U.S. government regulators have stepped in to try and stabilize the chaos kicked off by the sudden collapse of Silicon Valley Bank. A confluence of events (poor asset management, rising interest rates, and fear among SVB's tech start-up customers) led to a bank run, and stocks of other small and regional banks have sold off.
Fintech giants PayPal (PYPL 0.64%) and Block (SQ -1.57%) aren't exactly banks themselves, but investors may be wondering if similar risks could apply. Let's dig into some details.
Are PayPal and Block actually banks?
PayPal and Block are financial technology (fintech) companies that use software and computing technology to do business differently from traditional banks. Nevertheless, as they have grown, PayPal and Block have begun to look a bit more like typical banks.
PayPal and its digital wallet subsidiary Venmo are quite different from a bank. The typical user keeps small amounts of cash in their PayPal and Venmo account, opting instead to link their existing banking and credit accounts to PayPal and Venmo to make digital payments. PayPal primarily makes money by earning a small percentage fee taken on each transactions, much as Visa (V 0.33%) or Mastercard (MA -0.07%) do on transactions that cross their electronic payment networks.
However, like a traditional bank, certain PayPal and Venmo deposits do qualify for Federal Deposit Insurance Corp. (FDIC) protection known as pass-through insurance. This happens when PayPal or Venmo deposits funds on users' behalf with three FDIC-insured banks -- The Bancorp (TBBK -3.72%), Goldman Sachs (GS -0.23%), or Wells Fargo (WFC -0.56%). PayPal Debit Mastercard holders, users who have signed up for direct deposit into PayPal or Venmo, and cryptocurrency buyers using PayPal or Venmo qualify for this FDIC pass-through insurance. Cryptocurrency holdings and non-U.S. dollar balances do not qualify for FDIC pass-through insurance. This insurance offers no protection against the failure of PayPal or Venmo, however.
Block also earns most of its money from transaction fees. Block is a little different from PayPal, though, because it actually received a bank charter in 2021 when it bought a bank, now part of its Square Financial Services. On the Square merchant side of the business, Square Checking accounts are offered through Sutton Bank, a regional bank based in Ohio. Accounts are insured by the FDIC up to $250,000 per depositor.
On the Cash App consumer business, deposits are also eligible for FDIC pass-through insurance via Sutton Bank for customers that use the Cash App Cash Card (a Visa debit card). Again, any crypto or deposits made in anything other than U.S. dollars do not qualify for FDIC insurance.
Financial system risks for PayPal and Block
Technically, any financial services company that accepts and holds money on your behalf can run into a liquidity crunch -- including PayPal and Block. Why?
Per PayPal's 2022 annual report, the company holds users' balances as "direct claims against us which are reflected on our consolidated balance sheets as a liability classified as amounts due to customers." As of the end of 2022, these liabilities amounted to $36.4 billion, which were more than offset by $40.1 billion earmarked as "funds payable and amounts due to customers," which PayPal keeps in short-term liquid assets.
However, even short-maturity assets such as bonds and other fixed-income assets need to be sold before money is sent to a customer requesting a withdrawal. Though these are highly liquid, it still takes time to sell these assets on the market. Thus, too many withdrawal requests all at once could cause problems. PayPal disclosed that over $17 billion of funds receivable and customer funds were invested in short-term available-for-sale debt securities at the end of 2022.
Block's customer balances were significantly less than PayPal's at the end of 2022. It reported $3.18 billion in customer funds, and $1.75 billion of it was designated as cash, with the rest invested in money market and other short-term cash equivalents.
Additionally, both PayPal and Block have consumer and business lending operations that carry other types of risks. These include credit risk if a borrower stops making payments, and interest rate risk when market interest rates rise as they have for the past year.
Because it isn't a bank itself, PayPal uses partner banks for customer loans. As of 2021, Block can lend directly to its merchant customers through Square Financial Services. However, customer loans listed on PayPal and Block's balance sheets were much less than liquid assets available -- so these two companies still don't quite look like traditional banks.
PayPal listed $7.4 billion in loans and interest receivable as assets (which are only assets as long as customers keep making payments), but it had $10.8 billion in cash and short-term equivalents available, plus another $5 billion in long-term investments. Block only listed $474 million in customer loans as held for sale, since most of the loans it originates are sold to investors on the market. It reported $5.6 billion in cash and short-term investments on balance, and another $573 million in long-term investments.
In other words, both PayPal and Block have plenty of cash available if customers start defaulting on their loans.
Are PayPal and Block at risk?
Although PayPal and Block have begun to look more like banking operations, the bulk of their businesses still rely on fees earned from processing digital payment transactions. A cash crunch doesn't look likely for either company.
Nevertheless, as time progresses and PayPal and Block acquire more customer funds and delve more into the lending industry, traditional banking risks could emerge. I think PayPal and Block will come out on top once the current bear market ends, but it's important to mind the risks in both of these businesses.
