Founder and CEO of Silverbird.
In August 2020 the Federal Reserve adopted a new approach called “average inflation targeting.” This means that the Federal Reserve will tolerate some periods of inflation above 2% to offset periods below 2%. This raises two questions.
One: How long will the average inflation targeting approach continue? And two: Why does the U.S. need to target 2% inflation?
Differences between inflation rates have huge implications. They might be the difference between having a recession or not. They may mean millions of dollars for funds and people or not. But from a business perspective, the Federal Reserve target seems totally arbitrary.
The entire world is held hostage to the Fed’s target. Two or three years ago, they decided that it should be 2%. However, the world has changed drastically since then.
The current approach reminds me of the Communist Party trying to build a road by the first of May—not because the road needs to be built by this day for practical reasons, but simply because of the great communist holiday. It feels artificial.
This aside, the Federal Reserve’s policy and its consequences still catalyze the revolution within the fintech industry. But first, let’s understand the relationship between interest rates and inflation.
The Connection Between Interest Rates And Inflation
Inflation and interest rates tend to move together because interest rates are the primary tool used by the U.S. central bank to control inflation. The U.S. central banking system is called the Federal Reserve. It is mandated by the Federal Reserve Act to promote stable prices and maximum employment. To fulfill this mandate, since 2012, the Federal Reserve has aimed for an annual inflation rate of 2%. The Federal Reserve considers this rate a reflection of stable prices.
The Federal Reserve intentionally targets a positive inflation rate, which refers to a consistent increase in the overall price level of goods and services. This approach is taken because a sustained decrease in prices, known as deflation, can have detrimental effects on the economy. Furthermore, maintaining positive levels of inflation and interest rates gives the central bank the flexibility to lower rates when faced with an economic slowdown.
New Business Model For FinTech: From Transaction-Centric To Balance-Centric
Following the increase in interest rates, existing fintechs such as Revolut and Monzo have already increased their savings rates. However, I believe new fintechs appearing in 2023 and 2024 will be building products that incentivize customers to hold balances. Before that, it was all transactional: Fintechs and banks made money on people sending money. Now it’s changing from transaction-centric to balance-centric. Revolut and everyone else can make a lot of money.
On top of new banks that offer people incentives to keep their money, I expect to see more balance-holding features appear in existing banks: higher savings rates, perks and bonuses, you name it. In a way, we’ll return to the proper banking world, where banks are used for holding money.
Back To The Proper Banking World
It used to be the opposite for a long time: More money meant more problems for the bank, and transactions mattered more. In the past, banks would go as far as charging negative interest rates on large balances, because the more money a customer would hold with the bank, the less attractive that customer would become. More money meant more problems. It meant the bank made no profit managing all that money. Nowadays, it’s the other way around: We’re steadily moving back to more traditional banking, where holding money makes money.
Higher Interest Rates Mean Higher Profitability For Neobanks
As a leader in the fintech industry, I believe neobanks that maintain significant balances in customer accounts like Wise and Revolut can generate additional revenue due to high-interest rates.
This shift in dynamics alters the business operations of these neobanks. They can now generate substantial profits not only through unit economics, customer transactions, Forex and card interchange but also through the interest earned on customer balances. None of this was possible in previous years.
Previously unprofitable neobanks can now experience profitability. Higher interest rates enable them to invest more in product development and innovation using the revenue generated from the balances held by their customers.
For some, it will be an addition to their revenue. For others it will be the difference between going out of business and finding that much sought-after “product/market fit.”
More Valuation Cuts In New FinTech Funding Rounds
As interest rates rise, I see investors having a wider range of options, leading to an increased emphasis on risk aversion. With increased competition for venture capitalists’ cash, the valuations of fintech companies will be more grounded in reality. Money will become more expensive. Moreover, investors will demand more tangible and concise plans for achieving profitability.
It seems the era of “let’s build it, and they’ll come, simply because it’s fintech” is now over.
FinTech Brand Image Becoming More Important Than Ever, With Stability As A Key Factor
Following the downfall of Silicon Valley Bank, Signature Bank and Silvergate, customers have become highly cautious about rumors regarding stability concerns. Neobanks and fintech companies, in contrast to traditional banks, often lack comparable capital reserves and frequently need to secure new funding to support their growth. Consequently, even minor rumors can pose significant risks to their operations.
Furthermore, neobanks have additional concerns specific to their unique setup and structure. I predict that the significance of brand image in the fintech industry will escalate, with stability emerging as a crucial determinant.
The Bottom Line
One thing is certain: The landscape for fintech is changing. I am sure that in the future, we’ll see new fintech products introduced—mainly those focused on incentivizing people to hold balances. As with any major market changes, the Fed announcements will serve as a filter of sorts: Fintechs will be forced to enhance customer centricity and innovation while prioritizing cost efficiency and profitability over rapid growth. Is your company fit enough to survive? We’re about to find out.
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