3 Nov, 2022
Many US banks providing banking-as-a-service trade at lower valuations
By Yizhu Wang and Umer Khan
Many community banks selling banking-as-a-service to fintechs trade at lower valuations compared to the benchmark index, despite the group showing strong profitability metrics.
As of Oct. 24, among 10 select bank holding companies providing BaaS, Pathward Financial Inc., formerly MetaBank, had the highest price-to-tangible book value ratio of 290.1% based on 2022 estimation. The BaaS group's median P/TBV ratio was 129.9%, lower than the bank industry P/TBV median of 143.6% as of Sept. 30, according to data compiled by S&P Global Market Intelligence.
The disparity indicates that investors' concerns about BaaS outweigh their expectations of its rewards. Regulatory compliance, the potential to scale, and the viability of their fintech partners are among the top risks that investors are wary of, according to industry experts.
"There's still a lot of learning going on about what the risk parameters of this type of bank business are," said Michael Perito, managing director at Keefe Bruyette & Woods Inc. covering U.S. regional banks. "Generally speaking, regulatory compliance risk is elevated."
In a traditional banking relationship, banks retain full control of the services provided to their end customers. But BaaS models create an additional layer where fintechs are the actual operators, while banks still carry the fiduciary duty, Perito said in an interview.
Recent regulatory scrutiny on fintech-bank partnerships underscored compliance issues in the fast-growing sector, and banks could face regulatory enforcement actions and operational disruptions if such partnerships break down.
BaaS stocks largely generate lower returns
Pre-pandemic, shares of banks in BaaS typically traded at around a two-point discount on a price-to-earnings basis to the KBW Nasdaq Regional Banking Index, or KRX. During the pandemic, the relative gap closed, and there was a brief period when BaaS stocks traded at a slight premium to KRX. But since then, BaaS stocks have been back to a discount of about 1 to 1.5 points, Perito said.
Among BaaS providers, Coastal Financial Corp. had a higher one-year return than the S&P U.S. BMI Banks Index, while FinWise Bancorp's return reached a peak well above the benchmark around the first quarter but has fallen under it since, according to Market Intelligence data as of Oct. 26. Returns of The Bancorp Inc., Pathward Financial and Green Dot Corp. shares have been lower than the benchmark for most of the past year.
New entrants still need track records
For new entrants into Baas, earnings and revenue may not reflect upfront investments, putting downward pressure on valuations.
Half of the banks in this analysis had a 0% dividend yield as of Oct. 24. While the group median was 0.26%, the industry dividend yield median as of Sept. 30 was 2.98%.
MVB Financial Corp. is one of the players in this situation, said Brett Rabatin, director of research at Hovde Group LLC. As of Oct. 24, MVB's P/TBV ratio was 125.8%. The one-year total return of its stock was negative 39.8%.
"They've made some significant headway, where you can point to their gaming platform, in particular from a deposit perspective, as a huge success, but they're still in very early innings of showing the income that's going to hopefully come to fruition," Rabatin said in an interview.
MVB entered the fintech space in 2016 in search of fee income and deposit growth. In March, the bank hosted its first investor day in Las Vegas where it laid out a strategic plan to add $100 million in incremental revenue for 2024 driven by core product growth and fintech relationships.
Is $10B a dead end?
Many BaaS banks do not want to surpass $10 billion in assets because of regulatory hurdles that kick in at that threshold. Though larger players grow their assets closer to $10 billion, discounts on those banks' stocks could start to manifest, Perito said.
Banks with less than $10 billion in total assets have an inherent advantage in BaaS because they are exempt from the Durbin Amendment, allowing them to earn higher interchange fees on debit card transactions, which is critical since banks take a share of the interchange income generated by their fintech partners.
"So it's a long-term structural profitability question for all these players," Perito said. "Is the profitability of these banks just above average today because they're sub-$10 billion and they're earning more interchange, or in the longer term, is there actually a structural profitability advantage of this business model?"
The Bancorp, at $7.12 billion in assets as of June 30, Pathward, at $6.73 billion in assets, and Metropolitan Bank Holding Corp., at $6.87 billion in assets, are among the banks closest to the $10 billion threshold.
Investor education
For publicly traded BaaS providers, educating investors is critically important.
"We really try to educate [our investors] on what is the market for BaaS or embedded financial services; the difficulty that it takes to scale; the lesson that has to be learned over time to be sure you can be in good graces with your regulators, yet delivering innovation and products to your customers," said Tim Willi, senior vice president of investor relations and corporate development at Green Dot.
In addition to proactive communication, banks have also taken into account investors' feedback when formulating their BaaS strategies. BankProv, a division of Provident Bancorp Inc., carefully crafted the sweet spots for its BaaS relationships between companies in and out of digital assets, said Joseph Mancini, BankProv's COO. As of the first quarter, 8% of its loans and 12% of deposits originated from customers in digital assets.
"I think the feedback we've gotten has been to really find a good niche in the market space, something that we think we've done, and continue to offer this technology-driven approach," Mancini said.