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Russell, Kentucky, has survived three floods, a smallpox outbreak, a downtown blaze and a 200-mile oil spill. Its largest employer left in 1999.
Now the town is facing another potential calamity: First & Peoples Bank, its sole local lender with roots to 1907, has received notices from three regulators this year warning about its precarious finances.
The bank’s troubles do not stem from the region’s declining fortunes. Rather, they are emerging from exposure to the latest evolution of modern finance. First & Peoples is the most troubled of a growing number of small banks across the US facing problems due to ties to so-called shadow banks. Its struggles are illuminating the mostly hidden connection between the traditional financial system and the unregulated digital newcomers.
Four years ago the bank signed a partnership with a fintech, US Credit, that promised to turn First & Peoples into a financial disrupter. Instead, the relationship has led to tens of millions of dollars in soured loans, and questions about the bank’s ability to survive. If First & Peoples fails, it would be the first community bank collapse in the US to stem from an ill-fated excursion into the world of shadow lending, putting $200mn of customers’ deposits at risk.
“This bank is in considerable trouble and may need a capital infusion to survive,” said Bill Moreland, an industry expert who runs Bankregdata.com. “It’s a clear example where more oversight and guidance from the [Federal Deposit Insurance Corporation] would help community banks avoid getting into risky fintech relationships.”
A lawyer for First & Peoples, Robert Maclin, said the bank was working with the FDIC and Kentucky bank regulators, and was “aggressively pursuing” efforts to recover its money from US Credit.
Many of today’s shadow lenders are fintechs with sleek apps offering buy now, pay later and other new payment methods. Despite their innovations, the disrupters for the most part run on the same raw material as traditional banks: credit. And much of that credit comes from the same regulated banks that new-world finance says it is looking to replace.
Most fintechs’ financing comes from the nation’s largest banks, but in recent years a growing number of community banks, looking to reignite growth, have struck up deals to fund financial disruption.
The story of how First & Peoples, a family-run local institution, got swept on to the front lines of financial disruption and the brink of closure highlights how vulnerable traditional banks, especially small ones, have been to risks thought to be walled off from mainstream lenders, and how the growth of fintechs has exposed that.
Earlier this year, a study by economists from New York University and the Federal Reserve found certain categories of shadow lenders got a significant portion of their funding, as much of a third, from traditional banks.
“Traditional approaches to financial sector regulation view banks and non-bank financial institutions as substitutes,” the study said. “We argue instead that banks and [shadow banks] are better described as intimately interconnected.”
For all banks, loans to these non-banks have been one of the fastest- growing categories of lending. In February, bank loans outstanding to shadow banks topped $1tn for the first time.
More than a tenth of that, $120bn, came from small US-chartered banks, according to the Fed, though at dozens of small banks, such as First & Peoples, lending to shadow banks has become a much larger portion of their business.
As of the end of the second quarter, 53 per cent of First & Peoples’ total loans outstanding were to lightly regulated financial institutions, up from nothing two and a half years ago.
Increasingly these lending partnerships are getting small banks into trouble. In the first half of this year, bank regulators have brought 11 enforcement actions against banks that partnered with fintech groups, up from two in the same time in 2023, according to bank consultant Klaros Group.
The bankruptcy in May of Synapse, a formerly fast-growing technology company that connected fintechs to traditional banks, has had an impact on thousands of individuals and a handful of small banks that took money from it on behalf of other fintechs and now do not know who is owed what.
“It’s only been in recent years that a lot of smaller banks have sought out these partnerships as a way to survive,” said Jim Perry, a senior strategist at Market Insights, a consulting group that works with community lenders. “Some banks that have partnered with fintechs have ended up unknowingly expanding their risk far beyond what any regulator, or competent board, would have allowed them to do on their own.”
First & Peoples started working with US Credit, a fintech that promised to usher community banks into the world of online lending, in August 2020. Besides banks, US Credit partnered with merchants to offer its instalment loans as a method of payment to their customers. Although the money was coming from First & Peoples, US Credit did all the servicing of the loans, setting them up and collecting payments, as well as deciding who to lend to.
US Credit’s fastest-growing offering was an instalment loan borrowers could use to pay for online courses dubbed “Learn Now, Pay Later” by a rival.
Shortly after inking the deal with First & Peoples, US Credit signed up Growth Cave, an online education company that was co-founded by a social media influencer that offers courses in “digital marketing” and promises in its marketing materials to teach students how to make as much as “$5,000 a month while sitting on your toilet”.
Growth Cave was recently sued by former students who alleged they were defrauded. The company did not respond to a request for comment.
By mid-2022, First & Peoples executives told US Credit they were uncomfortable with the types of loans US Credit was extending, according to a lawsuit the bank filed against US Credit last year. Shortly after, the relationship between them began to deteriorate, the complaint said.
At the end of 2022, First & Peoples took its first big hit, writing off $10mn in loans it had made through US Credit. The bank took another $8mn in losses on its US Credit loans last year. US Credit filed for bankruptcy in January.
Earlier this year, the FDIC and Kentucky’s Department of Financial Institutions put the bank under a consent order. Among other things, the regulators ordered First & Peoples to figure out who the fintech had lent the bank’s funds to — something, according to regulators, it did not know.
First & Peoples chief executive is William Buffin Clarke, a third-generation banker who goes by “Buff” and got the top job in 2016 when his mother, Martha, retired after leading the bank for 36 years. Regulators gave Clarke and the rest of the bank’s management until the end of this month to come up with a plan to fix its financial problems.
Its previous writedowns have left First & Peoples with just $5.6mn left in provisions to cover additional loan losses. Yet at the end of June, it still had another $27mn in delinquent loans, almost all of which were originated by US Credit.
If the bank is forced to write off its delinquent loans, it would wipe out the remaining $15mn in capital.
“You have a lot of fintechs offering banks essential partnerships, and most are not bad deals for the banks,” said Perry. “It’s the partnerships where banks allow themselves to be in the shadows that require sufficient scrutiny and risk management.”