Is The Term "Brokered Deposits" Fit For Purpose In The Age of Fintech?

Fed Warns Goldman on BaaS Compliance, Prime Trust's "Wallet Event," CFPB's $2.7Bn Credit Repair Settlement

Sep 03, 2023

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Is The Term “Brokered Deposits” Fit For Purpose In The Age of Fintech?

In the wake of the 1980’s savings and loans crisis, in which brokered deposits played a key role, bank regulators and Congress set about enacting a number of reforms that attempted to address the root causes — including banks’ use of brokered deposits.

Somewhat amusingly, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), which added Section 29 to the FDI Act, doesn’t actually define “brokered deposits” directly, but did so by way of creating a prohibition on troubled institutions — those that did not meet certain capital thresholds — “(1) accepting deposits from a deposit broker without a waiver and (2) soliciting deposits by offering rates of interest on deposits that were significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions having the same type of charter in such depository institution’s normal market area.”

The emphasis on brokered deposits, at least in part, stemmed from the notion that, because these funds were not from direct customers of a bank, could exceed deposit insurance caps, and were typically seeking out the highest rates on offer, they were less “sticky” and more likely to be withdrawn at the first sign of trouble — meaning banks that were highly dependent on brokered deposits could be more susceptible to a deposit run.

Section 29 of the FDI Act defines a “deposit broker” as:

(A) any person engaged in the business of placing deposits, or facilitating the placement of deposits, of third parties with insured depository institutions or the business of placing deposits with insured depository institutions for the purpose of selling interests in those deposits to third parties; and
(B) an agent or trustee who establishes a deposit account to facilitate a business arrangement with an insured depository institution to use the proceeds of the account to fund a prearranged loan.

and provides certain explicit exceptions:

The term "deposit broker" does not include —
(A)  an insured depository institution, with respect to funds placed with that depository institution;
(B)  an employee of an insured depository institution, with respect to funds placed with the employing depository institution;
(C)  a trust department of an insured depository institution, if the trust in question has not been established for the primary purpose of placing funds with insured depository institutions;
(D)  the trustee of a pension or other employee benefit plan, with respect to funds of the plan;
(E)  a person acting as a plan administrator or an investment adviser in connection with a pension plan or other employee benefit plan provided that that person is performing managerial functions with respect to the plan;
(F)  the trustee of a testamentary account;
(G)  the trustee of an irrevocable trust (other than one described in paragraph (1)(B)), as long as the trust in question has not been established for the primary purpose of placing funds with insured depository institutions;
(H)  a trustee or custodian of a pension or profitsharing plan qualified under section 401(d) or 430(a) of the Internal Revenue Code of 1986; or
(I)  an agent or nominee whose primary purpose is not the placement of funds with depository institutions.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) created the “Prompt Corrective Action” capital regime and set thresholds for the brokered deposit and interest rate restrictions on banks falling below the “well capitalized” level.

Banks that are considered “well capitalized” do not have restrictions on their use of brokered deposits; banks that are considered “adequately capitalized” may seek a waiver from the FDIC to accept deposits from a broker; and institutions considered “undercapitalized” are prohibited from accepting brokered deposits.

Trump-Era FDIC’s “Brokered Deposits” Update

It’s worth noting that the original legislation defining “deposit brokers” was passed in 1989, when that deposit brokering activity was carried out by people via phone, mail, or fax. The legislation did not contemplate the rise of internet banking and rate comparison sites, and certainly didn’t envision the eventual development of non-bank fintech services like Chime and Cash App or intermediary banking-as-a-service platforms, like Unit, Treasury Prime, Synapse, Bond, and so on.

As part of the FDI Act, only Congress itself can change or amend the definition of a “deposit broker” by passing new legislation — something that feels considerably unlikely in today’s divided and highly partisan government.

But the FDIC does have authority under the FDI Act to issue regulations that further clarify the type of activities that would cause a person to be considered a “deposit broker” — which is exactly what Trump-era FDIC Chair Jelena McWilliams did. (Bank Director’s Kiah Haslett analyzed some of the history and potential implications at the time here.)

The new brokered deposit rule, which went into effect in December 2020:

establishes bright-line standards for determining whether an entity meets the statutory definition of “deposit broker,” and a consistent process for application of the primary purpose exception. Specifically, the rule identifies a number of business relationships, or “designated exceptions,” that automatically meet the “primary purpose exception” and also establishes an application process for entities that do not meet one of the “designated exceptions” but seek a “primary purpose exception.”

The rule made a number of important changes, including:

clarified the definitions of “engaged in the business of placing deposits” and “engaged in the business of facilitating the placement of deposits”
this clarification made explicit that a third-party placing deposits with only a single insured depository institution would not be defined as a “deposit broker”
clarify and expand the “primary purpose exception,” including by specifying 13 Designated Business Exceptions that automatically qualify; including placing deposits equal to less than 25% of a customer’s assets under management and placing 100% of a customer’s deposits in a transactional account that does not pay remuneration (interest) to the depositor
specifically states that brokered CDs are not eligible for the primary purpose exception
establishes an application process for entities to seek a “primary purpose exception” but do not meet one of the predefined “Designated Business Exceptions”

It’s worth noting that current FDIC Chair Martin Gruenberg, at the time an FDIC board member, voted against the rule change, saying in a speech at the time (spacing adjusted and emphasis added):

Experience in two financial crises demonstrates that brokered deposits pose a very serious safety and soundness risk to insured depository institutions and the Deposit Insurance Fund.
The changes to the brokered deposit rule proposed in this NPR seem less related to a careful evaluation of whether a deposit is brokered and the risks attendant to that designation than to a general objective to narrow the scope of the rule. While technology may have a role to play, it is not clear how it changes the fundamental considerations of the relationship between a bank, a depositor, and a third party intermediary, and the risks the relationship may pose.
This proposed rule will likely reduce dramatically the scope of deposits that are currently considered brokered without adequate justification and expose the banking system to significantly increased risk. For that reason, I will vote against this notice of proposed rulemaking.

The updated rule was explicitly seen by regulators at the time as facilitating and promoting bank-fintech partnerships.

Upon passage of the rule, then-acting OCC comptroller Brian Brooks said (spacing adjusted and emphasis added):

The rule regarding brokered deposits approved today by the FDIC Board helps modernize the concept of brokered deposits in ways that give consumers more choices and control over their financial decisions and promote innovation between commercial banks and the financial technology industry…
The new rule makes three basic improvements over the previous status quo.
First, fintechs that partner exclusively with a single bank deposit platform are not considered brokered-deposit arrangements under the rule; only arrangements where a broker has discretion to place deposits at any of multiple banks would trigger deposit-broker regulation.
Second, companies that simply facilitate consumers’ deposits into a bank via a more convenient interface and never take possession of the consumers’ funds will no longer be deemed brokered-deposit arrangements.
Third, companies that accept deposits as part of a suite of services focused on consumer lending will not be considered deposit brokers under the new rule’s “primary purpose” exception.

Where Do BaaS Platforms Fit In The Current Brokered Deposit Paradigm?

The updated brokered deposit rule does provide some increased clarity.

For instance, it makes clear that neobanks working with a single underlying bank partner, broker-dealers where deposits represent less than 25% of a customer’s assets under management, and prepaid cards are not considered deposit brokers.

But, as much as the updated rule does to clarify whether or not deposits sourced through certain types of bank/fintech relationships as “brokered,” ambiguity remains, as is made clear by looking at the levels of brokered deposits for banks active in the partner bank/banking-as-a-service space:

Data from Q2’23 FDIC call reports, except cost of funds, calculated as interest expense as a percent of assets from Q4’22 call reports

The share of brokered deposits range from functionally 100% (Hatch Bank) to zero for Stride (partners with Chime), Coastal Community (partners with ONE), and Lineage Bank (partners with BaaS platforms Synapse and Synctera).

In two cases — Sutton and Green Dot — the amount of brokered deposits exceeds the amount of interest-bearing deposits reported, which would seem to indicate a portion of the deposits reported as “brokered” are non-interest bearing.

It’s not immediately clear where banking-as-a-service platforms fit in the existing brokered deposits paradigm; and, indeed, there are important differences among the various BaaS platforms in their business models and how they facilitate relationships between their fintech clients, the clients’ end users and their deposits, and one or multiple underlying partner banks.

It’s worth stepping back and remembering the purpose of the original brokered deposit legislation, passed in the wake of the 1980’s savings and loan crisis: to have visibility into and to limit weaker banks’ exposure to deposits that may be at higher risk of flight in times of stress.

Whether or not banking-as-a-service-sourced deposits carry that risk depends on the specifics of the relationship.

On the one hand, BaaS-sourced deposits could strengthen a bank’s balance sheet, by enabling it to diversify its sources of funding beyond a limited geographic area or industry concentration (an argument Alex Johnson made in the wake of SVB’s collapse earlier this year.)

On the flip side, if partner bank- or BaaS-facilitated deposits are at risk of abrupt or coordinated withdrawal — for instance, if a neobank failed or if the BaaS platform has the ability to shift deposits to a different bank — a dependence on them could pose a safety and soundness risk.

One could imagine a regulatory approach for higher risk BaaS deposits consistent with brokered deposit regulations that restrict less-than-well-capitalized banks from accepting such deposits without regulators’ sign off.

But before any additional rules are even considered, regulators need to ensure banks are treating and reporting fintech/BaaS-sourced deposits in a consistent manner, such that meaningful analysis and comparison is possible.

Fed Warned Goldman On BaaS Compliance

A brief story (paywalled) in the Financial Times indicated that the Federal Reserve had cautioned Goldman Sachs’s Transaction Banking unit, including flagging insufficient due diligence and monitoring processes when accepting “high-risk non-bank clients.”

The Transaction Banking group, which Goldman refers to as TxB, includes its banking-as-a-service operations and partners with fintechs like Wise (formerly TransferWise) and powers Stripe’s Treasury product. While Wise is a customer in Goldman Sachs’ TxB line of business, Wise is not part of Goldman’s BaaS services. Instead, the company partners with TxB for traditional payment services

Stripe and Goldman announced the partnership on Treasury, Stripe’s BaaS offering, back in December 2020. In the US, Stripe also partners with Evolve Bank & Trust, which numerous sources have suggested is reducing its fintech and BaaS exposure, as it faces ongoing regulatory scrutiny; outside the US, Stripe partners with Citi and Barclays.

Based on a search for the required disclaimer language clients of Stripe Treasury are supposed to include, only three companies appear to be live or in development on Treasury via Goldman Sachs: Maker Swiss, which offers SMB bank accounts to creatives; QLife, which offers a marketplace and spending accounts for LGBTQ+ businesses; and Payello, a multi-currency business account designed for ecommerce stores.

Having experienced the lengthy and often manual due diligence and compliance processes at Goldman firsthand when I worked at its Marcus business, Stripe, with its emphasis on scalability through automation and self-service, always struck me as an odd partner for the 150+ year-old investment bank.

Stripe is very much an engineering- and product-driven organization; while Goldman has made efforts to elevate such functions, it remains driven more by bankers, traders, and risk managers, not technologists.

Still, the details in the reporting are scant, besides noting that Goldman “has stopped signing on riskier financial technology clients.” Banks generally aren’t permitted to reveal or comment on confidential supervisory information, so, unsurprisingly, Goldman didn’t comment on this report.

Prime Trust’s “Wallet Event” Precipitated Receivership, Bankruptcy

Nevada-chartered trust company Prime Trust, focused on serving crypto firms, has officially filed for Chapter 11 bankruptcy protection.

While the development isn’t unexpected, after the company faced a “shortfall” of funds to meet customer withdrawals, the filing adds additional context around the circumstances that led to the company’s failure.

The quick synopsis of what the filing refers to as the “Wallet Event,” which ultimately resulted in the company’s insolvency and bankruptcy:

in July 2019, Prime Trust migrated from using physical hardware crypto wallets to using service provider Fireblocks to hold crypto assets
in January 2021, Prime Trust “inadvertently” instructed customers to send crypto funds to an address associated with a legacy hardware wallet
as instructed, users sent funds to the deprecated hardware wallet
Prime Trust didn’t detect the error for nearly a year, only realizing the mistake when a user requested a large withdrawal of ether (ETH), and the company didn’t have adequate funds in Fireblocks to meet the withdrawal request
the company used customer funds to purchase additional ETH in order to meet withdrawal requests — ultimately ending up with a deficit of about $76 million from doing so
at one point, the company had both physical access devices (roughly analogous to a two-factor auth device) and a backup of the wallet’s “seed phrase” — engraved on “stainless, shockproof, acid-resistant and fireproof” steel plates — but the company was unable to locate either means of accessing the funds stored on the hardware wallet

Prime Trust attempted to replenish the inaccessible user funds by raising additional capital and by pursuing an acquisition, neither of which were successful.

Ultimately, the Nevada regulator forced the company in to receivership earlier this year.

According to its bankruptcy filing, Prime Trust hopes to use to Chapter 11 process to resolve customer claims while maintaining its licenses as it pursues “strategic alternatives,” including a potential sale.

Credit Repair Firms Reach $2.7 Billion Settlement with CFPB (But Are Unlikely To Ever Pay It)

The CFPB reached a $2.7 billion settlement with a collection of companies that operate some of the largest credit repair brands in the country, including CreditRepair[.]com and Lexington Law.

According to the Bureau’s press release on the proposed settlement:

[T]he Consumer Financial Protection Bureau (CFPB) entered into a proposed settlement with a ring of corporate entities operating some of the largest credit repair brands in the country, including Lexington Law and CreditRepair.com. The agreement follows a ruling from the court that the companies collected illegal advance fees for credit repair services through telemarketing in violation of federal law. If approved, the settlement would impose a $2.7 billion judgment against the companies. The order will also ban the companies from telemarketing credit repair services for 10 years.

In its complaint, the CFPB alleged the companies:

violated the Telemarketing Sales Rule (TSR) by charging advance fees before providing documentation to consumers that they had achieved the promised results
violated the Consumer Financial Protection Act (CFPA) by engaging in deceptive acts and practices, including through their use of marketing affiliates that used deceptive advertising, including falsely representing to consumers that use of the credit repair products was required to obtain certain products/services or that using the credit repair products would increase their likelihood of obtaining certain products/services

However, given the companies have already filed for Chapter 11 bankruptcy protection, it is likely that little, if any, of the $2.7 billion judgment will actually be paid.

Perhaps more important is the settlement’s order banning the defendants from conducting telemarketing of credit repair services for a period of 10 years.

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