Fintechs have been free-riding on the banking industry. Up until now they have been able to rely … [+]
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Customers and investors like fintech companies because they are perceived to be nimble and more capable than banks of delivering a superior customer experience. The impression remains, at least in the mind of some investors, that the fintech entrepreneurs are still able to live by the Facebook founder Mark Zuckerberg’s motto: “Move fast and break things.” Time for those perceptions to end.
When compared to banks the financial technology industry does have some systemic advantages to the participants, but to balance things out there are usually additional risks borne by the customers. To ensure that the United States maintains the world’s leading financial services industry we need to rebalance the distribution of risk so consumers are not stuck with the tab when things go wrong. One way to make that happen is to change the way banks interact with fintech firms, and the regulators seem to be making that happen.
The emerging cryptocurrency asset class and the failure of FTX is a great example of how the system in the USA has permitted the risk associated with institutional failure to migrate to the customers. Whether in payments, financing, or investing, today the majority of Americans use the services of one or more fintech firms, and many mistakenly believe they are afforded the same protections they receive from chartered banks.
Fintech Firms Take Advantage of Regulatory Arbitrage
One of the perceived advantages to fintech firms, at least to investors, is that they are not subject to the same capital requirements as banks, and therefore can be founded with much lower investment levels. This means the firms are not necessarily well equipped to survive periods of financial stress, and in the event of failure the costs are passed along to the customers through losses. The cryptocurrency world is now littered with such firms including FTX, Voyager Digital, Celsius
CEL
, Genesis, BlockFi and others.
The owners and managers of fintech firms are also subject to far less scrutiny. Anyone with access to funding may be a founder of a fintech firm, but the regulatory authorities ensure that bank operators are held to a much higher standard.
Part of the reason for the rise of the fintech economy was rooted in regulatory arbitrage. Simply put, banks and fintech firms have not been competing on a level playing field. Banks are heavily regulated by the government and must comply with strict rules and guidelines including capital requirements, lending standards, and consumer protections. The banks are also saddled with considerable burdens for compliance for which the fintech firms have thus far mostly avoided, and the penalties for technical failures are disproportionately larger for banking firms.
For example, consider what happened to USAA and Capital One
COF
. In March 2022, USAA Federal Savings Bank was assessed a $140 million civil money penalty by the Financial Crimes Enforcement Network (FinCEN) for failure to implement and maintain an effective anti-money laundering program, and in August 2020, the Office of the Comptroller of the Currency (OCC) assessed an $80 million civil money penaltyagainst Capital One related to a data breach.
Banks are required to have everything in place and working correctly at all times. New developments must be fully tested and completely integrated into the bank prior to introduction to customers, and things that go wrong are viewed very negatively.
Banking-as-a-Service Under Regulatory Pressure
Banking-as-a-Service (“BaaS”), somewhat similar to the concept of “Open Banking”, is one of the primary ways banks interact with the fintech and crypto-fintech community, and it is a target for regulatory pushback. BaaS is not dead, but the activity will need to be re-shaped as the regulators apply pressure to banks to take responsibility for their fintech customers.
Simply put, BaaS is the technologically enabled provision of banking products to non-bank third parties. These fintechs are customers of the bank who then directly acquire customers themselves, and those fintech customers most likely are not even aware that they are consuming products from the underlying bank.
The multiple U.S. banking regulators are increasing the scrutiny of the overall risk profile of banks, and that has led to considerably more attention to third-party relationships. Banks are under pressure to ensure that they fully understand the risk characteristics of firms that receive services from the bank.
In a BaaS relationship, the fintech is essentially interacting with the customer on behalf of the bank, and that means all the activities of the bank and the fintech must be compliant with the relevant regulations. Expect heightened attention to Know-Your-Customer rules, Bank Secrecy Act provisions (anti-money laundering), marketing and advertising standards, and all aspects of credit.
Banks Can Never Outsource Responsibility
Banks can outsource certain activities, but they can never outsource the responsibility. This means that banks are responsible for the ensuring their BaaS fintech customers are in compliance with the rules to the same extent that would be done if the bank were conducting the activity themselves.
There are a number of banks in the U.S. participating in the BaaS space. Expect them to demand more from their fintech partnerships. The cost model for the fintech companies will need to be reevaluated in light of the increasing compliance costs, and they will need to be far more transparent to their banking providers.
Regulatory enforcement has already started. In 2022, Blue Ridge Bank NA entered into a formal agreementwith the Office of the Comptroller of the Currency (OCC). Blue Ridge Bank agreed to increase the regulator’s oversight of the BaaS activities. Within the OCC order the bank agreed to obtain the OCC’s non-objection before entering into any new contracts with fintech partners or adding new products in cooperation with existing partners.
Perhaps for reasons related to cost and compliance of maintaining the banking relationship, the cryptocurrency exchange Binance announced that Signature Bank will no longer process Swift transactions of less than $100,000 for crypto exchange customers.
The fintech players have been free-riding on the banking industry. Up until now the U.S. financial technology industry has been able to rely upon banks to do the heavy lifting and absorb the costs of compliance and regulation. Perhaps that time is finally coming to an end.
The regulators are reminding banks that they are responsible for the activities of their fintech partners, and that will lead to change. No doubt there will be a change in the model that subtracts from the profitability of the fintech model. Perhaps banks will stop supporting the growth of their fintech competition and we can see banks once again safely and soundly leading the financial services customer experience.
The author’s employer is a customer of Signature Bank.
