top of page

The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

  • Ford Men on Amazon
  • Twitter
  • LinkedIn
  • Pinterest

Update: Square as a Bank

New York | One of the hot areas to watch in terms of risk and return in the coming year is the steady migration of “fintech” companies into a commercial banking model, in some cases combined with public ownership. We view this trend as a positive development and believe it confirms our view that “fintech” is merely a marketing term and insured depository institutions have a monopoly on payments in the US.

Back in January of 2020, The Institutional Risk Analyst published a comment (“Is it FinTech or OldTech?”) that asked the basic question, namely is there anything really “new” in the fintech model or are these just new age nonbank financial companies. Remembering that nonbank firms, are by definition, more nimble than commercial banks, but dependent upon depositories for access to the payments system, the answer seems to be that fintech is an overlay on the traditional bank model controlled by the Federal Reserve System.

Once the fintech “challengers,” as the media likes to call them, outgrow the pretense of cooperating with banks, then they must become banks themselves. Our experience has been and continues to be that the term “fintech” is mostly media hype, an inflated description for technology enabled finance companies that all must eventually become, well, commercial banks.

And once these fintech platforms become established and their once innovative products become commonplace, then the equity market valuations will tend to fall into line with the comps. In this regard, the evolution of fintech companies into regulated banks has implications for public market valuations.

We owned PayPal (NASDAQ:PYPL) and Square Inc (NYSE:SQ) in the early days, but took the triple digit gains off the table in 2018. In retrospect that may have been a poor tactical trade, but to paraphrase Jim Cramer on CNBC, in this Fed-manipulated market it is never bad to take profits. We have added PYPL and SQ to our financials surveillance group.




Square as Bank

In December, the Federal Deposit Insurance Corporation (FDIC) issued a final rule setting forth standards to apply to controlling shareholders of industrial banks that are not subject to consolidated supervision by the Federal Reserve System. The final rule will take effect April 1, 2021.

On the same day that it announced the proposed rule last year, the FDIC approved preliminary applications for deposit insurance submitted by SQ and Nelnet, Inc. This action paved the way for the two companies to establish the first de novo industrial banks in over a decade in 2021. A diagram of the current SQ business model is shown below from the company’s September 2020 investor presentation.

This year Square is aiming to launch an industrial bank called Square Financial Services. The non-bank will originate commercial loans to merchants that process card transactions through Square's payments system. Square Financial Services, Inc. will operate from a main office located in the Salt Lake City, UT. The bank will not take demand deposits in order to avoid being classified as a commercial bank and will be supervised by the FDIC and the Utah Department of Financial Institutions.

The FDIC approval for SQ and Nelnet followed shortly after an application by Great America Financial Services, a nationwide commercial equipment leasing firm, seeking an industrial bank charter application. The Edward Jones financial advisory firm filed an industrial bank charter application with Utah in July 2020; Rakuten (OTC:RKUNY) filed an industrial bank charter application with Utah DFS in July 2020; and General Motors (NYSE:GM) filed an industrial bank charter application with Utah DFS in December.

Most of these applications seek to create nonbank lenders that make loans and have access to the Fed’s payment system, thus the requirement for FDIC insurance. Even if the industrial bank does not intend to take demand deposits and thereby become a commercial bank as defined by federal statute, the fact of FDIC insurance (and regulation) allows the industrial bank to access the payments system and maintain a master account at a Federal Reserve Bank.


Looking at the recent performance of SQ, the stock has risen sharply since the start of the COVID pandemic. Even the most jaded of observers, however, have begun to ask if the valuation of SQ at 52x book value is a bit excessive. Even payments market leader PYPL, for example, trades at “only” 14x book, up 100% over the past year. As SQ matures as a company, we suspect that such comparisons will become more relevant.

The wave of demand due to COVID fueled SQ’s triple digit annualized revenue growth, almost 400% in Q4 2020. If this torrid growth is at an end, what does that say about this year? For 2021, the analyst consensus for revenue growth is just 30% for the year. Will the 40% five-year CAGR SQ has posted in terms of gross revenue expansion continue over the next five years?

Looking at SQ as a payments company, in the first nine months of 2020, it generated an $80 million net loss. Transaction and loan losses doubled along with revenue. Note that in Q3 2020, for example, SQ basically broke even on its dealings in bitcoin.

In the nine months ended September 2020, SQ generated $260 million in cash from operations, invested $530 million back into the business and raised $1.3 billion, mostly from the issuance of $980 million in senior debt and $100 million in equity warrants. Another $400 million in cash came from “proceeds from PPP Liquidity Facility advances.”

Written presentations say a lot. The company led by Twitter (NASDAQ:TWTR) CEO Jack Dorsey has fintech approach to investor disclosure, with pages of discussion of gross profits and market prospects, but little discussion of eventual net profitability. The slide below is taken from the September 2020 SQ investor presentation and shows SQ’s version of EBITDA. In is interesting to note that one of the requirements in the preliminary FDIC Order approving SQ’s bank application is to adopt and maintain an accrual accounting system.

Of note, SQ reported $1.3 billion in shareholder equity at the end of September 2020. If we treat SQ as a bank holding company and subtract the $300 million in goodwill on the firm’s books, that leaves $1 billion in Tier One capital to support the new bank. Any capital SQ invests in the new industrial bank subsidiary will be segregated from the parent company and subject to Reg W, which governs transactions with affiliates. We assume that SQ will be required to raise substantial additional equity to satisfy the FDIC’s capital requirements.

Given the above comments about growth and capital, does SQ really deserve to trade at 50x book value and over $100 billion in market cap, roughly the same as Citigroup (NYSE:C)? In this regard, we have two questions about SQ:

  • First, is SQ really a revolutionary model or merely an early starter as a provider of payments software able to adapt better to serve customers with new technology. Just as SQ stole the march on the big banks by breaking the model for small vendor accounts, are they now prey for the larger, better financed portals and tech names?

  • Second and more important, will SQ lose that highly valued “fintech” edge once it and other finance companies become industrial banks subject to the prudential oversight of the FDIC. The FDIC’s Order approving the SQ application for federal deposit insurance may be found here. Some of the requirements are pro forma, but others are quite serious and imply major changes in the way that SQ conducts business.

For example, like a commercial bank, SQ must now maintain and manage to a written business plan for the industrial bank, as stated in the FDIC’s order, and also accept regulation of the parent company. The FDIC will also want to see a coherent, five-year business plan from Dorsey as to the management of SQ. The FDIC Order is excerpted below:

“That the Bank shall operate within the parameters of the Business Plan submitted as part of the application for Federal deposit insurance and as updated. Annually, the Bank shall submit an updated Business Plan to the Regional Director of the San Francisco Regional Office for consideration by the FDIC. The Business Plan, as updated, shall be based on prudent operating policies, include current and three years of pro forma financial statements and other relevant exhibits, prescribe adequate capital maintenance standards relative to the Bank’s risk profile, and incorporate reasonable risk limits with respect to adversely classified assets, liquidity levels, and other relevant risk factors.”

The FDIC final rule requires a "covered parent company" such as SQ to enter into written agreements with the FDIC and the industrial bank to: (i) address the company's relationship with the industrial bank; (ii) require capital and liquidity support from the parent company to the industrial bank; and (iii) establish appropriate recordkeeping and reporting requirements.

Through the final rule on industrial banks, the FDIC seeks to accomplish two important goals:

  • First, ensure that the parent of and industrial bank approved for deposit insurance serves as the source of for the industrial bank; and

  • Second, provide transparency to future applicants and the broader public as to what the FDIC requires of parents of industrial banks.

Specifically, the Final Rule for covered companies that own industrial banks requires that they agree to a minimum of eight commitments, which, for the most part, the FDIC has previously required as a condition of granting deposit insurance to industrial banks. These include:

(i) providing a list of all parent company subsidiaries annually; (ii) consenting to examinations of the parent company and its subsidiaries; (iii) submitting to annual independent audits; (iv) maintaining necessary records; (v) limiting the parent company’s representation on the industrial bank’s board to 25 percent; (vi) maintaining the industrial bank’s capital and liquidity requirements “at such levels deemed appropriate” for safety and soundness; (vii) entering into tax allocation agreements; and (viii) implementing contingency plans “for recovery actions and the orderly disposition of the industrial bank without the need for a receiver or conservator.


We like SQ’s aggressive strategy for going to market and have long advocated that finance companies ought to consider a bank charter, yet the challenges of doing so are substantial and growing. Taking the flat, entrepreneurial management culture of a SQ and transforming it into a pyramidal management model required for the holding company of an FDIC insured depository is not an easy task and one that has discouraged many applicants in the past. This is the main reason why the FDIC lays out all of the responsibilities for owning an industrial bank in its Final Rule.

Can SQ and others offer their products and services on a national basis, using the first in class the technology, algorithms, and marketing savvy they have honed, but as a bank? If SQ is successful in gaining final approval from the FDIC and UT Department of Finance to actually launch its industrial bank this year, look for some significant changes in how the company operates and also how it reports its financial information to investors.

First and foremost, SQ is going to need to find a way to achieve profitability and thereby satisfy the key regulatory consideration for bank ownership, namely being able to serve as a source of financial and managerial strength to its subsidiary bank. The FDIC is not the Fed, but it will in fact serve as the prudential regulator of the parent of any federally insured industrial bank.

As SQ chases growth in an increasingly crowded market, we believe that the company will encounter greater difficulty as competitors from Alphabet (NASDAQ:GOOG) to Apple (NASDAQ:AAPL) roll out payments solutions for business. Indeed, it is interesting to note while looking at SQ that payments market leader PYPL shows no inclination yet to actually become a bank.

As more and more fintech companies migrate to a bank model, we suspect that investors will see more reasonable valuations. The upward skew in market valuations caused by COVID in 2020 is likely to moderate as we move through 2021 and the banks and nonbank players in the payments space intensify the competition for the new revenue that SQ seems to take for granted.


Recent Posts

See All


Les commentaires ont été désactivés.
bottom of page