Why payments matter
Payments are the key distinguishing feature of the highest profit retail products and a fee-based anchor for commercial relationships. Doing payments well is required to compete.
Payments anchor the two most profitable Retail products – DDA accounts and Credit Cards – but, the bulk of net revenue is spread-based, not fee-based. Payment’s revenue (transaction fees & net interchange after rewards costs) pales in comparison to spread-based revenue (lending & deposits); Most providers don’t even charge for routine payments in either product.
In Commercial, Treasury Services generates high-ROE fee income and low risk operating balances. This complements commercial lending revenues from wholesale clients.
Regulations effectively reserve these high-profit products for chartered financial institutions (Fis). Only FIs can directly take demand deposits and deliver most payment types. You can’t originate Fedwire, FedNow, RTP, CHIPS, ACH, or Zelle unless you have an FI charter. In Cards, a charter is required to be a full member of MasterCard & Visa. But, if all that is true, how are Fintechs taking share in payments markets?
The answer lies in how they compete. Charters reserve DDA balances & associated Payment’s connectivity to chartered Fis; but, those charters come with regulations to keep the payments system liquid and secure. These regulations include the Bank Secrecy Act (BSA), Truth in Savings, Reg E, Reg Z, Regulation II and a long list of others. So, the advantages of DDA payments comes with compliance obligations.
Access to DDA balances is critical to Lending. DDA balances are typically non-interest-bearing and sticky, providing FI lenders with a stable, low-cost source of funds. I have lived through several economic downturns where lenders dependent on wholesale funding went belly up as that funding disappeared – or became unaffordable. Lenders face their own laundry list of regulations including the Community Reinvestment Act and Truth in Lending.
So, a charter gives Fis access to payment systems, which in turn enables DDA accounts, which in turn helps lending margins. The tradeoff is a compliance obligation to ensure safety, soundness, and consumer protection.
How do Fintechs get to play?
Fitnechs compete in the outer ring: Customer Experience & Distribution. They aim to provide an end-to-end, digital experience in a direct-to-consumer model. They rely on chartered FIs to hold any deposits, execute any payments, and originate any loans – in a compliant fashion.
These white label services come under different names. An older name is BIN-sponsors; the newer terms are Banking-as-a-Service (BaaS), Payments-as-a-Service (PaaS), Lending-as-a-Service (LaaS), etc. The meaning of those terms has converged as BIN-sponsors adopt modern, cloud native, API centric technology. In all models, a chartered FI is at the back end.
Using an FI intermediary lets the Fintech focus on user experience and distribution rather than compliance and processing. The Fintechs focus on removing friction, while compliance often slows things down. The regulators are aware of these trade-offs, particularly around Know Your Customer (KYC), but hold the back end FIs responsible.
XaaS FIs are not household names. Chime uses Stride Bank and Bancorp Bank, Marqeta uses Sutton Bank, Affirm’s card products are issued by Evolve Bank. You likely never heard of any of those FIs – they are small banks that provide the inner rings of services in return for fees. That includes all the compliance duties.
Small Fis dominate the “Xaas” market. The bigger banks don’t want to cannibalize their lending and deposits businesses. They also don’t want extra compliance risk for the modest fees on offer. Smaller FIs also have a regulatory advantage on the Deposits side. Many Fintechs want to monetize via debit card interchange, but any FI over $10B in assets is subject to the Durbin Debit cap of 22¢ + 5bp. A smaller, “Exempt” bank can earn 2-3x more interchange for the same transaction. So exempt banks have a regulatory moat for debit.
Some Fintechs get around the XaaS model by using State-level licensing. That requires 45+ state licenses with diverse compliance requirements. Using a nationally chartered FI is usually a more straight-forward option.
A few Fintechs are getting their own charters. In theory, a captive charter allows less friction between the FI part of the value chain and the Fintech part of the value chain. Examples include Sofi (via acquisition), Block (de novo), Adyen (importing an EU charter), and Fiserv (via a de novo, special purpose charter). Captive charters have their own issues:
A charter may subject the entire entity to certain regulations, not just the FI subsidiary
The captive FI may not have the scale to deliver low unit costs
Captive Fis must be managed at arms-length, limiting full synergy
So XaaS will be the model of choice for most Fintechs. It frees them to focus on software, distribution, and service.
The “Fintech Charter” is another proposed solution. Some regulators proposed a limited purpose charter so that Fintechs can participate in the payments system without an incumbent FI as the intermediary. The Fintech Charter would have the same compliance obligations as other FIs, but would not be subject to regulations that don’t relate to their narrower models. This idea had its 15 minutes of fame a few years back, but seems to have gone dormant.
How do banks stay relevant?
Fundamentally, the charter reserves a privileged position in the value chain for regulated depositories (banks and Credit Unions). Most Fintech models pursue specialist functionality or specialist segments but rely on XaaS FIs for all the back-end plumbing. The reality is that Fis are increasingly competitive in Digital and still have the preferred DDA origination channel in branches. Even the biggest Neobanks have small deposit bases and virtually all credit card balances are originated by large Fis.
So, while some transactions are migrating to fintech specialists, balances are still concentrated in chartered Fis, and that is where the profits are. One way to bridge the gap is distribution partnerships. Instead of the XaaS model, the FI distributes fintech experiences under the FI’s brand. Bank of America and JPMorgan do this with BILL as just one example. These kinds of partnerships allow the Fintechs to specialize in the outer ring while the Fis specialize in the inner rings and distribute through their captive channels. Both sides win.
Is there a real disintermediation risk?
The banking industry has experience real disintermediation in the past:
In Commercial, large companies now access the capital markets to issue bonds, commercial paper, etc. rather than borrow from banks. This started in the 1970s
In Consumer, a large share of long-term savings is now in Mutual Funds, a capital markets product rather than deposits. This started in the 1980s
Fintech’s do not pose this scale of disintermediation threat. In general, Fintechs have captured transactions, but not balances. Virtually all deposits are still in chartered FIs – particularly, non-interest bearing DDA deposits. Most consumer and commercial loans are originated in FIs as well. Some low-balance deposit accounts have migrated to Neobanks, but the balances are held at a BaaS provider with a charter. So, the impact of the Neobanks is to shift deposit share from incumbent FIs to XaaS specialist Fis, but the balances are still at an FI with a charter.
The installment loan phenomenon disintermediates card loans, but share is still small. The loans may briefly touch a chartered FI at origination but are then usually securitized in the capital markets. Fis themselves securitize credit card receivables, mortgage loans, and auto loans at scale. The issue then is that the origination transaction runs through a fintech, but post-origination, these loans end up in the same capital markets that Fis use.
Capturing the outer ring does represent a potential disintermediation threat. If Fintechs can capture the user experience they might steer the customer away from an FI product to a Fintech equivalent. Most Fintechs articulate a strategy of that kind, but few have succeeded in pulling it off. Yet.
Key insights
While payments are fundamental to high-profit products (Retail DDA, Credit Cards, Treasury Services), most of the actual profit in those products is from spread revenue not from payment transactions revenue
The charter reserves Demand Deposits and related payments activities to regulated FIs. Those DDA deposits give FIs a cost-of-funds advantage in Lending. However, along with privileged positions in the key products comes compliance obligations to ensure safety and soundness
Fintechs generally focus on the outer “experience” layer but rely on chartered Fis for payments execution and balance hosting. These “XaaS” services, are typically hosted in smaller Fis.
This situation may change in the future:
Regulators may create a Fintech charter that give Fintechs direct access to payments systems
Regulators are encouraging open banking, which could remove some of the stickiness of DDA products
Some Fintechs are getting their own bank charters to create end-to-end processes, but once they have a charter this ceases to be disintermediation but instead straightforward market share shifts
FIs and Fintechs are partnering to deliver Fintech experiences over FI channels and infrastructure
Few Fintechs have pulled off meaningful disintermediation despite capturing some customer loyalty