Banks cannot continue to shoulder the costs and risks of crypto and fintech customers
Fintechs have been free on the banking industry. Until now, they have been able to trust … [+]
Cryptocurrency exchange Binance announced last week that Signature Bank will no longer process Swift transactions of less than $100,000 for cryptocurrency exchange customers. Until now, crypto firms and the US fintech industry have been able to rely on banks to do the heavy lifting and absorb the costs of compliance and regulation. Perhaps the era of free-riding is finally coming to an end.
Customers and investors like fintech companies because they are perceived as nimble and more capable than banks of delivering a superior customer experience. The impression remains, at least in the minds of some investors, that fintech entrepreneurs are still able to live up to Facebook founder Mark Zuckerberg’s motto: “Move fast and break things.” Time for these perceptions to end.
Compared to banks, the fintech industry has some systemic advantages for its participants, but to balance things out, there are usually additional risks borne by customers. To ensure that the United States maintains the world’s leading financial services industry, we must rebalance the distribution of risk so that consumers are not stuck when things go wrong. One way to make that happen is to change the way banks interact with fintech firms, and regulators appear to be making it happen.
The emerging cryptocurrency asset class and failure of FTX is a good example of how the system in the US has allowed the risk associated with institutional failure to migrate to customers. Whether it’s for payments, financing, or investments, today the majority of Americans use the services of one or more fintech firms, and many mistakenly believe that they receive the same protection as they receive from chartered banks.
Fintech firms benefit from regulatory arbitrage
One of the perceived advantages of fintech firms, at least for investors, is that they are not subject to the same capital requirements as banks and can therefore be established with much lower investment levels. This means that the companies are not necessarily well equipped to survive periods of financial stress, and in case of failure the costs are passed on to the customers through losses. The cryptocurrency world is now full of such firms, including FTX, Voyager Digital, Celsius
Owners and managers of fintech firms are also subject to far less scrutiny. Anyone with access to finance can be the founder of a fintech firm, but regulators are ensuring that bank operators are held to a much higher standard.
Part of the reason for the rise of the fintech economy was rooted in regulatory arbitrage. Simply put, banks and fintech firms 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 also have significant compliance burdens that fintech companies have so far avoided, and the penalties for technical failures are disproportionately greater for banking companies.
Consider, for example, what happened to USAA and Capital One
The banks are required to have everything in place and to function correctly at all times. New developments must be fully tested and fully integrated into the bank before being introduced to customers, and things that go wrong are viewed very negatively.
Banking-As-A-Service under regulatory pressure
Banking-as-a-Service (“BaaS”), which is similar to the concept of “Open Banking”, is one of the main ways banks interact with the fintech and cryptofintech community, and it is a target of regulatory pushback. BaaS is not dead, but the activity needs to be reshaped as regulators put pressure on banks to take responsibility for their fintech customers.
Simply put, BaaS is the technology-enabled delivery of banking products to non-bank third parties. These fintechs are customers of the bank who then directly acquire customers themselves, and the fintech customers are most likely not even aware that they are consuming products from the underlying bank.
The many US banking regulators are increasing scrutiny of the banks’ overall risk profile, and this has led to significantly more attention to third-party relationships. OCC recommends “cautious and prudent” approach to fintech-bank partnerships. The banks are under pressure to ensure that they fully understand the risk characteristics of businesses that receive services from the bank.
In a BaaS relationship, the fintech mainly interacts with the customer on behalf of the bank, and this means that all the activities of the bank and the fintech must be in accordance with the relevant regulations. Expect increased attention to Know-Your-Customer rules, bank secrecy (anti-money laundering) provisions, marketing and advertising standards and all aspects of credit.
Banks can never outsource liability
Banks can outsource certain activities, but they can never outsource responsibilities. This means that banks are responsible for ensuring that their BaaS fintech customers comply with the rules to the same extent as would be the case if the bank carried out the activity itself.
There are a number of banks in the US participating in the BaaS space. Expect them to demand more from their fintech partnerships. The cost model for the fintech companies will have to be reassessed in light of the increasing compliance costs, and they will have to be far more transparent to their bank suppliers.
Regulatory enforcement has already started. In 2022, Blue Ridge Bank NA entered into a formal agreement with the Office of the Comptroller of the Currency (OCC). Blue Ridge Bank agreed to increase the regulator’s oversight of its BaaS activities. Within the OCC order, the bank agreed to obtain the OCC’s non-objection before entering into new contracts with fintech partners or adding new products in collaboration with existing partners.
Regulators are reminding banks that they are responsible for the activities of their fintech partners, and that will lead to changes. Without a doubt, there will be a change in the model that detracts from 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 soundly lead the financial services customer experience.
The author’s employer is a customer of Signature Bank.
