By Ahon Sarkar, Senior Director of Product & Strategy at Q2

It wasn’t long ago that Google’s bank partnership announcement shook the financial world. Now Gusto—the rapidly growing payroll and benefits company that helps small businesses improve the financial wellness of employees—has positioned itself to establish primary banking relationships with these employees. This could be a tipping point in the digital restructuring of the financial industry.

Until recently, primary banking relationships—i.e., keeping and managing most of an account holder’s money—were solely in the domain of traditional financial institutions. And they’re considered the holy grail of financial services. Why? Competition is keen and customers in financial services are difficult to come by, so it’s important to keep them around for a long time in order to justify the acquisition effort.

When you combine this powerful incentive to retain customers with the notorious complexity of the traditional banking system, it’s no surprise that switching your primary banking relationship to a new FI can be a major hassle. A comparison to divorce wouldn’t be unfair.

In general, account holders must:

Compare new institutions and decide on the best option.
Capture and replicate all existing automated activity, including alerts, direct deposit, bill pay, subscriptions, and transfers.
Transfer their funds.
Monitor their old account for a period of time after transferring in order to avoid any surprise fees.
Update their direct deposit information with their employer.
Resist last-ditch pressure to keep their old account open.

It should be clear why rewards programs, or a few extra conveniences, aren’t usually enough to lure account holders away from their existing, comfortable banking arrangement. It requires significantly more value to make the pain of switching worthwhile.

A new relationship isn’t official without direct deposit

Direct deposit is the foundation of every primary banking relationship. In fact, FIs are so interested in attracting direct deposit accounts that they’re willing to offer financial incentives, such as fee waivers, to set one up. According to NACHA, 55% of individuals say their strongest motivation to continue their banking relationship is direct deposit—and that these individuals have three times as many accounts or service agreements as the average account holder, making them a major source of revenue for FIs.

It’s also important to note the heft of the direct deposit market: in 2018, an American Payroll Association survey found that 93% of Americans receive their pay through direct deposit via the ACH network. Yet despite this massive pie, customer-acquisition costs (CACs) in the financial services industry remain in the hundreds of dollars, and the iron-clad nature of primary banking relationships helps explain why.

While FIs were busily engaged with forming and maintaining these relationships, payroll companies emerged as helpful shepherds between employers and FIs. But to employees, payroll companies were always mere providers of commoditized information (mainly pay stubs and tax forms) and offered them little direct value. This is now changing.

Gusto has joined the game

Many payroll companies market themselves by focusing on hard financials and often refer to employees as numbers—instead of people—when speaking to business owners. This is somewhat understandable, given how far removed payroll companies are from Steve the Engineer or Mindy the Designer. But it’s also understandable why employees disengage from them the moment they switch jobs. To most employees, establishing a primary banking relationship with a payroll company would be… unusual.

But these days, it’s tough to find anything “usual” about the financial services industry.

For instance, the Gusto recently launched Gusto Cash Accounts, which provides employees with debit cards connected to interest-bearing checking accounts:

“From the moment their paychecks hit their Gusto Cash Accounts, employees start earning 0.34% APY (annual percentage yield)—8 times the current national average—so their paycheck is able to help them earn even more. And Gusto Cash Accounts have no typical fees—no overdraft fees, no minimum balance, and no ATM fees. Employees can easily access their Gusto Cash Accounts either through the new Gusto Wallet mobile app or new Gusto debit card.”

“Woah, wait a minute,” thinks Steve the Engineer, “My bank doesn’t pay me interest on my checking account!” If you haven’t heard it before, that’s the sound of a primary banking relationship cracking apart.

The classic hassle involved with switching your primary banking relationship from one FI to another is reduced by switching from an FI to a payroll company instead—just cancel your direct deposit information in the payroll app, where you should already be registered. It’s more efficient at the systemic level as well, because instead of your paycheck flowing from employer to payroll company to FI to you, the payroll company just moves the money from your employer to the bank account it manages for you.

In their article on Gusto’s announcement, TechCrunch points out another powerful weight on the payroll side of the “customer value” balance:

"Banks and other savings apps often try to get you to send your paycheck to their service, since if your money resides there, you are much more likely to use that service’s features. Gusto intercepts that transaction and owns it itself. Plus, because it ultimately is selling subscriptions to payroll and not financial services, it can offer many of these features outright for free."

FIs are always searching for new sources of noninterest income, but as a company that provides payroll, Gusto is based on noninterest income. This allows them to offer helpful services—such as savings goals and automatic paycheck splitting between accounts—for free, making an even stronger argument for employees to bump their primary banking relationship up the wage chain.

One of the most significant freebies that Gusto offers is Gusto Cashout, their short-term lending service offered with a bank partner. According to a 2018 report by the Fed, 39 percent of American adults couldn’t cover an unexpected $400 expense with cash or its equivalent. In these situations, many people turn to credit cards or payday lenders, whose crippling interest rates often send them into a financial tailspin. Instead, Gusto lets employees take an advance on their next paycheck without paying any fees or interest.

A new type of neobank

COVID-19 has elevated the utility and prominence of neobanks—banks that operate exclusively in the virtual space without any physical branches. However, Seema Amble, a fintech deal partner at the top-tier venture capital firm Andreessen-Horowitz, points out in a recent article that neobanks have lost many of their former competitive advantages (high-interest savings rates and customer acquisition) because the Fed has cut rates and traditional FIs have improved their digital onboarding capabilities. But instead of turning to fee increases, as many neobanks have done, Amble counsels them to consider other, more sustainable revenue models:

“CAC is likely lower and more stable for neobanks that targeted a customer segment underserved by traditional banks. The same goes for neobanks that offered a differentiated product early on, built brand trust, and quickly established a direct deposit relationship with customers—classic good business. Those neobanks are in a better position to capture more spend and cross-sell additional products, rather than relying on fee increases to quickly bring in revenue.”

A differentiated product, brand trust, and a direct deposit relationship… does that sound familiar? Innovative, employee-friendly payroll companies like Gusto are well-positioned to function like classic-good-business neobanks. Of course, many of the financial solutions these companies offer aren’t currently possible without traditional FIs providing services like compliance, card issuance, and being the bank of record for accounts and loans. But we may be looking at a future where certain FIs are forced to step aside and let payroll companies take over primary banking relationships.

However, this role reversal is far from inevitable. After all, FIs have the incumbent advantage, which is considerable, and even if FIs lose primary banking relationships, they still have a great opportunity to participate in the new system. But the emergence of Gusto and others with similar business models is a rallying cry for FIs to seek new, digital-centric sources of revenue—especially using FI-exclusive technology—that will allow them to offer free, innovative products and services that would help retain these primary banking relationships, if they so desire.

At Q2, we often say, “Digital is banking.” Well, this is what we’re talking about. Verticals are blending—and sometimes bleeding—together, traditional moats are running dry, and all financial services are becoming fair game.

For an in-depth look at this changing landscape and how Q2 helps fintechs grow their product ecosystems, download our eBook: The Age of Abundant Banking: How to stay innovative when every company offers a debit card.