Customers and investors like fintech companies because they are perceived to be agile and better able than banks to deliver a superior customer experience. The impression persists, at least in the minds of some investors, that fintech entrepreneurs can still live by Facebook founder Mark Zuckerberg’s motto: “Move fast and break things.” It is time for those perceptions to end.
Compared to banks, the fintech industry has some systemic advantages for participants, but to balance things out, customers often take additional risks. To ensure that the United States maintains the world’s leading financial services industry, we need to rebalance risk sharing so that consumers are not left with the tab when things go wrong. One way to make that happen is to change the way banks interact with fintech companies, and regulators appear 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 US has allowed the risk associated with institutional failure to migrate to clients. Whether in payments, financing or investing, today the majority of Americans use the services of one or more fintech companies, and many mistakenly believe that they have the same protections that they receive from licensed banks.
Fintech companies take advantage of regulatory arbitrage
One of the perceived advantages for fintech companies, at least for investors, is that they are not subject to the same capital requirements as banks and can therefore be founded with much lower levels of investment. This means that companies are not necessarily well equipped to survive periods of financial stress and, in the event of bankruptcy, the costs are passed on to customers through losses. The cryptocurrency world is now littered with firms like FTX, Voyager Digital, Celsius
Owners and managers of fintech companies are also subject to much less scrutiny. Anyone with access to finance can be the founder of a fintech company, but regulators ensure that bank operators are held to a much higher standard.
Part of the reason for the rise of the fintech economy is based on regulatory arbitrage. Simply put, banks and fintech companies have not been competing on a level playing field. Banks are heavily regulated by the government and must adhere to strict rules and guidelines including capital requirements, lending standards, and consumer protection. Banks are also saddled with considerable compliance burdens that fintech companies have so far largely avoided, and penalties for technical failures are disproportionately higher for banking companies.
For example, consider what happened to USAA and Capital One
Banks are required to have everything in place and working properly at all times. New developments need to be fully tested and fully integrated into the bank before being introduced to clients, 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 main ways banks interact with the fintech and crypto-fintech community, and is a target for pushback regulatory. BaaS is not dead, but the business will need to be reshaped as regulators push banks to take responsibility for their fintech customers.
Simply put, BaaS is the technology-enabled provision of banking products to non-bank third parties. These fintechs are customers of the bank who then directly acquire customers, and those fintech customers most likely don’t even know they’re consuming products from the underlying bank.
Multiple US banking regulators are increasing scrutiny of banks’ overall risk profile, and that has led to much more attention being paid to third-party relationships. Banks are under pressure to ensure that they fully understand the risk characteristics of businesses served by the bank.
In a BaaS relationship, the fintech essentially interacts with the customer on behalf of the bank, and that means that all bank and fintech activities must comply with relevant regulations. Expect increased attention to Know Your Customer rules, Bank Secrecy (Anti-Money Laundering) Act provisions, marketing and advertising standards, and all aspects of credit.
Banks can never outsource responsibility
Banks can outsource certain activities, but they can never outsource responsibility. This means that banks are responsible for ensuring that their BaaS fintech customers comply with the rules to the same extent as if the bank were doing the activity itself.
There are several banks in the US that are participating in the BaaS space. Expect them to demand more from their fintech partnerships. The cost model for fintech companies will need to be reassessed in light of rising compliance costs, and they will need to be much more transparent to their banking providers.
The application of the regulations has already begun. In 2022, Blue Ridge Bank NA entered into a formal agreement with the Office of the Comptroller of the Currency (OCC). Blue Ridge Bank has agreed to increase the regulator’s oversight of BaaS activities. Under the OCC order, the bank agreed to obtain the OCC’s no objection before entering into new contracts with fintech partners or adding new products in cooperation with existing partners.
Perhaps for reasons related to the cost and compliance of maintaining the banking relationship, cryptocurrency exchange Binance announced that Signature Bank will no longer process Swift transactions under $100,000 for cryptocurrency exchange clients.
Fintech players have taken advantage of the banking industry. Until now, the US fintech industry has been able to rely on banks to do the heavy lifting and absorb the costs of compliance and regulation. Maybe that time is finally coming to an end.
Regulators are reminding banks that they are responsible for the activities of their fintech partners, and that will lead to change. There will undoubtedly be a change in the model that reduces the profitability of the fintech model. Perhaps banks will stop supporting the growth of their fintech competition and we may see banks once again safely and robustly leading the financial services customer experience.
The author’s employer is a client of Signature Bank.