Partner banking (BaaS) Is A Lifeline For Beleaguered Community Banks

By Vince Curotto, director, Klaros Group

Between heightened regulatory scrutiny of partner banking relationships with fintechs and fintechs facing their own operating headwinds in a rocky market, it is reasonable to conclude right now is a bad time to launch partner banking services. But disruption breeds innovation. The challenges facing existing bilateral bank-fintech relationships will open opportunities for new partner banks to emerge as the Banking as a Service (BaaS) industry enters a new phase of its lifecycle. The current market environment not only presents a compelling opportunity to launch banking services that meet the demands of regulators and fintech partners, but also offers a lifeline to community banks struggling to accelerate growth and increase profitability from their current services.

The decades-long consolidation of the community banking sector is a widely known trend amongst industry participants and observers. In 1989, there were over 15,000 bank charters in the U.S.; today, the number of charters is just under 4,800. Among the 4,800 banks in the U.S., community banks—defined as banks with total assets less than $10 billion—represent over 95% of bank charters outstanding. 

The trend in bank consolidation will continue. Indeed, the annual consolidation rate since 1990 of 3.7% is equal to the last four quarters, but the drivers of consolidation have evolved. Since the financial crisis, increased regulatory and compliance costs have increased operating expenses. At the same time, a prolonged low-rate environment pressured interest revenue, and large portions of the loan market have moved outside the banking industry. In other words, rising costs and shrinking revenue opportunities have squeezed margins and, consequently, overall profitability for community banks. And while Covid and the resulting PPP program provided a temporary revenue lift for many, the pandemic's more significant, longer-term effect is the need for banks to accelerate tech investments, adding further pressure to an industry fighting for survival.

Against this bleak outlook, community banks have limited options. Most will choose to continue their go-it-alone strategy. Many management teams are emboldened by an improving rate environment that should alleviate net interest margin pressure and improve the bank’s bottom line. Still, longer term, the status quo for most community banks is insufficient given cost structure disadvantages. Selling is of course, a viable option, but as structural headwinds play out, buyers may be unwilling to pay large deal premiums. A third—and we believe, the best—option for community banks is to leverage their most decisive competitive advantage—their bank charter—to partner with fintechs and other non-banks to unlock new areas of growth through partnerships. Not only will investment in these partnerships open new areas of growth, but they will also allow banks to better serve their current markets by improving the bank’s tech infrastructure and risk functions. 

After a decade of rapid growth, fintechs face their own operating headwinds that will force consolidation and ultimately clear the playing field for scaled, successful firms that will demand resilience in their bank partners. Specifically, increased regulatory scrutiny of BaaS banks will raise the bar for these banks’ compliance and overall risk functions. To avoid disruption of their own businesses, fintechs will only partner with banks that boast the most robust and resilient compliance programs. Additionally, fintechs will require better tech from their partner banks that can easily scale with the growth of the fintech’s business. As fintechs continue to grow both existing and new products, the ability for the partner bank to seamlessly adapt with the fintech (rather than force it to seek a new partner bank) will prove vital.

Success in partner banking is not guaranteed. While many community banks are willing to forge this new path, most are ill-prepared, lacking the regulatory expertise, tech capabilities, and, more often than not, capital to successfully execute this strategic pivot. 

Notwithstanding resource limitations, some banks are better positioned than others. Critical factors increasing the probability of success include:

• Alignment between a bank’s management team and its owners (and buy-in from the board) is obvious but essential and far from guaranteed.

• A credible relationship between bank management and regulators, as buy-in from regulators will prove necessary. 

• A clean business with no legacy hurdles (e.g., credit) allows the team to focus on execution.

• An adaptable tech stack. It’s perhaps unintuitive, but one benefit of community banks’ underinvestment in tech is a “blank slate” tech stack that vendors and partners can build on without significant disruption to legacy infrastructure.

While the partner banking business model faces serious challenges from both regulatory and market trends, we expect demand for partner banking to continue to grow over the longer term. This supply-demand imbalance creates a large and growing opportunity for banks that can meet the increasingly high bar being set by their partners and their regulators.