On Wednesday, The Wall Street Journal reported that payments company Square (NYSE:SQ) planned to submit an application on Thursday for a bank charter in Utah. The purpose of the unit, Square Financial Services, is to offer loans and deposit accounts to small businesses.

To be clear, if Square's application is approved, it won't technically be a bank; it will instead be an industrial-loan company.

Square's physical payments system installed at a retail store, sitting on a counter between a variety of sweet baked goods.

Image source: Square.

From the perspective of the consumer, these two types of institutions are functionally equivalent, as they're both empowered to make loans and accept deposits insured by the Federal Deposit Insurance Corporation (FDIC).

The biggest difference from Square's perspective, however, is that an industrial loan company can be owned and controlled by a corporation that does things other than banking. A traditional charter doesn't permit this.

A decade ago, Wal-Mart (NYSE:WMT) applied for the same type of charter, which would have allowed a subsidiary of the company to offer banking services to its customers. The retailer ultimately withdrew its application after confronting criticism from others in the bank industry as well as reluctance on the part of regulators to allow Wal-Mart to own and operate a bank.

A second difference is that, unlike banks, industrial-loan companies don't subject their parent company to supervision by federal banking regulators, such as the Federal Reserve, the FDIC, or the Office of the Comptroller of the Currency. Regulators' jurisdiction would extend instead only to oversight of the banking subsidiary.

"It's good news for small businesses that Square is seeking a bank charter -- it will allow the company to continue to innovate inside the regulatory system," says Colin Walsh, co-founder and CEO of Varo Money, a provider of digital banking services that has applied for a national bank charter.

Walsh continued:

However, the choice of an industrial loan charter (ILC) over a full national bank license is likely to add fuel to the fire in a debate recently reignited by [online lender] SoFi. ILC charters are regulated by states and the FDIC but do not have to comply with the additional regulations of the Bank Holding Act and supervision by the Federal Reserve Board and Office of the Comptroller of the Currency, creating some controversy among community banks and community groups.

Moreover, while this isn't as big of a deal for Square, which doesn't rely on physical locations, only roughly half a dozen states permit industrial-loan companies. Utah has the most, and that's where Square has submitted an application, but California and Colorado are among the states that allow them as well.

The ability of a fintech company like Square to gain access to federally insured deposits would be viewed by many as a watershed moment for the bank industry. It would be seen as an opening for a company such as Square to siphon deposits away from traditional banks.

Fintech companies are particularly well positioned to do this given their lean operating structures, Walsh noted in a recent conversation. Because fintech companies don't operate expensive branch networks, they can afford to pay higher interest rates on deposits than a typical bank can.

The ability to attract deposits would give Square a stable and growing source of capital that could be used to expand its lending operations, through which it's already extended $1.8 billion worth of credit to small business clients of its payments services. This would ratchet up the competition against traditional banks on the asset side of the balance sheet as well as the liability side.

It's unusual for a company that doesn't focus on core banking services to evolve into a large banking institution, but it isn't unheard of. Capital One Financial (NYSE:COF) offers a case in point. Over the past quarter-century, the McLean, Va.-based company has transformed from a credit card issuer to a full-fledged regional bank.

What does Square's move portend for the future of banks? Assuming its application is approved, it seems fair to assume that others will follow in the payment company's footsteps. The net result for banks will be increased competition from corners of the financial-services market that they have largely been shielded from in the past.

John Maxfield has no position in any of the stocks mentioned. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy.