Traditional banks, fintech and trust

Security and the safe handling of customer funds have become a major topic for fintech and crypto trading platforms, and for good reason. Comparisons to traditional banks have been drawn - for better and for worse - and the topic of increased regulation has been pushed to the front of the conversation. What it all boils down to is the question of trust. Can we trust our financial institutions and service providers? What measures are they taking to fortify our trust in them? How does regulation play into it all? We’ll answer these questions and more below.

Reliability. Security. Transparency. These are the qualities we expect from our financial institutions, regardless if they’ve existed for centuries, as modern banks have, or have only emerged in the last couple of decades, as in the case of fintech neobanks and crypto platforms. It’s these qualities that can make or break a relationship between a bank and the consuming public, as Raija Anneli Järvinen writes in a paper titled Consumer trust in banking relationships in Europe: “Consumer trust in banks and banking services is based on consumer experience and is dependent on the ability of banks to behave in a reliable way, observe rules and regulations, work well and serve the general interest.” 

If financial institutions hold up their end of the bargain, then the trust relationship remains in balance. But what happens when they don’t? What happens when markets come crashing down or high-flying executives publicly flout the rules? What transpires when banks engage in risky practices or when new, unregulated technologies defraud investors? 

These questions have strained the trust relationship between banks and consumers for a while, and the rise of new fintech companies - their number nearly tripling in the European Economic Area in the last few years, according to Statista - are only throwing more spanners in the works. One thing is clear: trust and security in financial institutions have become more important than ever before.

What are banks?

Let’s start at the beginning. The concept of banking has its roots in the merchant banks that arose in antiquity, and the services provided by these early banks may have included bartering, deposits and possibly lending. Modern banking as we recognise it today evolved from the banks established in the Italian Renaissance by famous families like the Bardi and Medici, who opened branches in multiple cities across the country. People would deposit precious metals in exchange for a receipt, which they could then use to retrieve their metals. 

From its earliest inception, the very foundation of banking has rested on a trust relationship between the institution and the client: Depositors give their money and valuables to the bank expecting that they would remain there and would be accessible whenever they wanted to withdraw them again. 

That basic concept has prevailed for centuries, although the introduction of fractional reserve banking, which was developed in 17th-century London and has become the most widely used international banking system ever since, added potential complications to the client-depositor trust relationship.  

What is fractional reserve banking?

In the fractional reserve banking model, the bank is only required to hold a fraction of their customers’ deposits and can use the rest to lend to other customers. The fine balance here is stimulating the economy with cash flow while also having enough cash reserves in case customers want to withdraw funds - a balance that works a majority of the time, but in a minute we’ll take a look at some historical and recent examples of what happens when banks don’t have enough liquidity to meet customer withdrawal demand.

How are banks regulated?

The definition of a bank pursuant to different banking regulatory laws is quite important, especially in the age of fintech and neobanks. These definitions are crucial when it comes to determining how these institutions should be regulated. Most definitions include some reference to accepting deposits from the general public which is repayable on demand.

For traditional banks, there are checks and balances in place to ensure that they are compliant with the law, reduce risk and crime, and curb the mistreatment of customer funds. Regulation can vary wildly depending on local jurisdictions, but there are some general rules. Banks must acquire the appropriate licences, which subject them to supervision by a regulatory body. Supervision can take the form of on-site inspections, regular activity reports and the setting of regulatory frameworks for various aspects of the banking business. Banks are additionally required to maintain a minimum net worth, i.e. the amount of reserves the bank must have available. They must also disclose their earnings in financial reports, and there are restrictions on the types of activities banks can engage in and what type of things they can invest in. 

Overall, regulations seek to avoid financial crises and to ensure stability of overall financial systems and prudent behaviour of financial institutions.

Learn more about the regulation and legislation of banks and crypto platforms here.

The trust relationship towards traditional banks

Trust is the essential ingredient in the relationship between banks and their customers. Though officially the relationship rests upon a formal contract, the strong emotions that people have in connection to money take the relationship far beyond a signed document. As Jaervinen writes, beyond contractual trust, “competence trust and goodwill trust [are] appropriate to consider in this context.” When these three degrees of trust are met, then both sides can flourish. 

Though sometimes, either when banks commit (legal or illegal) actions that betray the integrity of the trust relationship, or when a perfect storm of outside forces does the job for them, things tend to fall apart rather quickly.

When trust fails: Panics, crashes and bank runs

One of the most recent and poignant examples of a failed trust relationship between consumers and banks is the 2007-2008 financial crisis. Though the culmination of several different events, the crisis that led to the Great Recession is most often pinned on the “excessive risk-taking” by global financial institutions, including the preying on a certain segment of low-income homebuyers for predatory financial products. The general sentiment was that these huge, monumentally wealthy bankers and hedge funds (“shadow banking”) were intentionally misleading and in some cases even defrauding the public. It became clear that regulation and oversight of certain segments of the banking world had been seriously missing.

During the 2007-2008 financial crisis, bank runs occurred on several banks globally, including Washington Mutual and Northern Rock in England. Symbolically speaking, a bank run is a clear indicator that trust in that bank has failed since it means that a large portion of customers demand their money back from that bank thinking it will soon collapse - a vicious circle, as the more customers run on a bank, the more likely it is to default.  

Something very similar happened only recently in March 2023 as three major banking institutions, Silicon Valley Bank (SVB), Credit Suisse and Signature Bank, all collapsed. SVB was the bank of choice for startups and companies in the tech sector. As the industry experienced some growth setbacks over the last twelve months, along with the pressures from inflation that led to the raising of interest rates, more and more SVB clients wanted to withdraw their funds. The bank had however invested a large portion of this money into treasury bonds (which they bought when interest rates were low) and was forced to sell these bonds at a discount (the value of the bonds had declined) in order to have enough liquidity to pay its depositors. It’s worth noting that a majority of the deposits were not insured. When SVB made their losses of nearly 2 billion dollars public, more customers started to panic, which led to the bank run and the bank’s collapse. 

Bank runs have happened throughout history, and have become a strong symbol of mistrust in the banking system. Especially during the Great Depression, the aftereffect of the stock market crash of 1929, bank runs were common, and even immortalised in Hollywood films, like in 1946’s It’s a Wonderful Life. 

This scene also illustrates the concept of fractional reserve lending, i.e. how banks use deposits to finance other activities. Deposit insurances, which are meant to cover a depositor and the bank in case of a bank’s inability to pay, may add a layer of protection. But critics of deposit insurance claim it actually heightens risky behaviour in both the bank and the customer. It’s like when you get full insurance when renting a car: you feel like you can be more careless because even if you get into an accident, you won’t be the one stuck with the damages.  

History tends to repeat itself. In spite of Great Depressions and Great Recessions, and despite total market crashes and financial devastation, the economy eventually recovers, and so does the risky behaviour. Still, one new thing did come out of the 2007/2008 crisis: the search for alternatives to the old ways of banking, as well as the introduction of new and updated regulatory rules, which set the stage for the age of neobanks - and a new trust relationship.

What are neobanks?

Fintech is a catch-all term for new technologies that are disrupting the financial sector and offering alternatives to traditional ways of dealing with money. Short for financial technologies, fintech has touched everything from banking to payments to taxes and investing. There’s hardly a financial service that hasn’t been disrupted by fintech. But by far one of the biggest booms has been the rise of the neobank.

Over the last few years, neobanks have earned their spot as the top choice for banking services among young urban professionals, millennials and Gen Z. Neobanks are not like traditional banks that prioritize on brick-and-mortar locations, but function more like branchless banks that operate online. Still, depending on the services they provide, they must obtain a full or partial banking licence from their local government in order to operate, although some can operate without a banking licence as electronic money providers.

Neobanks are digital-first and mobile-first. They offer checking and savings accounts, debit and credit cards, payments and other traditional banking services, however, they operate almost exclusively online. Most neobanks don’t have brick-and-mortar branches nor do they have ATMs. This is one major area where they save costs compared to traditional banks, and they can pass on the savings to their customers by offering their products mostly for free. Contrary to traditional banks, neobanks earn the majority of their revenue through transaction fees.

Neobanks became especially popular after the 2007/2008 financial crisis and are often referred to as “challenger banks.” Though the financial crisis wasn’t the cause for new banking alternatives to emerge on the market - they were already on their way - timing was certainly on their side. The development of financial technology, the improved digitisation of banking services and the quick adaptation of the public set the stage for neobanks. Presenting themselves as an alternative to traditional banking, in some cases using transparency, ease of use and equal access in their marketing messaging, underscored their position.

Their newness however is also one of their disadvantages as neobanks and fintech in general are still in a phase of proving their longevity, and building (and maintaining) a strong trust relationship is part of that journey. Coupled with the fact that currently there isn’t as much regulation in place, neobanks face a challenge similar to that of traditional banks - maybe an even greater challenge, considering how standard regulations do not apply and rules have to be modified or created to suit the digital nature of neobanks. 

Neobanks vs. crypto platforms

Cryptocurrencies add another layer to the booming fintech landscape. Neither a bank nor a neobank, crypto platforms that allow customers to digitally exchange and trade assets, like fiat currencies, for cryptocurrencies and other digital assets. Most often they make money on transaction fees.

Cryptocurrencies arose from the idea to offer a decentralised currency that would be accessible and usable by everyone around the world, without the need of a central authority like a bank or government running the show. But in order to reach a mainstream appeal and to ease the access to cryptocurrencies, centralised platforms arose and now effectively function as centralised intermediaries, as opposed to the early decentralised vision of crypto. They therefore face the similar trust and regulation requirements as banks and neobanks do.

Crypto platforms are not banks, however, they must also acquire certain licences and/or registrations from respective local governments to operate. In order to keep up with the increasing demand for easy ways to buy and sell cryptocurrencies, both traditional banks and neobanks have started including crypto trading capabilities on their platforms, often by partnering with an existing crypto broker or exchange and offering their services as part of a white label solution. Bitpanda Technology Solutions, for example, has partnered with the likes of N26, Lydia and Plum, to help them create their own customer experiences by leveraging the Bitpanda end-to-end automated trading infrastructure.

How are neobanks regulated?

Regulation for fintech varies drastically from country to country. And unlike for traditional banks, there usually isn’t one central regulatory body for all the fintech startups that are popping up across the map. Fintech banks and neobanks should obtain a licence from the jurisdictions they wish to operate in. In Germany, for instance, a neobank must obtain a licence from the BaFin, the regulatory agency, either a full or partial licence depending on the scope of the services they offer. Some fintechs ill-advisedly decide to forego regulations and licence applications and to scale faster and save costs. However, they often encounter problems in the long run, not to mention they are placing their trust, transparency and security principles at risk. Fintechs who do it right choose to be regulated by their local authorities.

Some neobanks are pure service providers that partner with traditional banks that are already federally regulated. This is how some neobanks obtain their deposit insurance. But overall, since financial services providers like neobanks are still relatively new in the grand scheme of banking, they aren’t as heavily regulated as traditional banks.

How are crypto platforms regulated?

Like neobanks and regular banks, crypto platforms must obtain licences and registrations to operate. These licences ensure that the business is functioning above board and is not engaging in unsavoury practices with customer funds. 

But crypto is still a nascent industry and regulation remains one of its growing pains. Some companies might be content with foregoing regulatory measures unless they are legally compelled to, but Bitpanda proactively seeks out and applies for crypto registrations and other financial licences in many different jurisdictions. We go above and beyond the legal requirements in order to establish a strong mutual trust relationship with our customers. Learn more about Bitpanda’s crypto registrations and licences.

Fintech and the trust relationship

Up until recently, neobanks typically had an easier time reaching younger professionals, urbanites, digital natives as well as groups who’ve had a negative experience with traditional banking. But when it comes to establishing a trust relationship with their customers, neobanks are in the same boat as traditional banks in that both have to work hard to earn the trust that isn’t stipulated by contracts and regulations, and work to restore trust after scandals.

The Wirecard scandal, for example, in which fraudulent accounting and reporting activities to maximise profits eventually led to the downfall of the German financial service provider, is probably the most poignant recent example of how neobanks are just as likely as traditional banks to breach the trust relationship.

Some crypto platforms have also not been exempt. In late 2022, the CEO of Binance sent out Tweets suggesting that not everything was right at FTX, a competing crypto platform. These suggestions triggered a run on deposits - the digital version of a bank run - which sent FTX into a liquidity crisis because they were unable to meet the requests of their customers. This scandal unearthed what appears to be calculated fraud and shady business practices on the side of FTX (investigation still in progress). But suffice it to say that the trust relationship has ruptured irreparably and, as during the 2007/2008 financial crisis, the actions of a few had a ripple effect across the entire industry.

Conclusion

Despite the growing popularity of digital-first banking businesses, traditional banks won’t be going away anytime soon. In fact, although traditional banks and neobanks compete with each other, they often partner up to offer a broad spectrum of financial products. Even on their own, traditional banks are stepping up their game in the digital banking realm in order to compete with fintech. 

When it comes to security and therefore who to trust, it’s important to seek out financial institutions and service providers that place regulation at the top of their priority list. Companies that choose to be regulated and obtain licences, regardless of whether they are strictly required by the law, are doing so because they want to build trust with their customers. Whether you like banking in person or online, make sure to choose an institution that you can rely on.

To learn more about what we do as a crypto platform to stay fully regulated and compliant, visit our security at Bitpanda page.