Partner Banking (BaaS) is a lifeline for struggling community banks

By Vince Curotto, Director, Klaros Group

Between heightened regulatory scrutiny of partner banking relationships with fintechs and fintechs facing their own headwinds in a tough market, it’s reasonable to conclude that now is a bad time to launch partner banking. But disruption breeds innovation. The challenges facing existing bilateral relationships between banks and fintech will open up opportunities for the emergence of new partner banks as the banking-as-a-service (BaaS) industry enters a new phase in its growth cycle. life. The current market environment not only presents an inescapable opportunity to launch banking services that meet the demands of regulators and fintech partners, but also offers a lifeline to community banks struggling to accelerate growth and increase the profitability of their current services.

The decades-long consolidation of community banking is a well-known trend among industry participants and observers. In 1989, there were over 15,000 bank charters in the United States; today, the number of charters is just under 4,800. Of the 4,800 banks in the United States, community banks—defined as banks with total assets of less than $10 billion— account for more than 95% of bank charters in circulation.

The trend towards banking consolidation will continue. Indeed, the annual consolidation rate since 1990 of 3.7% is equal to the last four quarters, but the drivers of consolidation have evolved. Since the financial crisis, increased regulatory and compliance costs have led to increased operating expenses. At the same time, a prolonged low rate environment put pressure on interest income, and much of the lending market shifted out of the banking sector. In other words, rising costs and shrinking revenue opportunities have reduced margins and, therefore, the overall profitability of community banks. And while Covid and the resulting PPP program has provided a temporary income boost to many, the more significant and longer-term effect of the pandemic is the need for banks to accelerate technology investments, adding additional pressure on an industry struggling to survive.

Faced with this bleak outlook, community banks have limited options. Most will choose to pursue their go-it-alone strategy. Many management teams are emboldened by an improving rate environment which should ease net interest margin pressure and improve the bank’s bottom line. Yet, in the longer term, the status quo for most community banks is insufficient given the disadvantages of the cost structure. Selling is of course a viable option, but as structural headwinds arise, buyers may be unwilling to pay significant premiums. A third option, and we believe is the best, for community banks is to leverage their most critical competitive advantage – their banking charter – to partner with fintechs and other non-banks to to unlock new areas of growth through partnerships. Investments in these partnerships will not only open up new areas of growth, but they will also allow banks to better serve their current markets by improving the bank’s technology infrastructure and risk functions.

After a decade of rapid growth, fintechs are facing their own operational headwinds that will force consolidation and eventually clear the playing field for successful, large-scale businesses that will demand resilience from their banking partners. Specifically, increased regulatory scrutiny of BaaS banks will raise the bar for these banks’ overall risk and compliance functions. To avoid disrupting their own business, fintechs will only partner with banks that have the most robust and resilient compliance programs. Additionally, fintechs will need better technologies from their partner banks, which can easily scale as fintech business grows. As fintechs continue to develop both existing and new products, the partner bank’s ability to adapt seamlessly to fintech (rather than force them to seek out a new partner bank) will prove vital.

Success in the partner bank is not guaranteed. While many community banks are ready to embark on this new path, most are ill-prepared, lacking the regulatory expertise, technological capabilities and, more often than not, the capital to successfully execute this strategic pivot.

Despite limited resources, some banks are better positioned than others. Critical factors increasing the likelihood of success include:

  • Alignment between a bank’s management team and its owners (and board buy-in) is obvious but essential and far from guaranteed.

  • A credible relationship between bank management and regulators, as buy-in from regulators will be necessary.

  • A clean business without legacy barriers (e.g. credit) allows the team to focus on execution.

  • An adaptable technology stack. It may not be intuitive, but one of the benefits of community banks’ underinvestment in technology is a “clean” technology stack that vendors and partners can build on without significantly disrupting infrastructure. existing.

While the partner bank business model faces serious challenges from both regulatory and market trends, we expect partner bank demand to continue to grow in the longer term. This imbalance between supply and demand creates a significant and growing opportunity for banks to meet the increasingly high bar set by their partners and regulators.