Varo, First Chartered Neobank, Could Run Out of Money By End of Year, Regulatory Filings Show (Updated)
What the Regulators Should (and Shouldn't) Do to Encourage Competition
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Varo Is Running Out of Money and Time. What Does It Mean For Other Fintechs Seeking Charters?
[editor’s note: the emailed version of this story included an error; I misread income- and expense-related data in Varo’s Call Reports as quarterly, when it was actually year to date. As a result, income/expense metrics for Q4 2020 & Q2-4 2021 were incorrect. This has been corrected in the web version.]
While Chime may be the largest US neobank by users, Varo has the unique distinction of having gone through the arduous process of obtaining a de novo national bank charter — a process that reportedly cost nearly $100 million and took three years. It looks like it may not have been worth it.
For neobanks, there are two main arguments for obtaining a charter.
A bank charter and accompanying deposit insurance enables them to directly hold their users’ deposits, instead of storing them at a partner bank; in turn, they can lend against those deposits to generate interest income. This is, after all, a primary way consumer banks make money.
Secondly, holding a charter would enable neobanks to issue their own debit and credit cards, instead of relying on a bank partner. Removing a parter bank from the stack would improve neobanks’ take rate of the interchange income generated when users swipe their cards.
These arguments seem to have underpinned Varo’s decision to pursue a charter.
Varo CEO Colin Walsh indicated to TechCrunch — just eight months ago — that the bank charter would allow Varo to “pursue growth and profitability at the same time” and to expand its margins (emphasis added):
“Being in the regulated system loop has allowed us to expand our margins considerably,” he said. “We also now have direct access to the payment network so our ability to generate substantial value both to our consumers as well as to our shareholders is becoming more and more apparent.”
Walsh also said that Varo is not yet profitable, but is on its way there. He predicts that Varo will achieve profitability in about two years, or three years after becoming a bank.
“One of the nice things that the charter affords us is that we can actually pursue growth and profitability at the same time,” Walsh said. “It’s very much within that three-year window of when we became a bank.”
Varo has struggled to build a meaningful loan book by lending to its customers. In its Q1 2022 call report, it indicated about $9.4 million in credit card balances — but Varo’s card offering is secured and does not generate interest income nor significant fee income, apart from interchange.
Varo did report about $3.6 million in “other revolving” loans to customers, which, presumably, is its Varo Advance small dollar unsecured lending product — an average of less than $1 outstanding per deposit account.
Despite the small amount of lending Varo does to its own customers, it still saw about $500,000 in charge offs against these amounts in Q1 2022; its charge offs for the quarter including “all other loans” (eg, apart from those to its own customers) totaled nearly $2.2 million.
The total amount of income-generating assets Varo has been able to hold has been constrained by the amount of equity it holds and the requirement that it hold a 10% or greater Tier 1 leverage ratio.
Because Varo is loss-making, it’s impossible for it to grow its income-producing assets beyond a certain level without continuing to raise outside capital — something that has likely become much more difficult in the current climate.
Based On Its Current Burn Rate, Varo Could Run Out of Money By the End Of Year
Varo raised a fresh $510 million in funding just last September — and it needed to.
In the prior quarter, it reported a $58 million (corrected) loss and had just $67 million in equity capital. Its precarious capital position had already forced it to shrink its asset holdings to $247 million.
While its $510 million Series E shored up its equity position, Varo has quickly been spending those funds. Based on the bank’s Q1 2022 equity of $263 million and burn rate of $84 million, it could run out of money before the end of the year — and would become less than well capitalized before then (though Varo does have an additional ~$37 million in equity at the bank holding company level). All of this puts immense pressure on Varo to cut costs and raise additional capital.
Dwindling Equity Not the Only Troubling Metric
Given the minimal lending Varo does, it shouldn’t be a surprise that its net interest income has been negative for most of its life as a bank (though note income from its Advance product is considered fee rather than interest income):
Boosting its interest income would require Varo to engage in more lending — either directly, to its own customers, or by deploying its balance sheet to purchase loans or debt securities from other issuers.
The former is difficult, as the typical Varo customer has just $83 in their account, and, presumably, skews subprime or thin/no file.
Regarding the latter, it’s likely Varo has chosen not to purchase assets originated by others, as it allows the bank to maintain a low risk capital/assets ratio — a necessity, as it remains unprofitable.
Highly Dependent on Interchange Income
98% of Varo’s income comes from interchange and fee income (out-of-network ATMs and Varo Advance loans).
But, with 768 full-time employees drawing about $32 million in salaries in Q1 and an estimated $38 million in Q1 marketing spend, costs continue to far outweigh non-interest income:
At least the marketing spending hasn’t been for naught — Varo has managed to significantly boost its number of deposit accounts. The company added some 2.7 million new accounts in 2021, though it’s unclear how many of these remain active. Dave, a comparable neobank offering, saw just 23% of its members use their accounts in a given month.
But, the average balance in a Varo customer’s account was just $83.24 in Q1 2022.
During 2021, the ARPU was just $32 (corrected) vs. a CAC of $45 — that equates to a 16 month “payback” period, and this doesn’t even include other costs of opening and maintaining the accounts.
But in Q1 2022, the CAC appears to have risen some 30% to $59 (based on estimated marketing spend), while the revenue generated per account was a mere $6.
If that trend held through the year, that would mean Varo is paying $59 to acquire a customer who would only generate ~$24 in revenue in a year.
What Happens Next
One banking exec that asked not to be identified described Varo as being “on life support.”
All things equal, if Varo continues to burn capital at the rate it did in Q1, it would run out of money toward the end of this year. That’s obviously not an option. So what is likely to happen?
A combination of cost reductions and raising additional capital. Employee compensation and marketing accounts for approximately 68% of non-interest expenses in Q1.
To preserve capital and better position itself to raise a new round, Varo is likely to cut both — layoffs and significantly reduced marketing spend.
But raising fresh capital may be a tough proposition in the current environment.
Varo raised at a $2.5 billion valuation last September, when fintechs were valued at 20-25x forward revenue. Since then, multiples for fintech broadly have collapsed to less than 5x forward revenue, a16z analysis shows.
Based on Varo’s approximately $22.5 million in revenue in Q1, a 5x multiple would value the company at around $450 million — a sharp drop from its last round, but not inconsistent with the corrections in other public and private market fintechs.
Between the changing market dynamics and its regulatory capital requirements, Varo finds itself in an incredibly weak position to negotiate a fresh round of funding.
Could An Acquisition Save Varo?
Todd Baker, longtime industry expert and fellow at The Richman Center at Columbia University, suggested it was time for Varo to merge with a lending-focused fintech that could take advantage of its national bank license and balance sheet:
Impact on Other Fintechs Considering Charters
Varo’s troubles may change some companies’ calculus about pursuing a charter (not to mention the OCC’s and state regulators’ willingness to grant them).
UK neobank Monzo found its attempt to secure a US charter quickly rebuffed. Revolut, which is applying for a California state charter, may find itself under increased scrutiny as it goes through the process (its reported ties to Russian money likely won’t help either).
The additional regulatory and capital requirements of a bank charter and FDIC insurance may be viewed more skeptically — increasing the appeal of the existing bank partnership model and newer Banking-as-a-Service middleware players, such as Unit and Synctera.
Sheel Mohnot, of Better Tomorrow Ventures, who raised similar concerns about Varo’s financial position last week on Twitter, suggests Varo’s charter has turned out to be more burden than benefit, saying:
“Very few of us on the sidelines thought that a bank charter would be a positive move for a neobank serving this demographic (where most of the revenue is from interchange), and I think the early results concur- it has been a very expensive journey for Varo, with limited benefits. I suspect that the OCC will be taking a harder look at new applications and banks serving fintechs in general. The vast majority of neobanks will find that partnering with a bank (via BaaS) is a better option.”
The CFPB Wants to Play Antitrust Enforcer in Bid to Boost Competition
Last week, the CFPB announced a reorganization that would see its Office of Innovation be renamed to the “Office of Competition and Innovation.” It’s the latest signal of the agency’s sharpening focus on competition or, inversely, antitrust, under Director Rohit Chopra. The agency’s new emphasis on competition/antitrust isn’t surprising, given Chopra’s previous stint at the FTC.
According to the statement announcing the change (emphasis added):
“The Consumer Financial Protection Bureau (CFPB) is opening a new office, the Office of Competition and Innovation, as part of a new approach to help spur innovation in financial services by promoting competition and identifying stumbling blocks for new market entrants.
The office will replace the Office of Innovation that focused on an application-based process to confer special regulatory treatment on individual companies.
The new office will support a broader initiative by the CFPB to analyze obstacles to open markets, better understand how big players are squeezing out smaller players, host incubation events, and, in general, make it easier for people to switch financial providers.”
Broad Agreement That “Competition” Is Good, But Little Agreement on How to Get There
There seems to be general consensus, even across political lines, that “competition” is good — but little agreement about what, exactly, that means or how to achieve it. While many Republicans may favor a more laissez-faire, market-based approach, many Democrats favor a more active, interventionist framework.
And while, no doubt, the largest US banks exert significant influence on the market, there remain over 4,200 banks in the US and another ~5,400 credit unions. The largest bank by total deposits in the US in 2020, Bank of America, held only an 11.21% share of deposits — significant, but hardly a monopoly.
Focus on “Big Tech” Is Misguided
On the other hand, there’s no doubt big tech companies like Apple, Google, Facebook and Amazon do exert significant, monopoly-like control in their respective markets and arguably engage in anti-competitive business practices. This is something already on the radar of a different federal regulator… Chopra’s previous employer, the FTC.
Through the CFPB’s lens, however, a case could be made that Big Tech’s entrance into financial services should be viewed as a positive for competition. Who else has the funding and resources to compete with Big Banking?
Besides, as it stands today, while Big Tech can engage in an array of banking activities, the Bank Holding Company Act’s separation of banking and commerce would generally prohibit a Big Tech company from actually owning a bank or holding insured customer deposits itself. Yes, yes, an ILC charter theoretically is an option, but politically is virtually unimaginable.
Besides Playing Antitrust Cop, How Can the CFPB & Other Regulators Promote Competition?
Encourage Creation of De Novo Banks
After the 2008 crisis, new bank formation understandably slowed to a crawl. While de novo formation has picked up since then, the process to obtain a newly created bank charter is laborious and expensive. One result has been fintechs acquiring banks instead of pursuing new charters — companies like SoFi, Lending Club, GreenDot, and Jiko have obtained charters through acquisitions.
While there are certainly plenty of small banks that could be acquired, it would seem encouraging the creation of de novo banks would be a more direct mechanism. Certainly all due care must still be taken to vet the viability of an applicant’s business plan to avoid negative outcomes (like, potentially, Varo’s).
Create New Types of Charters
Creating new types of banks could facilitate creating more competition. The OCC has proposed such “fintech” or “payments” charters, which could be reviewed in an expedited process, as they would not permit holding customer deposits. But the effort has faced pushback from other corners of the banking system, with a key argument being that the OCC lacks the authority under the National Bank Act to grant such charters.
Even for fintechs not seeking to hold deposits, presently, bank partnerships (and their regulatory complexity and expense) are often required or are the preferred approach vs. state-by-state licensing for activities like lending and payments.
Broaden What Types of Institutions Can Access Fed Services
Given the challenges the OCC faces in offering new types of non-depository charters, another option is to broaden what types of entities can directly access Federal Reserve services, like its payment networks and Fed master accounts.
The Fed has proposed a tiered approach, which would permit non-bank fintechs to apply for Fed master accounts, though their applications would face heightened scrutiny vs. insured and prudentially supervised institutions. The proposal has received pushback from the Conference of State Bank Supervisors, arguing it unfairly preferences federally-supervised banks over their state-chartered peers.
Faster Payments — FedNow, The Clearing House RTP
Real-time payments — common in many other parts of the world, from Europe to Mexico, Brazil, and India — also have the potential to promote competition by enabling new business models and novel products. Faster payments could benefit consumers and businesses, particularly those operating at the margin, who are more likely to utilize high-cost financing options while waiting to receive payments due to them.
Fintech/Bank Partnerships, Banking-as-a-Service
Fintech/bank partnerships, and their newest iteration, “banking-as-a-service,” are necessitated by legislators’ and regulators’ inability to progress some of the above initiatives.
Still, aspects of the model, particularly when it comes to lending, lack clarity. The fight over “true lender,” particularly as it relates to credit over 36% APR, is ongoing.
These partnerships, also key to popular neobanks, have come under attack for “making users vulnerable to losing their money” by legislators like Democratic Senator and Chairman of the Senate Banking Committee Sherrod Brown.
New Underwriting Approaches, Including AI/ML
FICO, the dominant credit score, works well for mid- and upper-income consumers with thick credit files. For consumers with thin- or no-file, or a damaged history, reliance on FICO, particularly in the mortgage market, becomes a major barrier.
There are a number of new data sources and modeling techniques that promise — with appropriate regulatory oversight — to improve credit access and pricing. Cashflow underwriting, made possible through “open banking,” gives insight into how an applicant manages their day-to-day finances that cannot be revealed by a traditional credit score.
Artificial intelligence/machine learning techniques can help draw conclusions from data that traditional modeling techniques miss. Novel modeling approaches should be subject to the same fair lending oversight as legacy approaches.
And while some new approaches to modeling may make it more difficult or impossible to comply with requirements to provide a reason for adverse action, perhaps that is a tradeoff worth making, if it improves access and pricing for historically underserved borrowers.
Open Banking / Open Finance
Perhaps the biggest opportunity is in “open banking” — an area in which the rules of the road are beginning to be hashed out.
The underlying concept of open banking is that a consumer, rather than their financial institution, owns the data associated with their account. The ongoing rulemaking process is trying to define what that means in practice and how to operationalize it.
Open banking has the potential to be supportive of competition by facilitating account switching, providing inputs for alternative approaches to underwriting, and powering products that compete directly with incumbents in areas like overdraft avoidance, remittances, and financial advice.
Such competition has the effect of improving services and pricing even for customers who don’t switch to fintechs by shifting the “Overton window” of what is possible. It’s doubtful that major banks would’ve reduced or eliminated overdraft fees or major brokerages would’ve eliminate trade commissions without pressure from fintechs.
Still, how supportive open banking can be of competition remains to be seen and will depend on how the rulemaking process unfolds. While there is general consensus on what kinds of data fields should be made available, there will be skirmishes over what is considered “proprietary” and how certain data elements made available via open banking can be used by other institutions.
Who gets to control who can and cannot access open banking infrastructure and how that data can be used also has yet to be determined. Where those lines get drawn — and by whom — will have a huge impact on how open banking impacts (or doesn’t) competition.
Other Good Reads
Tech valuations are down. A16z says fintechs are getting hit hardest. (Protocol)
Banks Must Act on Their Early Warning Systems or Risk ROE Downturn (PwC/Galytix)
A Super App for Home Owners (Fintech Takes)
The Three Body Problem: Finding the New Stable Points in Venture Capital (Frank Rotman/QED)
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Early stage startup looking to raise equity or debt capital
Why should it cost them $100m to get a charter? Varo did the right thing but did not focus on the right market.
Great analysis! Do you know what these “other loans” are? I dug through their FDIC filings but couldn’t find the nature of these loans — yield and losses are quite high