“We created these words like neo bank, digital-only bank, and fintech bank, but they are really just pass-throughs for various banking aspects,” – James Wester.
The 2008 financial crisis proliferated the technology driven financial services providers rapidly over the world. Handling operations outside the bank’s traditional reach, the brick-and-mortar system, these platforms provided a peer-to-peer system that is supported with a digital front. This led to the development of Banking as a Service, aka, BaaS.
Banking as a Service (BaaS) is a business model that allows non-bank businesses to offer banking services through their own platforms. BaaS can be used to offer services like bank accounts, cards, loans, investment solutions and liquidity management.
BaaS represents a semi-open model of banking that helps organizations which are generally outside the banking sector to provide the banking services to its customers. With the growth of BaaS model, even small towns are equipped with technologies that enables people to do scan-and-pay and tap-and-pay like mechanisms, thereby pushing the digital expansion forwards.
The BaaS model through Application Programming Interfaces (APIs) helps the banks to create and maintain platforms that can provide wide range of banking functions. This model enables third party companies, having little or no knowledge in banking or doesn’t possess a banking license, to provide banking services to its customers. As a result, these third parties can seamlessly offer these services leveraging the already established infrastructures and regulatory compliances of the bank in partnership.
While it is very much evident that today’s world which generally runs on the internet and technology requires such kind of innovations/ innovative measures, apart from the traditional brick-and-mortar system of banking, there exists a lot of challenges and issues. While fintech companies may operate under a financial institution banking license, their mindset normally doesn’t align with the traditional banking. Risk management and compliance in such instances are overlooked. Traditional financial services on the other hand have no margin for errors. Lately, it is observed that, technology often overshadows the financial supporting resulting in the technological advancements overriding the fundamentals of financial services.
The rebranding of financial services through Banking as a Service models brings risk and compliance into a grey area. This was accentuated by the failure of BaaS provider Synapse, which went bankrupt, thus throwing consumer accounts into a state of chaos and ambiguity.
The Evolve Bank and Trust chose to partner with Synapse a BaaS provider with a view to expand their footprint and to compete on a national scale.
Beyond encompassing their reach, Synapse persuaded Evolve Bank to take on the lion’s share of the bank’s financial services, including maintaining the ledger and managing customers’ debits and credits. Regrettably, Synapse did not meet its end of the bargain. After losing one of its most profitable customers, the company met enormous financial burdens that enforced its subsequent bankruptcy.
Fintech platforms offering deposit accounts often open FBO accounts at partner banks to hold their end customer funds, which are mirrored as a single account on the bank’s records but hold a pool of funds for many final users. Characteristically, a third party preserves exhaustive customer and transaction records in its systems. Cases where the bank fails, access to deposit accounts is usually frozen until the Insurance companies can evaluate the loss and the related insurance requirements.
However, the failure of Synapse opened the eyes of the regulators as well as the public to a different situation. What if the data is irrecoverable/ unavailable? It was later found out that Synapse had not maintained any ledger for Evolve Bank customers and instead mixed those funds into FBO accounts. Roughly $85 million was found short in the FBO accounts as against the Synapse’s records.
For the bank’s customers, bankruptcy of the fintech made it more difficult to determine which funds in the FBO accounts belonged to which customer. Adding salt to the wound of the customers, it was further revealed that Synapse was vouching on the FIDC Insurance available to customers in case of failure of banks, but since there was no failure of the bank involved and Synapse was a fintech, the same was not insurable to the end customers.
The Synapse’s failure highlights some of the key risks inherent in fintech programs that rely on a “for the benefit of” account and how the banks need to remain vigilant to address such issues
1. The agreements entered with fintech’s should clearly define individual roles and responsibilities, bank’s robust monitoring mechanisms, the frequency and scope of reporting to the bank, periodic audits and the criteria for assessing the partner’s performance and the process to be followed in case of divergences.
2. Banks should differentiate individually known sub-accounts from general pooled accounts, especially when middleware companies are involved.
3. Banks and fintech’s should have a contingency plan in case the partnerships fail anticipating the operational risk related to an account ledger outage, find ways to ease risk etc.
4. In bank-fintech partnerships, both parties should have leadership with profound expertise in risk management and bank supervision along with a strong compliance focus. Regular and adequate training programs and robust monitoring shall be incorporated to equip the team with latest changes in the financial world.
In the words of Mr. James Wester “We added an entire layer of technology and technologists, oftentimes without considering compliance. However, a bank is a real thing. It is a licensed institution that is regulated, and fundamentals like risk mitigation and ledger management should never fall by the wayside.” While technology and innovations are inevitable in today’s world, compliance shall not be taken for granted. Compliance should be baked into any financial services product irrespective of their size.
