FinTech Bank Options TL;DR
An overview of FinTech bank options
Banking regs are byzantine.
For FinTechs, the key question is whether they should partner with a bank or become a bank themselves.
But as a starting matter…
What Is a Bank?
Chances are, as someone reading a FinTech law TL;DR, you probably already know that banks take deposits and make loans.
But what defines a bank?
Can Elon Musk just wake up one day and decide to start the Bank of Dogecoin?
Legally, a bank is defined by having a bank charter, which is a sort of certification that says “congrats, you can do this thing!” Charters come in a few flavors, which we’ll get to.
Getting a charter generally requires what you’d expect: put a lengthy application together, meet capital reserve requirements, have a good compliance system, go through on-site exams, etc.
So why would a business want to be (or partner with) a bank?
Bank Activities
The main activities FinTechs need to partner with, or become a bank, for are:
Lending: having a charter solves a lot of lending license and interest rate headaches.
Deposits: you need a certain type of charter to be able to take deposits.
Payments: a bank charter enables you to access the Fed’s payment rails,1 and may circumvent the need to get state money transmitter licenses.
Charter Restrictions
Before we lay out the charter options, let’s walk through the different bank charter attributes that may vary based on the type of charter.
Primary Regulator
National banks are regulated by the OCC. State banks (i.e., normal charters and Industrial Loan Companies (ILCs)) are regulated by their state financial regulators.
States need their banks’ business and fees, so state regulators are known to have a better working relationship with banks.
Bank Holding Company Status
The parent entity that owns a bank is a “bank holding company” (BHC). For example, if a FinTech acquires a bank, the FinTech will be a BHC.
Generally, FinTechs may avoid being a BHC for a few reasons:
BHCs are prohibited from engaging in non-banking activity (think: a car manufacturer starting a bank, or Square buying Tidal2).
BHCs can become Financial Holding Companies (FHCs) if they meet certain capital requirements. FHCs can engage in a broader array of financial activities than BHC, but they’re still can’t engage in non-financial commercial activity.
BHCs must meet capital reserve requirements and “act as a source of strength” (aka, provide capital) to their subsidiary banks in times of distress.
BHCs are supervised by the Federal Reserve. This means that being a BHC triggers additional regulatory oversight, even if you’re a state bank that wouldn’t otherwise fall under the Fed’s purview.
Deposits
Not all banks can offer deposit or checking accounts. Some can only offer Negotiable On Withdrawal (NOW) accounts3 and Time Deposit Accounts.4
FDIC Insurance
To accept deposits, a bank must get FDIC deposit insurance, which requires FDIC approval and oversight.
Lending Powers
All of the charter options you’ll read about allow banks to lend with one key limit: banks can’t loan more than 15% of their capital to one borrower. However, they can loan an additional 10% if the loan is secured.
Interest Rate Export
Normally, banks can “export” the interest rate of the state where they’re chartered. However, states can opt out of allowing banks with state charters to export their home state interest rates. Only Puerto Rico and Iowa have opted out, though.
State Licensing
With some charters, you may still need to get state licenses for lending and money transmitting activities.
Charter Options
Right now, there are three key bank charter options for FinTechs: OCC, state, and ILC charters.
National (OCC) Charters
National banks get charters from the OCC. These tend to be the most expensive to obtain and maintain.
Examples: Varo, LendingClub, Jiko.
State Charters
FinTechs can also get bank charters from a state. State charters are generally less expensive than OCC charters, and state regulators are known to be more friendly to banks. Utah is the most popular state.
Examples: Green Dot (Utah) and Cross River Bank (New Jersey).
Industrial Loan Charters (ILCs)
The key attributes of an ILC charter are: (1) ILCs are not subject to BHC activity limits and (2) they cannot offer traditional deposit or checking accounts.
ILCs have an interesting history that’s worth exploring. They’re a relic from banks created in the early 1900s by Arthur Morris.
Morris would have fit in well at a modern day FinTech startup; he wanted to expand access to credit and “innovated” by using cosigners for loans. But his institutions weren’t strictly banks, so states created a new category for them, industrial loan companies.
These Morris banks eventually fell out of use when credit unions gathered market share. However, the ILC options stayed on the books in many states.
Then, in the 1980s and 90s companies like General Motors started operating as ILCs to avoid the BHC limits (because their main business wasn’t banking). Traditional banks weren’t a fan.
Enter Walmart. They applied for an ILC in 2005 which caused outrage by bank lobbyists. Ultimately, the FDIC and Congress imposed a moratorium on all ILC apps.
That decade and a half moratorium expired and, in 2020, the FDIC approved new charters for Square and Nelnet Bank.
Only a small handful of states have ILC laws that are still useful to FinTechs. Utah and Nevada are the most attractive options. California has an ILC option, but it effectively subjects the bank to the same BHC banking activity limits.
Examples: Square (Utah), Nelnet (Utah), Celtic Bank (Utah), WebBank (Utah).
FinTech Charter
In 2016 the OCC announced it would accept “FinTech charter” applications. This charter would allow lending and payments, but not deposits. FinTechs with this charter would be subject to less burdensome supervision and examination than traditional charters.
However, there’s a lot of uncertainty that makes a FinTech charter unappealing: states and lobbyists are suing the OCC over it and the CFPB wants to have the authority to issue FinTech charters instead of the OCC.
Wyoming
Wyoming introduced a “Special Purpose Depository Institution” (SPDI) charter in 2019. This charter is aimed at crypto companies:
You don’t need a money transmitting license.
You can access to the Fed’s payment rails.
It doesn’t cover lending.
It doesn’t require FDIC insurance; instead, you need to have a reserve that covers at least 100% of deposits.
It can require just as many compliance procedures and as much capital as a traditional bank app.
Examples: Kraken, Avanti Bank.
Savings Associations and Credit Unions
Savings Associations and Credit Unions are other types of charters. However, they impose limits that make them infeasible for most FinTechs.
Charter Comparison
Here’s an overview of how the FinTech charter options stack up:
Looking at this comparison, the key considerations for FinTechs are:
Do you want to avoid BHC restrictions? Go with an ILC.
Do you want a more friendly regulator? Pick a State or ILC license.
Do you want to avoid higher regulatory costs? Avoid the OCC/National charter.
FinTech-Bank Partnerships
FinTechs often partner with banks. If you have a deposit account with Chime, Chime doesn’t actually hold your deposits. Their bank partner does.
Whether a FinTech is better off partnering with a bank or becoming a bank is a case-by-case choice. There are some common trade-offs, though.
Pros of partnering:
Rely on the bank’s charter for lending, payments, and/or deposits.
Rely on the bank to access the Fed’s payment fails and ACH network (if the bank has access).
It’s not clear if a FinTech’s revenue is enough to justify a bank charter cost.
You don’t incur the costs of direct regulatory supervision.
Cons of partnering:
Rely on bank partner’s whims.
You’re still indirectly subject to bank compliance regs.
You have to invest resources is managing the partnership.
Banks aren’t as agile as FinTechs.
Bank partnerships can be expensive.
Investors
When a FinTech becomes (or buys) a bank, they may need to rethink their shareholders. If you’re a bank and your shareholders have “control,” you face extra regulation and must disclose info about those controlling shareholders.
Investors don’t want this. So they’ll stay below the “control” thresholds: 10% of a single class of voting equity or 33.3% of total equity. This may require selling or restructuring shares.
A shareholder also has “control” if they can control management and policies, so investor rights may need to be trimmed down.
Regulators may also require that foreign investors give up voting rights, too. For example, LendingClub had to pay off a non-U.S. investor to convert their shares into non-voting shares when it bought Radius Bank.5
About
Any views expressed are my own (well, sort of? I mean, they’re laws and regulations, so they’re not really “mine”). Nothing here is legal or financial advice.
Fed payment rails primarily include wire and ACH transfer systems. If you want to send a wire, you have to go through the Fed. If you want to send an ACH, the Fed is one of two options.
Square could do this because its subsidiary bank has a UT ILC, and UT ILCs don’t trigger the BHC limits on commercial activity.
NOW Accounts earn interest but require at least 7 days’ notice before any withdrawals, so they don’t function as good alternatives to checking accounts.
Time Deposit Accounts are interest-bearing accounts that are held for a fixed term. The most common example is a certificate of deposit.
See this for more info.