Rethinking The Business Model For Community Banking, February 5, 2018


Community banks and credit unions have been a key part of the American economy since its beginning. These are the lending institutions that make loans to small sole proprietors, first time home buyers and dreamers of all kinds. Over the years, the business model for these institutions hardly varied.  A review of the loan portfolios of community banks across the country will include three similar components:

·        CRE– Commercial real estate loans have been one of the mainstays of the community banking business. These loans provide a viable, recognizable and reliable (usually) source of income. The return on investment for these loans have been the source of a large portion of the earnings for community banks for many years.  The drawback for this type of lending is that it ties up a large portion of the capital of a bank and the return on investment takes a significant amount of time develop. A loss from one of these loans has the potential to threaten the existence of a small financial institution

·        CNI – Commercial and Industrial loans have been the beating heart for community banks for many years. Very much like CRE loans, the income from these loans is recognizable and except for a few notable exceptions, reliable. Not only do these loans have the same concerns as CRE, the competition for these loans is fierce and smaller institutions often finds themselves left with the borrowers who present the highest level of risk.

·        Consumer products – In the past 15 years, consumer loans have also proven to be a good source of earnings. Interest rates for consumer products have remained well above the prime rate and for a financial institution that is properly equipped, consumer products can provide a strong stream of income.  Consumer products also tend to be for smaller amounts, have higher rates of losses and are heavily regulated.

This three-pronged approach to earning income has been a steady, tried and true method for earnings at small financial institutions. However, there are several factors that are coming together that have threatened this business model.

·        Fintech – Financial technology (“Fintech”) companies are those companies that use software to deliver financial products. Today one of the most recognizable fintech companies is PayPal. Using just a smart phone, PayPal gives its users the ability to make payments, pay bills, deliver gift cards and conduct financial transactions with people throughout the country.  For community banks, the knowledge of the existence of PayPal is interesting, but what is more critical is the reason that PayPal was developed. PayPal, and its fintech brethren exist to fill a specific need that Banks were not meeting.

·        NBFI – The Operation Chokepoint program was a program spearheaded by the Justice Department that was aimed directly at Non-Bank Financial Institutions, aka Money Service Businesses. At the time the program was started, a decision was made that money service businesses represented an unacceptable money laundering risk.  Ultimately, Operation Chokepoint fell into disrepute and was ended. Although Operation Chokepoint has ended, its legacy is still prevalent. MSB’s still have significant problems getting bank accounts.   Despite this fact, the amount of money moved through remittances continues to grow.  MSB’s continue to serve this market for a huge population of people who are unbanked and underbanked.

·        Underbanked and Unbanked– The number of unbanked and underbanked families continues to grow. Unbanked families are those without a bank account and underbanked families are those that use minimal banking services.  The number of people in these families totaled  approximately 90 million in 2016[1].  Equally as important as the sheer size of the unbanked and underbanked population is the reason that many of these potential customers remain that way. High fees, poor customer service and bad public image have all been contributing factors for the large population of unbanked and underbanked customers.


Customer Bases in the Future 

The combination of these forces will greatly impact the future of the business model for community banks. Customers will continue to change their expectations for their financial institutions.  The traditional balance has changed, instead of being forced to choose the products that financial institutions offer, customers have come to demand products from their companies.

The financial needs of customers have also changed. Electronic banking, online account opening, remote deposit capture and iPhone applications are now almost necessities.  Younger customers, who make up a significant number of the unbanked and underbanked population rarely use traditional forms of community banking such as branch visits. Fast information, fast movement of money, low costs transactions and accessibility are most desirable to the potential clients of today’s financial institutions.

Implications for the Small Bank Business Model  

Fintech companies, NBFI’s and the need for new and different services presented by the unbanked and underbanked population will all continue to put pressure on community bankers to begin to make a change. Change may be hard, but it is also inevitable and necessary. For community banks and credit unions now is a good time to consider NBFI’s as viable and important customers. They are a vehicle for consumers to meet their ongoing needs and they need bank accounts.

Fintech companies reason for existing is to fill the unmet needs of unbanked and underbanked.  These companies have developed applications that allow everything from alternate means of credit scoring to international transfer of funds using applications. A community bank or credit union that creates a partnership with the right fintech company can offer products and services that will greatly distinguish them in the market and allow for continued growth and alternate means of income.  2018 is a great time to start thinking about a new business model.

[1] In our most recent survey, published in October 2016, the FDIC reported that 7 percent of households were unbanked, lacking any account relationship at an insured institution. The survey also showed that an additional one-in-five (or 19.9 percent of) households were underbanked, defined as households in which a member had a bank account, but nevertheless turned to alternative financial services providers during the year to address one or more needs for transactional services such as check cashing or credit. Altogether, the survey reported that some 90 million Americans, or nearly 27 percent of households, are unbanked or underbanked.

The Nexus of BSA &Fintech

august9blogTwo areas that will always be among the “hot topics” when it comes to compliance. The first is an institutions’ system for compliance with the requirements of the Bank Secrecy Act/Anti-Money laundering (“BSA/AML”) laws. Regulated financial institutions have been well aware of the fact that a well-developed system for compliance is a critical component of ongoing operations. A second area that is becoming increasingly important is the use of technology to transaction business by financial institutions. This area is often known as “fintech”. Although fintech is often a broadly used term, there are generally accepted definitions such this one offered by Fintech magazine:
Financial technology, also known as Fintech, is a line of business based on using software to provide financial services. Financial technology companies are generally startups founded with the purpose of disrupting incumbent financial systems and corporations that rely less on software.
PayPal, Apple Pay and Venmo are just a few examples of popular software applications that allow consumers to transfer money to one another with a just a few relatively easy steps.
As the number of firms that offer variations of fintech transactions grow, so does the need for a financial institutions’ BSA/AML system to adapt.

The Heart of BSA/AML- CIP and KYC
Although there are numerous components that make up a strong and complete BSA compliance program, the heart of all programs is the ability of the financial institution to know complete information about its customers. The two components of the BSA program that perform this function are the Customer Identification program (“CIP”) and the Know Your Customer (“KYC”) programs. The CIP program is made up of the policies and procedures established by an institution for the purpose of collecting identifying information about their new customers. The FFIEC BSA manual details the requirements of the CIP regulation and notes that at a minimum, a financial institution must obtain the following information before opening an account:
• Name
• Date of birth for individuals.
• Address.
• Identification number.

There are well established rules for the types of identification that are considered acceptable. The goal of the CIP program must be that a financial institution has to establish with a reasonable certainty that the person who is attempting to open an account is who they say they are. For business accounts, the requirements are the same although the form of identification takes on different forms e.g., name would be the legal name of a business and identification number would be the tax identification number.
Once the identity of a customer is established; the KYC portion of a compliance program comes into play. Depending on the types of transactions that the customer says that they will conduct, additional information is necessary. For example, if the customer is a flower shop, then information about how long they have been in business, who their customers are, how the flowers are sold and the means for payment, etc. are all pieces of information that are necessary for a financial institution. Using this information, the financial institution can keep transactions conducted by the customer in context. In other words, if the flower shop sells mostly orchids, it is reasonable that there would be wires to regions of the country where orchids are grown.

It is through CIP and KYC that all of the information that gathered on a client is filtered. Individual transactions may or may not be considered suspicious based upon the KYC and CIP obtained about a client. Using the flower shop example above, wires or ACH activity to war-torn regions of the world would seem at least very unusual for orchids.
CIP and Unintended Consequences
The need for complete CIP and KYC has been at the heart of a delicate balancing act for financial institutions and the customers that they serve. The FDIC separates people who do not use banks to fully serve their financial needs into two distinct categories. The unbanked have no ties to an insured economic institution. Essentially, they have no checking or savings account and no debit or ATM card. Meanwhile, the underbanked do use some of these services – often a checking account – but they also used alternative financial options within the past year.

When customers are the “unbanked” and “underbanked” communities, the issue of complete documentation of identification can be tricky. These customers may not have complete or traditional documentation available. For many institutions, the clash between the desire to serve underbanked and unbanked and the need for complete documentation has created an unintended consequence. The law of unintended consequences is defined as:
The law of unintended consequences is the outgrowth of many theories, but was probably best defined by sociologist Robert K. Merton in 1936. Merton wrote …a treatise which covers five different ways that actions, particularly those taken on a large scale as by governments, may have unexpected consequences. These “reactions,” may be positive, negative or merely neutral, but they veer off from the intent of the initial action.”

In the case of BSA, the desire to monitor and mitigate risk had the unintended consequence of shutting out entire industries that often are critical to unbanked or underbanked communities. MSB’s such as combination grocery stores and check cashers often serve as the bank and remittance service for migrant workers and expatriates of other countries. When the local bank makes a decision to stop proving services to these entities, the customers of the MSB are forced into transactions with entities that are completely underground.

Fintech to the Rescue?
Fintech companies have developed many products that allow customers to have many of the same services and abilities as a bank account. Digital wallets for example, allow customers to receive payroll, reload debit cards, payment bills and purchase gift cards among other things. These platforms also allow customers to send wires, ACH’s or other transfers.
The very nature of fintech relationship are often that the customer and the provider are not in physical contact with one another. The identification process is completed through various means such as texts to telephones, IP address verification and scanned copies of documents. The ability of fintech companies to discern fraud and detect unauthorized use of an account has become increasingly adept.
The development of fintech products gives financial institutions that opportunity to reach out to customers that have been largely overlooked due to BSA/AML concerns. The time has come to reconsider the possibilities.

For a detailed review of how Fintech can improve overall Community Reinvestment Act performance, non-interest income and BSA/AML compliance please go to and fill out the “Contact Us” form.

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