Banks are stable and reliable. Fintechs are innovators and risk-takers. Their relationship is crucial to the economy
Over the past decade, financial technology firms — or fintechs, for short — went from being competitors of traditional banks to becoming integrated parts of the financial services supply chain. Now, regulators are struggling to wrangle these partnerships.
On the heels of the stunning bankruptcy of fintech firm Synapse, the Federal Deposit Insurance Commission (FDIC) board of directors last month proposed rules that would significantly strengthen record-keeping for deposits that banks accept from nonbank third parties, such as fintechs.
But that’s just the tip of the iceberg when it comes to tackling the gaps in regulating bank-fintech partnerships. Logan Allin, managing partner and founder of asset manager Fin Capital, an investor in fintech software companies, said regulators need to be more active when it comes to addressing these issues.
“The regulators need to regulate,” Allin said. “They need to put legislation in place that really, finally, addresses fintech. Regulation through enforcement doesn’t work because it doesn’t create any permanency.”
Allin said regulators need to come up with a framework for how banks, asset and wealth managers, and insurers — also known as “the legacy financial services community” — work with modern companies and establish the rules of the road.
Amy Matsuo, national lead of KPMG’s U.S. Regulatory Insights Practice, said the biggest barrier here is regulators’ jurisdiction, which limits how sweeping some controls can be.
For banks, increased regulation would involve ensuring risk management; monitoring and testing fintech partnerships; and enhanced supervision of banks’ operational resiliency, she said. For fintechs, that would mean regulators expanding the reach of existing rules, especially when it comes to financial crime and consumer protection.
Synapse’s bankruptcy highlighted some of the biggest hurdles when it comes to regulating third parties.
For nearly a decade, Synapse helped other fintechs offer banking services by acting as a middleman between the firm and banking partners. Most people had never heard of this company, and many probably didn’t know their money was being handled by this largely unknown — and unregulated — entity.
But in April, Synapse was thrust into the national spotlight when it filed for Chapter 11 bankruptcy. At that point, a court-appointed trustee revealed that about $95 million of clients’ money was unaccounted for, affecting about 116,000 accounts across all of its banking partners.
In the aftermath, the Federal Reserve, Office of the Comptroller of the Currency, and the FDIC warned of a number of risks tied to banks’ overreliance on these partnerships, including the elimination or reduction of a bank’s controls over deposits, banks’ failure to meet regulatory requirements, and a lack of compliance with consumer protection laws and regulations.
The agencies separately requested information from the industry on an array of bank-fintech arrangements, including deposits, payments, and lending products and services. Through that “request for information,” the agencies are looking for input on the nature and implications of bank-fintech arrangements and their risk management practices as they begin to build up regulations of the sector.
One of the biggest reasons banks partner with fintechs is to modernize and innovate — areas where banks don’t necessarily excel, according to Chris Daniel, chair of law firm Paul Hastings’ Global Fintech & Payments Group.
“Banks historically have not been the most innovative of institutions — and that’s not necessarily bad — but it does beg the question that if banks aren’t going to be allowed or don’t have the right mindset to be innovative, where’s the innovation in financial services going to come from?” Daniels said.
A number of major U.S. banks still rely on the Hogan Core Banking system, a legacy software introduced in the 1980s that was built on COBOL, a programming language developed in the late 1950s.
The more than 40-year-old software is in desperate need of updates, with regular service disruptions known as “brownouts” and other bugs that haven’t helped promote digital growth at traditional banks.
Partnerships with fintechs help banks build technology on top of that core in order to integrate modern tools such as APIs that allow banks and third parties to communicate with each other for mobile payments and open banking, Allin said.
Some financial institutions have entirely swapped out the Hogan system for a more modern platform. JPMorgan $JPM Chase (JPM), for example, replaced its U.S. core banking system with Vault, a cloud-native system from U.K.-based fintech Thought Machine in 2021.
But more needs to be done to allow banks and their fintech partners to innovate while also ensuring the stability of the financial system, Daniel said. And it’s not clear where that push will come from.
“I don’t think regulators who are generally risk averse and banks which are unquestionably risk averse are necessarily the right parties to create the right balance between safety and soundness and innovation,” he said. “On the other hand, you can’t leave this question solely to the fintechs, either.”
For Daniel, what needs to be answered is: How much are banks relying on fintechs to carry out important banking functions, such as reviewing internal documents and monitoring financial records?
“The risk here, to state it simply, is how much of the banking services or the services that banks typically offer are outsourced to the fintech,” he said. “If it’s solely the technology and how the user interface interacts with the public, fine. But if it’s the ledgering and the Bank Secrecy Act obligations and the technology, then you have to start thinking about oversight in a more proactive way.”
Other top areas for partnership between banks and fintechs include payment facilitation and money movement, fraud and risk management, and mobile wallets — all areas that require access to technology and knowledge that most banks don’t have on hand or that are difficult to build up capacity for on their own.
In 2019, the average number of fintech partnerships per bank was 1.3, according to data from banking consultancy firm Cornerstone Advisors. By 2021, that number almost doubled to 2.5. Within that same time frame, the average dollar investment in fintechs by banks more than quadrupled to $9.69 million from $2.3 million.
Citi has continued to ramp up its investments in this field. In March 2022, it began collaborating with IntraFi to facilitate deposit sweeps, a process where money is automatically moved between accounts to manage cash balances and earn bigger returns.
However, these partnerships aren’t always a success. HSBC (HSBC) revealed in regulatory filings last month that it offloaded its entire $35 million investment in U.K.-based software firm Monese, just two years after building a minority stake in the company.
JPMorgan’s $175 million acquisition of Frank in 2021 — which CEO Jamie Dimon called a “huge mistake” — ended in a messy, and continuing, legal battle after the largest U.S. bank sued the startup’s founder for allegedly inflating company figures to entice JPMorgan into a deal.
Goldman’s fintech practices also drew early scrutiny last year after its transaction banking business — known as TxB — received a warning from the Fed over insufficient due diligence and monitoring processes in vetting high-risk nonbank clients. TxB subsequently stopped signing on riskier fintech clients, Financial Times reported at the time.
Despite the challenges, Daniel said there’s “tremendous benefit” from bringing banks and fintechs together.
“We just need to be collectively thoughtful about how we do it, and it’s going to take a balancing of interest,” he said. “The banks and their supporters aren’t going to be happy. The fintechs and their supporters probably aren’t going to be happy, either, but there’s a lot of money to be made, a lot of improvement in the U.S. economy to be had, and a lot of wealth to be created by allowing those two parties to cooperate in a manner that’s thoughtful and beneficial.”
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