FinTechs requires reinforcement to weather this storm, and those who emerge from this crisis unscathed are the ones who make tough decisions.
According to IDEA, FinTechs, financial technology innovators, after years of significant growth and development, are now facing one of their first major challenges. Money has become scarce. With central banks raising interest rates, attracting more customers, and penetrating new markets comes at a higher cost for newcomers. Unlike traditional banking, fintechs whose income is mainly limited to capped fees cannot compensate for their shortfall in one sector during a recession by offering a diverse range of products in another. Expanding product portfolios and obtaining banking licenses are also very costly and challenging for these fledgling players.
Those who were born into abundance of money
The economic crisis of 2008 is considered the biggest crisis of the modern era, following the Great Depression of the twentieth century. However, this very crisis laid the foundation for the growth and advancement of the startup ecosystem. Central banks lowered interest rates to near zero, effectively making money cheap.
The cheapening of money had two consequences. First, investors flocked to futuristic (and in many cases, optimistic) tech startups. As a result, new business models emerged; models that cannot survive in different circumstances.
Fintechs are examples of such business models. Many challenger banks, electronic payment services, digital wallets, and more emerged, capturing a share of the traditional banking market.
Their success was based on offering customer-centric products better than traditional examples.
Engaging apps, low or even zero fees, and discounts or higher interest rates caught the attention of customers. However, what remained hidden was the long-term strength of the business foundations of these fintechs and their ability to withstand changes in the macroeconomic conditions. Investors and players in this field paid little attention to these issues.
But today, the fate of fintechs is hanging in the balance. Over the past two years, central banks have raised interest rates from the lowest levels in the pandemic era to the highest rates in recent years, weakening the foundations of those attractive business models.
The Achilles of Fintech
The primary source of income for most fintechs is transaction fees. These fees are essentially commissions paid to the card issuer, payment networks, and banks when making a purchase.
Fintechs rely on varying fee structures, and this revenue makes up a significant portion of their total income. For example, the American neobank Chime had an income of six hundred million dollars solely from fees in 2020. Despite the importance of fees to the survival of fintechs, these costs are mostly hidden from customers.
Two significant issues arise here: first, even though the amount of fees depends on the type of account, credit, current, etc., and the region of the card’s activity, fintechs can only charge up to a specific one percent as fees, and as a result, their income cannot exceed a certain limit.
Another issue is the interest rate, which has no limit. Central banks primarily determine interest rates based on external economic conditions. In challenging conditions, such as a recession or a pandemic, interest rates are lowered to increase liquidity and boost consumer confidence. When inflation rises, central banks increase interest rates to curb economic activity.
This alone is enough to put fintechs, which mainly rely on fees, at a significant crossroads. While their income is limited by a specific fee rate, the cost of borrowing and obtaining liquidity can increase indefinitely.
On the other hand, since the fee cost does not go directly into the pockets of most fintechs, the problem is exacerbated. As we have seen in the past decade, one of the most valuable parameters for startup foresight is customer acquisition, and the best way to achieve this is by offering discounts or higher interest rates.
Therefore, fintechs have turned to selling shares or taking on debt as a means of survival. However, this solution is not sustainable, and with the worsening of macroeconomic difficulties, budget acquisition becomes more challenging, and this trend continues until conditions improve.
Inflexibility
It is worth mentioning that this crisis, contrary to people’s perceptions, only affects fledgling fintech startups, and traditional financial institutions are not facing any issues. One of the reasons for this is that traditional banking does not require significant efforts to attract new customers. A century-old bank doesn’t need to go to great lengths to validate its new customers.
However, the biggest advantage of these established institutions is their diversity. Thanks to their long history, banks offer a wide range of services, from loans and insurance to credit cards and mortgages. This diversity has to some extent shielded older players from the impact of rising interest rates, making the traditional sector more capable of navigating future years with ease.
But on the other hand, most fintech startups lack sufficient diversity. Their income is mostly derived from fees, and even if they have other ancillary products, they are not as widespread. The problem lies in their nature, as these emerging players are not yet registered as banks and their regulation is different. Consequently, they have focused on specific segments of the market.
In the United States, only banks have the ability to hold depositors’ assets. Therefore, banks can offer a variety of products and have more opportunities for service diversity. However, the process of becoming a bank is lengthy, exhausting, and costly, and it becomes more challenging over time. For fintechs, going through this process is not cost-effective, so they address the problem by collaborating with banks.
Moreover, becoming a bank has its drawbacks. The level of legal regulation is much higher, and many startups cannot bear this burden. Reverting from such a path is also very costly.
Canceling a banking license is practically a logistical nightmare and a stain on an institution’s reputation, stemming from some form of error or deviation from the law. Of course, it is possible, and it doesn’t always imply wrongdoing, but such cases are very rare. Marlin Bank in Utah abandoned its banking status to merge with a large investment fund. However, this process is by no means simple. It must be determined what happens to customer accounts or offered products. The transition process is time-consuming, expensive, and arduous.
The Challenging Path Ahead
The original sin of many startups, including fintech companies, is their reliance on the assumption that the economic conditions of the 2010s will continue indefinitely. Inflation and interest rates will always remain low, and they will never face a shortage of cheap and accessible capital.
There will be no major upheaval. There won’t be a war in Ukraine, and there is no reason for their business foundations to shake.
The utopian city that many companies had imagined is now crumbling. They have a few options: they either need to continue with a limited set of products or consider incentives to retain customers. This issue is especially important for players in the corporate card market, who, despite earning income from fees, must offer substantial discounts or profits to customers.
McKinsey also warned of the impact of rising interest rates and fixed fees on fintechs in its 2022 Global Payments report and stated that the business models of many fintech startups, especially those that buy now and pay later, have not yet proven their credibility in tough macroeconomic conditions.
One thing is clear: high-interest rates, contrary to past perceptions, are not transient, and their longevity is the focus. Therefore, we should not expect low-interest rates in the coming years. Fintechs will survive this period by making tough decisions regarding incentives or expanding their product offerings to adapt to changing conditions.
However, this does not necessarily require a change in their core values. Based on the experience of the most successful fintechs, the best way to attract customers is to offer a much better experience than traditional options.
The right software is a reason for customers to use fintechs instead of traditional, albeit cumbersome, options and, as a result, reduces the company’s reliance on fees and commissions. Instead of focusing on customer volume and transaction growth, the main goal should be problem identification and resolution, opening up new opportunities for your business with new capabilities or unique products.
Furthermore, fintechs can sell their software licenses to organizations and find a new income stream. If the main risk for fintechs is excessive dependence on fees, then diversification is the best way to counter it.
We are not dealing with a new concept here. Microsoft today generates income from various channels – operating systems, Office software, cloud computing, gaming consoles, and laptops. Google, Apple, Amazon, and numerous other successful companies have a similar setup.
However, building and offering new capabilities takes time. Excellent software – truly excellent – requires talent, money, and a long-term roadmap. This level of stability and consistency is a long-term vision for most companies, but it must be remembered that in tough macroeconomic conditions, profitability is not the primary concern of investors, and growth and development are more critical.
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