In 1936, American sociologist Robert K. Merton labeled a phenomenon that humanity has witnessed throughout history: The Law of Unanticipated Consequences. In the vein of modern day Freakonomics, the idea is that a movement meant to instill change for a specific purpose yields changes, unexpectedly, somewhere else. One of the best examples of this in fintech is the unanticipated consequences of the Durbin Amendment, a 2010 legislation that is making waves in the startup world more than a decade later.
Financial institutions came under intense scrutiny following the market crash of 2008, and subsequently, laws such as the 2009 Dodd-Frank Wall Street Reform and Consumer Protection Act were put into place. About a year later, Illinois Senator Richard Durbin introduced—and passed—an amendment to that act, the Durbin Amendment, which gave the Federal Reserve the ability to regulate debit card interchange fees.
The impact of the Durbin Amendment has been felt far beyond its initial intention of cost savings for businesses and consumers. This is something that we have seen firsthand at Ramp (and discussed in depth in an interview with Stratechery) and something that we feel has set into motion—and accelerated—entrepreneurial innovation across the fintech ecosystem. Essentially, a Senator’s bid to protect the people birthed the modern fintech industry as we know it today. Merton would be intrigued.
The perfect storm of sentiment, senate, and small-bank exemptions
Several factors were at play in the post-2008 banking scene that led to the fintech boom. First—and unsurprisingly—consumer trust in financial institutions was low. (By June 2009, only 22% of Americans surveyed said they had confidence in banks.) Second, professionals departed struggling financial institutions in droves, flooding the talent market. While they might have been done with big banks, many recognized the value of joining their expertise with technology startups—or founding their own.
The real inflection point came when these shifts combined with the sweeping regulatory changes introduced with Dodd-Frank. Oversight from the newly established Consumer Financial Protection Bureau jolted the balance of power away from the largest financial institutions while the Volker Rule limited their ability to engage in certain formerly-lucrative investment activities.
However, it was those institutions that weren’t subject to some of these sweeping changes that have had an outsized impact. The Durbin Amendment carved out an exemption for small regional and community banks with assets valued at less than $10 billion. The goal was to protect their profitability, which would have been eviscerated had they been lumped in with the largest banks (80% of debit volume in the U.S. is with Durbin regulated banks). This exemption laid the groundwork for fintech’s big debut.
A major blow to banking’s traditional business model
To understand why the fintech movement was so successful so quickly, it’s worth examining how the traditional banking model was impacted by the new regulatory standards—and that begins with the cost of doing business.
It’s expensive for banks to service deposits. The annual cost to a bank of servicing a checking account is $250-400 a year. These high fixed costs render about 40% of checking accounts unprofitable. To try and make up for the lost interchange revenue in a post-Durbin world, banks routinely imposed fees—overdraft fines, account service fees, enforced minimum balances, and monthly deposit fees, among other add-ons. At the same time, the large banks shifted their focus towards the more-lucrative higher-earning segment of the market. These customers not only spend more but are also great to cross-sell additional financial products to (e.g. mortgages, credit cards, wealth management services). Marketing efforts, ad dollars, and customer reward programs went towards attracting these customers—shunning those living paycheck to paycheck and leaving them with the burden of new punitive fees.
This gap created opportunities for innovation in consumer finance—financial startups wanted to build solutions for the rest of the market and customers searched for providers they could trust without predatory fees. Chime is one example. The company focuses on serving lower income consumers, and gained its initial momentum by leaning heavily into messaging that highlighted fee-free banking. Similarly, peer-to-peer (P2P) payments products like Venmo and Cash App emerged as a fee-free way to make small denomination payments. They relied on Durbin-regulated rates as a low-cost way of allowing consumers to fund their digital wallets by linking a debit card.
Enter new banking and infrastructure
Concurrently, Durbin-exempt banks struggling to compete with large, national banks saw an opportunity to work with emerging fintechs that excelled at digital customer acquisition and messaging. And fintechs needed these banks for two reasons. First, It’s extremely difficult to get a banking license in the U.S.—short of buying a bank—so most fintechs could not legally operate without partnering with a regulated entity. The second is that consumer fintechs, because they aren’t banks, can’t rely on a net interest margin business model and instead rely heavily on interchange fees to make money. By partnering with smaller banks, fintechs could bypass licensing logistics and benefit from the higher interchange, creating fertile ground for fintech growth. The partner bank model was born: small banks lend out their charters to powerful fintech players. This allows fintech companies to offer financial products legally while also driving deposit and revenue growth for the partner banks. In fact, these banks consistently have better ROE and ROA metrics than the industry average.
However, from a tech perspective, these partnerships were far from easy. Most of these Durbin-exempt banks are smaller and have outsourced their tech systems to third-party providers like FIS, Fiserv, and Jack Henry. Fintechs needed to build secure infrastructure that would allow their modern platforms to speak to bank back-end systems (many of which are still run on mainframes and rely on COBOL, a dying programming language popular in the 1960s), as well as meet compliance requirements. As a result, most early fintechs found themselves spending up to two years—and millions of dollars—just building connections into their partner banks’ legacy infrastructure.
Because partnering banks don’t have internal software development muscle, nearly all of the building burden fell on the startups—and this is where another significant pivot happened. Realizing the broad applicability of the pain they experienced, many of the startups that started out as direct-to-consumer service models shifted to become infrastructure businesses and provide what they’d built to other companies looking to offer financial services. For example, Marqeta started as a pre-paid gift card business before it moved into card issuing as a service. It wasn’t long before these re-imagined fintechs realized that there was (and is) enough breadth in the fintech ecosystem that they can thrive in serving other fintechs, not just banks—which are typically painful to sell to.
Which brings us to fintech today
Fast forward to today, there is now a robust toolkit of fintech infrastructure players that are API-first and developer-focused for anyone looking to build financial products. Their services include data aggregation, identity verification, know-your-customer/anti-money laundering (KYC / AML), card issuing, banking as-a-service, among others. With all the innovation on the infrastructure layer, there now exists a set of modular lego boxes that can be recombined to create new financial products and experiences.
Why does this matter? As a highly regulated industry, companies vying for a spot in the financial services sector have faced near-insurmountable barriers to entry for a long time. The ensuing lack of competition led to a complacency and stagnation that has been largely resistant to innovation—until now.
Thanks to the broad range of modern fintech infrastructure solutions that exist, the barriers to entry are lower than ever. It is easier than ever across every dimension to bring a new solution to market. Consider the following example comparing the paths of Capital One with Ramp, both in the corporate card space but founded pre-Durbin and post-Durbin respectively.
The ripple effects set into motion by the Durbin Amendment have fundamentally changed not only what it takes to launch a financial product but also who can do so. With infrastructure readily available, we’re seeing a broader range of participants developing and offering financial products. Non-finserv companies such as marketplaces, social platforms, and software providers can offer financial services through third-party partners without being subject to direct regulations. These products tend to be of higher quality, more tailored to individual needs, and more affordable. Traditional banking institutions, facing robust competition, have been forced to modernize their tech stacks and business models.
Most importantly, this is redefining who can be served. Consumers and businesses that had been shut out of the financial ecosystem or forced to pay steep fees for access previously now have a set of better quality options to choose from.
In other words, we’ve entered into a golden era of innovation. While not the primary outcome intended from the 2008 reform, it's one that may still favor consumers in unexpected ways. As Merton's findings suggest, only time will tell.