Could a Bank Charter Actually Limit SoFi's Valuation?

After years of pursuit, SoFi Technologies (SOFI 2.13%) finally has a bank charter. The all-in-one financial services company's move into banking became official recently when it won regulatory approval and then completed its acquisition of Golden Pacific Bancorp.

There's a lot to like about SoFi's new look -- but investors may want to consider how becoming a bank impacts the company's valuation, since the market traditionally expects very different things out of banks and tech companies, and the bank-fintech combo is still a bit new for the market. Let's take a look.

What does becoming a bank mean?

There's obviously a reason SoFi chose to become a bank. First, the bank charter allows SoFi to bring all the deposits it has been gathering through its SoFi Money cash management account into the company because non-licensed banks can't hold deposits insured by the Federal Deposit Insurance Corporation (FDIC). Then, SoFi can use these deposits to fund a portion of its loan originations, which will save it money because SoFi has been relying on higher-cost funding sources.

Image source: Getty Images.

Having a bank charter will also give SoFi better regulatory clarity and set up a better framework for holding loans on the balance sheet and collecting recurring monthly interest payments. At the very beginning of 2021, SoFi showed that having a bank charter would increase earnings before interest, taxes, depreciation, and amortization (EBITDA) by close to $200 million this year and as much as $300 million in 2025. Things may have changed since then, but clearly, SoFi sees this as a win.

On the other hand, becoming a bank means SoFi is entering one of the most heavily regulated industries. Banks in the U.S. typically answer to three different regulatory agencies: the Office of the Comptroller of the Currency (OCC), the Federal Reserve, and the FDIC. Banks must hold regulatory capital, which ensures they can cover unexpected loan losses and continue to lend to individuals, families, and businesses during an economic downturn.

Now, we don't know exactly what SoFi's regulatory capital requirements are just yet. But the OCC said in its approval of SoFi's banking charter that the company "shall have initial paid-in capital of no less than $750 million contributed in cash." SoFi Bank is expected to have $5.3 billion of assets upon completion. That would equate to a tier 1 leverage ratio (core capital as a percentage of assets, one of several regulatory capital ratios banks must follow) of more than 14%. While that would be high for a bank, it wouldn't be overly surprising, considering LendingClub -- another fintech that became a bank last year -- has a leverage ratio requirement of 11%.

Regulatory capital thresholds must be maintained. Earnings help build capital, but we know SoFi isn't profitable yet. If companies are growing fast and want to maintain their capital ratios, they need to increase capital, which can dilute shareholders and stymie returns.

How SoFi will be valued

At recent prices, SoFi is being valued as a high-growth tech company, with investors awarding it a nearly $10 billion market cap without any profitability yet. The idea is that SoFi is building a big base of high-income members that it will be able to monetize heavily down the line, so forgoing profits for now makes sense. But in addition to earnings, banks also tend to trade based on their tangible book value (TBV), which is what a bank would be worth if it were liquidated. Let's take a look at SoFi's valuation compared to some of the most highly valued and tech-forward banks in the industry.

Source: YCharts.

As you'll notice, SoFi already trades at more than three times its TBV, which falls in the middle of this group of top bank stocks. You might be saying, well, that makes sense because SoFi is much more innovative than a traditional bank. But if you do some research on most of these other banks, I think you'll find plenty of disruptors with growth potential, powered by technology that's at least as impressive as SoFi's.

SoFi does offer more than just banking products. Its growing tech platform Galileo, which helps fintech companies carry out front- and back-end operations, is diversifying the company's revenue stream. But the bulk of revenue right now is still coming from the bank's lending operations.

Regulatory capital requirements can limit a lender's growth, because a fast-growing bank may need to raise more capital to maintain its regulatory requirements -- which in turn hurts metrics like return on equity. Also, if SoFi holds more loans on the balance sheet, some credit costs and wonky accounting policies come into play.

LendingClub is an interesting example of the struggle because it is a fintech in the lending space that secured a bank charter last year. The charter has done wonders for the company in terms of profitability. But it has led the bank to increase equity over the past year to support future growth, and investors seem to be struggling over how to value it. After LendingClub management implied less growth than anticipated in recent guidance for the year, the stock got crushed as investors seemingly valued it more like a bank. Yet, if you watch daily trading activity, LendingClub continues to move with fintech companies like SoFi, Upstart, and Affirm.

The wild west

I still think we are in a bit of the wild west in fintech-bank land when it comes to valuations. Adding the bank should greatly help SoFi improve profitability, but watching how these former tech companies manage their regulatory capital is important. Unlike LendingClub, SoFi does have Galileo, but it also already has a high valuation relative to tangible book value. If growth slows from the crazy pace that tech investors are used to, it's possible investors may look at SoFi as more of a bank than some would like. That isn't the worst thing. Banks are highly profitable, and strong banks can certainly trade at 15 or 20 times earnings, that can produce very good results over the years.

Ultimately, valuing these newer fintech-bank models is still filled with some uncertainty right now. I see SoFi as a good test in the experiment. Maybe nothing changes, but thinking about this dynamic is a good exercise for SoFi investors.