The internet has led to great efficiencies in finance, but it has also created opportunities for exploitative finance through “imitation banks,” which pose serious risks to their depositors.
In recent years fintech firms have been imitating banks to intentionally lure in consumers who may have been historically locked out of more traditional wealth-building opportunities.
“In recent years, a number of financial technology (fintech) firms have used clever but misleading marketing to create online-only presences and act like banks while evading the banking laws that protect customers and the financial system.”
In recent years, a number of financial technology (fintech) firms have used clever but misleading marketing to create online-only presences and act like banks while evading the banking laws that protect customers and the financial system. These “imitation banks,” so named because they imitate banks to intentionally lure in customers, are actively putting users’ livelihoods at risk.
Policymakers and scholars alike have long recognized the importance of regulating banks as unique institutions that engage in activities critical to depositors and the macroeconomy, such as deposit-taking and lending. Yet shadow banks, which are institutions that function as banks but are not regulated as such, have a history of evading government oversight and causing harm to the financial system and millions of users. Imitation banks are just another in a long line of shadow banking endeavors. Among the many examples are the private bankers who accepted deposits and made loans without government supervision and helped contribute to the Panic of 1929; the large broker-dealers, for whom the term “shadow bank” was coined, that helped cause the 2008 financial crisis; and money market mutual funds, which were created as a regulatory arbitrage alternative to bank deposits and required government bailouts in 2008 and 2020.
Imitation banks, despite how much they rely on modern technology and exploit the language of innovation, carry similar risks to the general public whose money is at stake. Like other shadow banks, imitation banks are at risk of running, yet are not subject to capital, liquidity, disclosure, and other regulatory requirements, nor to prudential or consumer protection supervision; do not have access to the Federal Reserve’s discount window; and have depositors that do not receive federal deposit insurance. But unlike other shadow banks, imitation banks use the misleading language of banking, not investment, to appeal to depositors. And like the rise of crypto assets over the past decade, imitation banks tend to promise unusually high returns, thereby marketing themselves as attractive options for the millions of low-income and/or Black or brown Americans who have been historically locked out of more traditional paths to wealth building. Indeed, the chairman of the Senate Banking, Housing, and Urban Affairs Committee has raised concerns that imitation banks “may give consumers the false impression that their money is as safe as a deposit at an FDIC-insured bank” (Brown 2023).
As has been seen time and again—from automated mortgage origination that caused the housing bubble in the early aughts to the rise and fall of crypto assets this decade—technological innovation has opened new horizons to exploitative finance that puts people and their livelihoods at risk. We need a broad and coordinated governmental approach to rein in imitation banks. Because they borrow on the faith the public has in banks and the institutions that regulate them, the imitation banks that are gaining ground today must be recognized as the dangerous shadow banks that they are before they can further take root and harm customers.
Regulators should use their authorities to shut down imitation banks or subject them to the same regulation as traditional banks. And because unregulated deposit-taking is dangerous to depositors and the financial system, Congress should consider legislation that would permit only prudentially regulated institutions to take deposits.
Imitation Bank Examples
Compound Real Estate
Compound, formerly known as Compound Banc, has directly borrowed the vernacular of traditional banks to capitalize on the faith the public has in banks and the institutions that regulate them. Compound’s deposits are its own bonds, called “Compound Bonds,” that are purchased and sold to Compound account holders through its web portal and phone application (Compound Real Estate Bonds, Inc. 2022). Although Compound may argue that it is only selling bonds, that customers may only purchase and redeem bonds through Compound’s web portal makes the transactions similar to traditional banks’ deposits. Unlike the other imitation banks, Compound’s bond offering has been registered with the Securities and Exchange Commission, which allows investors to investigate the purchasing risk. Compound invests customer funds in real estate assets, and—notably—many of the statements in the bonds’ offering circular contradict statements made on Compound’s website. For example, whereas Compound’s website states that bonds can be redeemed for cash at any point, the 2022 offering circular stated that “[y]ou should be prepared to hold your Compound Bonds as [they] are expected to be highly illiquid investments.”
Tellus is a fintech backed by the venture capital firm Andreessen Horowitz that, in addition to serving as an imitation bank, is also a tool for property managers (Tellus 2023). The debt Tellus offers to customers serves as its deposits, and it uses the cash received for residential real estate lending. That is, it borrows cash from customers and uses it to make loans, just like banks. Unlike Compound, Tellus’s accounts are not registered as investment products with the Securities and Exchange Commission, and the only information available on Tellus’s risks is from its website and media reporting. Although Tellus advertises the high quality of its assets, media reports note that Tellus “fund[s] riskier types of borrowers than it advertises,” such as real estate speculators and subprime borrowers (Adelman 2023).
Zera advertises to customers three percent interest every month on deposits, which amounts to a whopping 42.6 percent annual return (Zera 2023). Yet its barebones website fails to explain at all how it achieves these astronomical returns or their associated risks. At most, Zera explains that “customers give us an unsecured loan and in return we give you a fixed interest rate”—the very definition of a bank deposit. Unlike the other imitation banks, Zera asks customers to lock-up their deposits for a set period of time (e.g., six months, 12 months), with interest rates dependent on the term period, akin to bank certificates of deposit. Zera claimed that customer deposits were insured by the FDIC, including claiming that deposits were insured “with no max limit,” until the FDIC issued a cease-and-desist letter in February 2023 (FDIC 2023).
Confetti is an imitation bank that failed. Like the other imitation banks, Confetti issued debt to customers that it lent to borrowers. But unlike the others, it lent customer deposits to crypto speculators, all the while explaining that deposits are “lent out to trustworthy, vetted financial institutions.” To illustrate its supposed safety, Confetti’s website explained that borrowers post collateral valued at more than their loan, and described three scenarios that could occur:
- First, borrowers could repay their loans, in which case Confetti’s depositors would be repaid with interest.
- Second, the value of borrowers’ collateral could fall below 150 percent of their loans. Borrowers would then face margin calls and, if they could not post additional collateral, the initial collateral would be liquidated to repay Confetti’s depositors.
- Third, if borrowers could not repay their loans, their initial collateral would be liquidated and Confetti’s depositors would be repaid.
Nothing on Confetti’s website indicated that what actually did happen was a possibility: Borrowers did not repay their loans, their collateral precipitously dropped in value, and Confetti’s depositor accounts lost value. Despite some acknowledgment that depositors could face losses, the website urged that depositors can be assured that “your funds are safe and your account is secure.”