Executive summary
Many non-banks consider acquiring a bank, or establishing a de novo bank, to serve their customers and capture the various benefits afforded to a bank. Before embarking on this strategy, it is critical to determine the order of magnitude of the benefits as well as the costs of operating in the tightly controlled bank environment.
There are three key benefits for non-banks: lower borrowing cost, savings on payment processing fees, and the value of low-cost deposits. On the cost side, myriad regulations, administrative burdens, and compliance requirements must be weighed against them.
A non-bank that can transfer loan receivables to a bank, for example the loan pipeline of a mortgage bank or loans made by a non-bank finance company, benefits from lower borrowing costs. Payments business, including wires, ACH, debit card, and credit card, flows through banks, so those fees remain in the new bank. And deposits are valuable, with franchise value rising to the extent the company controls them.
Borrowing cost
Borrowing costs for non-bank finance companies are usually far higher than bank costs. Non-bank finance companies are never on a level playing field relative to their bank competitors, and since interest expense is effectively their cost of goods sold, borrowing costs matter enormously. As a result, non-bank finance companies are often only successful with products or customers that banks do not serve. Alternatively, non-banks may follow an originate-to-distribute model where loans are not held to maturity, so the borrowing cost disadvantage matters less.
Examples of non-bank assets span consumer and commercial customers. Consumer finance companies write personal installment loans or serve non-prime customers, or both. Commercial finance companies handle factoring, mezzanine debt, leasing, and other products, or serve clients that do not fit inside the normal bank loan box.
Meanwhile, banks face Community Reinvestment Act pressure to serve the under-banked. In some cases it makes sense to combine non-bank and bank portfolios, primarily to lower the non-bank's borrowing cost but also to serve underserved communities. In place of a payday loan, a bank can offer overdraft protection for a fee that achieves similar economics, and overdraft and insufficient funds fees are often a significant part of bank fee income. The Community Reinvestment Act encourages banks to lend actively in their communities so that their portfolio reflects the entire community, especially the marginalized segments.
Mortgage banks in particular can dramatically lower borrowing cost and boost profitability as a bank. A typical mortgage bank finances its pipeline of loans closed with borrowers but not yet sold to investors at a rate of LIBOR plus 2 to 3 percent. The same loans, when pledged as collateral to the Federal Home Loan Bank, can be financed at LIBOR flat. Assuming a 30-day hold period, that amounts to a 20 basis point increase in profit margin, which is substantial given that the average margin is normally about 40 basis points.
In the fintech space, lenders originate to distribute in order to minimize their cost of borrowing, serving as intermediaries connecting borrowers with lenders, typically banks, investors, or peer-to-peer networks.
There is no free lunch. Banks come with tighter regulation. Moving non-bank activities into a bank requires a carefully constructed business plan examining the loss history of the new asset type as well as scenario-based stress testing. In the right situation, borrowing cost savings alone can make it worthwhile.
Payments and transaction processing
Non-bank lenders can save by running transactions through their own bank. Mortgage banks, for example, wire funds to the title company or closing agent, who in turn wires funds to pay off any existing mortgage and wires the rest to the seller. As a bank providing title services, the company can avoid all three wire fees. Wire fees alone can make it profitable for a title company to buy a bank. Then, when servicing the mortgages, fees for card payments or setting up transfers are kept by the bank.
Consumer finance companies can capture ATM fees and debit card interchange revenue. Banks earn fees with every swipe of a consumer's card, and to the extent that consumer finance non-banks can direct this traffic in house as a bank, they capture the revenue stream.
Fintech companies are disintermediating both bank and finance company service offerings. Some are obtaining bank charters or pursuing partnership and vendor agreements. Considering the technology spend at large banks, one could argue they operate captive fintech companies. For the most part fintechs are better positioned to manage transaction volume than to hold assets on a balance sheet, so when a fintech pursues a bank charter it is usually about controlling the payments process.
Getting paid for deposits
Mortgage servicers control escrow deposits, which are core deposits. Escrows vary state by state but can average as much as 1 percent of the principal balance of mortgages serviced. Bringing these balances in house increases non-interest-bearing deposits and can dramatically increase the franchise value of a bank.
Consumer finance customers hold one type of deposit: prepaid card balances. Bankers do not normally think of sub-prime consumers as deposit customers because they have low savings balances, but these customers often use prepaid cards to meet their needs. Every time a card is loaded, those funds become a deposit somewhere. Controlling these balances is often an ancillary benefit when a finance company considers a bank charter.
Fintechs and digital banking are disrupting the core deposit business. Fintechs are pursuing deposit customers, in some cases encouraging traditional depositors to become investors. Online account opening has enabled many banks to advertise, attract customers, open accounts, and grow deposits without branches or staff intervention, a business model that fits the core competencies of many fintechs.
Regulatory considerations
It is never easy for a non-bank to become a bank. From an approval perspective, bank regulators focus first on credit risk, then interest rate and liquidity risk, and finally operating risk. Evaluating a deal should address these risks in that order.
Credit risk needs to be nailed down. Banks face severe restrictions on loans to officers, directors, and material shareholders under Regulation O, as well as loans to affiliates under Regulation W. These rules are tight enough that most banks simply avoid lending to employees, even overdrafts, and to affiliates. To the extent the deal takes advantage of lower borrowing cost, the assets financed need to be creditworthy. The bank's credit policy must address the new class of assets by setting limits on borrower eligibility and concentrations.
Financial risks like interest rate and liquidity risk can usually be covered by setting and consistently meeting conservative policy limits.
Operational risk depends on whether current practices and procedures are tightly controlled. Bank regulators' requirements for a tightly controlled operating environment are a hurdle for most non-banks. Think of today's bank vault as the core system and the IT infrastructure as the security guard.
The business plan must address protocol and performance metrics used to manage risk within internal processes, vendor management protocols, disciplined change management and structured project management, customer privacy protections and data sharing protocols, risk assessments for new products and new operational practices and new technology, business continuity and operational resilience practices and the testing of them, information security, and management and board governance routines.
Governance, policies, and risk practices are equally critical. The governance plan must include the roles, responsibilities, and management routines of the board of directors, its committees, senior management, and management committees. Compliance practices and financial crime programs need to be robust, including anti-money laundering and know your customer, fair lending, and many others.
Regulation W and transactions with affiliates
Regulation W limits transactions between a bank and its affiliates. Any company or individual within the same corporate family or under common control is deemed an affiliate. Restrictions include limits on lending, capped at 10 percent of the bank's capital; processing payments, which must be at the same service level and pricing as other customers; and other transactions between a bank and its affiliates, which must be on fair market terms.
Conclusion
Evaluating the cost and benefit trade-off of becoming a bank is important for many non-banks. Endurance Advisory addresses these topics proactively, helping institutions understand what a bank charter would require, which businesses fit inside the bank, and how to design an acquisition plan that will achieve approval. Our team has deep risk, operational, and technology expertise in banking and mortgage, and direct experience with the complexities of non-bank conversions.
It is difficult and time-consuming for a non-bank to get into the banking business. Endurance has worked with private equity investors, family offices, and mortgage companies through bank merger and acquisition approvals.
