Time to Fire Your Bank for FinTech?
- by Peter Cohan
I had a great time getting my MBA at Wharton. But one thing at which I failed abysmally was getting an interview with a venture capital firm before graduating. Fortunately, that did not stop me from investing in startups. I’ve invested in seven. Three failed, three were sold for over $2 billion and one is in limbo.
But that in-limbo investment—Social Finance (SoFi), a San Francisco-based financial technology (FinTech) startup that recently raised $1.4 billion and is valued at about $4 billion—seems to be doing well.
My investment in SoFi would not have happened were it not for one of the failed companies, Epesi Technologies, a developer of software to help businesses to partner online. Epesi’s CEO later took a position as vice president of sales at SoFi, and he introduced me to its CEO, Mike Cagney.
Interestingly, Epesi’s chief technology officer, James Park, went on to co-found and become CEO of publicly traded health monitoring device maker Fitbit. Sadly for me, I tried unsuccessfully to invest in Fitbit before its initial public offering.
But back to SoFi: As a customer of Bank of America, I look forward to the day that I can take my money from my accounts there and move it to SoFi. Ever since the financial crisis, I have been hoping that a new form of financial institution—one that’s free of the moral hazard of relying on government-guaranteed consumer deposits to finance risky lending that enriches unaccountable bankers—might replace the traditional banking industry.
SoFi and many of its FinTech peers are beginning a journey that will siphon depositors and borrowers away from traditional banks.
Before getting into that, let’s look at what I thought over four years ago would help wean ourselves off traditional banks. As I wrote several times starting in 2010, the idea was to create deposit-only banks, which would offer consumers an ATM network where they could deposit funds in safe money market accounts financed with depositor fees or advertising.
SoFi’s idea is much better. It offers below-market-rate student loan refinancing, mortgages and other consumer loans using funds obtained from institutional investors and wealthy individuals, to whom it pays as much as 6.5 percent annual interest depending on the borrower’s rate of loan repayment. SoFi, which has been profitable for the last six quarters, has bigger ambitions. As Cagney told CNBC, “We actually are trying to change a fundamentally broken [banking] system.”
With the $1.4 billion in new capital, Cagney plans to expand banking account alternatives through “initiatives in wealth management” to give “a holistic solution [that will lead] people to leave their existing banking relationship and just work with SoFi,” he said.
Here are five reasons that SoFi could take business from traditional banks:
1. Market segmentation
Traditional banks are highly regulated, and they can’t get away with cherry-picking the best borrowers and ignoring the rest. SoFi, which does not take deposits and is regulated at the state level by the Consumer Financial Protection Bureau, has more strategic flexibility. SoFi prospers by targeting students at relatively selective schools whose alumni tend to get high-paying jobs and to be financially responsible.
2. Lower loan rates
The typical borrower refinancing a student loan would save about $14,000 under the SoFi model. Fixed rates start at 3.50 percent and variable rates start as low as 1.90 percent (with AutoPay). My efforts to find the interest rate that Bank of America charges for a student loan refinancing came up empty. But rival Citizens Bank charges what sounds like more. Fixed rates range from 4.74 percent to 8.90 percent (with AutoPay) and variable rates range from 2.33 percent to 6.97 percent (with AutoPay).
3. Higher deposit rates
Like most traditional banks, Bank of America pays a barely detectable 0.03 percent interest rate to depositors, but it can go up as high as 0.08 percent for those with an account at its Merrill Lynch unit. SoFi does not take consumer deposits. However, individuals who qualify to provide cash to borrowers can earn yields of up to 6.5 percent depending on the rate at which borrowers repay.
To be sure, the people who provide capital to SoFi are taking a much bigger risk than a depositor at a bank. But with deposit rates near zero for the last eight years, SoFi offers a substantial reward to those willing to take that risk.
4. Better customer experience
A comparison of SoFi’s loan application process to Bank of America’s reveals one reason why consumers might prefer SoFi. SoFi offers a lending rate within two minutes based on the borrower’s response to questions asked on its website. Bank of America’s website lets a potential borrower fill in an application, but does not guarantee the time it will take to deliver the rate quote.
5. More rapid response to change
Since I first wrote about SoFi in 2011, its business strategy has evolved in response to market feedback, changing technology and upstart competitors. It started off in student loan refinancing and broadened its sources of capital from wealthy alumni to include securitizing and selling the loans to institutional investors. SoFi has completed over $2 billion worth of student loan securitizations so far. Then it expanded into mortgages. About 60 percent of SoFi’s loans are for student loan refinancing, but by the end of the year, new origination in mortgages and consumer loans will top student debt refinancing, Cagney told Fortune recently. As Cagney said, achieving his vision requires taking chances, which is “difficult to do as a public company, when you’re on a quarterly reporting calendar.”
Perhaps that concern with quarterly results helps to explain why the adequate—but not great—products and services I have received from Bank of America have not improved notably over the last four years. Bank of America is hardly the only bank that could lose business to FinTech upstarts. It will be interesting to see how SoFi and other insurgents like it evolve as they grow and whether incumbents can adapt.