Regulation

The Seven-Minute Loan Shakes Up Washington And The 50 States

It takes seven minutes for Kabbage to approve a small-business loan. “The reason there’s so little lag time,” says Sam Taussig, head of global policy at the Atlanta-based financial technology firm, “is that it’s all automated. Our marginal cost for loans is very low,” he explains, “because everything involving the intake of information – your name and address, know-your-customer, anti-money-laundering and anti-terrorism checks, analyzing three years of income statements, cash-flow analysis – is one-hundred-percent automated. There are no people involved unless red flags go off.”

One salient testament to Kabbage’s automation: Fully $1 billion of the $5 billion in loans that it has made to 145,000 discrete borrowers since it opened its portals in 2011 were made between 6 p.m. and 6 a.m.

William Phelan, President and Co-founder, PayNet

Now compare that hair-trigger response time and 24-hour service for a small business loan of $1,000-$250,000 with what occurs at a typical bank. “Corporate credit underwriting requires 28 separate tasks to arrive at a decision,” William Phelan, president, and co‐founder of PayNet—a top provider of small-business credit data and analysis – testified recently to a Congressional subcommittee. “These 28 tasks involve (among other things): collecting information for the credit application, reviewing the financial information, data entry and calculations, industry analysis, evaluation of borrower capability, capacity (to repay), and valuation of collateral.”

A “time-series analysis,” the Skokie (Ill.)-based executive went on, found that it takes two-to-three weeks – and often as many as eight weeks—to complete the loan approval process. For this “single credit decision,” Phelan added, the services of three bank departments – relationship manager, credit analyst, and credit committee – are required.

The cost of such a labor-intensive operation? PayNet analysts reckoned that banks incur $4,000-$6,000 in underwriting expenses for each credit application. Phelan said, moreover, that credit underwriting typically includes a subsequent loan review, which consumes two days of effort and costs the bank an additional $1,000. “With these costs,” Phelan told lawmakers, “banks are unable to turn a profit unless the loan size exceeds $500,000.”

According to the National Bureau of Economic Research, the country’s very biggest banks — Bank of America, Citigroup, J.P. Morgan Chase, and Wells Fargo—have been the financial institutions most likely to shut down lending to small businesses. “While small business lending declined at all banks beginning in 2008,” NBER’s September, 2017 report announces, “the four largest banks” which the report dubs the ‘Top Four’—“cut back significantly relative to the rest of the banking sector.”

NBER reports further that by 2010—the “trough” of the financial crisis—the annual flow of loan originations from the Top Four stood at just 41% of its 2006 level, which compared with 66% of the pre-crisis level for all other banks. Moreover, small-business lending at the “Top Four” banks remained suppressed for several years afterward, “hovering” at roughly 50% of its pre crisis level through 2014. By contrast, such lending at the rest of the country’s banks eventually bounced back to nearly 80% of the pre-crisis level by 2014.

Kenneth Singleton, Professor, Graduate School of Business – Stanford University

That pullback—by all banks—continues, says Kenneth Singleton, an economics professor at Stanford University’s Graduate School of Business. Echoing Phelan’s testimony, Singleton told deBanked in an interview: “Given the high underwriting costs, banks just chose not to make loans under $250,000,” which are the bread-and-butter of small-business loans. In so doing, he adds, banks “have created a vacuum for fintechs.”

All of which helps explain why Kabbage and other fintechs making small business loans are maintaining a strong growth trajectory. As a Federal Reserve report issued in June notes, the five most prominent fintech lenders to small businesses—OnDeck, Kabbage, Credibly, Square Capital, and PayPal—are on track to grow by an estimated 21.5 percent annually through 2021.

Their outsized growth is just one piece—albeit a major one—of fintech’s larger tapestry. Depending on how you define “financial technology,” there are anywhere from 1,400 to 2,000 fintechs operating in the U.S., experts say. Fintech companies are now engaged in online payments, consumer lending, savings and investment vehicles, insurance, and myriad other forms of financial services.

Fintechs’ advocates—a loose confederacy that includes not only industry practitioners but also investors, analysts, academics, and sympathetic government officials—assert that the U.S. fintech industry is nonetheless being blunted from realizing its full potential. If fintechs were allowed to “do their thing,” (as they said in the sixties) this cohort argues, a supercharged industry would bring “financial inclusion” to “unbanked” and “underbanked” populations in the U.S. By “democratizing access to capital,” as Kabbage’s Taussig puts it, harnessing technology would also re-energize the country’s small businesses, which creates the majority of net new jobs in the U.S., according to the U.S. Small Business Administration.

But standing in the way of both innovation and more robust economic growth, this cohort asserts, is a breathtakingly complex—and restrictive—regulatory system that dates back to the Civil War. “I do think we’re victims of our own success in that we’ve got a pretty good financial system and a pretty good regulatory structure where most people can make payments and the vast majority of people can get credit.” says Jo Ann Barefoot, chief executive at Barefoot Innovation Group in Washington, D.C. and a former senior fellow at Harvard’s Kennedy School. But because of that “there’s been more inertia and slower adoption of new technology,” she adds. “People in the U.S. are still going to bank branches more than people in the rest of the world.”

Jo Ann Barefoot, CEO, Barefoot Innovation Group

Barefoot adds: “There are five agencies directly overseeing financial services at the Federal level and another two dozen federal agencies” providing some measure of additional, if not duplicative oversight, over financial services. “But there’s no fintech licensing at the national level,” she says. And because each state also has a bank regulator, she notes, “if you’re a fintech innovator, you have to go state by state and spend millions of dollars and take years” to comply with a spool of red tape pertaining to nonbanks.

At the federal level, the current system— which includes the Federal Reserve, Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC)—developed over time in a piecemeal fashion, largely through legislative responses to economic panics, shocks and emergencies. “For historical reasons,” Barefoot remarks, “we have a lot of agencies” regulating financial services.

For exhibit A, look no further than the Consumer Financial Protection Bureau created amidst the shambles of the 2008-2009 financial crisis by the 2010 Dodd-Frank Act. Built ostensibly to preserve safety and soundness, the agencies have constructed a moat around the banking system.

Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington, D.C. consultancy, is a banking policy expert who frequently provides testimony to Congress and regulatory agencies. She wrote recently that the country’s banking sector has been protected from the kind of technological disruption that has upended a whole bevy of industries.

“The only reason Amazon and its ilk may not do to banking, brokers and insurers what they did to retailers—and are about to do to grocers and pharmacies,” she observed recently in a blog—“is the regulatory structure of each of these businesses. If and how it changes are the most critical strategic factors now facing finance.”

Cornelius Hurley, Executive Director, Online Lending Policy Institute

Cornelius Hurley, a Boston University law professor and executive director of the Online Lending Policy Institute, is especially critical of the 50-state, dual banking system. State bank regulators oversee 75 percent of the country’s banks and are the primary regulators of nonbank financial technology companies. “The U.S. is falling behind other countries that are much less balkanized,” Hurley says. “Our federal system of government has served us well in many areas in our becoming a leading civil society. It’s given us NOW (Negotiable Order of Withdrawal) accounts, money-market accounts, automatic teller machines, and interstate banking. But now it’s outlived its usefulness and has become an impediment.”

Take Kabbage, which actually avoids a lot of regulatory rigmarole by virtue of its partnership with Celtic Bank, a Utah-chartered industrial bank. The association with a regulated state bank essentially provides Kabbage with a passport to conduct business across state lines. Nonetheless, Kabbage has multiple, incessant, and confusing dealings with its bank overseers in the 50 states.

“Where the states get involved,” says Taussig, “is on brokering, solicitation, disclosure and privacy. We run into varying degrees of state legislative issues that make it hard to do business. Right now we’re plagued by what’s been happening with national technology actors on cybersecurity breaches and breach disclosures. We are required to notify customers. But some states require that we do it in as few as 36 hours, and in others it’s a couple of months. We’ve lobbied for a national breach law of four days,” he adds, which would “make it easier for everyone operating across the country.”

Then there’s the meaning of “What is a broker?’” says Taussig, who as a regulatory compliance expert at Kabbage sees his role as something of an emissary and educator to regulators and politicians, the news media, and the public. “The definitions haven’t been updated since the 1950s and now we have wildly different interpretations of brokering and solicitation,” he says. “The landscape has changed with e-commerce and each state has a different perspective of what’s kosher on the Internet.”

Sam Taussig, Head of Global Policy, Kabbage

Washington State is a good example. It’s one of a handful of jurisdictions in which regulators confine nonbank fintechs to making consumer loans. In a kabuki dance, fintech companies apply for a consumer-lending license and then ask for a special dispensation to do small-business lending.

And let’s not forget New Mexico, Nevada and Vermont where a physical “brick-and-mortar” presence is required for a lender to do business. Digital companies, Taussig says, would have to seek a waiver from regulators in those states. “Many companies spend a lot of money on billable hours for local lawyers to comply with policies and procedures,” Taussig reports, “and it doesn’t serve to protect customers. It’s really just revenue extraction.”

All such restraints put fintechs at a disadvantage to traditional financial institutions, which by virtue of a bank charter, enjoy laws guaranteeing parity between state-chartered and federally chartered national banks. The banks are therefore able to traverse state lines seamlessly to take deposits, make loans, and engage in other lines of business. In addition, fintechs’ cost of funds is far higher than banks, which pay depositors a meager interest rate. And banks have access to the Fed discount window, while their depositors’ savings and checking accounts are insured up to $200,000.

The result is a higher cost of funds for fintechs, which principally depend on venture capital, private equity, securitization and debt financing as well as retained earnings. And that translates into steeper charges for small business borrowers. A fintech customer can easily pay an interest rate on a loan or line of credit that’s three to four times higher than, say, a bank loan backed by the U.S. Small Business Administration.

Kabbage, for example, reports that its average loan of roughly $10,000 typically carries an interest rate of 35%-36%. It’s credits are, of course, riskier than the banks’. The company does not report figures on loans denied, Taussig told deBanked, but Stanford’s Singleton says that the fintech industry’s denial rate is roughly 50 percent for small business loans. “Fintechs have higher costs of capital and they’re also facing moderate default rates,” notes Singleton. “They’re not enormous, but fintechs are dealing with a different segment. Small businesses have much more variability in cash flows, so lending could be riskier than larger, established companies.”

Even so, venture capitalists continue to pour money into fintech start-ups. “I’ve gone to several conferences,” Singleton says, “and everywhere I turn I’m meeting people from a new fintech company. One of the striking things about this space,” he adds, “is that there are lot of aspiring start-ups attacking very specific, very narrow issues. Not all will survive, but someone will probably acquire them.”

Contrast that to the world of banking. Many banks are wholeheartedly embracing technology by collaborating with fintechs, acquiring start-ups with promising technology, or developing in-house solutions. Among the most impressive are super-regionals Fifth Third Bank ($142.2 billion), Regions Financial Corp. ($123.5 billion), and BBVA Compass ($69.6 billion), notes Miami-based bank consultant Charles Wendel. But many banks are content to cater to familiar customers and remain complacent. One result is that there’s been a steady diminution in the number of U.S. banks.

Over the past ten years, fully one-third of the country’s banks were swallowed whole in an acquisition, disappeared in a merger, failed, or otherwise closed their doors. There were 5,670 federally insured banks at the end of 2017, according to the Federal Deposit Insurance Corp., a 2,863-bank, 33.5% decrease from the 8,533 commercial banks operating in the U.S. in 2007.

It does appear that, to paraphrase an old expression, many banks “are going out of style.” In recent years there have been more banking industry deaths than births. Sixty-three banks have failed since 2013 through June while only 14 de novo banks have been launched. In Texas, which is known for having the most banks of any state in the country, only one newly minted bank debuted since 2009. (The Bank of Austin is the new kid on the Texas block, opening in a city known as a hotbed of technology with its “Silicon Hills.”)

One reason there’s so little enthusiasm among venture capitalists and other financial backers for investing in de novo banks is that regulators are known to be austere. “If you’re a company in the U.S.,” says Matt Burton, a founder of data analytics firm Orchard Platform Markets (which was recently acquired by Kabbage), “and you tell regulators that you want to grow by 100 percent a year – which is the scale you must grow at to get venture-capital funding – regulators will freak out. Bank regulators are very, very strict. That’s why you never hear about new banks achieving any sort of scale.”

But while bank regulators “are moving sluggishly compared to the rest of the world” in adapting to the fintech revolution, says Singleton, there are numerous signs that the status quo may be in for a surprising jolt. The Treasury Department is about to issue (possibly by the time this story is published) a major report recommending an across-the-board overhaul in the regulatory stance toward all nonbank financials, including fintechs. According to a report in The American Banker, Craig Phillips, counselor to Treasury Secretary Steven Mnuchin, told a trade group that the report would address regulatory shortcomings and especially “regulatory asymmetries” between fintech firms and regulated financial institutions.

Christopher Cole, Senior Regulatory Counsel, ICBA

Christopher Cole, senior regulatory counsel at the Independent Community Bankers Association—a Washington, D.C. trade association representing the country’s Main Street bankers—told deBanked that, among other things, the Treasury report would likely recommend “regulatory sandboxes.” (A regulatory sandbox allows businesses to experiment with innovative products, services, and business models in the marketplace, usually for a specified period of time.)

That’s an idea that fintech proponents have been drumming enthusiastically since it was pioneered in the U.K. a few years ago, and it’s something that the independent bankers’ lobby, whose member banks are among the most threatened by fintech small-business lenders, says it too can support. Treasury’s Phillips “has said in the past that he’d like to see a level playing field,” the ICBA’s Cole says. “So if (regulators) are going to allow a sandbox, any company could be involved, including a community bank. We agree with him, of course, because we’d like to take advantage of that.”

In March, 2018, Arizona became the first state to establish a regulatory sandbox when the governor signed a law directing that state’s attorney general (and not the state’s banking regulator) to oversee the program. The agency will begin taking applications in August with approval in 90 days, says Paul Watkins, civil litigation chief in the AG’s office. Watkins told deBanked that he’s been most surprised so far by “the degree of enthusiasm” from overseas companies. With the advent of the sandbox, he adds, “Landlocked Arizona has become a port state.”

The OCC, which is part of the Treasury Department, may also revive its plan to issue a national bank charter to fintechs, sources say (EDITOR’S NOTE: This had not yet been implemented before this story went to print. The OCC is now accepting such applications) – a hugely controversial proposal that was put on ice last year (and some thought left for dead) when former Commissioner Thomas J. Curry’s tenure ended last spring. At his departure, the fintech bank charter faced a lawsuit filed by both the New York State Banking Department and the Conference of State Bank Supervisors. (Since then, the lawsuit was tossed out by the courts on the ground that the case was not “ripe” – that is, it was too soon for plaintiffs to show injury).

Taussig, the regulatory expert at Kabbage, reports that the Comptroller of the Currency, Robert J. Otting, has promised “a thumbs-up or thumbs-down” decision by the end of July or early August on issuing fintechs a national bank charter. He counts himself as “hopeful” that OCC’s decision will see both of the regulator’s thumbs pointing north.

Margaret Liu, Deputy General Counsel, CSBS

The Conference of State Bank Supervisors, meanwhile, has extended an olive branch to the fintech community in the form of “Vision 2020.” CSBS touts the program as “an initiative to modernize state regulation of non-bank financial companies.” As part of Vision 2020, CSBS formed a 21-member “Fintech Industry Advisory Panel” with a recognizable roster of industry stalwarts: small business lenders Kabbage and OnDeck Capital are on board, as are consumer lenders like Funding Circle, LendUp and SoFi Lending Corp. The panel also boasts such heavyweights in payments as Amazon and Microsoft.

Working closely with the fintech industry is a “key component” of Vision 2020, Margaret Liu, deputy general counsel at CSBS, told deBanked in a recent telephone interview. CSBS and the fintech industry are “having a dialogue,” she says, “and we’re asking industry to work together (with us) and bring us a handful of top recommendations on what states can do to improve regulation of nonbanks in licensing, regulations, and examinations.

“We want to know,” she added, ‘What the main friction points are so that we can find a path forward. We want to hear their concerns and talk about pain points. We want them to know the states are not deaf and blind to their concerns.”