Banking as a service grows as regulators catch up

Banks’ relationships with fintechs, particularly banking-as-a-service (BaaS) deals, have garnered increased attention among regulators and lawmakers in recent months.

BaaS, a business model that allows fintechs and unchartered companies to offer financial services to their customers using a bank’s regulated infrastructure, is changing the risk profile of the financial industry, Michael Hsu, the acting comptroller of the Office of the Comptroller of the Currency (OCC), said in a speech last month.

The model represents the “disintegration” of banking, a trend that has made it difficult for customers, regulators and the banking industry to distinguish between “where banking stops and tech business begins”, a- he declared.

“It looks like the OCC is still learning what banking as a service is,” said fintech analyst and author of the Fintech Takes newsletter Alex Johnson, in response to Hsu’s speech. “I got the sense that it doesn’t even seem like the OCC necessarily fully understands what all the banks it oversees are doing in terms of fintech partnerships and banking as a service, and they’re trying always master it.

To better understand the space, Hsu said the OCC aims to subdivide bank-fintech deals into cohorts with similar security and soundness risk profiles and attributes.

As the OCC delves deeper into BaaS, Hsu said a wide range of questions around accountability, trust and risk need to be answered to make real progress.

“Who’s responsible for what when things break?” he said. “How do banks and their third parties view and treat customers in bank-fintech agreements. When do customers transition from customer to product, and how is consumer protection maintained?”

The OCC’s quest to map the BaaS space and its impact on the financial services industry is a natural step for the regulator, which has spent years trying to get to grips with BaaS partnerships, said Jonah Crane, partner at Klaros Group, a financial advisory and investment firm.

“Now that they feel like they have their arms at least halfway around them, they’re developing ideas and frameworks on what kinds of standards they should be holding banks to, and that’s why you see all this regulatory activity now,” he said.

But the OCC’s signaling of a greater focus on BaaS has angered some Republicans who fear more regulation will come at the expense of innovation.

In a letter, House Republicans called on Hsu to clarify how the OCC plans to regulate bank-fintech partnerships.

“Under the previous administration, the OCC worked to provide banks and their customers with a clear understanding of the regulatory and prudential expectations surrounding emerging products and services and how to properly assess risk,” five House Republicans, led by Rep. Patrick McHenry, R-NC, wrote the acting comptroller this month. “While we expected the OCC to continue to provide clear rules of conduct and support innovative banking services, this has not been the case.”

In their letter, the lawmakers pointed to a speech Hsu gave at a bankers’ conference in Texas, where he discussed the various risk considerations associated with community-based bank-fintech partnerships.

“[Y]We recently highlighted five areas that the OCC would prioritize in support of community banks,” the lawmakers wrote. “Fostering fintech relationships was not among the top five.”

When done properly, the benefits of bank-fintech partnerships outweigh the risks, the Republicans wrote.

“Fintech partnerships can lead to cost savings for fintechs and banks, increase competition, and deliver faster, better, and cheaper banking products and services to consumers,” they said.

The way to do it

Meanwhile, the global BaaS market is expected to reach $74.55 billion by 2030, according to a study published last month by Grand View Research.

And one March report by financial software company Finastra found that 85% of 1,600 senior banking executives surveyed are already implementing or plan to implement BaaS within the next 12-18 months.

But like any other business, banks should exercise caution when entering into BaaS partnerships with fintechs, especially in light of increased regulatory scrutiny, Crane said.

“If I was a bank trying to run a fintech referral program, I would really double down and clarify my agreements with my fintech partners on who does what,” he said.

Banks need to ensure they can access the data they need in a timely manner to ensure the fintech program complies with the bank’s regulatory obligations, Crane said.

“Ultimately the bank is going to be on the hook, and at the end of the day that’s what you see manifesting in regulator concern,” he said. “The bank must be responsible because it is the regulated party. They take advantage of their charter.

A enforcement action The OCC issued against Blue Ridge Bank last month gives the industry insight into the specific types of concerns a regulator may have when BaaS isn’t done right, Johnson said.

According to a Securities and Exchange Commission (SEC) depositthe OCC ordered the Charlottesville, Va.-based bank to improve its oversight of fintech partnerships with third parties.

Blue Ridge, which counts Unit and Neobank Upgrade among its BaaS partners, was ordered to strengthen its anti-money laundering risk management, suspicious activity reporting and information technology controls after that the regulator “found practices unsafe or unsound,” the filing said. .

Under the order, Blue Ridge must obtain no objection from the OCC before entering into any new contracts with fintech partners or adding new products in cooperation with existing partners.

The action signals that regulators will take a closer look at bank-fintech partnerships going forward, and they will expect banks to show in granular detail how they ensure partner operations are compliant. bank’s regulatory compliance, Crane said. .

But for banks investing in compliance, the return could be lucrative as demand for BaaS grows, he said.

“There’s going to continue to be such a demand for these kinds of programs because all of these fintechs — in fact, very few of them — will ever become banks,” Crane said. “There will be a reward for being a bank that runs one of these programs in a way that both satisfies its stakeholders and meets regulatory expectations.”

Fintechs seeking integrated banking may also become more selective as regulators increase oversight, he said.

“They can prioritize resiliency and stability and a bank that is committed to getting the right compliance over speed, where before speed to market was a big factor. for fintechs looking for banking partners,” Crane said.

A boon for community banks

As businesses compete for consumer accounts, the BaaS model has emerged as a cost-effective way for community banks to increase deposits without having to expand into new markets.

“It’s very lucrative from a revenue perspective, but also quite capital-light,” Johnson said. “You can participate in it without having to spend a lot of resources, which I think is the main constraint that has a lot of community banks struggling right now. They simply don’t have the resources to launch direct-to-customer products like fintech companies or big banks do.

But under the Durbin Amendment, banks below the $10 billion asset threshold are not subject to a cap on interchange revenue like their larger competitors.

In a typical BaaS model, the fintechs acquire the customers and are in charge of the user experience, while the sponsor bank remains in the background, managing the financial infrastructure of the operation and fulfilling the regulatory obligations that come with ownership. of a bank charter. The fees generated by the exchange of debit cards are often shared between the two parties.

Banks that choose to venture into BaaS can also partner with a third-party infrastructure provider, which acts as “middleware” between the financial institution and the fintech.

A sponsor bank with 1 million consumer accounts, growing 2% per month, which shares revenue from most revenue streams with a BaaS infrastructure provider and shares exchange revenue with the sponsor company, would generate about $17.2 million in annual noninterest revenue by providing BaaS, according to a February report by Cornerstone Advisors.

Annual BaaS revenue would reach $24 million for a bank that also provided the service to 300,000 business customers, growing 2% per month, according to the study.

“The BaaS business model presents an intriguing ‘get out of jail’ card for many community banks that would otherwise struggle to grow or have no choice but to acquire,” Johnson said.

To Honolulu Central Bank of the Pacificthe impetus to launch a BaaS program came after seeing local customers open accounts with mainland-based neobanks during the pandemic.

“We could continue business as usual and continue to focus on traditional community banking in Hawaii, or we could take a different approach,” said David Morimoto, the bank’s executive vice president and chief financial officer. “We have chosen to participate in the disruption rather than simply allow this disruption to occur and impact our business.”

Pacific Central Bank, with assets of $7.34 billion, is using its partnership with Swell Financial, the digital bank it incubated during the pandemic and created this year, to access the broader US market.

“Hawaiian banks have been exploring ways to gain more access to the US banking market rather than being geographically limited,” Morimoto said. “In the past, this required a physical presence on the continent. In today’s environment, this physical presence is no longer so important.

BaaS allows banks to reach more customers at a significantly lower cost of customer acquisition, according to a Oliver Wyman study.

The cost of acquiring a customer is typically in the range of $100 to $200, according to the report’s estimates, but BaaS can help banks reduce this cost to $5 and $35.

For community banks struggling to increase deposits amid growing competition from non-banks and domestic institutions, BaaS can be an attractive solution.

And that’s something regulators will likely assess when developing future guidelines or regulations, Johnson said.

“[Regulators] are going to take into consideration that banking as a service is a lifeline for a lot of these community banks,” he said.