Banking-as-a-service grows as regulators catch up
Banks’ relationship with fintechs, particularly banking-as-a-service (BaaS) schemes, has received increased attention from regulators and lawmakers in recent months.
BaaS, a business model that allows fintechs and unchartered companies to offer their customers financial services using the regulated infrastructure of a bank, is changing the financial industry’s risk profile, Michael Hsu, the acting controller of the Office of the Controller of the Office. Currency (OCC), said in a speech last month.
The model represents the “de-integration” of banking, a trend that has made it difficult for customers, regulators and the banking industry to distinguish “where the bank stops and where the technology company starts,” he said.
“It seems like the OCC is still learning about what banking-as-a-service is,” Alex Johnson, a fintech analyst and author of the Fintech Takes newsletter, said in response to Hsu’s speech. “I got the sense that it didn’t even necessarily seem like the OCC had a perfect understanding of what all the banks they oversee are doing in terms of fintech partnerships and banking-as-a-service, and they’re still trying to get a handle on that. »
To better understand the space, Hsu said the OCC aims to divide banking fintech events into cohorts with similar security and soundness risk profiles and attributes.
As the OCC dives deeper into BaaS, Hsu said a wide range of questions regarding liability, trust and risk must be answered to make real progress.
“Who is responsible for what when things break?” he said. “How banks and their third parties view and treat customers in banking fintech arrangements. When do customers go from being the customer to becoming the product, and how is consumer protection maintained?”
The OCC’s quest to survey 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 its arms around BaaS partnerships, said Jonah Crane, a partner at Klaros Group, a financial services firm. consulting services and securities companies.
“Now that they feel like they have their arms around them at least a little bit, they’re developing ideas and frameworks for what kind of standards they should hold banks to, which is why you’re seeing all this regulatory activity now,” he said.
But the OCC’s signaling of a greater focus on BaaS has irked some Republicans who fear that more regulation will come at the expense of innovation.
In a letter, House Republicans asked 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 regulatory and supervisory expectations around new 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 driving rules and support innovative banking services, that has not been the case.”
In their letter, the lawmakers pointed to a speech Hsu gave at a banking conference in Texas, where he touched on the various risk considerations associated with community bank-fintech partnerships.
“[Y]You recently highlighted five areas the OCC would prioritize to support community banks,” the lawmakers wrote. “Promoting fintech relationships was not among those five priorities.”
When executed properly, the benefits of bank-fintech partnerships outweigh the risks, the Republicans wrote.
“Fintech partnerships can lead to cost savings for both fintechs and banks, increase competition and provide faster, better and cheaper banking products and services for consumers,” they said.
How to proceed
Meanwhile, the global BaaS market is expected to reach $74.55 billion by 2030, according to a study released last month by Grand View Research.
And a March report from the financial software company Finastra found that 85% of 1,600 senior executives in the banking industry have already implemented or plan to implement BaaS in the next 12 to 18 months.
But just like any other enterprise, banks should exercise caution when entering into BaaS partnerships with fintechs, especially in light of increased regulatory scrutiny, Crane said.
“If I were a bank trying to run a fintech sponsorship program, I would really double down and get clear on my agreements with my fintech partners about 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 is compliant 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 coming through in the regulator’s concern,” he said. “The bank has to be on the hook because they are the regulated party. They are taking advantage of their charter.”
An enforcement action The OCC issued against Blue Ridge Bank last month gives the industry a glimpse into the specific types of concerns a regulator might have when BaaS isn’t good, Johnson said.
According to a Securities and Exchange Commission (SEC) archivingthe OCC ordered the Charlottesville, Virginia-based bank to improve its oversight of third-party fintech partnerships.
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 the regulator “found unsafe or unsound practice(s),” the filing indicated. .
Under the order, Blue Ridge must obtain the OCC’s no-objection before entering into new contracts with fintech partners or adding new products in collaboration with existing partners.
The move signals that regulators will be looking much more closely at bank-fintech partnerships going forward, and they expect banks to demonstrate in detailed ways how they ensure the partners’ operations are consistent with the bank’s regulatory compliance obligations, Crane said. .
But for banks investing in compliance, the returns 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 not all of these fintechs — in fact, very few of them — are going to 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 their partners and meets regulatory expectations.”
Fintechs that trade for embedded banking may also become more selective as regulators increase oversight, he said.
“They may prioritize resiliency and stability and a bank committed to getting the compliance piece right over speed, whereas speed to market used to be a big factor for fintechs looking for their banking partners,” Crane said.
A boon for community banks
As firms compete for consumer accounts, the BaaS model has emerged as a cost-effective way for community banks to grow deposits without having to expand into new markets.
“It’s very lucrative from an income 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 limitation that has a lot of community banks struggling right now. They just don’t have the resources to throw at direct-to-customer products like the fintech companies or the bigger banks do.”
But under the Durbin amendment, banks below the $10 billion threshold are not subject to a cap on interchange revenue like their larger competitors.
In a typical BaaS model, fintechs acquire the customers and are responsible for the user experience, while the sponsor bank remains in the background, managing the financial infrastructure of the operation and fulfilling the regulatory duties that come with having a bank charter. The fees generated through debit card exchanges are often split between the two parties.
Banks that choose to enter BaaS can also partner with a third-party infrastructure provider, which acts as a “middleman” between the financial institution and the fintech.
A sponsor bank with 1 million consumer accounts, growing at 2% per month, sharing revenue for most revenue sources with a BaaS infrastructure provider and sharing interchange revenue with the sponsor firm, would generate approximately $17.2 million in annual non-interest income from offering BaaS , according to a February report from Cornerstone Advisors.
Annual BaaS revenue would grow to $24 million for a bank that also provided the service to 300,000 commercial customers, a growth of 2% a month, the study estimated.
“The BaaS business model presents an exciting get-out-of-jail-free card for many community banks that would otherwise struggle to grow or would have no choice but to acquire,” Johnson said.
For Honolulu-based Central Pacific Bank, the impetus to launch a BaaS program came after seeing local customers open accounts with mainland-based neobanks during the pandemic.
“We can be business as usual, continuing to focus on traditional community banking in Hawaii, or we can take a different tack,” said David Morimoto, the bank’s senior executive vice president and CFO. “We chose to participate in the disruption rather than simply allow it to occur and affect our business.”
The $7.34 billion-asset Central Pacific Bank is using its partnership with Swell Financial, the digital bank it incubated during the pandemic and spun off this year, to tap into the broader U.S. market.
“Hawaii banks have been exploring ways to access more of the U.S. banking market rather than limiting themselves geographically,” Morimoto said. “In the past, it required a physical presence on the mainland. In today’s environment, physical presence is no longer as important.”
BaaS allows banks to reach a larger number of customers at a significantly lower customer acquisition cost, according to one study by Oliver Wyman.
The cost of acquiring a customer is typically in the $100 to $200 range, the report estimates, however BaaS can help banks reduce this cost to $5 and $35.
For community banks struggling to grow deposits amid increasing competition from non-banks and national institutions, BaaS can be a tempting solution.
And that’s something that regulators will likely evaluate when creating future guidance or regulation, Johnson said.
“[Regulators] is going to take into account the fact that banking-as-a-service is a lifeline for many of these community banks, he said.
