Who’d want to be a bank?

On the coat-tails of Monzo, Starling and other ‘challengers’, e-money and payment service providers are increasingly looking to “upgrade”: become authorised to be a bank. There is a logical path to be taken: starting as a payment services firm, which is not able to hold customer balances overnight, to becoming an e-money firm, which can hold e-wallet balances for the benefit of a customer backed by a separate client money trust account, to finally becoming a bank where the “customer” is really a creditor of the bank and the deposit sits on the bank’s balance sheet to lend as it sees fit.

The reasons payment firms, particularly e-money firms, give as to why they want to be a bank are to do with the e-wallet balances held at the end of each day. For the e-money firm, those wallet balances are held in a separate client money trust account which is usually held at an authorised bank and represent money that has not yet been transferred/utilised. Surely – the payment firms say – it would be better commercially if we were a bank, because we could then use this money on balance sheet and lend it out to customers. Surely –  they cry – lending will increase our revenue opportunity on relationships we already hold, we could offer overdrafts and other personal lending or lending to SMEs (very few mention residential mortgages in the post RDR world). And – they round off – we could offer interest on the balances which is good for the clients; the world of virtually zero interest rates will come to an end soon!

Alternative to being a bank

The process to launch a bank is complex, time consuming and costly. The ongoing cost drag from capital and liquidity requirements and governance costs are high; and in the retail deposit and loan market, competition is fierce. In the face of this, we challenge the assumption that the logical end of the journey for an e-money proposition has to be a banking authorisation. In the same group, you can have an e-money firm that provides payment services with an ongoing balance facility on an e-wallet backed by a protected account. The e-money firm can be sitting next to a consumer credit firm that provides small loans on its own balance sheet and a wealth firm that manages or advises on excess monies. If you can give the customers what they need through this route, we say why go through the pain of becoming a bank? Each of those authorisations is easier to obtain and the effect of a proposition combining them for a customer is much the same as an authorised bank. In fact the permission to cover “accepting deposits” which can then attract an interest rate is the only one that cannot be obtained in the model we set out.

What are the downsides?

The main one from the customer perspective is zero interest on the balance in their e-money wallet and no cash withdrawals. In an era of very low interest rates this may not matter at all to customers. How about the capital to provide loans? The balances in an e-wallet, should that become a bank account in a banking authorisation, would be current account monies. However, the ability to lend those current account monies would be surely constrained by their treatment under liquidity rules (not forgetting capital haircut applied to loans). Most e-money propositions are volume based, but you need real volume to lend from this book. However if/when interest rates rise, the lack of an interest rate offering on an e-wallet that is effectively a current account will become a competitive disadvantage.

But clever usage of money market funds could allay these fears. If interest on excess balances is really important, then an automated sweep into a regulated and daily trading money market fund could be an answer. Although this has a fairly bad reputation with the regulator due to some spectacular rent seeking with such funds in the 2008/9 crisis, it is a model that can work.

Although potentially more complex, it may also be in reality as safe as or safer for customers than a bank account. Why might we say that? The current (as of writing in June 2018) UK banking deposit guarantee scheme covers customers up to £85,000 – enough for most. But, if your e-money institution has a client money bank account, it is held by that bank on trust for the customers of the e-money firm for the benefit of those e-money customers. So even if the e-money firm and the client money holding bank went bust other creditors have no claim on that money. So in fact as a customer, where you have in excess of £85,000 it can be safer with an e-money firm, or indeed investment firm (although without some sort of money market sweep you won’t earn any interest) than with a bank.

As an entrepreneur in the e-money, payments, lending or deposit space, you should be asking yourself why the prize of a banking licence is so important. You may end up with a model that makes it worthwhile, but you should challenge the timing, costs and route to get there.