The role of Bitcoin for community banking

Summary

  • Community banking is essential for the development of local economies.
  • Technology expenses, regulatory spending and limited access to distribution channels are challenges for community banks today compared to their commercial counterparts.
  • The open and global network of Bitcoin, the free and open source software applications built on top and its functional properties around non-custodianship can address these challenges.
  • As a result decreasing barriers of entry can spark a new wave of community based financial services.
Can community banks benefit from adopting bitcoin?

Idea of community banking

There are varying definitions that regulators and community banking studies have used to define a community bank. Typically, community banks are considered institutions that fall below a certain size as measured by total assets. Previous research has used total asset sizes ranging from $750 million to $5 billion as the threshold to define a community bank.¹ Additionally, community banks are often defined by a limited geographical reach and a focus on more traditional banking activities as their primary operations. Accordingly, many community-banking studies expand the empirical definition beyond asset size to incorporate limitations on the geographic and operational scope of the institution.² In the community banking model, the deposits that the bank gathers are sourced locally — from members of that bank’s community and lent back out locally again. Consequently, by choosing your local community bank, you are reinvesting in the place where you live, work, and play. Your bank is leveraging your money to strengthen and grow your community.

Community banking is a form of empowerment-based economics, which falls under the larger umbrella of micro-finance. Micro-finance as a whole is centered on entrepreneurial efforts of individuals, generally with a goal of lifting low-income or disadvantaged groups out of poverty and providing the means for them to prosper.³ Although there are many different models of community banking, the goal is always located in the socio-economic growth of communities through the sharing of resources.⁴ While this can include the participation of banks or other traditional money-lending institutions, this is not necessarily the case. The specific framework and practices of the community bank depend largely on its location in the world and the culture that has shaped it.

The concept of micro-finance is not a novel phenomenon, savings and credit groups have operated for centuries for example the “tontines” in West Africa⁵, “susus” of Ghana⁶, “chit funds” in India⁷, “cheetu” in Sri Lanka⁸ “arisan” in Indonesia⁹, “tandas” in Mexico¹⁰ or “pasanaku” in Bolivia¹¹, as well as numerous savings clubs and burial societies found all over the world. Formal credit and savings institutions for the poor have also been around for decades, providing people who were traditionally neglected by commercial banks a way to obtain financial services through co-operatives. Microfinance has wide-ranging potential benefits such as female empowerment and access to credit for those previously excluded from the financial system.¹² The origin of micro-finance is found in several places but one of the popular micro-finance institutions is the Bangladesh Grameen bank founded by Professor Muhamed Yunus in 1976. According to him, poor households not only have the capability for loan repayments but they also profit from the loans they borrow.¹³

However, community banking is not only a phenomenon of developing countries. The U.S. banking industry consists of thousands of small banks in rural and urban communities. Due to the balance of power that exists between the federal and state governments and despite numerous challenges to its existence over the years, the dual banking system has remained in place. Restrictive branching laws and the rural population base of many states fostered the creation of an extensive network of community banks since their introduction in 1819.¹⁴ As a result, 4,750 community banks compared to only 427 non-community banks were operating in the US by 2019.¹⁵

The value of community banks

Community banks focus on providing traditional banking services in their local communities. They obtain most of their core deposits locally and make many of their loans to local businesses. For this reason, they are often considered “relationship” bankers as opposed to “transactional” bankers.¹⁶ This means that they have specialized knowledge of their local community and their customers. Because of this expertise, community banks tend to base decisions on local knowledge and nonstandard data obtained through long-term relationships, which leads to several advantages for the community.

Active investing in the local community: Community banks have traditionally been an important provider of credit to small businesses. During the financial crisis, banks with less than $1 billion in total assets generally maintained their small-business loan volumes (as a percentage of total loans) compared with larger banks while larger banks experienced a decline. Small businesses arguably foster economic growth, and thus, their ability to find credit today and in the future is of consequence. Community banks have a comparative advantage in providing credit to small businesses, particularly in their ability to properly assess “informationally opaque” borrowers due to their knowledge of local conditions. Their focus on relationship-based lending saves borrowers without histories suitable for lending models with credit-scores from being completely cut out of the credit markets. This advantage is mutually beneficial for both the lender and the borrower. Empirical literature using data from developed nations generally supports the hypothesis that large banks are disadvantaged in SME lending. Studies often find that large banks allocate a much lower proportion of their assets to SME loans than small banks do.¹⁷

Personal service: Community banks can develop these close relationships with customers because they tend to be smaller and only conduct business locally. The larger the institution, and the more places it does business, the more difficult it is to manage relationships at a personal level. These relationships allow community banks to better serve customers and to create individual solutions that better fit their banking needs. This relationship approach to financial services is particularly important to small businesses that rely on community banks for loans and other services. Small businesses, particularly small start-up companies, may be unable to satisfy the requirements of the more structured approach to underwriting that larger banks use or to qualify for other financial services.

Decentralization: Community banks are also more likely to be privately owned and locally controlled than larger banks. Even when community banks have public shares, they are usually not traded on the major exchanges. This means that they may weigh the competing interests of shareholders, customers, employees, and the local community differently from a larger institution with stronger ties to the capital markets.¹⁸

This table provides a comparison of community banks and universal banks:

Comparison of community banks and universal banks

These facts make clear how community banking can be essential for the development of local economies. However, apart from providing pure financial products, community banks take over another role: As they are deeply rooted in local communities, they have a strong interest in promoting its economic development. Therefore, most banks see financial literacy similarly important for their customers. Supporting the financial education of consumers also benefits the bank. Dedication to financial literacy creates better customers, supports the bank’s mission, its brand, and maintains strong partnerships within the community.

This might be especially beneficial for the adoption of financial innovations such as Bitcoin that require efforts to educate people about its properties and ways of usage. Community banks can become a key player in accelerating Bitcoin adoption because of their unique capabilities and aligned interests with the community. But can community banks also benefit from Bitcoin? To answer this question we look at the recent history and existing challenges of community banking.

The changing landscape and challenges of community banking

Today, community banks exist in an environment where competition is intense and financial innovation has stripped away much of a bank’s cost advantages in acquiring funds and its revenue advantages on assets. The number of community banks is shrinking in most countries, as are their shares of loan and deposit markets. Both the number and market share of community banks in the US have approximately halved between 1980 and 2010, a loss of more than 11,000 institutions. Of the 6,802 institutions identified as community banks in 2011, almost 30 percent had closed eight years later.¹⁹

The recent wave of bank consolidation has been attributed to a number of factors including stricter regulation associated with higher cost for compliance. These changes have mostly favored large banks who have fully staffed legal departments and can afford to standardize their underwriting operations for instance. Advances in information technology, new financial instruments, innovation in bank production processes and increased competition have created a less friendly environment for community banks²⁰ but are not the sole reason for consolidation as many local banks still manage to offer customer focused financial products and build innovative mobile banking solutions, too.

Despite continued demand for the products and services offered by community banks, technology and regulatory costs and standardized loan products have hurt their market share and profitability. Because community banks lack scale, technology and regulatory costs are spread across a smaller customer base. Studies show that compliance costs²¹ for banks with assets of less than $100 million averaged 7–10% of non-interest expenses while the largest banks reported average compliance costs of 5%.²² In other words, the burden for the smallest community banks is almost double that of larger banks. Standardized products could be a solution to drive down costs but such uniform consumer and small-business loan programs as larger market participants offer today, are less profitable in the low-scale community bank environment.²³

Similar economies of scale are observed for expenses associated with information technology and data processing. These costs relatively increase with decreases in bank size, which is consistent with the view that spreading technology expenses over a bigger customer base may be one source of cost advantage for larger banking firms.

Distribution access is another reason why smaller banks cannot compete with bigger ones.²⁴ The top banks in terms of size cover whole countries with their ATM and branch network. Customers fear that they may not be able to access services such as using an ATM or depositing cash outside the network of their community bank. The reach of their distribution channels allows big banks to strive as they not only cover local areas but regions, complete countries and are even internationally accessible.

These trends raise the question if the community banking business model will continue to be viable in the future. The specter of a declining, or perhaps a disappearing, community banking sector has potentially serious implications for local economies such as the United States where community banking is a relevant industry. Most obviously, the small business sector — a historically crucial source of innovation and new job creation — has traditionally relied on small local banks for credit.²⁵ Local businesses often have limited operating history and rely on the reputation of the owners and managers. Local community banks use qualitative factors, in addition to traditional quantitative methods, to judge the creditworthiness of a business. However, if lending decisions are no longer made in the community, there is no way to capture these very important qualitative details and business loan requests are, possibly too often, denied.²⁶ Consequently, small businesses are most adversely affected by bank consolidation.

To sum up distribution access for customers and the lack of scale in relation to cost for technology and compliance are major caveats for a thriving community banking sector.

How can Bitcoin solve this?

There are two ways to improve the bottom line of organizations. The most direct approach is to increase efficiency in core business lines. According to a study by the St. Louis Fed, the most important driver of high earnings in small banks is control of operating expenses.²⁷ Considering the current challenges, this section explores potential benefits of the adoption of a globally accessible²⁸, peer-to-peer monetary network²⁹ based on open-source technology³⁰ such as Bitcoin for community banks.

Free and open-source technology to reduce technology cost

The Bitcoin Core reference client is the product of over several thousand unique code contributions from over 800 individual contributors.³¹ The software is available for free use and modification under the permissive MIT copyright license. The full history of development is visible within a public software repository hosted by Github, a cloud-services provider that allows anyone to sign-up, upload new code, and track changes (discussions how to derisk reliance on Github are also ongoing).

Likewise there are many applications being built on top of the network that pursue an open source strategy, too. This database covers more than 600 projects with similar permissive software licenses that build on Bitcoin and the Lightning Network.

Many organizations have caught on to open source software (OSS) and realized significant cost savings in technology expenditure as a result. The unique characteristics of OSS in resolving obstacles associated with technology acceptance and implementation consist of improved customization, and lower cost of acquisition and maintenance.³²

To provide some guidance we show what expenses businesses can expect when adopting Bitcoin according to the total cost of ownership model, a concept to evaluate the cost of a certain software from evaluation to the actual operation. To define necessary components, let us use a rather exemplary software stack for a Bitcoin based service consisting of a Bitcoin node, a Lightning Network node, the server application and a user interface.

The user interface and application server are usually very project specific and therefore not elaborated further.

The user interface and application server are usually very project specific and therefore not elaborated further.

Financial institutions have to spend 3–4% of non-interest expenses on IT.³³ On the other hand, implementation of OSS can significantly reduce development costs compared to commercially licensed or in-house developed software. These cost savings start with acquisition, but extend to deployment, support, and maintenance and can result in savings of 20–55% over commercial solutions.³⁴

The following table gives an overview of total cost of ownership of such a software stack:

Overview of total cost of ownership of a Bitcoin based financial service and a fiat based bank

This table only lists major differences between bitcoin and fiat based banking services. Software stack specific and non-core technology spending such as IT compliance and security costs incur in both of them, but depend on the final business model and regulatory requirements.⁴³

At the same time knowledge barriers, legacy integration, technological immaturity are often mentioned as barriers of adoption.⁴⁴ Active communities can mitigate these challenges by higher quality support than detached commercial organizations. Users, who are actively involved, benefit from the community and often receive help for free.

It is not surprising that due to these benefits open source software has created considerable excitement in the business world over the last decade. These applications, designed by groups of volunteer or sponsored software developers, have the potential to break the current dominance of proprietary software and restrictive licenses for many business applications. They reduce software development time, vendor lock-in and improve software quality.⁴⁵ However, most importantly, they bring much needed software applications within the reach of individuals and small businesses, who cannot otherwise afford comparable commercial software. Further, unlike proprietary software, open source software applications make their source code available for free, which can be customized to fit the unique needs of specific organizations.

Using some of the hundreds of available OSS applications being built on top of Bitcoin and Lightning Network can bring great benefits to the bottom line of community based financial services and banks regardless of the innovation potential for their own product portfolio.

Non-custodial financial services to limit regulatory cost

Ever since the advent of Bitcoin, the regulatory approach to cryptocurrencies has primarily focused on mitigating risks to financial integrity. This has largely meant addressing their misuse for illicit purposes. Following the footsteps of the Financial Action Task Force (FATF), law and policymakers have started extending the scope of anti-money laundering (AML) and counter-terrorist financing (CFT) rules to the crypto sphere.

AML compliance is traditionally imposed on selected entities, such as banks, to detect and report suspicious monetary transactions. Duties placed on these gatekeepers encompass, among others, Know-Your-Customer (KYC) measures and monitoring financial flows. However, the efficacy of these duties is up for debate.⁴⁶

In the United States, cryptocurrency businesses like hosted wallet providers, custodial exchanges, fiat “on-ramps,” and over-the-counter (OTC) brokers are regulated as money services businesses (MSBs) and are therefore responsible for compliance with the Bank Secrecy Act (BSA), official sanctions, financial surveillance, and AML/CFT requirements.⁴⁷

The EU included ‘fiat-to-crypto exchanges’ and ‘custodian service providers’ in its scope in the Fifth AML Directive.⁴⁸ Parallelly, FATF’s ‘crypto’ travel rule lays down obligations of information collection and exchange concerning beneficiaries and originators of crypto transactions.⁴⁹

But what if the funds are kept out of the reach of regulated (and regulatable) intermediaries?

Self-hosted or non-custodial cryptocurrency wallets have a significant impact on the efficacy of AML rules. They let individuals and organizations store and use their digital assets in a self-determined manner, without depending on an intermediary such as a financial institution to store their coins. Users can create a wallet by downloading third-party software on their computers or mobile phones and use hardware devices that store the keys to manage their digital assets.

In principle, intermediaries can be thoroughly bypassed, with the exception of transfers originating from self-hosted wallets but received by custodial wallets, or vice versa.

If regulated entities are involved, they may be required to collect information from the customer. For instance, the U.S. Financial Crimes Enforcement Network (FinCEN) Notice of Proposed Rulemaking, released in December 2020, would introduce duties to report transactions and collect counterparty data, such as beneficial owners, when regulated entities have certain interactions with self-hosted wallets.⁵⁰ On the contrary, in self-hosted wallet to self-hosted wallet transactions no third party can be held accountable for AML oversight. Consequently, peer-to-peer transactions, non-custodial digital asset platforms, and self-hosted wallets at first sight are not regulated under the BSA in the US.⁵¹ (Assessed at the time of writing of this article. Not to be considered legal advice).

There are certainly more nuances in assessing the legal requirements for custody based services as there are different forms of custodianship. Mentioned rules and proposals usually apply when a business holds funds on behalf of its clients. To fulfill regulatory requirements businesses have to have measures in place such as customer and counterparty identification, account monitoring for suspicious activities, transaction reporting and recordkeeping.⁵² Leaving aside the effort and time to apply for licenses in each single country or even state, it obviously can become a costly undertaking for businesses to provide custody based services. Non-custodial solutions on the other hand take the custody factor out of the equation and bring benefits for service providers by reducing the administrative burden and cost for compliance. In fact, Bitcoin provides the possibility for users for self-custody. Financial services that see the chance and embrace this technology in the way it was built for can reach higher levels of efficiency by lowering their operating expenses.

An open monetary network to facilitate access to the own distribution network

Today’s customers and especially tech savvy younger generations expect digital banking that is available across channels and tailored to their immediate needs and on their own terms. If banking services might not be accessible when and where they want due to limited distribution channels they would search for alternatives. Often big commercial banks outperform community banks in this regard.

Big banks benefit from strong brands and high barriers to entry. This has been evident in the industry’s extremely low levels of churn — generally, less than 5%. However, in an age of digital convenience, consumers feel unrespected by banks’ slow processes and parts of the old value chain are under pressure. In terms of customers’ willingness to advocate for banks’ services, retail banks rank ninth out of ten industries. Today’s consumer bank provides services across physical branches, ATM, call center, online and mobile channels; the branch is by far the most expensive of the channels to manage when measured in normalized cost to serve for a sample of active customers.⁵³ Digital channels are essential for cutting distribution costs and boosting revenues. A new, more automated and channel agnostic distribution model can catalyze a profitability boost of as much as 25%.⁵⁴

To get there banks must offer customers any channel as an entry point independent of time and location. Bitcoin can play an integral role for the distribution model of the future. Compared to today’s banking networks, Bitcoin does not know banking hours or national borders. Bitcoin markets are open 24/7/365 allowing users to invest and trade whenever they want. Users and operators pay fees for transactions but not for accessing the network. More importantly the network is accessible to anyone using a Bitcoin based service or running an own client by themselves, regardless of the location if not via internet, then by satellite.

Bitcoin’s network uptime of 99.99% in more than twelve years since its inception might be unrivaled compared to traditional payment networks.⁵⁵

Already today Bitcoin not only serves as a store of value but as means of payment for many users enabled by the Lightning Network a decentralized, privacy preserving system for instant, high-volume micropayments at low transaction fees.⁵⁶ Since its inception in 2018 the Lightning Network has developed into a whole ecosystem of hundreds of merchants accepting Lightning payments and hundreds of apps and projects offering a variety of services ranging from wallet to merchant and financial services.⁵⁷ Apps to stream music or other digital content in return for bitcoin are no rarity anymore in this industry. Hence, users wanting their banking services to work like the music and shopping apps they use every day will literally find what they are looking for.

Bitcoin’s accessibility can become a central enabler for community banks to build the distribution model of the future with unlimited distribution access in an increasingly competitive, technology-driven, and dynamic banking landscape.

Conclusion

The history of credit and saving unions provides great examples of how crucial they are for the development of local economies and the adoption of new technologies. Active education, economic and social cohesion, available technology and investment capital are necessary building blocks to set up community based financial services. The global monetary network of Bitcoin and its free and open-source software stack have the potential to reduce technology cost and facilitate access to its public distribution network for community banks.

Another proven strategy to build a competitive advantage is to seek out new business opportunities and revenue sources. But this we keep for another part. If you want to have a sneak peak of a playbook for developing a Bitcoin based community banking business model and concrete technical solutions in advance, please reach out to us to exchange ideas.

Bitcoin gives us the toolset to rethink community banking, as we know it today. Its technology is a chance to go back to the original idea of unions, where people of a community united to provide financial services directly to each other without the formal terminology of a bank and the necessary regulatory setting. Instead, Bitcoin’s global accessibility and technical properties around self-determined participation might mitigate the need for financial community services to grow in order to benefit from economies of scale and become formally regulated banks. Moreover, it might lower barriers of entry and spark a new wave of communities supporting their members with financial services soon. To a certain extent, this is already happening through Bitcoin Beach project in El Salvador supported by many Bitcoin enthusiasts, developers and companies such as Galoy.

While writing this article, we received feedback from industry veterans and we would like to thank all of them and others who took the time to submit thoughtful contributions.

If you have further interest in the subject matter and would like to keep updated: Fulgur Ventures’ Lightning resources web page aggregates statistical data on the Lightning Network and visualizes the activity of the Lightning ecosystem since early 2019. Check it out here.

About the authors

Moritz Kaminski is a business development specialist with years of experience in tech ventures and early stage funding. Oleg Mikhalsky is a partner at Fulgur Ventures focused on the Lightning Network and Bitcoin ecosystem.

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Fulgur Ventures

Fulgur Ventures

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We invest in early stage startups focused on Bitcoin and the Lightning Network