Despite the size and robustness of the US banking system, banks haven’t really been functioning well for quite a while.
The banks have gotten bigger and more profitable, but the banks have largely become disconnected from the vast majority of the population that they once served.
Banks have gone from largely local institutions (e.g. your local community bank) to globe-spanning titans that can hardly locate 99% of the cities or customers in which they now “serve”.
And this disconnect has, unfortunately, led to reduced economic dynamism.
Economic dynamism serves as an important foundation for any well-functioning economy. Without it, economies tend to stall out in the long-run and become rigid as we may be seeing in certain parts of the domestic economy.
This shift began many decades ago.
When this shift started, the disconnect likely grew largely out of carelessness…the banking system was undergoing dramatic change, driven by consolidation and the repeal of something known as the Glass-Steagall Act. And through these two major changes, banks were able to continue to coast along, never suspecting that carelessness for their historical customer base would eventually sow the seeds of their own irrelevance.
While some banks have woken up to reality, the world has changed. Our economies have changed. And banks cannot undo the damage by simply caring now because the old way of doing things no longer work even if banks start to care.
The good thing is that fintechs have largely stepped into the void. However, the sustainability of fintechs and emerging fintech business models are widely debated. Many argue that fintechs only exist because they are able to circumvent regulations that hold down banks.
But I believe fintechs exist because the structure of the economy has changed. And even if regulations were to normalize between fintechs and banks, fintechs would still excel because they have evolved organically from the world of Now and not from the world of Yesterday.
Because of this, I believe fintechs like Square (still) have immense opportunities ahead of them. In addition, I believe changes to the structure of the economy are the primary reasons leading to the proliferation of fintech as an add-on to all verticals as opposed to operating as a standalone industry as it was previously.
Years ago, banking used to be different.
Banking used to be local.
Banking used to be more friendly.
And banking used to be more approachable.
Banks were important cornerstones of local communities and brought together lots of people.
Source: The Balance
This is because banks used to be truly locally-run and operated.
And whether it was profitable or not depended on its ability to help assist the local financial needs of the community. In other words, their incentives were aligned with the locals.
Yes, religious texts and stories from antiquity all warn about the evils of banking, but at least banks used to have a vested interest in the local community. As evil as bankers could be, they were still in symbiotic relationships in which their own well-being depended on economic dynamism within the local community. Extracting too much from the local community would be a long-term death sentence for the banker, too.
Today it is different.
Although Chase, Bank of America, Citi, and Wells Fargo still have local branches, those local branches have largely fallen out of touch with the local communities. These branches still operate as important channels for deposits, but banks have largely shed their roles as local lenders, especially when it comes to non-mortgage / non-consumer loans such as small business loans.
Part of the reason is because decision-making has shifted up the corporate ladder.
After years and years of banking consolidation, there are very few local banks left (note the significant consolidation of the banking space just within the last 25 years…there were even more banks if we go back a few decades further). What we have left are a few global banks that just happen to have local branches.
When banks were run locally, branch managers ultimately controlled lending decisions.
However, today, lending decisions often require underwriting / risk approvals from centralized teams that live and work somewhere (potentially) far away.
Why does this change matter?
It matters because lending decisions are very sensitive to assumptions that go into it. Ultimately, a bank needs to believe that it will be able to get its money back and that the borrower can ultimately pay the agreed upon terms.
This ultimately depends on data and analysis.
While data can be useful, useful data is not always available, especially when it comes to new small businesses or new small ventures, which form the lifeblood of every dynamic economy. Unless a bank is funding a serial entrepreneur with a track record, funding a small business is becoming increasingly a risky venture due to limited data.
But this was not always the case.
When banks were run locally, the bank still faces the same questions and same risk, but the qualitative aspects of a loan were more easily considered.
If someone is trying to launch a restaurant or a grocery store in a specific location, local bank managers are much better at assessing whether there is a local need for such a business. This is because the local bank managers are part of their local communities. They understand what the community needs or wants, not least because they are one of the consumers within it. They can understand whether a loan might make sense, even when there is a lack of data in a way that modern global banks cannot.
Centralization has pushed decision-making further up the stack in a way that makes this harder to do. Qualitative judgments are harder to get approved these days simply because it does not fit into standardized questionnaires well.
And this is before taking into consideration the shift in the economy towards services. Today, consumption expenditures make up 70% of GDP. But of that 70%, only 25% is related to goods / products, while 45% is services. This is important because part of the risk equation from the bank’s perspective involves the amount of assets / collateral they can repossess if a borrower defaults. Small businesses that sell things have inventory and equipment that can be repossessed. Small businesses that sell services do not. The shift to services requires more qualitative judgments, and this happened at the exact same time in which decision-making shifted in a way that makes qualitative judgments harder to consider.
(You may wonder where all the businesses that sell products went…well they still exist, but they aren’t small businesses anymore and don’t need capital. They are the likes of Walmart, Target, Amazon, etc. And structurally, consumers want more experiences rather than products, these days.)
Alongside consolidation, the repeal of Glass-Steagall has drastically transformed the interests of banks. The Glass-Steagall Act was originally passed in 1933 (after the onset of the Great Depression) to separate retail banking activities from investment banking activities. The architects of the Glass-Steagall Act rightfully diagnosed that separating risky investment banking activities from retail banking would be a healthy change for the system. With the repeal of Glass-Steagall in the late 1990s, banks were once again free to bring both under the same house.
Well, it turns out that investment banking is a pretty profitable thing to do…much more profitable than old school lending. And even better yet, you can do more investment banking-type activities and take more risk when you have large stable retail banking deposits attached.
So the large global banks likely sat down sometime in late 1999 when Glass-Steagall was repealed and wondered why they don’t just do more of the profitable thing and less of the less profitable thing instead.
Are we surprised by how this has played out? We shouldn’t be.
The result is a banking system that has largely become disinterested in the local communities they used to serve. They will still gladly take your deposits so that they can do more investment banking-type stuff…but banks have really turned their attention away from what dynamic communities needed them for most.
And it is into this void that many fintech companies have emerged.
Some are focused on providing more flexible and fair credit.
Some are focused on serving underbanked communities…communities that may be low income or rural in a way that the large banks don’t even bother to put up a local branch to take their deposits, let alone lend to them.
Some are focused on serving young professionals or consumers where qualitative judgement suggests they might be good borrowers (e.g. because they might have an Ivy League degree) even if their credit history / data record is short.
Some are focused on serving the same customer base as banks, but with more attention and better customer service.
But the ones that intrigue me most are hte ones that have come into the void on the small business side, where banks have essentially completely deserted. This is an area that will be very difficult for banks to get back into the game even when they finally wake up from their multi-decade slumber.
And of course, one of the largest and most successful fintech companies in this area is none other than Square.
What’s interesting is that I’m not sure Square actually ever set out to be that involved in banking / lending (and if they did, that’s a lot of foresight!).
Square started out with this (which I remember delightfully using back in 2011 to run a small local operation):
The winds of change were already blowing with the mobile revolution rapidly underway, and Square had already understood that the existing banking and payments infrastructure were too hard to implement.
But it likely wasn’t inevitable that they would need to encroach on the turf of banks. They could have forever remained just a tech-driven company focused on solving small business issues, offering everything in this following graphic except for Finance (e.g. lending).
But in the quest to solve small business issues, it’s hard to ignore the fact that finding funding via traditional channels is one of the most challenging problems facing small businesses today.
Today, the Seller ecosystem is quite rich, spanning payments, tools, vertical- / industry-specific software, and financial services (e.g. banking). It all sits on top of a robust technology / API-drive platform.
And products come together in a way that forms a complete business ecosystem centered around their POS hardware and payment solutions.
According to the company, the opportunity is largest in payments followed by Square Capital / lending. But I’m willing to bet Square Capital can be much bigger in the long run. And their penetration into that opportunity today remains extremely small.
Hopefully, if you’ve read this far, I’ve been able to convince you that this is a large market with an obvious unmet need.
But what happens when the banks eventually wake up as they appear to be doing now? What then?
Most analyses of fintechs / Square I’ve seen seem to either suggest this is a real issue and hence should be off limits (and that is only if such analysis can get past the valuation hurdle) or this is not an issue because…something something tech always wins.
I do believe the tech-enabled player (like Square) will win, but I have strong reasons to believe so primarily because I believe the economy has shifted in such a way that even if banks were to bring their A game, they would no longer have the advantages that you would expect from large-scale incumbents.
Fundamentally, the large banks have two major advantages:
1/ Widespread local branches, and
2/ Low cost of funding in the form of deposits.
Having branches everywhere was an enormous advantage. Being everywhere ensures that they are always closest to every potential customer (whether borrower or depositor).
But you and I know that no matter how close a branch is to you, it will never be more convenient than mobile banking.
The shift of the economy towards the internet has substantially reduced the power an value of local branches.
But perhaps if the banks wake up and go back to their locally-driven banking model there might be some value and advantage even if physical banking is no longer all that convenient? Perhaps a local bank that knows you and your community might still have some value above-and-beyond what a digital bank managed from afar might offer?
This might still be true today, but it certainly won’t be true in the future because our lives in totality are substantially migrating into the digital sphere. The qualitative and soft data that a local branch might have been able to derive in the past by understanding its local community is no longer possible if we all essentially live our daily lives in the cloud. That data now exists in the cloud and is no longer observable to people in the physical world.
For example, as local businesses start to do more omnichannel business (e.g. food delivery if it is a restaurant or e-commerce via Amazon / Pinterest / Facebook / Etsy if it is a product-type business), the observable data and surface area will increasingly become invisible to banks.
Even if banks want to lend, they would have neither quantitative or qualitative data.
A bank manager cannot stand on Main Street and realistically understand how much potential there is for a given business idea because increasingly Main Street exists in the cloud.
And I think this is the biggest change that will reshape the banking space and why banking functions are increasingly becoming add-ons to verticals rather than operating as standalone operations.
On the lending side of the equation, banks have always been a business about data. It is data that drives lending decisions and risk management. That data used to be observable out in the open…the bank just needed to be close to the community to observe it. Now, increasingly, that data is no longer available at all. That data is now controlled by the players that control those verticals. And whoever controls that data, controls the ability to lend.
Hence, Square is very well positioned to lend into the restaurants and salons and small businesses that they interact with.
Hence, Shopify is very well positioned to lend into the e-commerce stores that they enable.
Can banks just digitize?
They could, but that is likely just a stop gap. Banks in its current form likely will not exist decades from now because they no longer control the most important thing that enables lending – Data.
(You might think my statements are hyperbolic, but consider the recent COVID-19 stimulus…even the Fed realized that they need more than the banks to reach the real economy and had to work with fintechs like Square, PayPal, and Intuit to distribute loans to small businesses as well as stimulus checks to consumers. The Fed has tried for years and years to encourage the banks to lend, offering them 0% borrowing rates and infinite capital, yet the banks do not lend…)
For the banks, the last leg that keeps them standing is the other side of the equation – Funding.
Banks still retain the advantage of very, very cheap (and a lot of) deposit funding. Last I checked, Chase is paying me…0% for my money. But they can lend that out and charge someone 18% on ac credit card balance (even while they continue to neglect the more important sphere of small businesses)!
As long as banks can hold this advantage, they have a place in this world, but increasingly this advantage seems to be eroding, too.
Digital wallets such as Square’s Cash App is increasingly gaining share as a place for people to hold their money (effectively deposits). Historically, banks would fight for deposits by offering attractive interest rates (and convenience). But, digital wallets have become even more convenient, and in a world with 0% interest rates, it doesn’t really matter where you put your money. With interest rates so low, Cash App doesn’t need to offer much to get consumers to increasingly move their funds out of their primary bank.
And it is this combination of business lending and the potential of Square’s Cash App that makes me incredibly excited about where we go from here, even despite Square’s strong performance.
Square’s Cash App boasts an ecosystem that is as rich as the Seller ecosystem today, if not richer.
Years ago (circa 2016/2017), I was a relatively non-believer in Square…primarily because I thought Square and Shopify would eventually collide as Square’s merchants move online while Shopify’s merchants move offline. And I believed and still believe the online-first company will likely have an advantage and a superior flywheel vs the offline player trying to move online. Shopify has indeed outperformed Square but not by as much as I thought it would have, and I think a significant contributor to that surprise has been Square’s ability to execute and create the Cash App ecosystem. If Cash App succeeds in the long run, it would cement Square as one of the few players that have the potential to fully attack both sides of the banking equation.
Now, that is a dream worth waiting for.
And if Square is not your cup of tea, there will be plenty more opportunities if the world continues to evolve as I anticipate. Banking will no longer be a standalone thing but will become a part of everything as companies in each every major vertical become banks (regulations, permitting).
Disclosure: I own shares in Square, Shopify, Pinterest, and Facebook. I have no intention to trade any shares mentioned in the next 48 hours.