Fintech and the Banks: An Evolution

Milton Ezrati

Chief Economist

The relationship has almost come full circle.  A little over a decade ago, the banks entirely dominated lending.  All but the largest businesses, which relied on the bond market, came to them.   Community banks had a lock on small business lending.  Beginning in earnest about ten years ago what journalists refer to ominously as “shadow banking” began to use emerging technologies to challenge this bank monopoly, most especially community banks.  These so-called fintech applications gained ground rapidly.  But then, typical of capitalism generally and American capitalism, in particular, matters changed yet again.  Banks began to alter and, in some instances, jettison their old business models and apply fintech themselves and do so in imaginative ways.  This move has shadowed the difference between shadow and traditional banking and opened still more opportunities for customers.

Phase one of this process began right after the financial crisis and the great recession of 2008-09.  Then, bankers, for obvious reasons, decided to pull away from risk, especially in real estate and small business lending.  It is easy to understand why.  The crisis and recession had bankrupted many small- and medium-sized businesses and, were it not for the government rescues, the losses would have brought down many banks.  At the same time, regulatory demands, especially from the Dodd-Frank financial reform legislation, imposed tremendous restraints on bank risk-taking.  The Fed’s desire in the crisis to bring short interest rates down to zero further encouraged the banks’ retreat by giving them a substitute.  Rather than lending, they took advantage of the huge gap between what they paid for short-term funds and what they could get on long bond yields, or as the traders say, arbitraged along the yield curve.

But borrowers – small businesses and others – still sought credit.  Fintech opened the way to get funds to these eager borrowers.  Technology users introduced a mind-boggling array of business models.  Aside from the luxury of lying outside the burdens imposed by arcane banking regulations, the fintech “shadow banking system” drew strength from technologies that introduced newer and more powerful ways to collect and process data.  Rapidly, peer-to-peer lending, on which the fintech “shadow” lenders were already making comparatively large and unsecured business loans, expanded to other sources of funds, from private equity and banks, even those with which they competed.

The banks soon found themselves at a tremendous disadvantage.  Fintech introduced non-traditional credit tests that made the loan application process faster and less onerous than at the banks.  Because the technologies enable “shadow” lenders to reduce risk with new monitoring techniques and using their technological prowess to arrange payments through automatic deductions from incoming receipts, the whole package also allowed the “shadow” lenders to pass borrowers more quickly, securely, and effectively and lend at more attractive rates than the banks would offer.  Fintech’s command of data allowed “shadow” lenders more flexibility than the banks, allowing them to offer credit more readily by making trade-offs between interest rates, loan commitments, and lending limits, something infinitely more appealing than the bank practice of simply saying yes or no according to standard arrangements.  Most devastating to the banks, the data use of the “shadow” system ran around the one great advantage community banks had in small business lending: knowing the borrower.  It is hardly surprising then that after the introduction of the fintech alterative, one-fifth of the nation’s community banks closed their doors.

Over time the realization of fintech’s superiorities has driven the banks began to close the circle, render it “unbroken” in the words of the old hymn.  Of course, the Fed, having raised rates, has inadvertently spurred the banks on.  By raising short-term rates and so narrowing the gap between short rates and long yields, it rendered the bank’s old arbitrage strategy much less profitable.  But the bankers always knew that that game could not last forever.  The primary spur to change came from the competition’s clear superiorities.  Larger banks have begun to build their own fintech divisions and in many cases have acquired the competition.  Smaller community banks have also made acquisitions.  More interesting and perhaps indicative of the future are the cooperative links community banks are forging with their one-time fintech rivals.

These associations have enabled both banks and fintech non-banks to better serve customers than either could independently.  Through them, community banks can not only ride the new technologies but when regulation or bank practice prevents lending, these arrangements give community banks options beyond the simple rejection that once was their only choice. Now if need be they can now refer a would-be borrower to a more flexible non-bank lender that might have a way to advance credit.  Non-bank lenders gain from the associations as well, finding more secure sources of funding from the bank or banks with which they associate themselves.  They can also use the bank partners to gain exposure to a broader population of potential customers and a means to offer existing customers banking services that these notoriously short-staffed operations could not when they operated entirely independently.

Society, it seems, has also begun to realize benefits.   With these associations, customers for financial services have at their disposal more complete information about their options than previously and, because the associations have brought together regulated and non-regulated firms, greater transparency as well.  At the same time, the regulations imposed on banks have begun to influence the non-bank sector in ways that they did not when the divide was sharper.  The frequent media warnings about the astronomical growth of non-bank lending many remain serious, but these latest steps in this story draw out some of their sting.

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