FDIC’s Proposed “Synapse Rule” May Not Have Actually Applied To Synapse
Yotta Accuses Evolve of “Brutal Theft,” “Grotesque Misconduct,” How Are the Economics of BaaS Banks Doing?
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How Are The Economics of BaaS Banks Doing? It Depends.
In June of 2020, famed venture capital firm Andreessen Horowitz, popularly known as a16z, published a post highlighting what it termed the “partner bank boom,” highlighting the potentially lucrative role banks can play by partnering with fintechs.
The firm certainly had an interest in promoting the model; after all, it was a major investor in now-bankrupt intermediary platform provider Synapse, which partnered with Evolve Bank & Trust, and co-led a $620 million round into a major player in partner banking, Cross River.
And while one can quibble with some of a16z’s characterizations — is Comenity really a partner bank? Is Wells Fargo? — it correctly identified the trend in 2020 of a gold rush mentality around partner banking and banking-as-a-service, driven in part by outsized economic performance of many banks engaged in the business model.
But a lot has changed since 2020. The glut of VC money flowing to fintechs, taking off around 2018 and exploding in the early part of the pandemic, drove a spike in demand of fintechs looking for partner banks to work with.
The loose funding environment and growing demand helped spur the creation of more intermediary platform providers, like Solid, Bond, Unit, and Synctera, all founded in 2019-2020.
This increase on the demand side helped spur an increase in supply: more banks entered the partner banking space, attracted by the opportunity to source cheap deposits, generate fee revenue, and the potential to drive outsized ROE.
Many partner banks new to the space were sold a vision by middleware providers that the model was “plug-and-play” — that the middleware platforms would handle the bulk of the tech, sales and business development, onboarding, and compliance work.
That turned out to be anything but the case.
Since peaking around 2021, the tide began to turn in 2022, with rumors beginning to swirl about heightened regulatory scrutiny and, by early fall, Blue Ridge Bank, a significant player in the BaaS space, receiving its first of two enforcement actions.
Since then, numerous other partner banks have received enforcement actions: Choice, Cross River, Evolve, Green Dot, Lineage, MCB, Piermont, Sutton, Thread, and others.
Some banks, like Blue Ridge and MCB, have chosen to wind down their banking-as-a-service programs altogether. Banks that have decided to stay the course are realizing there is no free lunch, with expenses rising as they make necessary investments in staff and systems to meet longstanding compliance expectations.
Middleware platforms have come under stress as well, with Bond selling to FIS and Rize to Fifth Third.
As it became increasingly clear that regulators disfavored the intermediated model pursued by some, platforms like Treasury Prime, Synctera, and Unit began to attempt a pivot to selling software to banks to facilitate “direct” relationships, rather than acting as program managers and thinking of their regulated bank partners as “vendors.”
Growing regulatory scrutiny, enforcement actions against partner banks, and pressure on the middleware operating model took place against the backdrop of shrinking VC investment in fintech. The reduction in VC funding was more of a return to the mean than an absolute collapse, but it has, logically, meant less demand from existing and newly formed fintechs for the services provided by bank partners.
The impact of shifting supply and demand and the necessary investments to meet compliance expectations is beginning to show up in partner banks’ financial performance, though the severity of the impact varies considerably.
It’s worth noting that comparing financial performance across “partner banks” is complicated by numerous factors: many partner banks specialize in specific areas, like BIN sponsorship or lending, that have unique financial characteristics; how sizable a bank’s partner program is vs. its traditional lines of business; the age of the bank and how long it has been in the partner banking space; and, if applicable, the impacts and costs associated with remediating enforcement actions, to name but a few factors.
The industry average ROE and ROA for banks with $3 billion to $10 billion in assets declined slightly in 2023, to 11.38% and 1.06%, respectively, from 13.64% and 1.30% in 2022.
For partner banks, as was the case in 2022, some continue to post outsized returns, like Sutton, Green Dot, The Bancorp, and Celtic, many post more or less average returns, and a number, especially newer banks, those new to BaaS, and those dealing with consent orders, posted losses.
Some partner banks have seen profitability decline as a result of making investments to enable responsible growth in the future. For example, FinWise has made significant investments in broadening and deepening its capabilities, lowering ROE in the short-term but paving the way for future growth.
In 2023, at least six partner banks posted losses and negative ROE: Thread Bank (-0.55%), Cross River (-1.74%), Hatch (-2.75%), Lineage (-9.19%), Grasshopper (-14.43%), and Blue Ridge (-20.16%). While there are still outliers to the upside, there has been some compression, particularly compared to the heights of 2021.
Unsurprisingly, ROAs have seen a similar compression compared especially to 2021, though some partner banks, particularly those that specialize in lending programs, like Comenity, Celtic, and FinWise, continue to post outsized ROAs.
Some specific partner banks have seen far more pronounced swings in key metrics, including net income, ROE/ROA, and asset and deposit size.
For example, Blue Ridge, which received its first enforcement action in late 2022 and a second in January 2024, has swung from over $50 million in net income in 2021 to more than $40 million in losses in 2023, driven by a mix of falling non-interest income, rising non-interest expenses, and sharply higher interest expenses, as it has offboarded fintech programs and their less expensive deposits, replacing them with more expensive brokered deposits.
It’s worth noting that it isn’t all bad news. For example, Column, which officially launched in 2022, posted a loss that year, which isn’t surprising for a recently acquired bank making the necessary investments to pursue a new business line. By 2023, the bank had swung to a modest profit, posting $311,000 of net income.
Cross River, which entered into a consent order with the FDIC in the spring of 2023, swung to a loss of about $17 million from net income of over $100 million the year prior, on rising non-interest expenses and sharply higher interest expense.
Evolve, perhaps the most prolific (and problematic) partner bank, was already showing signs of stress in late 2023, as it attempted to unwind its partnership with now-bankrupt Synapse, while retaining their marquee partner, Mercury. While Evolve still posted respectable profitability metrics in 2023, its asset and deposit size began declining as it parted ways with some fintech programs.
Hatch Bank, perhaps best known for its partnership with high-yield savings app HMBradley, saw its deposit volume drop nearly in half as HMBradley shut down and closed consumers’ accounts toward the end of 2023. Rising interest expense, especially as rates climbed in 2023, pushed Hatch to a net loss of about $795,000 that year.
But, as some banks have pulled back from banking-as-a-service or exited the space altogether, others have leaned in. Lead Bank has continued to grow assets and deposits year over year and saw its net income jump substantially in 2023, on sharply higher interest and non-interest income.
Lineage, known as Citizens Bank & Trust until its acquisition in 2021, has posted losses since it began attempting to build out a partner banking business, despite rapid growth. Things are unlikely to improve for Lineage anytime soon, as its executive team faced a board room coup in late 2023, the bank was hit with a wide-reaching enforcement action in February 2024, and it has been a key player embroiled in the ongoing collapse of Synapse.
Piermont, founded as a de novo bank that began operations in 2019, posted losses from its inception through 2022, which is typical for newly formed banks. Piermont did turn a modest profit in 2023, but was hit with a consent order related to its BaaS business in early 2024 and decided to part ways with Unit, one of the intermediary platform providers it worked with.
There is no question that US fintech and the partner banking model are in a state of flux. But the industry is too complex and varied to lend itself to simple truisms like “BaaS is dead.”
Indeed, absent the creation of some kind of national “fintech” charter (payments institution, e-money institution, etc.) there is no clear alternative to fintechs partnering with banks to carry out regulated activities: holding deposits, issuing payment cards, processing payments, and a simpler path to lending nationwide.
The current period of turbulence is likely to continue for some time, given the high likelihood of additional enforcement actions and new regulations, including the recently proposed rollback of 2020’s brokered deposit rule and the FDIC’s newly proposed rule on recordkeeping requirements for “custodial accounts with transaction features” (more on this below.)
Another Bank Quits BaaS, Points To “Evolving Regulatory Expectations”
Financial Institutions, Inc., the parent company of $6 billion-asset Five Star Bank, announced it will begin winding down its banking-as-a-service business line.
As of the end of Q2 2024, fintech partnerships accounted for about 2% of Five Star’s deposits, or about $108 million, and less than 1% of its loans, or about $31 million.
In a press release, company and bank CEO Martin Birmingham pointed to changing regulatory expectations, including the proposed brokered deposit rule rollback, saying (emphasis added):
“Since our entry into BaaS, we have moved forward at a measured and conservative pace to balance growth with effective risk management. Following an internal review that considered many factors, including the contribution of BaaS to our core financial results, evolving regulatory expectations and a proposed rule regarding the re-classification of BaaS deposits as brokered, in addition to the future investments in talent and technology necessary to achieve scale, we are prioritizing our core community banking franchise and intend to begin winding down our BaaS offerings.”
The bank said it is working on a plan to support the orderly transition for its BaaS partners and expects completion of its wind down plan sometime in 2025.
Five Star supported direct programs and, beginning in late 2023, worked with intermediary platform provider Unit, though the two appear to have collaborated on only a few programs.
Five Star will make the fourth bank to part ways with Unit, joining Blue Ridge Bank, Piermont, and Choice in doing so.
Looking to learn more about banking-as-a-service? Pre-order my forthcoming book on the topic: Banking as a Service: Opportunities, Challenges and Risks of New Banking Business Models.FDIC’s Proposed “Synapse Rule” May Not Have Actually Applied To Synapse
Last week’s FDIC board meeting saw the introduction of a Proposed Rulemaking on Requirements for Custodial Deposit Accounts with Transactional Features and Prompt Payment of Deposit Insurance to Depositors, better known as the “Synapse Rule,” as it is widely understood to be a response to the collapse of the middleware platform.
The full text of the proposed rule weighs in at 83 pages, but the key elements and requirements can be boiled down as follows:
Defining the concept of a “custodial account with transactional features” as when “(1) the account is established for the benefit of beneficial owners; (2) the account holds commingled deposits of multiple beneficial owners; and (3) a beneficial owner may authorize or direct a transfer through the account holder from the account to a party other than the account holder or beneficial owner.”
Requiring insured depository institutions that hold any such accounts to maintain records that “would identify, for each custodial deposit account, the beneficial owners of the custodial deposit account, the balance attributable to each beneficial owner, and the ownership category in which the beneficial owner holds the deposited funds.”
Prescribing a specific electronic file format for maintaining these records.
Maintaining certain “internal controls” that include maintaining accurate account balances, including the respective beneficial ownership interests associated with custodial deposit accounts and conducting reconciliations against the beneficial ownership records no less frequently than at the close of business daily.
The proposed rule acknowledges that many banks work with third parties to maintain such records. For banks that rely on third-party service providers to maintain these records, the rule would require the bank “to have direct, continuous, and unrestricted access to records maintained by the third party…, including access in the event of a business interruption, insolvency, or bankruptcy of the third party.”
When banks rely on third-parties to do such recordkeeping, the rule would further require contracts between the parties to include certain risk mitigation measures and to clearly define roles and responsibilities for recordkeeping.
FDIC Board Votes 5-0 In Favor Of Proposed Rule
While the board voted unanimously, 5-0, in favor of adopting the notice of proposed rulemaking, there was some dissension in board members’ comments on the proposal.
The ostensible justification for the rule is to help ensure that the FDIC can promptly payout deposit insurance claims, as required by law, in the event an insured depository institution fails. Making such payments for the types of “custodial accounts” described by the rule, where beneficial owners are covered by pass-through insurance, is dependent on the availability of accurate books and records.
But the long shadow cast by Synapse’s failure — and its bank partners’ inability to promptly return customer funds — is evident in the board members’ commentary on the proposed rule.
Chairman Gruenberg opined at length about the Synapse bankruptcy in his statement, saying in part (emphasis added):
“During the bankruptcy of Synapse, consumers have been unable to access their funds for an extended period of time due to significant deficiencies and discrepancies in the records essential to accurately determine individual consumers’ account balances…
These circumstances have highlighted the importance of complete, accurate, and reliable deposit account records, particularly when banks have arrangements with third parties that deliver deposit products and services directly to consumers…
These events also highlight substantial risks with respect to the FDIC fulfilling its statutory mandate to maintain public confidence in the banking system by ensuring the prompt and accurate payment of deposit insurance in the case of a bank’s failure. If a bank fails, the FDIC cannot pay deposit insurance to depositors based on inaccurate or incomplete records.”
Vice Chairman Hill also pointed to the Synapse fallout in his remarks, saying in part (emphasis added):
“While the Synapse story is still unfolding, these problems could have been identified much sooner if the partner banks maintained better records and conducted frequent, routine reconciliations. The proposal today would, in part, address these issues by requiring banks with certain types of pass-through accounts to maintain records of end-user depositors and conduct reconciliations at the close of each business day.”
And while Hill did vote in favor of the proposal, he highlighted several areas of concern and encouraged industry participants to comment on aspects of the proposed rule, including:
Setting a minimum threshold at which the requirements of the rule would apply
Removing or qualifying a compliance certification requirement
Reducing the burden on institutions to comply by, for example, removing the requirement for banks to establish and maintain written policies and procedures
Hill also pointed out that he would’ve preferred the board to wait until receiving comments from the recently extended interagency RFI on bank-fintech partnerships, which includes questions relevant to the proposed rule.
Would This Rule Have Prevented The Synapse Meltdown?
It’s impossible to say if, had this rule been in place, it would have prevented the Synapse catastrophe.
In fact, it isn’t clear if the rule, as proposed, would have applied to Synapse. The rule includes a number of exemptions, including for accounts established by brokers or dealers under the Securities and Exchange Act of 1934 and investment advisers established under the Investment Advisers Act of 1940.
In its final so-called “modular banking” incarnation, Synapse offered end users brokerage accounts with cash management features through its wholly-owned subsidiary, Synapse Brokerage LLC — suggesting the rule, as proposed, may not have even applied to Synapse.
Even if the rule had existed and applied to Synapse, rules are only effective to the extent that those governed by them adhere to their requirements. Synapse’s primary bank partner, Evolve Bank & Trust, has an established track record of non-compliance with law and regulation.
Supervision is a key process to ensuring banks follow such rules and regulations; but, in Evolve’s case anyway, the problem appears to be less a lack of rules and authority, and more that its regulators, the St. Louis Fed and Arkansas State Bank Department, were asleep at the wheel.
Yotta Accuses Evolve Bank & Trust of “Brutal Theft,” “Grotesque Misconduct” in Explosive New Lawsuit
Evolve’s legal woes continue to multiply.
The bank has been unable to return a single dollar of FBO funds held on behalf of Synapse end users, while the other three key banks involved have returned the large majority of funds they held. End users of programs like Yotta and Juno have filed multiple suits against the bank.
Separately, Evolve is facing potentially significant liability from a wave of civil cases stemming from the Russia-linked hack of its systems and data breach, which are likely to be combined into a class action.
Now, Yotta, the largest program caught up in the Synapse collapse, has filed an explosive new lawsuit that accuses Evolve of “brutal theft” and “grotesque misconduct.”
Key claims and allegations of Yotta’s suit include that:
Evolve “utterly failed in its most basic duty to its customers, misappropriating and/or misplacing tens of millions of dollars in customer funds”
Evolve and Synapse “conspired” to “simply take” end user funds, causing the still-unknown shortfall, which ranges between $65 million and $96 million
Evolve “lie[d] to Yotta about missing user funds”
Evolve “[stole] from customers,” including by “taking funds from the FBO accounts that commingled end user monies”
Evolve caused or allowed over $13 million in fees Synapse and/or Evolve owed to a third-party payment processor, TabaPay, to be debited from end user funds
Evolve “botched” the process of migrating business banking startup Mercury off of Synapse’s systems to Evolve’s, “causing Mercury and/or its users to receive almost $50 million more than they were entitled to”
Yotta’s suit lists causes of action that include fraud, conspiracy to commit fraud, negligent misrepresentation, negligent interference with a contract, negligence, violation of California’s unfair competition law, and unjust enrichment.
Yotta is seeking nominal, compensatory, liquidated, statutory, and punitive damages plus costs and expenses.
Other Good Reads & Listens
Failing Banks (NBER)
How Do Crypto Flows Finance Slavery? The Economics of Pig Butchering (SSRN)
‘Pig-Butchering’ Scams Cost Americans Billions. This Lawyer Is Taking Them On. (Wall Street Journal)
The Future of the Financial Data Economy (Fintech Takes)
The rise of AI Agents in Financial Services (Fintech Brainfood)
Listen: The Fintech Crash No One Saw Coming (11FS Fintech Insider)
Listen: Hot Takes: Regulatory Headwinds for BaaS, Live from Finovate (Breaking Banks)
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