Signals 2/24: It's all fun and games until The Fed raises rates

Hey fintech friends,

The modern fintech landscape was born in a prolonged era of low interest rates, and for the most part it’s all that fintechs have ever known. This year the Fed is expected to raise rates as high as 2% (its steepest hike since 2005), and fintechs who pioneered – and built their businesses on – new models for delivering financial services will need to adapt to a world where capital is harder to come by.

Buckle up, we’re diving into how interest rate hikes are going to impact business for neobanks and fintech lenders.

Traditional banks thrive when interest rates rise. The basic business model of a bank is to 1. Collect customers’ deposits 2. Lend those deposits to borrowers 3. Profit from the difference between the interest that borrowers pay and the interest paid to depositors (AKA the net interest income). When interest rates go up, banks could raise rates for lenders and depositors by the same amount. It turns out, though, that banks are in the business of making money, and there’s a lot of money to be made by charging more for loans while keeping depository interest steady.

Neobanks operate on a different business model, primarily earning money from payment interchange and customer fees. Net interest income (NII) isn’t lucrative for neobanks because the activities that generate NII are only profitable if they’ve obtained a bank charter, which is– simply put– a huge pain in the ass. So neobanks like MoneyLion will wrap a partner bank that provides the underlying banking products through their own charter (in MoneyLion’s case, MetaBank). This helps neobanks avoid a lot of headache in getting to market but means that they miss out on net interest income, which is one of the largest revenue drivers in the traditional banking model.

Source data: JPMorgan Chase & Co.’s Q3’21 Earnings Release Financial Supplement  MoneyLion’s Q3‘21 10-Q

Rate hikes are bad news on the deposit side because neobanks offer relatively high yields on deposits to attract customers, generating a net loss that will compound when rates increase. You may be thinking: “Okay, so neobanks can just charge more for loans the way that traditional banks do and call it a day, right?”– and you’d be right, IF the neobank is chartered. Otherwise, they’d need to acquire lending licenses on a state-by-state basis (once again, huge pain). Consequently most neobanks don’t offer complex lending products like credit cards or mortgages.

As a number of neobanks gear up to IPO in 2022, investors will likely press questions around whether it makes financial sense for these companies to become chartered banks in order to capture net interest income like their traditional banking counterparts. This process could slowly (read: slowly) be getting easier– regulators Europe and the UK are already amenable to issuing bank licenses to fintechs like Monzo, N26, and Revolut. In approving Varo to become the first chartered neobank in the US in 2020, the OCC also signaled that they’d be open to having other fintechs join Varo’s ranks.

Pure play lenders don’t hold deposits that they can tap to issue credit. Instead, they fund loans by:

Like banks, lenders make profit on the spread between interest charged to borrowers and the cost of capital. Unlike banks, lenders don’t control their cost of capital, so when interest rates rise this spread tightens. Lenders can of course cushion the blow to profits by charging customers more in interest and fees. They’ll also need to reduce the cost side of the equation by getting creative in how they access capital.

The lender profitability playbook, in a nutshell.

One trick to lower capital costs is to bundle the loans that have been issued into securities and sell them to investors– otherwise known as debt securitization. We’re seeing lenders like Affirm and Upstart double down on this strategy, which lets them move the liability off their balance sheet, book gains up-front, and quickly re-deploy the funds to new loans. Securitization is costly and time-consuming (think 6-9 months at a cost in the mid-six figures per registration) so smaller fintech lenders historically haven’t taken part. The tide may now be turning, as Nelson Chu, Founder/CEO of Percent, explains: “Advancements in fintech infrastructure have reduced much of the effort required to create a securitized product and service it over the course of its life, making it possible for smaller issuers to do mini-securitizations that give them the track record needed to tap into broader institutional markets earlier than ever before.” Percent is one of the players leading the charge by offering smaller fintechs the technology to securitize loans at a fraction of traditional costs. As rates hikes prompt lenders to hone in on capital costs, we’ll likely see a greater number of fintechs spanning from early-stage startups to established platforms (👀Klarna) move towards securitization as a tool to bolster the bottom line.

Affirm is doubling down on securitized loans to shore up capital. From Affirm’s Q2 ‘22 Earnings Supplement.

Other players are looking beyond outside capital and moving to capture the sweet, sweet net interest income dynamics that banks get to enjoy, by… becoming banks? LendingClub broke new ground as the first fintech to acquire a bank when it bought Radius Bank in early 2020. SoFi followed suit and earlier this month finalized their acquisition of Golden Pacific Bank. Both LendingClub and SoFi nowlend customers' deposits instead of relying on costly outside capital, in LendingClub’s case widening interest spreads by over 3%, and it’s all thanks to  the fact that they’re operating under their own– drum roll please– ✨federal bank charter✨.

As interest rates increase after years of perpetual lows and the money printer starts to slow to a gentler brrr, fintechs will need to adjust their business models as a function of their exposure to rate hikes. Over the coming year or so, expect to see:

These playbooks will require new forms of technology to integrate, expanding the opportunity for tech infrastructure players to also play a role. Even though traditional banks haven’t been known for their sense of imagination, the combination of disruptive fintech companies, streamlined tech stacks, and cheaper access to capital could result in some really interesting fintech innovations.

- Sophie Vo