From Book to Bank: How a Fintech Firm Found Its Calling
Knowledge@Wharton: How did you come to write this book, and how did that lead to building a bank? Vladislav Solodkiy: The first edition of the book summarizes five years of my experience in the fintech industry. The second, updated edition, reflects comments from readers, including industry experts. Our investments and exits are well known in the fintech industry because we publish our Money of the Future reports. Many people, after reading our reports, asked me to predict the next big thing in the fintech industry. That is how I came up this idea of the book, where I tried to predict and imagine what could happen in fintech over the next few years.
Knowledge@Wharton: What does the fintech bank of the future look like? How is it different from a traditional bank in terms of its opportunities and its risks?
Solodkiy: When neo-banks or challenger banks like Simple Bank (in Portland, Oregon) came to the market, they were very different in comparison with traditional banks, and relied on online channels of distribution. (Neo-banks typically do not have banking licenses and partner with traditional banks, while challenger banks – called so for “challenging” traditional banking – possess bank licenses and target areas underserved by bigger, traditional banks.) However, they had a branch-oriented approach. [As their customer], you first must go to the physical branch to sign a few papers to start your relationship with the bank, and after that, you can use the bank’s other products and services including online access.
The first wave of neo-banks and challenger banks started with a mobile-first approach. You could download your bank’s app from the Apple Store or Google Play and start your relationships without any obligation to visit a physical branch, or to sign any physical documents. You could begin the relationship immediately and start using the bank’s services.
The first wave of digital banks provided basic products and services such as money transfers. But this approach does not provide you as the customer an ability to replace your traditional bank because your traditional bank could deliver up to 20 product verticals to cover all your possible needs.
The second wave of digital banks, which I describe in my book, could replace traditional banks for you as a customer, and deliver all possible products and services. I describe the different ways for new players to deliver those services, and different scenarios for the market itself, and how to build or even to imagine these banks.
Knowledge@Wharton: What was the significance of the name of the bank?
Solodkiy: When Jeremy Berger, co-founder and chief operations officer of Arival Bank, and I decided to build this bank, we also started to think about how to brand and name this bank. Jeremy is only 24 years old, and the youngest digital banker in the world at this moment. We took this game of words, like the arrival of the first fintech bank.
We have won three fintech awards in three weeks. (In October 2018, Arival Bank won an award at the FinovateAsia conference in Hong Kong. A week later, it won the FintechInn competition in Vilnius, Lithuania, organized by Central Bank of Lithuania. Next, it won the silver at the 2018 Driven x Design award of the London Design Awards.) I think three awards in three weeks is a good sign from the universe that we are doing something new and attractive for our audience.
Knowledge@Wharton: Why do you think Arival Bank won these awards? What is it about the bank that appealed to the judges in all three locations?
Jeremy Berger: Three key elements of our bank attract businesses and judges. The first is we have a heavy approach in our compliance and our KYC (Know Your Customer) processes. We are targeting underbanked businesses, if you will, like SMEs, startups, freelancers, charity organizations, and even crypto-related businesses.
The second is the way we deliver products and services. We have an open API banking approach. (APIs, or application programming interfaces, allow different pieces of software to work with each other, making it possible for third party developers to develop solutions to problems.) This means we can partner with hot fintechs in the market and deliver their products and services that are designed for business customers. Third, we have an authentic strategy in terms of interacting with customers. We don’t believe in chatbots; we believe in having this authentic communication that is transparent. We make a big effort in understanding our customers and their day-to-day business needs.
Knowledge@Wharton: What led you to launch Arival Bank in Puerto Rico? What challenges did you face initially in setting up the bank? Are there any special regulatory issues in setting up a fintech bank in the U.S. compared with other countries?
Berger: My background relates to Puerto Rico. I went to university in South Florida, and so I was familiar with some of the opportunities emerging in Puerto Rico. After [Hurricane Maria] struck in 2017, the Puerto Rico economy was looking for rejuvenation, and fintech might be a natural remedy for economic boosts. The government has been extremely vocal in encouraging startups to come set up shop here, and in looking for fintechs, VCs, and so forth.
Initially, after we started getting all this traction and publicity with Slava’s book, we looked at 20 or 30 smaller banks in Europe and the U.S., in terms of buying them. But then we realized buying a bank doesn’t happen overnight. The amount of resources, capital and time it takes is equivalent to building it from scratch and going through the licensing process. So, we started looking at different jurisdictions.
In Asia, Hong Kong offers a virtual banking license; the U.K. has an e-money license, and in different places in Europe there are EMIs, or e-money institutions. The more due diligence we did, the more we realized that a lot of the banking systems globally try to emulate the U.S. market, in terms of its sophistication and its durability. Everything was leading us back to the U.S. market.
I am not going to say [the U.S. banking industry] is the most innovative, because it is not, and it is not due to lack of innovative minds; it is because of how competitive the playing field is. There are almost 9,000 small or community banks in the U.S., so it is hard for banks to come out on top. In countries like Italy, Poland, and even in Africa, you see many innovative digital banks.
Puerto Rico is a U.S. territory, and it is under the U.S. federal banking system, so there are many advantages and benefits of being in the Puerto Rican banking system, [including] allowing a gateway to the U.S. market. The U.S. is the hardest market to get into. We thought that if we are going to do it right and we want the integrity and the credibility going forward, why not start with the hardest market? That is how we identified Puerto Rico as the initial entry point.
At the same time, we are already expanding into different markets. The EMI license in the EU is certainly on our agenda. We hope to apply for that at the end of this year. We are also looking at [securing an] e-money license in the U.K. We want to move as global as fast as possible.
Solodkiy: We also are in negotiations with regulators in Japan, Hong Kong, Singapore and Dubai. The U.S. is like the mother market for us. Digital banking started in the U.S.
Knowledge@Wharton: How do you think about who your customers are, and how do you use data and analytics to gain a competitive advantage over traditional banks?
Berger: The story of Arival started about a year-and-a-half ago when our VC fund, Life.SREDA, was approached by hundreds of different businesses with the same problem. Some banks were closing and freezing their accounts, and crypto-related businesses, freelancers, startups, independent contractors, and even charity organizations were facing this challenge of being disconnected from the banking system.
After three or four months of research, we understood that the problem was universal. You could read stories any day of the week that banks in Australia, Thailand, Israel, and the U.S. were closing or freezing the accounts of those businesses. That is how we identified them as our target customers.
We know there is huge demand and opportunity, but we want to make sure we are targeting an exclusive class – those that have obtainable data, where we can evaluate their risk ratings. We evaluate them in terms of customer retention or longevity. We believe that data is the driving force of the future of banking.
Solodkiy: When you decide to build a licensed bank, the regulator – the Federal Reserve –– will listen to your innovative ideas and your predictions for the fintech industry. But 99% of their questions will be on compliance, compliance, compliance. The disrupters mostly care about innovation, but regulators must gauge the risk, and [protect] the citizens of the country.
When we told the regulator about the types of customers we want to serve, their immediate answer was ‘It is an interesting idea, and for sure it is not forbidden, but you have to understand that these are high-risk clients.’ They referred to not only crypto-related customers, but also charity funds, legal sellers of weed in different U.S. states, and other businesses excluded from banking system.
When you decide to work with such high-risk clients, you must show [the regulator] that you are able to implement all the technologies in KYC and AML (anti-money laundering) to track origin of their money and their social connections. It is everything about big-data analysis – not only transactional data and financial data, but also social data, the devices they use, their friends, colleagues, and family members, who the senders and receivers of money are, who their colleagues are and other social connections.
Fourteen banks came to us when they found how we go about our compliance processes and asked us if they could use our compliance as a service instead of setting up their own compliance department. One of 10 biggest companies in the world that I cannot name came to us and asked us if they could use our KYC model [for their processes in] ‘know your employees’, ‘know your partners’, ‘know your businesses’, and ‘know your customers’. One of the biggest messenger companies, which has several hundreds of millions of users, asked if they could use our compliance model.
Knowledge@Wharton: How do you ensure compliance with banking regulations, especially the Know Your Customer and Anti-Money Laundering rules, as you pursue new opportunities with high- risk clients like crypto-businesses?
Berger: From the get-go, we had to be transparent and open with the regulators. From day one we made it clear that these are the kinds of businesses we want to go after. At the same time, we are not a crypto bank, so we share a lot of similarities with traditional banks in terms of fiat [currency] transactions and such like.
Going back to your question regarding compliance, we had to engage some of the top names in the compliance consulting world. In addition, it is important to understand the three most important things in compliance: customer, product, and geography. That is basically about who your customers are, what they want from you, and where they are located. Once you obtain this information during the KYC process, you put them into your risk matrix, which should tell you the risk rating. Based on this risk rating, you proceed internally with due diligence with KYC verifications that you need to validate for every customer that you either want to onboard or not.
Going back to this old school compliance model is important. At the same time it is crucial to understand where compliance is heading. Right now, with traditional banks, most of us can agree it is very time consuming, costly and done manually most of the time. It is not designed for high-risk businesses.
We have made it our goal and priority to develop compliance that is designed for these kinds of businesses. We show them that we understand the businesses, what they are doing day to day, what kind of investors they interact with, what kind of auditing should we expect from them, and what kind of business plans we evaluate as being feasible.
At the same time, we are looking ahead. Three, five or eight years down the road, we see a big level of deep tech, machine learning and data analytics in banking, because we want to remedy the faults you see now with traditional banks. If we could automate many of these processes, it will make compliance a lot easier, and increase the chances of us effectively onboarding high-risk businesses.
Solodkiy: [First], before creating this cutting-edge solution for ourselves, we tried to become a customer for other compliance firms. We found that while many companies were trying to provide solutions and technologies for the KYC process, only few provide solutions for the Know Your Business, or KYB process.
Second, all compliance firms focus on the onboarding process. But 80% to 90% of these ‘bad guys’ can be verified as ‘bad guys’ only when they proceed with a transaction. This is clear from recent investigations by the U.S. government in money laundering cases. The real bad guys – or the big money laundering specialists – will be able for sure to successfully proceed with your onboarding process. But where you could find them, track them, and cage them is only during ongoing compliance. Only a few companies worldwide provide solutions not only for onboarding verification but also for ongoing compliance.
The reporting and the architecture of your compliance process are also important. An open API-based technology could be used not only by yourself but also by other companies, including other startups. In the beginning, we created our architecture as open architecture, based on open APIs. A third-party player could use each element, including our compliance solution.
For all banks across the world, compliance is expensive and a headache. For our bank, it is a passion and we have a real love for it. It is one of the biggest income streams for the bank.
Knowledge@Wharton: How do you work with other institutions as part of the financial services ecosystem? Do you see other banks as competitors, or as partners, or both? How do you manage your relationships with them?
Berger: Many banks have approached us. We don’t see them as competitors. If anything, we want to create a learning platform, to educate one another, because certainly they know some things that we don’t, and we know some things that they don’t. This book is about how fintechs and banks need to collaborate and cooperate. There are many benefits and advantages to doing that, whether in monetization strategies, or market share, or sharing customers and referral agreements.
In terms of how we want to work with banks, we are looking at sub-licensing for expansion into different markets that are a little bit more conservative, especially in places in Asia, such as in Japan or in Singapore, where we are talking with some banks passively in terms of partnerships there.
It’s not that we have this anti-mentality against traditional banks. Of course, we want to do something a little bit differently, and we think this fintech banking strategy is real, and the time for it is now. That said, we don’t have an active approach in terms of partnering with [traditional] banks yet, but we certainly see some potential down the road.
Knowledge@Wharton: What are the biggest risks you foresee for Arival bank in the future? How will you mitigate those risks?
Solodkiy: The biggest risk is to onboard the wrong client, and wrong money from hidden sources of funds. We want to be super-transparent to regulators and other counterparts across the financial markets when we onboard the wrong customers.
[Two aspects are important here.] First, who will spot the mistake [when you onboard an undesirable customer]? If it is you or your bank, it is a plus for your karma. If the regulator [discovers that], it is a minus [for your bank]. Second, [a lot depends on] how fast you share information about such cases with the regulator. If you do it immediately, and in a transparent manner, it is a plus for your karma. If you wait a few months, or even years – as it happened recently with several banks – you could face fines from the regulator of hundreds of millions of dollars.
Third, it is important for the regulator to know what you have done before to predict and to hedge such risks. The fourth aspect is about what you will do after that the event. How would you upgrade your internal processes, compliance requirements and compliance technologies to avoid such risks with other clients?
If you can [satisfactorily] answer those four questions, nobody will punish you, because regulators in the U.S. and in other jurisdictions understand that you cannot protect 100% your business from potential enemies. Some wrong people will try to use your brand for their illegal plans.
Source: Knowledge Wharton