Banks can trump Fintech at the end of the zero rate era


This is the third column in a Heard on the Street series on the end of zero interest rates.

Disrupting the banks when interest rates are close to zero is kind of playing on easy mode. As the rates increase, the game will become more difficult, but not impossible.

Banking activity has fragmented in recent years. Businesses such as finance companies, providing mortgages, trading fast-moving markets, and providing consumer loans have migrated to so-called “shadow banks” or fintech startups. Regulation, technology and the banks’ own missteps have played their part in this change. But one of the main drivers has been cheap financing.

Historically, banks have an advantage when they get other people’s money, lend it out, and collect the difference in interest rates. This is because they have deposits, a very cheap form of borrowing. This advantage diminishes, however, when markets are flooded with liquidity and investors are willing to provide it in a desperate search for yield.

So, with interest rates rising and money not flowing as freely, the question is whether new entrants who have thrived on market financing will again be disadvantaged.

Even a glimmer of this dynamic can spook investors. Affirm Holdings AFRM 10.78%

offers consumers short-term loans and installment payments for “buy now, pay later” purchases, which it finances through a combination of loan sales, securitization transactions and lines of credit from banks. It decided to suspend a securitization deal in mid-March, as other issuers have recently done. Affirm had plentiful funding from other sources, but its shares still fell more than 15% on the day of the news.

Savvy investors, however, should look for fintech companies that may continue to have a technological or business advantage. For example, with Affirm, installment payments are so short-term that financing costs are only a relatively small part of the equation. The same pot of money can spin multiple times. The big banks are not really in direct competition, often offering variable rate card loans. Merchants might be willing to pay Affirm more to allow zero-rate financing to customers when rates are higher.

New players can also adopt different financing models. Upstart Holdings UPST 7.63%

works with banks to allow them to make loans using its artificial intelligence-based underwriting technology; its financing costs are in fact their financing costs. Some online consumer lenders have even become deposit takers themselves: LendingClub LC 2.56%

acquired a bank and now uses deposits to fund loans. The same lending volume of around $3 billion in the fourth quarter brought in almost $30 million more than the same period in 2019.

One thing that makes deposits so attractive is that even though these rates track headline rates, they tend to lag, what’s called a low ‘beta’, because it can be difficult for people to change banking relationship. Deposits have increased during the pandemic, which means banks could be content to let some customers go before raising rates too much.

Many analysts actually think betas could be high now, in part because the Federal Reserve is expected to move so quickly. Rapid rate jumps tend to wake up depositors. Notably, the Consumer Financial Protection Bureau said it would monitor whether banks compete effectively for customers’ money. Fintechs that have dabbled in banking – the so-called neobanks – could aim to lure customers in with attractive deposit rates. However, higher costs of equity as rates rise will make it harder to maintain loss-making strategies to capture market share.

Rather than financing, investors might want to monitor credit. Along with cheap financing, loan losses due to non-payment have been very low recently. As long as a lender can pass on higher rates to consumers, they can adjust to financing costs. But if those higher rates start to cause more missed payments or defaults, especially as other consumer spending also increases, investors will demand more compensation to fund the loans.

After all, financing costs ultimately reflect risk. The difficulty level of the game may change, but the rules rarely change.

The Federal Reserve’s primary tool for managing the economy is changing the federal funds rate, which can affect not only borrowing costs for consumers, but also influence broader business decisions, such as the number of people to hire. The WSJ explains how the Fed manipulates this single rate to guide the entire economy. Illustration: Jacob Reynolds

Write to Telis demos at [email protected]

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