the existence of PayPal is interesting,
but what is more critical is the reason that PayPal was developed. PayPal, and its fintech brethren exist
to fill a specific need that Banks were not meeting.
- NBFI - Operation Chokepoint was a program spearheaded
by the Justice Department that was aimed directly at Non-Bank Financial
Institutions, aka Money Service Businesses. At the time the program was started, a
decision was made that money service businesses represented an
unacceptable money laundering risk.
Ultimately, Operation Chokepoint fell into disrepute and was
ended. Although Operation
Chokepoint has ended, its legacy is still prevalent. MSB’s still have significant problems
getting bank accounts. Despite
this fact, the amount of money moved through remittances continues to
grow. NBFI’s MSB’s continue to
serve this market a huge market of people who are unbanked and
underbanked.
- Underbanked and Unbanked- The number of unbanked and
underbanked families continues to remain significant. Unbanked families are those without a
bank account and underbanked families are those that use minimal banking
services. The number of people in
these families totaled
approximately 23 million in 2021[1]. Equally as important as the sheer size
of the unbanked and underbanked population is the reason that many of these
potential customers remain that way.
High fees, poor customer service and bad public image have all been
contributing factors for the large population of unbanked and underbanked
customers.
Fintech’s to the Rescue?
Financial inclusion, especially providing services to those
people and small businesses that traditionally avoided full-service banking,
has long been a calling card for financial technology (“Fintech”) firms.
Interest rates near zero and an untapped market of millions
of adults helped the industry flourish, from financial services firms to
cryptocurrency startups.
But inflation and rate hikes have slowed new funding to a
trickle. As investors’ push for profits grows, so too does concern that FinTechs
will abandon their pledges to cater to the underserved.
Consider the online bank Varo Bank, which raised $510
million and boasted a $2.5 billion valuation last September. Then, like many FinTechs,
it hit a wall in 2022.
With losses mounting, it laid off 75 staffers, cut back on
advertising and shifted strategy, moving away from growing its total client
base and shedding what CEO Colin Walsh called “expensive customer acquisition”
in an interview this month with Axios.
Those expensive customers usually end up being from Black,
brown and other marginalized communities that cost more to reach and generate
the lowest revenues, said Mehrsa Baradaran, a professor at the University of
California Irvine School of Law and author of the book “How the Other Half
Banks.”
Preparing to fill the breach are community development
financial institutions—small, community-based lenders that focus on providing
funding to largely women- and minority-owned small businesses with less than $1
million in revenue, said Patrick Davis, the senior vice president of strategy
at Community Reinvestment Fund USA.
The Biden administration has committed more than $1 billion
accessible through CDFIs for the smallest startup businesses. Banks have also been
increasing their contributions to CDFIs with the express goal of getting money
to hard-to-reach small businesses.
Customer Bases in
the future
The combination of these forces will greatly impact the
future of the business model for community banks. Customers will continue to change their
expectations for their financial institutions.
The traditional balance has changed, instead of being forced to choose
the products that financial institutions offer, customers have come to demand
products from their companies.
The financial needs of customers have also changed. Electronic banking, online account opening,
remote deposit capture and iPhone applications are now almost necessities. Younger customers, who make up a significant
number of the unbanked and underbanked population rarely use traditional forms
of community banking such as branch visits.
Fast information, fast movement of money, low costs transactions and
accessibility are most desirable to the potential clients of today’s financial
institutions.
Implications for the Small Bank Business Model
Fintech companies, NBFI’s and the need for new and different
services presented by the unbanked and underbanked population will all continue
to put pressure on community bankers to begin to make a change. Change may be
hard, but it is also inevitable and necessary.
For community banks and credit unions now is a good time to consider NBFI’s
as viable and important customers. They
are a vehicle for consumers to meet their ongoing needs and they need bank
accounts.
Reimagining Compliance as a Potential Product or
Service
For many institutions the barrier to entering the Fintech, or
NFBI market is a lack of the proper compliance resources. However, much like the shared services
agreements that are being made with vendors in other areas, compliance
resources can also be expanded with the right partnerships. For the institution that is properly
positioned, the possibility exists that compliance resources and expertise can
be package and outsourced.
We will explore the possibilities for compliance in our
series this month. In Part Two- we will
ask- What if compliance could be a profit center?
James DeFrantz is
the Principal of Virtual Compliance Management Services
For more Discussion and or Questions contact him at contactus@VCM4you.com
[1] An
estimated 4.5 percent of U.S. households were “unbanked” in 2021, meaning that
no one in the household had a checking or savings account at a bank or credit
union (i.e., bank). This proportion represents approximately 5.9 million U.S.
households. Conversely, 95.5 percent of U.S. households were “banked” in 2021,
meaning that at least one member of the household had a checking or savings
account at a bank. This proportion represents approximately 126.6 million U.S.
households.
An estimated 14.1 percent of U.S.
households—representing approximately 18.7 million households—were
“underbanked” in 2021, meaning that the household was banked and in the past 12
months used at least one of the following nonbank transaction or credit products
or services that are disproportionately used by unbanked households to meet
their transaction and credit needs
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