Banks Can Trump Fintech as Zero-Rate Era Ends

The business of banking has been carved up in recent years. Activities such as financing companies, originating mortgages, trading fast-paced markets and making loans to consumers have migrated to the likes of so-called “shadow banks” or financial-technology upstarts. Regulation, technology and banks’ own missteps have played their parts in this shift. But one core driver has been cheap funding.

Historically, banks have an advantage when getting other people’s money, lending it out and collecting the difference between the interest rates. That is because they have deposits, a very cheap form of borrowing. That advantage shrinks, though, when markets are awash in cash and investors are willing to provide it in a desperate reach for yield.

So as interest rates rise, and money isn’t sloshing around quite so freely, the question becomes whether upstarts that have thrived on market funding will once again be at a disadvantage.

Just a glimmer of this dynamic can spook investors.

Affirm Holdings

AFRM 10.78%

provides consumers with short-term loans and installment payments for “buy now, pay later” purchases, which it funds through a mix including loan sales, securitization deals, and credit lines from banks. It decided to hold off on a securitization deal in mid-March, as have some other issuers recently. Affirm had plentiful funding from other sources, but its shares still tumbled over 15% on the day of the news.

Savvy investors, though, should seek those fintech firms that may continue to have a technology or business-model advantage. For example with Affirm, installment payments are so short term that funding costs are a relatively small part of the equation. The same pot of money can turn over several times. Big banks don’t really compete directly, instead often offering floating-rate card loans. Merchants might be willing to pay Affirm more to enable zero-interest financing to customers when rates are higher.

Newer players also can adopt different funding models.

Upstart Holdings

UPST 7.63%

works with banks to enable them to make loans using its artificial-intelligence underwriting technology; its funding costs are in effect their funding costs. Some online consumer lenders have even become deposit takers themselves:

LendingClub

LC 2.56%

acquired a bank and is now using deposits to fund loans. The same roughly $3 billion in loan origination volume in the fourth quarter earned nearly $30 million more than it did in the same period in 2019.

One thing that makes deposits so attractive is that, while those rates do track with rates overall, they tend to lag behind—known as having low “beta”—because it can be a hassle for people to change banking relationships. Deposits surged during the pandemic, meaning banks might be content to let some customers leave before bringing rates up too much.

Many analysts actually think betas might be high now, in part because the Federal Reserve is expected to move so rapidly. Fast rate jumps tend to wake up depositors. Notably, the Consumer Financial Protection Bureau has said it would be monitoring whether banks compete effectively for customers’ cash. Fintechs that have gone into banking—so-called neobanks—could aim to snag customers with attractive deposit rates. However, higher costs for equity capital as rates rise will make it harder to sustain any money-losing strategies to grab market share.

Rather than funding, investors might want to watch credit. Alongside cheap funding, loan losses due to nonpayment have been superlow recently. So long as a lender can pass along higher rates to consumers, it can adjust for funding costs. But if those higher rates start to lead to more missed payments or defaults, especially as consumers’ other expenses rise too, investors will demand more compensation to fund the loans.

After all, funding costs are ultimately a reflection of risk. The difficulty level of the game may change, but the rules rarely do.

Write to Telis Demos at telis.demos@wsj.com