(Bloomberg) -- In the age of digital banking, an increasing number of financial-technology companies are partnering with small and midsize “sponsor banks,” to provide services — but not without a cost.
An estimated 75% of such sponsor banks have suffered losses of $100,000 or more as a result of compliance violations, according to identity risk management platform Alloy’s “2024 State of Embedded Finance” report. That includes fines associated with regulatory enforcement actions against the banks, as well as direct financial losses associated with the compliance failures.
“Running a sponsor bank program is inherently complex because you have banks who are highly regulated working with companies that are often new, fast-growing, and creating entirely new ways for consumers to interact with money,” said Tommy Nicholas, chief executive officer and co-founder of Alloy.
Because most fintechs, whether its Venmo or CashApp, are not banks themselves, they rely on partnerships with FDIC-insured institutions for financial services, and in turn, provide banks with easy-to-use digital interfaces. In theory, the partnership between banks and fintech companies was supposed to be a happy marriage. However, a number of them are falling apart. Most notably, the collapse of one of the largest middleman fintechs, Synapse Financial Technologies Inc., in May, has left millions of dollars’ worth of customer deposits frozen in the bank accounts it partnered with.
Just because a fintech is linked to an FDIC-insured bank doesn’t mean that it is backed by the Federal Deposit Insurance Corp. — a common misconception that brings the safety of using third-party banking services into question. Almost 40% of sponsor banks have lost $250,000 or more, with 6% reporting losses of $1 million or more, according to Alloy’s report.
Banking regulators aren’t turning a blind eye, but they’re focusing their attention on supervising sponsor banks themselves. The US Federal Reserve hit Arkansas-based Evolve Bank & Trust, one of the banks Synapse worked with, with an enforcement action related to its risk management, but said it was not overseeing Synapse.
“To the extent banks are working with fintech partners, banks have a responsibility to manage the risks,” Michael Barr, the Federal Reserve’s vice chair for supervision, said in a July 9 speech in Washington.
A bevy of fintech bank sponsors have been targeted for compliance issues, dating back to Cross River Bank. Last year, the Teaneck, New Jersey-based state-charted and FDIC-insured bank received a cease-and-desist order from the FDIC over what the agency said were “unsafe or unsound” practices related to fair-lending laws. Since the beginning of 2024, 25.6% of the FDIC’s formal enforcement actions have been directed at sponsor banks, according to data from Klaros Group.
Despite the compliance challenges, embedded finance, or the integration of financial services into non-financial products, continues to be a huge money maker for sponsor banks. Around 50% of sponsor banks surveyed in Alloy’s report said that both revenue and deposits are driven by fintech partnerships in embedded finance and banking-as-a-service, with 96% of them operating more than five embedded finance partnerships.
Industry groups that represent both fintech firms and banks, such as the American Fintech Council, have called for additional regulatory clarity.
“AFC has long advocated for a clear and consistent regulatory framework that reflects responsible industry developments and clarifies supervisory expectations for innovative banks and financial services business models, products, and services,” the industry group said. “We need to streamline the current patchwork of rules and regulations and ensure fair and consistent enforcement throughout our industry.”
©2024 Bloomberg L.P.