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- Killing Fintech Isn’t an Option
After Synapse melted down in May of this year, the FDIC published a consumer-facing newsletter about how the protection afforded by FDIC insurance extends to third-party apps:
Here’s the short answer:
It depends! Super useful!
The FDIC continues:
It is important to be aware that nonbank companies themselves are never FDIC-insured. Even if they claim to work with FDIC-insured banks, funds you send to a nonbank company are not eligible for FDIC insurance until the company deposits them in an FDIC-insured bank and after other conditions are met.
For example, after the nonbank places your funds on deposit at a bank, records must be kept to identify who owns the money and the specific amount that each person owns. Ownership of the money is important and is typically determined by the applicable deposit account agreements and state law. There are other requirements as well. It is important to make sure you read the disclosures and terms of service carefully to understand if the account may be eligible for FDIC insurance.
In short, the FDIC’s advice relies on the assumption that every consumer is willing to read a fintech company’s terms and conditions and understand what they mean — a questionable assumption when even wealthy, sophisticated depositors appear unable to do this.
Here’s the thing, though: even if a consumer did read and understand everything there is still no way for them to verify that a fintech company is actually meeting the requirements necessary for insurance coverage to apply. In fact, no one knows if insurance coverage will apply for fintech customers, not even the FDIC, until after the bank in question has failed!
So, reading the Ts&Cs? Not great advice!
However, this portion of the FDIC’s statement suggest that might be a feature, not a bug:
However, FDIC deposit insurance does not protect against the insolvency or bankruptcy of a nonbank company. In such cases, while consumers may be able to recover some or all of their funds through an insolvency or bankruptcy proceeding, often handled by a court, such recovery may take some time. As a result, you may want to be particularly careful about where you place your funds, especially money that you rely on to meet your regular day-to-day living expenses. (emphasis added)
It’s difficult to read that and not come away with the impression that the FDIC thinks that consumers should just keep their money directly with banks and stop playing around with this silly fintech thing.
And the FDIC isn’t alone. Fed Chair Jerome Powell testified before the Senate, in response to a question about what the Fed was doing to restore Synapse customers’ access to their money, that, “We do supervise the bank. We don’t supervise Synapse, let alone the fintechs that feed into Synapse.”
Despite having the regulatory authority to directly supervise fintech companies, including Synapse[1], the Fed chose not to do that, to the eventual peril of the customers of Juno, Yotta, and the other fintech companies that had been built on top of Synapse and Evolve Bank & Trust.
Now, this “fintech isn’t our problem” attitude wouldn’t be entirely unreasonable from bank regulatory agencies if it just resulted in a lack of direct supervision of non-bank financial services providers. It wouldn’t be my preferred regulatory approach, but it would at least be consistent with the agencies’ narrow interpretation of their statutory authority and responsibilities.
The issue is that the federal banking agencies aren’t just saying that fintech isn’t their problem; they’re also undertaking rulemaking and enforcement actions to assign the problem to banks, and doing so in a way that puts consumers and the industry at risk.
Restricting Supply
Regulators are engaged in a multi-year process of applying a great deal more scrutiny to the banking side of banking-as-a-service (BaaS) partnerships. This has resulted in numerous consent orders (some of which have limited BaaS banks from taking on new fintech programs or expanding existing ones) as well as significantly more onerous supervisory exams for banks that are engaged in BaaS.
The effect of this increased regulatory pressure has been to raise the cost of compliance in BaaS significantly. One bank executive I spoke with estimated that it would cost a new bank getting into BaaS between $3 million and $5 million over approximately six years to build and staff the business to meet regulators’ current expectations and that the bank wouldn’t start to see a profit until it was 18 months into that six-year journey, at the earliest.
Additionally, regulators’ suspicion of technology as a solution for scaling compliance means that it will be incredibly difficult for banks to increase their profit margin over time because, from regulators’ point of view, more programs = more human compliance staff.
When you raise the costs of selling into a market, you reduce the available supply for buyers.
This is precisely what has happened in BaaS over the last 6-12 months. Banks that are still offering BaaS and that aren’t under the restrictions of a consent order have been flooded with more demand from fintech companies than they can possibly supply, which has led those banks to institute higher floors for the fintech programs they are willing to onboard. This looks a bit different, bank-to-bank, but can include the fintech company having raised a certain amount of venture capital or reaching a specific revenue run rate.
The end result is that many early-stage fintech startups are unable to obtain bank partners, regardless of how compelling their product is or how buttoned up they are on compliance. They’re simply too small to be worth it for the limited supply of BaaS banks in the market.
This is an existential risk to the future of fintech.
And it’s not the only one.
Breaking Brokered Deposits
In 2020, the FDIC made some changes to the rules that govern banks’ use of brokered deposits. Those changes were specifically designed to reduce the compliance burden and costs for banks associated with deposits sourced through fintech partnerships, as opposed to the more traditional form of deposit brokering, which was the focus of the original 1989 rule.
Here’s how then-Acting Comptroller Brian Brooks described the 2020 change:
Under the previous status quo, the broad definition of brokered deposits discouraged bank and fintech partnerships by imposing unnecessary burden and costs—specifically, by deeming app-based fintech services that facilitate consumer savings accounts potential deposit-brokering activity.
This rule recognizes that fintech partnerships help banks reach new customers and extend their services to previously unbanked and underserved populations without triggering onerous regulatory requirements.
Now, the FDIC, under the leadership of Chair Martin Gruenberg, has proposed a rule that would functionally roll back the 2020 change made by the prior FDIC leadership. The effect of this rule would be to designate a large percentage of bank deposits, including much of what is currently sourced through fintech partnerships, as brokered. That brokered deposit designation carries additional costs (banks pay higher deposit insurance assessments on brokered deposits) and restrictions on which banks can accept brokered deposits (they are restricted, to varying degrees, for banks that are less than well capitalized).
This rule is being framed by its proponents as a mechanism to address the risks exposed by recent fintech failures, such as Synapse and the crypto brokerage Voyager.
But here’s the part that doesn’t make sense — Synapse’s primary bank partner (Evolve) and Voyager’s bank partner (Metropolitan Commercial Bank) were well-capitalized in the lead-up to their fintech partners’ failures, which means that neither of them would have been prohibited by the FDIC in accepting deposits from those partners, even if they had been classified as brokered. All that would have happened if the proposed rule had been in effect is that Evolve and Metropolitan would have had to pay more in insurance assessments on those deposits.
If your goal is to granularly understand and manage the risks of different deposit products and deposit acquisition strategies, this doesn’t seem like sound policy.
However, if your goal is to restrict the supply of banks that are willing and able to partner with fintech companies and, thus, push fintech further outside the mainstream, this policy starts to make a lot more sense.
We Need Fintech
I do not believe that most federal bank regulators want to kill fintech. However, I do believe that many of them wouldn’t exactly be devastated if the U.S. fintech market slowly withered away.
To be honest, I can empathize with that feeling.
The most recent fintech boom in the U.S. (roughly 2019-2022) brought a lot of unserious founders and operators into the financial services space. Many consumers, banks, and regulators are now paying the price for the mistakes that those entrepreneurs made.
A regulatory correction was (and still is) needed.[2]
We just need to make sure it’s not an overcorrection.
After all, the fundamental purpose of regulation in this country is to harness the benefits of market forces while constraining their risks.
Fintech, for all of its risks, delivers a lot of benefits to the financial industry[3] and its customers:
Predatory overdraft protection products have been pushed out of the mainstream. We have fintech to thank for that.
Most major credit card issuers now offer an installment lending feature that consumers are using to reduce their revolving debt levels. We have fintech to thank for that.
Two-day early access to your paycheck is now a table stakes deposit account feature and free embedded tax filing is on its way to becoming one as well. We have fintech to thank for that.
Put simply, fintech forces banking to work better for consumers. That’s not something that federal bank regulatory agencies should ignore. And it’s certainly not something that they should kill, intentionally or otherwise.
The opinions shared in this article are the author’s own and do not reflect the views of any organization they are affiliated with.
[1] Read this article by Jason Mikula for more details.
[2] And there are some good corrections happening! I love the federal bank regulatory agencies’ joint RFI on bank-fintech partnerships and this reported rule coming from the FDIC on ledgering and reconciliation for FBO accounts sounds like a step in the right direction.
[3] It’s worth stating that fintech also helps smaller banks and credit unions remain viable in an increasingly consolidated market. Many federal banking regulators have expressed a desire to maintain a large and diverse banking system. Fintech can help with that!
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