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Over the past decade, financial technology companies – or fintechs for short – have gone from competitors of traditional banks to become integrated parts of the financial services supply chain. Now regulators are struggling to make these partnerships difficult.
Following the stunning bankruptcy of fintech company Synapse, the Federal Deposit Insurance Commission (FDIC) board last month proposed rules that would significantly strengthen the recording of deposits that banks accept from non-bank third parties, such as fintechs.
But that’s just the tip of the iceberg when it comes to addressing the gaps in the regulation of bank-fintech partnerships. Logan Allin, managing partner and founder of asset manager Fin Capital, an investor in fintech software companies, says regulators need to be more active when it comes to tackling these issues.
“The regulators have to regulate,” Allin said. “They need to introduce legislation that finally tackles fintech. Regulation through enforcement does not work because it does not create sustainability.”
Allin said regulators need to come up with a framework for how banks, asset managers and insurers – known as “the traditional financial services community” – work with modern companies and set the rules of the road.
Amy Matsuo, national head of KPMG’s U.S. Regulatory Insights Practice, said the biggest barrier here is the jurisdiction of regulators, which limits how invasive some controls can be.
For banks, more regulation would entail ensuring risk management; monitoring and testing of fintech partnerships; and strengthened supervision of banks’ operational resilience, she said. For fintechs, this would mean that regulators expand the reach of existing rules, especially when it comes to financial crime and consumer protection.
Lessons from Synapse’s bankruptcy
Synapse’s bankruptcy exposed 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 an intermediary between the company and banking partners. Most people had never heard of this company, and many were probably unaware that their money was being managed by this largely unknown – and unregulated – entity.
But in April, Synapse was thrust into the national spotlight when it filed for bankruptcy. A court-appointed curator announced this at that time $95 million of customers’ money went missing, which had consequences approximately 116,000 accounts with all its banking partners.
In the aftermath came the Federal Reserve, the Office of the Comptroller of the Monet, and the FDIC warned of a number of risks associated with banks’ overreliance on these partnerships, including the elimination or reduction of a bank’s control over deposits, the inability of banks to meet regulatory requirements and a lack of regulatory compliance and consumer protection regulations.
The agencies separately requested information from the sector on a range of banking-fintech arrangements, including deposits, payments and credit products and services. Through that “request for information,” the agencies are seeking input on the nature and implications of banking fintech arrangements and their risk management practices as they begin to build regulations for the sector.
Out with the old
One of the biggest reasons banks partner with fintechs is to modernize and innovate – areas where banks don’t necessarily excel, said Chris Daniel, chairman of law firm Paul Hastings’ Global Fintech & Payments Group.
“Banks historically haven’t been the most innovative institutions – and that’s not necessarily a bad thing – but it does raise the question that if banks aren’t allowed or don’t have the right mindset to be innovative, then where is the innovation in financial services will come from?” Daniels said.
A number of major U.S. banks still rely on the Hogan Core Banking system, an outdated 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 frequent service outages known as “brownouts” and other bugs that have failed to fuel digital growth at traditional banks.
Partnerships with fintechs help banks build technology on top of that core to integrate modern tools like APIs that allow banks and third parties to communicate with each other for mobile payments and open bankingAllin said.
Some financial institutions have completely exchanged the Hogan system for a more modern platform. JPMorgan Chase (JPM), For example, replaced America’s core banking system with Vault, a cloud-native system from British fintech Thought Machine in 2021.
But more needs to be done to enable banks and their fintech partners to innovate while ensuring the stability of the financial system, Daniel said. And it’s not clear where that momentum will come from.
“I don’t think that regulators that are generally risk averse, and banks that are unquestionably risk averse, are necessarily the right parties to create the right balance between safety, soundness and innovation,” he said. “On the other hand, you can’t just leave this question to the fintechs.”
What Daniel needs to answer is: to what extent do banks rely on fintechs to perform important banking functions such as reviewing internal documents and monitoring financial data?
“The risk here, to put 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 just about the technology and the way the user interface communicates with the audience, then fine. But when it comes to accounting, Bank Secrecy Act obligations and technology, you have to think about supervision in a more proactive way.”
A growing practice
Other top areas for collaboration 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 do not have at hand or are difficult to build. capacity for itself.
In 2019, the average number of fintech partnerships per bank was 1.3, according to data from banking consultancy Cornerstone Advisors. By 2021, that number had almost doubled to 2.5. Within that same time frame, the average dollar investment in fintechs by banks more than quadrupled from $2.3 million to $9.69 million.
From 2021 Citigroup (c) and Goldman Sachs (GS) were the two banks investing in the largest number of fintech startups, with 25 and 22 respectively, according to a Visa report published last November.
Citi has continued to increase its investments in this area. The time has come in March 2022 started working with IntraFi to facilitate deposits, a process of automatically moving money between accounts to manage cash balances and earn greater returns.
However, these partnerships are not always successful. HSBC (HSBC) revealed in regulatory filings last month that it has divested entirely Investment of $35 million in British software company 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 “big mistake” — ended in a messy and ongoing legal battles after the largest US bank sued the startup’s founder for allegedly inflating company figures to lure JPMorgan into a deal.
Goldman’s fintech practices also received early attention last year after the transaction banking firm – known as TxB – received a warning from the Fed over inadequate due diligence and monitoring processes in vetting high-risk non-bank clients. TxB next stopped signing up riskier fintech clientsthe Financial Times reported at the time.
Despite the challenges, Daniel says there are “huge benefits” in bringing banks and fintechs together.
“We just have to think collectively about how we do it, and it will require a balancing of interests,” he said. “The banks and their supporters will not be happy. The fintechs and their supporters probably won’t be happy either, but there is a lot of money to be made, a lot of improvement in the US economy possible, and a lot of wealth to be created by allowing these two companies to work together on a way that is thoughtful and useful.”