In the last module, we talked about Online FinTech lending, and how many of these FinTech lenders have formed partnerships with banks to help underwrite loans which begs the question, why don't these FinTech lenders become banks themselves? In fact, many FinTech lenders are starting to think seriously about becoming a bank due to the inherent advantages involved. The biggest advantage of being a bank, is access to government insured deposits which provides a cheap source of stable funding. Just thinking about how much you're earning on your checking your savings account and you'll understand why FinTech company would be interested in funding their loans with deposits. Another advantage to being a bank is the ability to operate nationwide without having to get a license at every state you wish to do business in or comply with each state's interest rate limits. There's also a potential competitive advantage if you're one of the first FinTechs to become a bank. Becoming a bank as we'll talk about is difficult. FinTech companies who complete the rigorous process may be able to quickly grow market share over their competitors. As I mentioned it is not easy to become a Bank of the United States. This is because unlike most other companies, banks need permission from the government before they begin operating. Just think Bill Gates and Paul Allen didn't need the government's permission when they started Microsoft in a tiny Albuquerque garage. Sam Walton didn't give the government's approval before he opened the first Wal-Mart and Rogers Arkansas in 1962. So, what makes banks different? Banks are different because they play a unique and critical role in our economy which therefore warrants intense government scrutiny. The most important role banks play is that of a custodian. Businesses and consumers alike place their hard earned money at banks and trust that their bank will keep their money safe. When consumers lose trust in their bank, a bank run may occur whereby a large number of a bank's customers withdraw their deposits simultaneously due to concerns at the bank may go out of business and take their money with it. Bank runs were a common site during the Great Depression but have since become less frequent, due to the advent of government deposit insurance in 1933. Banks are also unique because they allow the money supply to grow through what is known as Fractional-Reserve Banking. When I put a deposit into a bank, the bank is going to hold a certain portion of that as a reserve and then they will lend out the rest to accompany or individual who will in turn deposit some amount of the funds received into a bank and the process repeats. Fractional reserve banking is critical for economic growth. Banks also facilitate commerce through their role as intermediary. Savers of capital are able to safely place their funds at a bank who in turn will lend those funds out to businesses and consumers who have a constructive use for this capital. This is a far more efficient process than me trying to lead my savings directly to other individuals or businesses. Because banks play an essential role in our economy, if a bank or series of banks were to fail it could potentially destabilise the entire financial system and negatively impact the rest of the economy. This is essentially what happened in 2008 when a decline in home prices lead to many bank failures in the worst recession in the United States has seen since the Great Depression. Because of these critical roles that banks play in our economy and the potential consequences when banks fail, the government tightly controls who is allowed to become a bank and imposes regulations on existing banks that dictates what they can and cannot do. Now that we know why banks are unique, let's talk about the process to become a bank. And the different types of banks that exist in the US. Banks have to obtain a charter before the begin operating, which requires a sign-off of at least two regulatory agencies. The application process is rigorous and time-consuming. Taking a year or more. Extensive information about the organizers, the business plan, senior management team, finances, capital adequacy, risk management infrastructure and other relevant factors must be provided to the appropriate authorities. In a little bit, I'll talk more about who these authorities are and the roles they play. This chart highlights the challenges associated with starting a new bank. In the wake of the financial crisis, new bank formation came to a standstill. With no new banks being created between 2009 and 2012. The reasons for this precipitous decline or many, but I will highlight a few. First regulators became much more cautious and risk averse after the financial crisis. This is lead them to more closely scrutinized new bank applications and impose more stringent regulations on existing banks. Both of which disincentivize new bank applications. Second, there has been a challenging business environment of late for smaller banks, with many struggling to cover their cost of capital. This makes it less attractive for those interested in starting a bank. More recently, regulatory agencies have taken steps to encourage new bank formation but their efforts have had little success. This is why many policymakers support the idea of allowing FinTech companies to become banks. Many believe it promote healthy competition in the banking sector that will ultimately benefit consumers. There are multiple charters available to bank applicants. The most common type of charter by far is what's known as The Commercial Bank Charter. Commercial Banks offer your standard consumer and business making services. Thrift Charters, are the next most common form. Thrifts are much like commercial banks except that they are charged with a specific mission of promoting and bankrolling homeownership. Then there are Credit Unions. Credit Unions are non-profit financial savings and lending cooperatives whose members are also part owners. The next charter type worth mentioning, is The Industrial Loan Company charter or ILC. ILCs are state chartered institutions that operate in seven states and have nearly all the same powers has commercial banks. However, ILC differ greatly from banks and that ILCs meeting certain conditions may be owned and operated by firms engaged in commercial activities. Thus cutting the prohibitions and mixing banking and commerce that apply to virtually all other depository institutions. The ILC charter is an attractive option for many FinTech companies due to the limited federal oversight that comes with it. We will talk more about this later in the module. There are several other charter types that are worth briefly mentioning. These include mutual savings banks, Limited Purpose Trust Companies and Credit Card Banks. We'll touch briefly on Limited Purpose Trust Companies and Credit Card Banks when we explore the Office of the Comptroller of the currencies proposed FinTech charter later. Commercial Bank Charters, Thrift Charters and Credit Union Charters, can either be granted by the federal government or the states and this is the concept that's referred to as Dual Banking. So for the most common form of Bank Charter, the Commercial Bank Charter, the charter can either be granted at the federal level by the Office of the Comptroller of the Currency or OCC or by the State Banking Agency in the applicants home state. It's important to note that there is essentially no difference in the kinds of activities a state or federal charter commercial bank can engage in. Any commercial bank either federally chartered or state charter, is required to obtain FDIC Federal Deposit Insurance Corporation insurance. This means that the FDIC was also approved new bank charter applications. In addition, federal charter banks, so those banks are chartered by the OCC are required to become a member of the Federal Reserve system. We can think of a Federal Reserve system in this context, as simply a bank for other banks. So the federal reserve system allows banks to place deposits at their local Fed district bank, access to Federal Reserve payment system and access emergency liquidity assistance of the Federal Reserve stands ready to provide to member banks in need. While state chartered banks must obtain FDIC insurance if they wish to accept customer deposits, they are not required to become members of the Federal Reserve system although they may do so if they wish. The majority of both nationally and state chartered banks are wholly owned by holding companies. And these holding companies are referred to as bank holding companies because they own a banking subsidiary. The Federal Reserve Board is the agency responsible for regulating bank holding companies. While the bank subsidiary that sits underneath the holding company, are supervised by either the OCC or the relevant state-making authority. In its role as bank holding company regulator, the Federal Reserve will supervise all activity that occurs within and underneath the holding company, including activity in the bank subsidiary. Many financial entities prefer the holding company structure because it gives them greater flexibility into the types of activities they can engage in. In addition, holding companies have greater flexibility when it comes to buying back their stock which is something that shareholders are typically supportive of. This chart provides more perspective on the predominant types of bank charters by displaying the share of FDIC insured deposits held by charter class. We can see that over 60% of deposits are held at nationally chartered commercial banks falling behind that, you have 16% of deposits that are held by state chartered commercial banks who choose to be members of the Federal Reserve system and then, 15% of deposits are held by state chartered commercial banks that are not members of the Federal Reserve system. All in all, we can see that the vast majority deposits in the banking system are held by state and nationally chartered commercial banks. Note that credit unions are not listed on this chart because their deposits are insured but the national credit union administration not the FDIC. Now that we've explored the different kinds of bank charters, let's talk about the government agencies responsible for regulating the various kinds of banks. Even for people in the banking industry, this can be a confusing subject. So I'll do my best to explain the bare essentials. The first thing you need to know, is that most banks are regulated by at least two agencies. This will include their prudential regulator, who's focused on ensuring the bank is operating in a safe and sound manner and another agency who may have a more narrow focus. Let's begin with the FDIC who have supervisory authority over any institution that accepts customer deposits outside of credit unions. Regardless of if it is state or federally chartered, the OCC is a primary regulator for all nationally chartered banks, while the applicable state agency will be the primary regulator for state chartered banks. Because all nationally chartered banks are required to become members of the Federal Reserve system, the Federal Reserve will also supervise national banks as well as state chartered banks that choose to become members of the Federal Reserve System. The Federal Reserve is also the primary regulator for all bank holding companies and savings and loan holding companies. Finally, the Consumer Financial Protection Bureau which was created after the financial crisis has supervisory authority over banks, thrifts, credit unions with assets over $10 billion as well as their affiliates. I realized that all this information is confusing but when it comes to FinTech, it is important to know because it highlights that there is no single government agency that has sole discretion over whether or not a FinTech company can become a bank. We will talk more about this challenge later on in the module.
