A guide for bank-fintech partnerships

QED recently co-authored a whitepaper looking at the potential for bank-fintech partnerships and examining why banks, particularly the regionals, need to be acting today to safeguard their long-term viability.

Regional banks are not one homogenous lump. Some of them are specialists and some of them are generalists, but many of them are, in a sense, oligopolistic banks in a certain geography – say in San Diego or Detroit or Austin.

As the inextricable move to digital continues and legacy banks with branch-based infrastructure become less en vogue, what are their options for not only surviving, but thriving?

If there’s M&A, it's largely going to be regional banks buying smaller versions of themselves – trying to save as much revenue as they can and reducing their cost structure dramatically. That alone may be a catalyst to dramatically downsize branch infrastructure, and that has been the historic approach.

But in addition to banks buying other banks, there is a huge opportunity for banks to partner with fintechs.

So, what have banks got that the fintechs covet and vice versa? Banks have got profits, brand and lots of trust as a result of FDIC insurance. They've got large customer bases and they’ve got proprietary data, if they can leverage it. They have access to debt funding and the cost of funds are nothing. They're replete with deposits, and they have networks and local distribution.

They’re historically good at credit risk management and they are great at managing the regulators and compliance issues.

What do fintechs have? Fintechs have great tech, terrific user experience and net promoter scores that are double or triple what the bank has. Fintechs have talent and verve and analytic capability and an ambition to grow.?They’re scrappy and entrepreneurial in ways that banks could never be, and they start with a customer problem rather than a distribution system. Many are focused on their unit economics – a consistent pillar of QED’s investment thesis.

If you could put two plus two together, you basically fill in all the corners of the value added chain. In this case, two plus two can equal five.

Conceptually, regional bank should be buying fintechs. Why aren't they?

Banks are typically risk-averse. You get to be at the top of a bank by never making a mistake, not by creating a really disruptive platform.

Often, the banks will talk themselves out of buying something.

Secondly, they have no track record by which to measure the synergies. If I buy the local bank that looks like me only smaller, I can estimate what the value is going to be. With a fintech, I don't know how much value there's going to be and I don't know if the management team will stay. The regional banks often not in the fintech hubs of Silicon Valley or New York or Miami. In short, the banks don't have a muscle to know how to buy fintechs and do it well.

Thirdly and no less importantly, when I talk to banks about buying a small fintech – one that may be getting enormous traction with real escape velocity – the banker will often say that they don't know how sustainable it will be and that it's not industrial strength. By the time it is industrial strength and it's really working, the valuation will be so high, there will be earnings dilutive, and they won't be able to do it. It can be a null set.

The result is that there may be virtually no overlap between when they want to do the deal and when they can do the deal. I think that is a real challenge, especially when you consider some of the reasons to hypothesise why some of the smaller banks or regionals may be in trouble.

They’ve not cleared hurdle rate returns since the last recession, the regulatory climate is more complicated and costing more money than ever before and the hangover of a branch distribution system is like a weight around their neck.

Fundamentally, many simply don't understand their own unit economics. When you combine that with a reluctance to innovate and an inability to ship code fast enough to be able to keep up with the fintechs, you can see the clear warning signs.

I think it was Churchill who once said that Americans and Brits were separated by a common language. It’s the same with banks and fintechs in that they use the same words but talk past one other. Banks say this and fintechs hear that.

So what needs to be true for bank-fintech partnerships to work? We touched on several factors in our whitepaper with our good friends at BCG, but it’s worth highlighting a couple other important points, including the biggest one that it starts with leadership.

Banks need their executives at the top of the chain saying this is a massive existential threat and openly discussing with their staff the realization and appreciation that you don't have to do everything in the value-added chain. You don't have to be all things to all people everywhere all the time.

Banks need staff in key fintech hubs to open meaningful dialogues with fintechs in the major cities – New York, San Francisco, London, Mumbai – and they need to compensate talent like you would compensate a partner at a consulting firm or an investment bank or a venture capital firm.

Considering the small window I mentioned to make a potential partnership work, leadership needs to have a framework already crystalized so that when an opportunity does arise, they are in a position to execute the plan in the narrow time frame. Whether fintechs get on a bank’s radar before it is industrial strength or after it has escape velocity, the timing just won’t work out. But by reviewing the video instead of simply looking at a photo – an individual snapshot – from one moment in time, banks can be better informed to make accurate decisions. When combined with building relationships with fintechs, those partnerships and acquisitions may not only be possible, but fruitful.

The final point that is important to make is that even if the timing is right, and even if the bank has opened meaningful dialogues, and even if the C-suite staff has pinpointed a need and an opportunity, there is still a chance the partnership fails.

Why? Because banks and fintechs have wildly different cultures. Speed, nimbleness, structure and decision-making processes are often polar opposites, so there’s a real need to find the agar jelly to make a partnership work.

I don’t want to be too flippant about banks’ futures and I don’t want to imply that every regional bank is headed for catastrophe. What I do think, however, is that banks need to use empirical data to ask what's happening through the lens of resource allocation. Banks either have to say, “I've got a way of winning and I have comparative advantage and here's how I'm building on it”. Or, they have to say, “I'm going to lean into this fintech environment and figure out how that can make me better.”

Both strategies can be viable options with the right people and the right structure in place, but the expectation at QED is that the banks that leverage the unique skill sets of fintechs will be the ones that ultimately leapfrog the competition.

Expect more fintechs buying fintechs – the rise of the ‘super fintech’ – as well as more of the progressive banks like Fifth Third, KeyBank and J.P. Morgan increasingly doing the same. With valuations down, runways will shorten as raising funds gets harder and fintechs will be more affordable.