One of the best things about the Internet is that it both provides infrastructure for society but also demystifies that infrastructure. I’ve spent the last few years going deep on financial infrastructure while working at Stripe, and thought it might be useful to geek out about finance with software people and software with finance people.
Obligatory disclaimer: these are my own views, not those of anyone I am associated with.
Community Banking: The Dark Matter of the U.S. Financial System
The United States has many more banks than peer nations. There are more than 5,000 banks in the U.S. but only about 400 in each of the U.K. and Japan, for example. One reason for this is that the U.S. is dependent on community banks throughout much of the nation.
A community bank is a locally-oriented financial institution, generally much smaller than regional or national banks, focused largely on the “traditional business of banking” (taking deposits and lending) versus the capital markets functions that the “money center” banks also engage in.
Community banks are often assumed to run on small town values, glad handing, and sleepy scenes reminiscent of It’s A Wonderful Life. This causes them to be overlooked by technologists and the wider financial industry, to our mutual discredit. Community banks are actually financial dark matter; their market impact and the policy regime supporting them influence all Americans’ access to banking services and many fintech product offerings.
Sketch of a community bank
Let me sketch out a small software-enabled company with approximately 40 employees and a cap table that can fit around a dinner table:
The 50th percentile [community bank] … held nearly $169 million in total assets. … At a 4 percent margin (the difference between the yield on loans and the interest paid for deposits), a $169 million bank generates roughly $6.5 million in annual revenue. … [C]ommunity banking is essentially a highly regulated small business enterprise. [0]
Banks in the U.S. can be chartered by the federal government or the state; community banks (and their close cousins, credit unions) are dominantly chartered by states. They form the largest portion of the banking industry in exurbs and rural America; 20% of counties have no bank branch except through community banking [PDF]. While they’re smaller as a percentage of banking activity than they have been historically, they still represent about 10% of all loans and deposits kept in the country.
The business of a community bank is taking deposits cheaply and lending at a higher rate. Both of these functions are historically local in nature, but that is changing. Community banks sell themselves on convenience and having a human-centric relationship with customers, as opposed to the driven-by-algorithms approach of the money center banks.
The local nature of community banks is not just a source of warm fuzzies. It is also an important risk factor. If you are the bank in a factory town, and the factory closes, your deposits will be spent down (and so your cost of funding goes up) at the same time your loan customers suffer financial stress (and your credit quality deteriorates). This dynamic kills banks without diversified customer bases, particularly during financial crises. The global financial crisis is often remembered as a cautionary tale about big banks and the global financial system, but the friendly bank on Main Street suffered the worst; over 400 banks failed between 2008 and 2011. More than 85% were prototypical community banks; small, local institutions with less than $1 billion in deposits.
The financial system is a policy arm
The U.S.’s financial system is best conceived of as a public/private partnership. Each financial institution is in constant competition with all others for customer relationships, deposits, loans, and ancillary product revenue. However, the government does put a thumb on the scale, particularly for politically powerful groups.
Community banks are surprisingly powerful in the U.S., largely because they are very popular with their customers relative to Big Finance, they are indispensable for politically powerful local groups like landlords, real estate developers, and farmers through their commercial loan books, and they have earned an appealing narrative about financial access. It is difficult to overstate how dependent commercial real estate is on community banks in much of the country, and it is a symbiotic relationship; the investors who organize them are usually local business owners with heavy real estate interests.
Branches are not cheap to create or operate, and the large banks concentrate them in densely populated areas with relatively wealthy customers and businesses nearby. Community banks are willing to take worse economics to have branches in places where the large banks don’t; this keeps those places tied to the national financial system.
This is a policy aim of the government, both due to the economic impacts and because most residents being banked is core to orderly provision of benefits, taxation, and other government functions. A bank branch is a retail point-of-presence for the SSA getting funds to a pensioner, for the IRS collecting payroll taxes, and for the DEA interdicting fentanyl, staffed and funded by the private sector.
Impact of community banking outside the system
Because the continued existence and thriving of community banking is a policy goal, regulations or competitive measures which would disfavor them versus the large banks and other financial players are actively undermined. Fintech frequently feels the ripples of this.
Many technologists ask why ACH payments were so slow for so long, and come to the conclusion that banks are technically incompetent. Close but no cigar. The large money center banks which have buildings upon buildings of programmers shaving microseconds off their trade execution times are not that intimidated by running batch processes twice a day. They could even negotiate bilateral real-time APIs to do so, among the fraternity of banks that have programmers on staff, and indeed in some cases they have.
Community banks mostly don’t have programmers on staff, and are reliant on the so-called “core processors” like Fiserv, Jack Henry & Associates and Fidelity National Information Services. These companies specialize in extremely expensive SaaS that their customers literally can't operate without. They are responsible for thousands of customers using related but heavily customized systems. Those customers often operate with minimal technical sophistication, no margin for error, disconcertingly few testing environments, and several dozen separate, toothy, mutually incompatible regulatory regimes they’re responsible to.
This is the largest reason why in-place upgrades to the U.S. financial system are slow. Coordinating the Faster ACH rollout took years, and the community bank lobby was loudly in favor of delaying it, to avoid disadvantaging themselves competitively versus banks with more capability to write software (and otherwise adapt operationally to the challenges same-day ACH posed).
Durbin Exempt Interchange
In the wake of the global financial crisis, a broad swathe of reforms was passed to clip the wings of the financial industry. One amendment to the 2010 Dodd-Frank bill, named for its sponsor Senator Durbin, imposed a limitation on the amount of interchange that could be charged on debit card transactions. The amendment had a carve-out for smaller financial institutions with less than $10 billion in assets.
A full recounting of the effects of the Durbin amendment would have to cover free checking accounts, insufficient funds fees, and the competitive dynamics of interchange within a multi-sided credit card ecosystem. The part most relevant to technologists, however, is that the Durbin exemption for small financial institutions makes debit cards very lucrative if and only if they are issued by a small financial institution.
Think of a fintech company with a debit card. Square’s Cash App. Chime. Robinhood. Stripe Issuing, and users like Ramp and Bench. All of them, virtually without exemption, are brought to you courtesy of a small financial institution that you are unlikely to have heard of (unless you work in fintech or read Terms and Conditions for fun). Durbin exempt interchange is the revenue model which got a thousand pitch decks funded, because it is free to the ultimate consumer and protected by a moat guaranteed (for the moment) by Uncle Sam, contingent on the consumer choosing to use your app’s card.
This let a generation of those apps compete on user experience without being crushed by large banks' pricing power. Customer acquisition for fintechs would be difficult if you could walk into any of the top ten banks and walk out with a 1% rewards debit card (which previously existed but don't anymore at large institutions, due to the Durbin amendment capping their revenue substantially lower than that).
Fintech as the banks’ Finfriendemy
Fintech has a complicated relationship with community banking. Community banks had already suffered some of their business leaking to larger banks as banking moved increasingly online, but were not worried about large banks competing with them from branches in their core markets. The math never penciled out.
Online customer acquisition, however, has allowed well-funded fintechs to provide better services cheaper than the local small business financial institution. Some customers are voting with their wallets. This has become even more acute during the pandemic, when footfalls (the delightful bricks-and-mortar phrase for what technologists might call eyeballs) at branches declined precipitously. One of the key themes for the industry in the past year has been maintaining the sense of human connection with someone who never sees your staff anymore.
At the same time, partnering with fintechs has allowed some community banks to greatly strengthen their franchises. Cross River Bank is an interesting example; a major line of their business is originating loans for fintechs which are then largely sold to funding sources that the fintech has lined up (such as investors looking for yield in a low interest environment). This gives CRB an interesting cross section of credit risk across the U.S. footprint of their customers’ customers rather than just the credit risk local to the bank in New Jersey, and allows them to share in the risk with the fintech and associated lenders rather than taking it entirely themselves.
One commentator [1] waggishly described Affirm as an API between Peloton and CRB, due to Peloton being a very large account at the time of their IPO. This is probably unfair to all three parties; ~30% revenue concentration is certainly notable, but each company is in a very different business. None could engineer their to the desired user experience without both other partners.
It is an open question as to whether many community banks are positioned to create niches like this for themselves in the Internet economy. One model that reduces the sophistication required and level of strategic risk is platforms providing them capabilities which bolt onto the traditional business of banking.
Brokered deposits are one example of a function which is increasingly becoming a platform. Banks use deposits as a cheap source of funding for loans, but the growth of deposits in a local community is constrained by, among other things, the underlying economic growth of the community, and banks might max out their deposit base without being able to serve the demand for loans in their community. The traditional remedy is tapping deposit “brokers” outside the community, who largely represent large, sophisticated pools of money which will go anywhere with nationally competitive interest rates.
In recent years this is getting intermediated by software rather than by people serially negotiating over phones on a daily basis, to the mutual benefit of community banks, firms which have lots of end users with deposits, and those end users.
This model forms a major portion of the revenue mix for virtually every discount brokerage (with the notable exception of Robinhood). A brokerage might have billions of dollars of customer cash on hand but, if it doesn’t have an affiliated bank, very limited ability to turn that cash into net interest revenue.
A platform like StoneCastle intermediates between the brokerage and banks, solving both incredibly fun operational challenges of storing and moving money, and effectively bidding the deposits out daily to the banks most willing to pay to support their loan books. The brokerage's customers get FDIC insurance on their deposits and liquidity which might feel quite close to cash. Meanwhile, the net interest spread the broker collects for this subsidizes the other services of the brokerage. This allows them to offer e.g. commission-free trading and asset management "for free." (It is popularly believed that payment for order flow is the primary subsidy brokerages receive. This belief is straightforwardly wrong for every brokerage except Robinhood.)
Brokerages have gigantic staffs of engineers, customer support agents, and other professionals. All of them are paid for by, effectively, the imbalance between checking account balances and demand for commercial real estate loans at a particular small bank in Kansas.
The financial infrastructure the world rests atop of causes many underappreciated ripples in our lives. It is full of these delightful rabbit holes. I hope to explore many of them with you in future issues of Bits about Money.
Further reading
[0] This quote is from The Most Fun I Never Want to Have Again, a swashbuckling startup tale about a Georgia community bank. It is part personal career narrative, part fundraising journey, part paean to the public image of community banking, and part behind-the-curtain look at how sophisticated executives at them evaluate their own success. Highly recommended.
[1] Marc Rubinstein, the above cited waggish commentator, writes a monthly newsletter on banking which is compulsory reading for anyone interested in the space.
The community banking community itself publishes surprisingly many podcasts, particularly during the coronavirus era. They’re an interesting mix of marketing content, shooting the breeze with peer professionals, and (to mangle the Picasso observation) artists getting together and passionately talking about where to find cheap turpentine. I particularly enjoyed an episode about the business benefits of colocating a cafe (even when, as it turns out, regulations forbid a bank from actually selling coffee).
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I write about the intersection of tech and finance, approximately biweekly. It's free.