Fintechs are not banks, here’s why that’s a good thing

Since the unraveling of the most well-known bank in Silicon Valley earlier this year, we’ve received many questions from founders about Fintechs, Neobanks, and actual banks. They are concerned with how their money is protected, what safeguards are in place, where their money goes, and ultimately who is responsible. They’re also interested in understanding how Fintechs can offer banking services to them and why Fintechs can offer higher FDIC coverage than traditional banks. If you are in a similar boat and have questions about how banking works and the types of banks that exist, then this guide is for you. The one thing to take away? Fintechs are not banks and that’s a good thing—let’s dive in!

An overview of traditional banks

Before we dive into some of the more advanced concepts around banking, we figured it would be helpful to provide an overview of what a traditional bank is. Traditional banks are what most people would consider “actual” banks. They have physical branches with teller lines, ATMs, and a vault, as well as personal bankers, mortgage loan officers, and business bankers onsite. Traditional banks have banking charters, and as such, they can invest and lend out their customer’s deposits.

Traditional banks generate revenue primarily through two avenues: deposits and credit.

• Deposits - banks generate revenue through the float between the rates they receive for lending funds to other banks, which is tied to the Federal Reserve (EFFR), and the yield they pay out to depositors. Check out this guide for more information on how and why bank deposits generate yield. 
• Credit - banks generate revenue by charging interest on the loans they provide to startups and small businesses (lines of credit, venture debt…etc), and consumers (auto loans, mortgages…etc).  

In addition to these avenues, traditional banks also generate revenue by charging exorbitant banking fees, charging fees for the basic banking features, processing transactions (interchange revenues), and providing investment banking and brokerage services.

An overview of Neobanks 

Neobanks, also known as “challenger banks”, do not have a physical presence, they operate completely online. Some of the more well-known Neobanks include Chime, Varo, and Sofi, they provide a wide range of banking services, budgeting tools, integrated payments, and more. Due to their low-cost nature, these Neobanks offer a host of benefits over traditional banks:

• Low/No Fees - Neobanks typically don’t charge fees on essential banking products and services.
• Digital First - Neobanks have best-in-class UI and UX and have built integrations with other technology providers: accounting, payroll, subscriptions & billing…etc.
• Feature Rich - Neobanks typically offer a wider range of services and features than traditional banks, such as embedded financing, budgeting tools, and financial insights.

Some Neobanks have a banking charter, while others do not. Those who do not, are not legally allowed to take custody of or lend out their customers’ deposits. They must rely on partner banks, with actual banking charters to provide banking services and are known as “Fintechs”.

For more information, check out this guide on traditional banks vs Neobanks.

An overview of “Fintechs” and partner banks

If you’re in the market for your first bank account or a new bank account, you’ve likely come across this disclaimer: “XXXX is a financial technology company, not a bank. Banking services are provided by YYY”. If you see this disclaimer, don’t fret — it simply means that the company does not have a banking charter. As such, they must rely on a partner bank (or a series of partner banks) to provide white-labeled banking services.

You can think of Fintechs, as operating similarly to Lyft: Fintechs provide the interface that allows a startup to deposit, withdraw or transfer funds, in the same way, that Lyft provides the interface and technology that connects drivers to riders. The partner banks are the drivers that ultimately serve the end depositors, even though the depositors solely interact with the Fintechs. The Fintechs provide customer service, pay out the yield…etc.

Partner banks, on the other hand, provide the regulatory compliance, infrastructure, and expertise that enables the money to move. They also:

• Process the ACH, Wires, and RTP payments
• Facilitate the automated bill payments
• Offer money market accounts and money market funds
• Offer brokerage accounts that are used to set up T-Bill Ladders
• Are protected by FDIC Insurance or SIPC Coverage

Fintechs multiply this FDIC coverage, by leveraging cash sweeps to disburse a startup's cash across a series of partner banks. For example, if a startup has $10M in cash parked in a single traditional bank, only $250k would be covered, and the remaining $9.75M would be at risk. Fintechs take the $10M and disburse it over 40 FDIC-Insured banks to protect the total amount. Even though the startup technically has 40 accounts, they only see a single account in their dashboard. Check out this guide for more information on maximizing FDIC insurance through cash sweeps and partner bank programs.

Even though partner banks offer the basic banking infrastructure, most Fintechs prefer to work with an intermediary, that provides “Banking-as-a-Service”.

An overview of “Banking-as-a-Service”

Banking-as-a-Service (BaaS) refers to a model in which non-bank financial institutions (Fintech) can leverage the infrastructure and services of licensed banks (through APIs) to provide financial services to their customers. These APIs enable companies to access banking services, such as account creation, transactions, and payments, and to offer these services to their customers under their branding without having to invest in costly banking infrastructure or regulatory compliance.

Some of the most common services that BaaS enables include:

• Digital Banking - BaaS allows Fintechs to offer digital banking services such as account opening, deposits, withdrawals, and other basic banking features through a mobile application or web portal.
• Payment Services - BaaS enables Fintechs to offer payment services such as online transactions, mobile payments, and RTP payments.
• Lending Services - BaaS allows Fintechs to offer lending services such as revenue-based financing and venture debt to other startups, and personal loans and mortgages to consumers.
• Investment Services - BaaS enables businesses to offer investment services such as treasury management, brokerage services, and robo-advisory.
• Compliance Services - BaaS enables businesses to access the regulatory compliance and anti-money laundering infrastructure of established financial institutions.

Here’s how you can think of BaaS in the context of the Lyft example used above:

• Fintech - Acts as Lyft, by providing the interface that riders interact with
• Partner bank - Acts as the driver that picks up the rider
• Depositor - Acts as the rider, which books the transportation through the Lyft app 
• BaaS - Acts as the cell phone that the Lyft app runs on

When Fintechs integrate directly with the partner bank, without involving a BaaS provider, they effectively act as both the phone and the app that the end consumer interacts with. This is beneficial as they can build deeper integrations and minimize the points of failure. That said, while some Fintechs have built this direct connection, most choose to use a BaaS provider as it speeds up the development timeline and subsequent time-to-market.

The most popular banking-as-a-service providers include: 

• Intergiro - the all-in-one embedded financial toolkit that helps Fintechs build financial services into their products.
• Solaris - Europe’s leading embedded finance platform that enables businesses to easily provide trusted and innovative financial experiences to their customers through smart APIs.
• Stripe - the financial infrastructure startup that helps companies embed financial services into their marketplace or platform.
• Treasury Prime - that builds API banking technology to improve the economics of banking to empower transformative financial services.
• Unit -  the platform that “powers the next generation of financial services” through its  simple and powerful banking-as-a-service API that helps companies launch new banking products in weeks - not years.

The mechanics behind how Fintechs make money & pass along yield to end users

Now that you understand how Fintechs, partner banks, and BaaS providers interface, the next logical question is how do Fintechs make money if they’re not real banks and how do they pass along yield to their depositors—the answer is quite simple.

• Checking or savings accounts - For deposits stored in these accounts, Fintechs earn a percentage of the effective federal funds rate (EFFR) that their partner bank receives. Their BaaS provider keeps some of this amount, their depositors get some of this amount and the remainder is what they keep as revenue. 
• Money market funds or brokerage accounts - For deposits stored in these accounts, Fintechs typically take a management fee. This can be structured as a flat monthly access fee or a percentage of the assets under management. Note: most Fintechs do NOT have a broker license, and thus you’ll find a disclaimer like this on their site: “XXXXX is not an investment advisor. Brokerage services provided by YYYY, Member SIPC”. 
• Treasury bills / T-Bill ladders - These are highly dependent on where the Treasuries were purchased from. If from TreasuryDirect, typically Fintechs don’t earn any money, however, if the T-Bills were purchased from an exchange or through a broker, then Fintechs earn a management fee. 
• Super FDIC-Insured cash sweep accounts - Like the checking and savings accounts, these accounts earn the full EFFR. However, unlike those accounts, there isn’t a partner bank, but rather a partner broker who keeps some of the EFFR. The Fintechs earn the percentage of the EFFR minus what their partner-broker keeps, and what they pass along to the end depositor.

In general, there are no set regulations around the amount of fees Fintechs and traditional banks can charge or the specific percentage of yield that Fintechs must pass back to depositors for checking or savings accounts. For the other accounts, Fintechs may advertise a headline yield rate, which is the gross rate, but they must also provide a set of disclosures that outlines their fees and the net rate (which is the return that your startup generates on its invested or idle cash). When comparing accounts between providers, always compare net APY to net APY, and when comparing loans between providers compare the APR to APR—those are apples-to-apples comparisons.

Fintechs are not banks, here’s why that’s a good thing

As mentioned several times throughout the article Fintechs are not banks—we think that’s a good thing. Why? Well, first, because Fintechs are not banks, and they do not have physical branches or the associated overhead, they have a much lower cost to serve customers. This results in low-to-no-cost banking products and services. Second, because Fintechs typically leverage BaaS providers, they have best-in-class UI/UX and integrations with other technology providers which vastly improves the experience. Third, because Fintechs don’t hold the deposits on their balance sheets or earn the direct EFFR, they’re incentivized to work with multiple partner banks which results in higher FDIC coverage for depositors. Lastly, because Fintechs are digital-first they can quickly spin up new services and features, such as embedded financing, and treasury management.