Transcription:
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Penny Crosman (00:03):
Welcome to the American Banker Podcast. I'm Penny Crosman. The disputes between banking-as-a-service middleware provider Synapse and its banking partners have cast doubt on the whole practice of banking as a service, where fintechs build relationships with customers directly and bank partners keep the money in their vaults. Today we're here with Karen Petrou, managing partner at Federal Financial Analytics, to get her take on this whole situation and what the way forward might look like. Welcome, Karen.
Karen Petrou (00:36):
Thank you very much. Pleasure to be here.
Penny Crosman (00:38):
Thanks for coming. So you recently wrote a memo and I think you talked about a Faustian bargain. What did you mean by that?
Karen Petrou (00:49):
I think banks, most of whom are smaller, often engage in these fintech "partnerships" because they are facing significant strategic challenges. The basic business of banking, not as a service but banking as banking, has been under tremendous stress in recent years due to a combination of new rules, slow growth and now higher interest rates along with the technological and nonbank challenges. And many smaller banks are also, as a result of all those challenges, so heavily invested in commercial real estate and perhaps underserved depositors that they have vulnerable and low-profit business models. So they've got to come up with something else to survive and sometimes, as I suggested, they essentially sell their soul, the whole purpose of a regulated bank charter, to a fintech to try to get some fee income and make ends better meet that way. I don't think anybody would be doing these deals, which is essentially are opening default to the competition, if they didn't have to.
Penny Crosman (02:04):
Now also in your memo, you noted that Synapse triggered red flags for you or could have triggered red flags from the very beginning. What were some of those indicators?
Karen Petrou (02:15):
Well, looking at it with 20-20 hindsight, one of them was apparently the Synapse founder had never had a job before. I think a little bit of customer due diligence might have identified the fact that there were unlikely to be effective internal controls. Certainly there do not appear to have been any. I'm all for bright young things getting into new businesses, but that's not enough for a durable, viable business proposition.
Penny Crosman (02:45):
Are there certain basic due diligence measures that you think a bank should do before it partners with a company like this?
Karen Petrou (02:54):
Absolutely. I think they really need to kick the tires and not just look at the fee revenue, but at the resilience of, and the promises, but at the resilience of their counterparty in these deals. Clearly one of the issues with Synapse is at least a hundred million dollars of customer money is missing, and while the scale of trillion dollar financial crises, that might not seem like a lot, it's a lot to the individual households, and we're still trying to figure out whether Synapse even had a general ledger. It doesn't appear to, that should have been a real red flag.
Penny Crosman (03:34):
Well, yeah, that seems to be one of the major issues here is that there are four banks involved, and the banks say X amount of dollars are in these customer accounts and Synapse says Y amount of dollars are in these accounts. Should there be shared ledgers that the banks and these partners can access at the same time, maybe even a distributed ledger, blockchain style?
Karen Petrou (04:05):
Absolutely. The fintech partner is building its business based on promises that it is providing FDIC insurance so that anyone who gives it their money in order to get some services is taking no risk with the money. Well, sometimes they're taking a lot of risk with the money because as we saw at Signature Bank, for example, the money doesn't even go into the bank. It goes into a pooled account held by the fintech or the crypto company at the bank, and it's up solely to the fintech or crypto company to know whose money that is because the bank is just sitting on a hundred million dollars worth of X, Y, Z money and it has no obligation who the counterparty's liabilities are, and then sometimes, as appears to be the case in the Synapse situation, there are in fact insured accounts open on behalf of each of Synapse's customers at the bank, but FDIC insurance promises them nothing if Synapse fails. This is misleading, false advertising. If you give your money to a Synapse or a similar entity and are told that it is safe and sound because it's in an FDIC-insured bank, that is only true if the insured bank fails. It is demonstrably not true if the fintech fails.
Penny Crosman (05:45):
I thought it was interesting that the FDIC recently issued a warning to customers talking about how FDIC deposit insurance does not protect against insolvency or bankruptcy of a nonbank company. In such cases, the consumer may be able to recover some of their funds through an insolvency or bankruptcy proceeding. Such recovery may take some time. That's a pretty scary warning, I think. Did you agree with that warning and how they put it?
Karen Petrou (06:16):
I wouldn't say "may." I mean it's legal language — may take some time, sure will take some time, and there may be losses, there will be losses — but how many regular average consumers follow the FDIC and their social media feeds or read the FDIC's website to catch these things? It's frankly an irrelevant form of customer warning, consumer protection. There's something known as asymmetric disclosures, which means that people don't see, or sometimes if the disclosures are complex, don't understand the disclosures they're getting and that's exactly what this FDIC notice is all about. The only people who are going to see it are banks looking at the FDIC website, and they're not the problem.
Penny Crosman (07:10):
Right, right. Is there a better way of helping people understand these relationships and that there is
Karen Petrou (07:20):
I don't think so. I mean, I think there's a better way of regulating the risk when banks enter into these relationships. We have spent so many years of countless, countless placards and posters and statements from the president under stress that your money is safe at an FDIC insured institution. That is an extraordinarily difficult perception to change, your money is safe at an FDIC insured institution — unless.
Penny Crosman (07:53):
Right, right. Well, yeah. I also thought it was sort of ironic. I looked at Synapse's website today just to see if they had any updates or anything, and at the top of their website, they have "Synapse's fintech stress test can help you determine your risk."
Karen Petrou (08:13):
Well, I'm sure that was rigorous to the end of the grid.
Penny Crosman (08:18):
And it kind of walks you through, OK, how many bank partnerships does your fintech have and what does your fintech do, etx., but the real risk was Synapse itself. In hindsight, what kinds of risk management, if a bank is working with a company like this, and as you said, perhaps they weren't that careful in their due diligence, what do they do from there in terms of monitoring and making sure that nothing blows up?
Karen Petrou (08:55):
I think those are the terms of engagement. You need to have both robust controls at the outset and extra controls based on what promises the fintech is making. I think banks may not have a legal liability and if they have a moral obligation to know that they should not and put regular people's money at risk. They have FDIC insurance, they get those placards on the bank as a public good, and it's not good for the public when banks just sell it, again, the Faustian bargain. They need to look and not make promises their business counterparty can't keep. I know this sounds really forceful, but real people lose real money and that's not right.
Penny Crosman (09:47):
Well, you said in your memo that bank regulators need to close this barn door. What did you mean by that? What might that look like?
Karen Petrou (09:56):
I think it looks like the higher due diligence, constant controls and the particular restrictions based on the nature of the relationship including and most especially the promise of FDIC insurance. I would like to think banks will not enter into these arrangements without taking all those steps, but we sadly know that they do and they will. The regulators need to go beyond hoping that they can make the speculative fintechs behave, but that's fruitless. That will never happen to ensuring that the bank held their parties do.
Penny Crosman (10:39):
Obviously banks are being much more prudent about who they partner with at this time, given this case and given the many consent orders the banks have gotten around their BaaS relationships, but do you see a Synapse as something of an anomaly because it did have an unusual degree of problems, for instance, with its accounting that hopefully are not prevalent among other middleware providers. Or do you think we will see this again and again?
Karen Petrou (11:16):
Well, we certainly see enough consent orders in from various banks with counterparties that aren't Synapse to assume that it is a significant concern, not just a one-off bad bit of case history.
Penny Crosman (11:29):
In a lot of these consent orders, the banks are basically being given the compliance responsibility for their fintech partners. They have to make sure that know your customer and Bank Secrecy Act and sanctions regulations are all being met. They have to monitor customer accounts. They're being given a lot of responsibility, at least in these specific orders for kind of babysitting or watching over their fintechs. Do you think that's sort of the answer or part of the answer?
Karen Petrou (12:10):
When these orders are actually enforcing preexisting guidance, the obligation to ensure, to take the compliance responsibility for your counterparties is a longstanding one for banks, recently reinforced by guidance, not a rule, but guidance from the banking agencies, which say that. That the consent orders are being issued because the banks did not adhere to prior standards. The banking agencies do need to decide if enough consent orders concentrates the attention of banks contemplating high-risk relationships. If they deem that insufficient, again, back to the Faustian bargain, I think it may be hard for some banks to resist temptation. Then it may be time for a more stringent rule, but the FDIC can only entreat fintechs to do better. Most of these business models are not premised on internal controls, sound practices, compliance, robust capital and liquidity for effective resilience. These are high-risk, high-return venture-capital fueled businesses, and their model is the opposite of what we expect of community banks.
Penny Crosman (13:42):
A lot of people in the fintech community would argue that these relationships have helped bring affordable financial services to a lot of consumers. For instance, small-dollar loans that people would otherwise have to go to a payday lender for. Or some of the fintechs were the first to come up with early access to paychecks, and some of them have loan underwriting that doesn't require a high FICO score. Those are just a few examples. Is there a legitimate case to be made that the fintech community is improving financial access?
Karen Petrou (14:23):
In some cases, yes. In other cases, it's profiting by the rules that the public has come to expect. If banks deal with fintechs that are expanding financial access in a sound way, then none of the controls I'm suggesting will impede that. I do not understand why fintechs believe that tougher restrictions on with whom banks do business or hurt them unless they in fact do not think they can stand up to scrutiny.
Penny Crosman (15:00):
Do you think part of the problem is that a lot of the banks that are doing banking as a service are under $10 billion because they are not subject to that Durbin cap on interchange fees, but these small banks don't necessarily have a huge compliance department, the technology to do lots of on-premise monitoring. They're not necessarily as well equipped as say, a larger institution may be. Do you think that's part of the challenge?
Karen Petrou (15:39):
I think the problem is not the Durbin Amendment small bank exception, which I think is often less meaningful than it seems because of the nature of the overall market and price setting. It's the lack of controls. If community banks can make a better offer to fintechs because they can offer debit card services at a lower price because of the interchange fee, that's all good as long as the deposit account linked to the debit card is safe and sound and the promise of FDIC insurance is not false or misleading.
Penny Crosman (16:22):
Are there any specific types of fintechs or bank-fintech partnerships that you are especially worried about right now besides Synapse?
Karen Petrou (16:31):
I don't think the appropriate answer is by categorization. I think it's by internal controls, because I don't see why any of the more robust fintech arrangements that really do offer lasting consumer value and stand up to scrutiny. One of the longstanding early warning signals I've learned to see in my career is that if somebody doesn't want regulators looking too closely, it's not necessarily because that's a burden, it's because there are things they don't want the regulator to see.
Penny Crosman (17:05):
That's a good point. Well, what do you think the future might look like for this whole concept of banking as a service? Do you think we're just going to see some banks pull away from it? Do you think we'll see regulators come out with new rules defining exactly what banks' responsibility is or something else?
Karen Petrou (17:29):
I hope this is one of these wake-up calls in which sound innovation perceived buttressed by the effective controls, it often hasn't had. There is a lot to be said for these partnerships, if they're key partnerships, not just exploiting public benefits that banks are increasingly trying to leverage to preserve their charters. Good partnerships between community banks and sound counterparties could do a lot for smaller communities where the level of outside financial services, particularly for lower income households, may not suffice. But they can't be high risk because particularly for these vulnerable populations, losing your money just makes it worse.
Penny Crosman (18:18):
Yes, yes, absolutely. Well, that makes a lot of sense. Well, Karen Petrou, thank you so much for joining us today and to all of you, thank you for listening to the American Banker Podcast. I produced this episode with audio production by Kellie Malone Yee. Special thanks this week to Karen Petrou at Federal Financial Analytics. Rate us, review us and subscribe to our content at www.americanbanker.com/subscribe. For American Banker, I'm Penny Crosman and thanks for listening.