Why are Fintechs Underserved by Legacy Banks?

According to the World Fintech Report, 50% of fintech executives claim they haven’t found the right collaborative partner. Furthermore, more than 70% of fintechs are frustrated with banks’ process barriers, while only 21% of banks have systems agile enough for collaboration with fintechs.

There are two ways to look at this problem. One way is to accept that legacy banks “just don’t get it” while believing that fintechs are the shining stars that will lead us to the future. Sound familiar? The relationship between legacy banks and fintechs represents a generational clash in many ways, but any one-sided view won’t do anyone much good. We must find a middle ground between the two claims.

Fintechs are born and bred in the digital era, where “fast is better than slow” and having a bright business idea implies you're already halfway to ultimate success. While there’s nothing wrong with being fast and dynamic, fintechs can learn a thing or two from legacy banks’ books. On the other hand, banks that can reinvent their approach to working with fintechs will benefit from the rapid-growing economy evolving around the fintech landscape.

To understand how both can be complementary to one another, let’s take a closer look at the foundations and nature of this relationship.

Why does a fintech need a bank?

Fintech is an extensive umbrella term that includes many services from onboarding and compliance to payment and lending solutions. The closer a fintech gets to offering services involving core financial systems, such as cash processing, the higher it becomes dependent on banking services.

To start operating, the first and foremost obligation for a fintech is to acquire a license. Licensing contains a set of complex procedures with multisectoral touchpoints, such as regulatory authorities, advisory and banking. A payment service provider (PSP) or an electronic money institution (EMI) has obligatory procedures that only a bank can provide. A payment institution must have a safeguarding account to be able to operate and qualify as a candidate for a license. This special type of segregated account ensures that the clients' funds are separated from the company's operational funds. Such accounting services can only be provided by banks.

Another necessary component the need for balance sheet management. Many fintechs are founded by those with pure technology backgrounds. As such, they need help managing their finances, especially in areas such as balance sheet management. Even if a fintech is well-versed in these types of tasks, they merely become accounting consultancies. Thus, they may still prefer to rely on a bank to track and report their assets and liabilities. Balance sheet management with a banking partner will provide fintechs with a better understanding of their financial health and a better position regarding credit requests and investment rounds.

Accessing a correspondent banking network is also vital for fintechs wanting to facilitate cross-border, multicurrency, or alternative channel payments. This can be done by either working directly with a bank or through a third-party fintech institution such as an EMI that provides access to a correspondent banking network. However, these EMIs must also work with banks to provide this network service. In addition, there are certain correspondent banking networks, such as Target2, that can only be provided by a bank.

Legacy banks’ risk approach vs. fintechs’ needs

All banks have – and should have – sound procedures for risk management. This means significant investment and understanding of risk management, as well as an established risk culture in order to be able to mitigate any possible risks. Due to their business models, fintechs are defined as high-risk clients. Even when risk-scoring algorithms indicate a fintech as medium-risk, legacy banks mostly prefer to stay on the side of caution.

Thus, for now, most legacy banks have concluded that the revenue possibly generated by new lines of fintech business will not cover the additional risk management costs that would be needed to appropriately manage the risks. This approach is founded on the idea of a relatively small fintech market, an idea that has now been dispelled thanks to the sector's sustainable growth patterns and increasing number of unicorns. Furthermore legacy banks’ insufficient understanding of how the fintech ecosystem works with a wide range of business models, further deepened this bias.

Legacy banks’ reluctance to work with fintechs is further increased by the nature of their businesses. Many fintechs facilitate payments, resulting in a high number of transactions. Detecting anomalies within numerous small transactions by end users is rather different, compared to assessing fewer but larger transactions by corporations or by key clients. It requires an alternative approach, additional capabilities, new algorithms, and sometimes new software or partnerships for risk assessment.

Looking beyond the risk perspective

Fortunately, there are recently licensed banks in the banking ecosystem that have a different point of view, because they better understand the fintech ecosystem and have streamlined their procedures accordingly to fit this new market’s needs. Some legacy banks have also taken a renewed approach toward fintechs, often through a separate business unit or under a different brand.

Fintechs have undeniable potential. According to the State of Fintech 2021 Report, global fintech funding reached a record $132B in 2021, which more than doubled the previous year. Market Data Forecast’s report declares that the global fintech market is expected to be worth $324 billion by 2026 with a CAGR (Compound Annual Growth Rate) of 25.18% between 2022 and 2027.

As one can see, there are many benefits for both fintechs and banks when they manage to work well together.

How does EMBank respond?

As European Merchant Bank (EMBank), we understand the nature of fintech business: as such, we can evaluate and assess their needs before formulating a solution. As a challenger bank, we prefer to be flexible regarding  the requests of our clients - including fintechs, SMEs, and corporates - by focusing on innovative solutions delivered with a human touch, instead of strict procedures and tiresome bureaucracy. We invest in building our organizational capabilities to build processes and flows to better mitigate possible risks and be solution-oriented partners for credible, compliant and competent fintechs.

If you’re looking for a dynamic bank and an extraordinary partnership, please send an email to info@em.bank to arrange a telephone call.

Sarp Demiray - European Merchant Bank CEO