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Small banks you've never heard of are quietly enabling the tech takeover of the financial industry


February 15, 2019

5 min read


February 15, 2019

Small banks you've never heard of are quietly enabling the tech takeover of the financial industry

  • They aren’t from Wall Street. Roughly two dozen banks, such as Cross River Bank, Sutton Bank, Celtic Bank and Evolve, are the ones handling the “financial” side of billion-dollar financial technology start-ups.

  • By forming these partnerships, the banks handle the federally regulated side while start-ups focus on building apps and platforms for digitally savvy consumers.

  • But experts say there are risks to such relationships, from hidden credit risks to hesitant regulators.

Instead of trying to beat a wave of high-growth financial technology start-ups at their own game, a group of small banks is opting to join them.

These low-profile community banks quietly run the plumbing underneath billion-dollar fintech firms such as Square, Stripe and Robinhood — handling mundane banking activities for them like holding customer deposits and underwriting loans — while the tech firms remake finance for a digital age.

For some, it's a match made in heaven. These smaller banks, with names like Cross River, Celtic, Sutton Bank and Evolve, say they don't care about having a household name so much as they need new lines of business as consumers increasingly switch to mobile banking. And the fintech companies, adept at luring new customers at a low cost, need the blessing of federal regulators and someone else to handle the money.

The booming fintech industry has been pegged as the ultimate bank "disruptor." Technology spending has put pressure on even the biggest banks, which are trying to compete with the likes of J.P. Morgan's commitment to spend $10.8 billion on technology in 2018. Southern regional giants BB&T and SunTrust announced a $66 billion merger last week, which will make them the sixth-biggest U.S. bank by assets. A huge motivator of that deal was the need to compete on technology, both CEOs said.

Community banks that work with fintech companies have found a way to do that without the heavy lifting.

"A few years back there was a lot of disruption talk about how the fintechs were going to destroy the banks," said Jo Ann Barefoot, co-founder of Hummingbird Regtech and a former deputy U.S. Comptroller of the Currency, which regulates national banks. "There's much more talk in the last few years about the need to partner."

Reviving community banks

Large and small banks alike needed a face-lift after the 2008 financial crisis. The number of commercial banks has dropped to 4,703 as of the end of last year from more than 7,000 a decade ago, according to the Federal Deposit Insurance Corporation. There were more than 12,000 banks in 1990. Since then, banks have failed or folded into larger competitors.

"All banks were struggling after the financial crisis," said Karen Mills, a senior fellow at Harvard Business School and former head of the U.S. Small Business Administration during the Obama administration. "It was tough for community banks to recover, particularly in small business lending."

Fintech companies filled a void left by some of those struggling banks. These young companies are still moving into everything from lending to mobile payments to financial advising, making the most of consumers' changing behavior and attachment to smartphones.

Some banks took it as an opportunity for their own "revival," Mills said.

Evolve Bank & Trust was among them. The bank formed in 1925 as First State Bank to lend to local farmers in Cross County, Arkansas, about an hour's drive from the Tennessee border. It became a member of the Federal Deposit Insurance Corporation in 1934, when President Franklin D. Roosevelt was president. In 2005, new owners bought it and renamed it.

Luckily for the new owners, the bank was "small and clean" and had none of the mortgage-backed security issues that brought down some of its peers in 2008, its chairman said.

"We saw fintech coming down the pipeline, and really embraced it as another avenue for us to get deposits," Evolve Bank chairman Scot Lenoir said in a recent interview. "We decided from a strategic standpoint why not embrace that and collaborate with them?"

Global financing for the fintech industry hit a new record in 2018, according to a recent report from CB Insights. The amount of venture capital money pouring into fintech climbed to $39 billion, more than double what it was a year earlier, according to the report. There are now 39 fintech "unicorns," or private companies valued at more than $1 billion, across the globe.

Hummingbird's Barefoot pointed out the struggles smaller banks have keeping up in a changing industry: They use older technology; their physical branches are proving less necessary as consumers go mobile; and they are highly regulated.

But they also have natural advantages that make them attractive for fintech start-ups. The banks already have customers, their ability to take deposits gives them a ready pile of low-cost funds, and they already have permission from regulators to conduct banking business.

Evolve's fintech-related business is its fastest-growing by far, with more than 200 percent deposit growth month over month and almost no advertising spending. "We're not Citi, we're not Wells Fargo — we're not spending that money to be a brand, which is a long expensive road," Lenoir said.

Another advantage a small bank has is ability to move quickly, said Cross River Bank CEO Gilles Gade, a former investment banker at Barclays Capital and Bear Stearns. A meeting with a big Wall Street bank can take months to set up, he said, and getting regulatory approval for a bank charter takes even longer.

Cross River, which works with fintechs such as Coinbase and RocketLoans, started around the same time as Evolve. As a bank with responsibility for abiding regulatory rules on anti-money laundering and internal accounting controls, Cross River has a role in how the fintech industry is taking shape.

Banking regulators expect them to be the ones checking that the fintech start-ups are following the rules, which often means turning away business. Last year, Cross River signed 250 nondisclosure agreements for multipurpose loans and ended up signing only 14 new fintech partners. The process can be self-selecting, he said.

"The platforms get weeded out by the process because of the amount of compliance that we require them to implement — others disappear just because they were denied funding or didn't have adequate controls," said Gade.

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