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The Smallest Bank in Tennessee Grew Fast With BaaS. Why It May Give The Entire Industry A Hangover.
As Evolve Cuts Ties, Synapse Uses Control of Deposits to Pressure Lineage To Approve More Programs
Hey all, Jason here.
I’m back home in Utrecht (for now, anyway.) The 10+ hour flight from Mexico City to Amsterdam is a real killer — folks who are capable of working on flights (especially in economy), you’re my hero. All I’m good for is watching movies, listening to podcasts, and sleeping.
Speaking of podcasts! If you didn’t catch last week’s Fintech Recap, Alex Johnson and I had the chance to discuss the launch of FedNow, among other things, with Federal Reserve Chief Payments Executive Mark Gould. If you have any interest in US payments, I highly recommend giving it a listen!
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A Tennessee Banking Family Bought The State’s Smallest Bank And Pumped It Up With BaaS. Why It May Give The Entire Industry A Hangover.
Lineage Bank, now a significant player in fintech through its banking-as-a-service partnerships with Synapse and Synctera, was known as Citizens Bank and Trust Company — the smallest bank in Tennessee — until 2021.
Since its acquisition, which closed at the beginning of 2021, the bank has seen its assets balloon by an astounding 790%, from $27.25 million at the end of 2020 to over $242 million just two years later.
While still small by bank standards, the rate of growth has been astronomical — banks in its peer group grew assets by less than 10% a year during the period.
Such rapid growth, while not always a sign of a problem, is a potential red flag that should invite further review of whether or not a bank’s controls are keeping pace with its increasing size, complexity, asset quality, asset-liability management, and so on.
But to really understand what’s happening at Lineage, you have to understand the family running it: the Herringtons.
Richard Herrington, the chairman of the board, and his son, Lineage CEO Kevin Herrington, who once referred to government regulators as “the enemy,” have a long history of running banks — not always successfully — in and around Franklin, Tennessee, a small town just south of Nashville in well-to-do Williamson County.
Franklin National, Civitas, Consent Orders — And Embezzlement
Richard Herrington’s banking career in the region dates at least as far back as 1989, when he co-founded Franklin National Bank, eventually taking parent company Franklin Financial Corp. public. By the early 2000s, the bank had grown to hold some $787 million in assets.
Ultimately, in 2002, the bank agreed to merge with the Tennessee subsidiary of Fifth Third in a transaction valued at about $240 million, though the transaction didn’t actually close until 2004.
Richard stepped down from the president and CEO roles at Franklin National Bank in September 2002, but he didn’t waste any time in finding his next project.
John S. Wilder Sr., the chairman of Cumberland Bancorp — and the lieutenant governor of Tennessee at the time — had noticed Richard’s success at Franklin National and pursued him to become CEO of Cumberland.
Cumberland Bancorp, quickly renamed Civitas by newly-appointed CEO Herrington, was a bank holding company with five loosely affiliated bank subsidiaries that operated independently. The holding company itself had only three employees and a part-time CEO. Its component banks ranged from tiny $11 million Bank of Mason to relatively larger $293 million Cumberland Bank, as well as owning 50% stakes in two “start up” banks, Insurors Bank of Tennessee and Murray Bank.
According to reporting at the time of his appointment as CEO, “Mr. Herrington said the biggest flaw of the skeleton holding company was inadequate oversight of the banks’ policies and procedures.”
Herrington quickly moved to beef up the holding company in order to centralize operations, hiring over 30 new staffers. And he made it a family affair, bringing on sons Kevin Herrington as head of information technology and Jason Herrington — at the time, about 24 years old — to manage the company’s investment portfolio. Both had also worked with their father previously at Franklin Financial Corp.
But everything did not go smoothly for the family at Civitas.
In 2004, according to news reports and SEC filings, a “routine audit” revealed that Jason Herrington embezzled as much as $500,000 from the bank — reportedly to cover his sports gambling habit. A Civitas director also conveniently sold shares just days before the fraud was publicly revealed — dropping the company’s stock price by some 20%. (The embezzlement matter wasn’t the younger Herrington’s only brush with the law — about a decade later, in 2015, he was arrested and charged with patronizing prostitution, drug possession, possession of drug paraphernalia, and not wearing his seatbelt.)
Shortly after the embezzlement incident became public — and shortly before the bank holding company faced a wide-ranging enforcement action — Civitas began divesting from banks in its smaller markets. In the span of six weeks, the company sold or agreed to sell three of its banks; the other two, Cumberland Bank and Cumberland Bank South, merged into a single bank focused on the fast-growing Nashville area.
In reporting at the time, the elder Herrington attributed the change in direction, at least in part, to his younger son’s scandal: “Mr. Herrington said it was at that point that he realized the company needed to go in a different direction and to tighten its focus.”
The decision also may have had something to do with the brewing enforcement action. In April, 2005, Civitas CEO Richard Herrington signed off on a written agreement with the Fed that required the bank to (emphasis added):
retain an independent consultant to conduct a review of Civitas’ management, directorate, and organizational structure to “aid in the development of a directorate and management structure, consisting of qualified and trained personnel, that is suitable to Civitas’s enterprise-wide needs” — including “an evaluation of each Civitas officer and director to determine whether the individual possesses the ability, experience, and other qualifications required to competently perform present and anticipated duties”
develop and submit a written management plan that “describes the specific actions that the board of directors proposes to take in order to strengthen Civitas’s management and improve the board of directors’ supervision of Civitas”
enhance Civitas’ enterprise-wide internal audit function, including oversight of subsidiary banks’ “wire transfer, teller operations, lending, investment securities, and the organization’s consolidated balance sheet, and income and expenses”
enhance Civitas’ enterprise-wide credit administration policies, procedures, and practices
enhance its independent loan review program
develop an acceptable written plan to maintain a sufficient capital position for the consolidation organization
develop a written strategic plan that includes goals for improving consolidated earnings
cease declaring or paying dividends (with the exception of stock dividends) without prior written approval
not incur any additional debt without prior written approval
appoint a compliance committee to monitor and coordinate compliance with the written agreement
Despite the wide-ranging and significant requirements on Civitas, the order was terminated less than a year later, in February, 2006. Less than a year after that, in January, 2007, Civitas agreed to merge with Greene County Bancshares.
Upon completion of the merger, around May, 2007, Richard and Kevin Herrington stepped down; but despite the termination of the order and merger with Greene County Bancshares, subsequently renamed GreenBank, significant problems seem to have remained at the newly merged bank.
By 2011, as a result of a jointly completed safety and soundness examination, the FDIC and Tennessee Department of Financial Institutions (TDFI) sought a formal enforcement action against GreenBank aimed at strengthening its financial position, which culminated in a consent order with the FDIC.
Capital Bank was eventually acquired by and merged with First Horizon — another Tennessee-based bank active in the banking-as-a-service space (which, in turn, was supposed to be acquired by TD Bank, before the merger fell through because of issues at TD.)
The Next Act: De Novo Franklin Synergy Bank
The Herringtons wasted no time in starting their next venture.
Just six months after officially departing Civitas, in November, 2007, Franklin Synergy Bank, a state-chartered de novo, commenced operations and received Fed approval to be acquired by its bank holding company, Franklin Financial Network, Inc.
From the beginning, Franklin Synergy had aggressive growth goals. It posted its first quarterly profit after roughly just 15 months of operation by leaning in to mortgage refinance and origination — against the backdrop of the brewing subprime mortgage crisis.
Richard Herrington told the Nashville Post in October, 2009: “Mortgage banking has always been a fundamental part of our strategy as a real estate bank in Williamson County. In the first half of 2009, we originated more than $100 million in first mortgage residential real estate loans, the vast majority of which we sold into the secondary market.”
In the same interview, he told the paper a challenge Franklin Synergy faced was how to fund that loan growth, saying, the bank “had to look for out-of-territory and non-traditional funding sources.”
Franklin Synergy kept up its breakneck pace of growth, posting strong, double-digit growth in assets year over year:
To power this asset growth, Franklin leaned on more expensive out-of-market and brokered deposits:
The rapid growth didn’t go unnoticed by Franklin Synergy’s regulators.
In November, 2016, parent company Franklin Financial Network revealed a memorandum of understanding it had reached with the Federal Reserve and Tennessee Department of Financial Institutions in an SEC filing to raise an additional $62 million in capital.
The MOU stemmed from the bank’s heavy exposure to commercial real-estate — approximately 55% of the bank’s loan portfolio consisted of CRE loans, as of September, 2016.
The prospectus also acknowledged the bank’s heavy reliance on non-core sources to fund its balance sheet, stating (emphasis added):
“Although we are increasing our effort to decrease our use of non-core funding sources, we can offer no assurance that we will be able to increase our market share of core-deposit funding in our highly competitive service areas. If we are unable to do so, we may be forced to accept increased amounts of out of market or brokered deposits.
As of September 30, 2016, we had approximately $612.1 million in out of market deposits, including brokered deposits, which represented approximately 27.6% of our total deposits.”
And according to reporting in American Banker at the time, the MOU further required “Franklin’s bank to improve its underwriting, internal controls, risk management policies and portfolio stress testing, largely as a result of its commercial real estate growth and exposure.”
The MOU, entered into in November, 2016, was terminated a little over two years later in January, 2019.
About two months after the MOU was lifted, CEO and President Richard Herrington and his son, COO Kevin Herrington, abruptly stepped down from the company.
Less than a year after the Herringtons’ abrupt departure, Franklin Synergy was acquired by FB Financial Corporation, parent of FirstBank.
Rich Men South of Richmond: Lineage Bank Is Born… And Quickly Grows
The Herringtons wasted no time organizing their next venture — what would become Lineage Bank.
In February 2020, Lineage Financial Network, Inc., announced its intention to acquire two small Tennessee banks: Sumner Bank & Trust, of Gallatin, and Citizens Bank & Trust Company, of Atwood, as well as Citizens’ holding company, Bumpushares, Inc.
But with the onset of COVID in March, the newly formed company was only able to raise enough capital to acquire one of the two — Citizens, at the time, the smallest bank in Tennessee, with just over $25 million in assets.
Once the deal closed, at the beginning of 2021, the Herringtons quickly set about bulking up the bank, with assets growing by nearly 60% in the first quarter under their control. By the second quarter of 2021, Citizens was officially re-christened as Lineage Bank and relocated from Atwood, Tennessee, to Franklin.
In the first year under the Herringtons’ control, the bank grew its assets by a stunning 250%, from $27.25 million at the start of 2021 to $95 million by the end of the year:
Lineage kept up its torrid pace of growth, increasing assets by a further 155% in 2022, to end the year with $242.6 million in assets. Still small by banking standards, but explosive growth nonetheless.
In the same time period, other banks in Lineage’s peer group of those holding $100-$300 million in assets grew their balance sheets by less than 10% per year on average.
Much like the playbook they ran at Franklin Synergy, Lineage loaded up on construction/land development loans, residential mortgages, and commercial real estate loans, as well as residential and commercial mortgage-backed securities.
A meaningful portion of Lineage’s loan and lease portfolio has a remaining maturity of three years or longer, while a considerable share of the securities it holds have a remaining maturity of five years or more.
But Lineage seemed determined to avoid the dependence on expensive out-of-market and brokered deposits the Herringtons experienced at Franklin Synergy.
The key to unlocking a new source of cheap deposits? Banking-as-a-Service.
The key to unlocking a new source of cheap deposits? Banking-as-a-Service.
As those deals came online in the back half of 2022, the composition of Lineage’s deposits rapidly shifted.
The bank offloaded expensive brokered deposits it had used to fund growth, and the share of non-interest bearing deposits jumped significantly, from 14% of the bank’s deposits in Q2’22 to nearly 55% just one quarter later:
From Q2’22 to Q3’22, the quarter the Synapse deal was publicly announced, Lineage’s non-interest bearing deposits jumped an astounding 470%.
Leveraging BaaS-sourced deposits allowed Lineage to keep its cost of funds low — significantly lower than its peer group.
In Q3’22, as its activity with Synapse and Synctera picked up, Lineage’s cost of funds, calculated as interest expense as a share of assets, was just 0.15%. Its peer group banks reported a cost of funds of 0.40%, or 2.6x higher.
The difference has become even more pronounced since then, as Fed rate hikes and declining deposits have driven up the cost of funds across the banking system:
While the cheap funds from its BaaS partners supported its growing balance sheet and drove favorable net interest margins (NIMs), they left Lineage in the vulnerable position of being highly dependent on those same partners.
That vulnerability is something at least one of those partners — Synapse — has taken advantage of.
Try Fintech In A Small Town, See How Far You Make It
Synapse is widely seen as the pioneer of the banking-as-a-service platform model.
Founded in 2014, the company has long worked with another Tennessee bank: West Memphis-based Evolve Bank & Trust. Synapse founder and CEO Sankaet Pathak studied at the nearby University of Memphis, where he completed a bachelor of science in computer engineering and a master’s in electrical engineering.
But Evolve, both through Synapse and on its own, has had a number of its partners garner regulatory attention or collapse in spectacular fashion, including FTX, BlockFi, MAGA neobank GloriFi, Money Ave, and “anonymous” debit card ZELF, among others.
With regulatory pressure increasing on Evolve, the bank began working to cut ties with Synapse late last year, multiple sources have previously told Fintech Business Weekly. Two days after that report, in December, 2022, Synapse and Evolve put out a brief statement, claiming to “renew” their relationship.
But in reality, any extension seems to have been primarily for the purpose of giving Synapse and its clients time to transition off of Evolve. Evolve no longer appears on Synapse’s list of program banks, and multiple sources have indicated the relationship is winding down as Evolve seeks to de-risk in the face of ongoing regulatory scrutiny.
(In response to questions for this story, a representative for Evolve declined to comment; representatives for Synapse didn’t respond to a request for comment.)
Synapse, which last raised funds over four years ago, in 2019, has been unable to raise additional funding or find a willing buyer, people with knowledge of the matter have said.
Losing Evolve as its key bank partner puts Synapse in a desperate position.
Against that backdrop, it’s not surprising that Synapse used its control over a significant portion of Lineage’s deposits to exert pressure on the bank to continue growing its relationship with Synapse and to approve increasing numbers of Synapse’s questionable client programs, according to people familiar with the situation.
Can Synapse’s “Modular Banking” Ever Work?
While Lineage works with both Synapse and Synctera, sources have pointed to Synapse as the bigger source of the bank’s problems.
Unlike BaaS platforms that act as a technology and relationship intermediary with underlying bank partners, Synapse’s so-called “modular banking” model disaggregates banking functionality and effectively forms a barrier to interaction between fintechs and bank partners.
In this modular approach, a single fintech client of Synapse’s may have various banking capabilities — payments processing, DDA/FBO accounts, card issuing, and so forth — spread across multiple bank partners. Synapse currently directly partners with Lineage, AMG, and American Bank.
Synapse has an added layer of complexity, in that the company possess its own broker-dealer license.
Multiple sources have said that Synapse’s position with bank partners, at least in regards to certain programs/capabilities, is that Synapse’s brokerage, rather than fintech clients, is the client of the bank — meaning, in Synapse’s view, that the bank shouldn’t worry about who the fintechs and the fintechs’ end customers are.
And while broker-dealers have their own BSA/AML, KYC/KYB, and third-party risk management obligations, that doesn’t immunize partner banks from regulatory liability.
If anything, by adding another layer and disaggregating a single fintech’s activities across Synapse and multiple partner banks, the complexity of monitoring risk and implementing controls only increases.
Asked if Synapse’s modular model could ever work, from a regulatory and compliance perspective, the consistent answer from experts was “yes, but” — it would require adequate compliance management, technology, and personnel across each link in the chain: Synapse’s fintech clients, Synapse itself, and each of Synapse’s partner banks.
Synapse, with about 250 employees, Lineage, with just 38, AMG, with about 120, and American Bank, with about 230 employees, do not seem to be up to the task.
That’s even more the case, given the number, complexity, and riskiness of Synapse’s fintech clients.
Synapse-powered programs include crypto and defi clients like Kraken, Riot Blockchain, MetalPay, and Donut; programs offering consumer and business banking services outside the US, like Nomad, Momento, DolarApp, GrabrFi, and Utoppia; and small-dollar lending and credit-building fintechs like SoLo Funds, Nize, and Dave.
In practice, Synapse, its fintech clients, and its partner banks lack the sophistication, technology, and staffing to adequately manage the outsized risks that exist across Synapse’s sprawling collection of programs and their various geographies and product lines.
This is already evident, with a number of Synapse clients being subject to regulatory actions.
Utoppia received a cease and desist order from the FDIC for making false and misleading claims related to deposit insurance. SoLo Funds has been the target of numerous regulatory actions, including in Connecticut, California, and Washington, DC. And the CFPB opened an investigation into Dave, but ultimately decided not to pursue an enforcement action.
Lineage Is Exactly What Regulators Are Worried About
It’s becoming increasingly clear that the kinds of risks posed by Synapse and its partner banks, including Lineage, are top-of-mind for regulators:
Blue Ridge’s agreement with the OCC represented the first significant regulatory action of the modern BaaS era
the OCC’s 2023 supervision plan explicitly included fintech and banking-as-a-service as a focus area (American Bank is OCC supervised, though Lineage and AMG are not)
Cross River’s settlement demonstrated scrutiny by the FDIC as well as focus on lending programs
inter-agency guidance from the OCC, Federal Reserve, and FDIC shows a concerted effort to align oversight and discourage regulator shopping
the Fed’s recent announcement of its “novel activities” supervision program specifically targets “complex, technology-driven partnerships” and risks to banking organizations from a high concentration of crypto and/or fintech
Lineage Bank, regulated by the Tennessee DFI and FDIC, with its holding company overseen by the Fed, would seem to be exactly the kind of situation regulators are seeking to avoid. Its high concentration of deposits from fintech — and deploying those deposits into medium-to-long maturity loans/leases and securities — has made it vulnerable to demands from its BaaS partners.
Lineage, together with its BaaS partners and their fintech clients, lack the resources, capability, and will to appropriately manage these risks.
And Lineage, together with its BaaS partners and their fintech clients, lack the resources, capability, and will to appropriately manage these risks.
All of this together risks encouraging regulators to drop the hammer on banking-as-a-service and bank/fintech partnership models.
But it’s worth noting that there is a wide variety of approaches to how fintechs work with banks: from direct models, like Chime with Bancorp, BaaS models where there is a direct relationship between fintech and bank, like Unit and Treasury Prime vs. Synapse’s “modular banking” model, which, seemingly intentionally, obscures lines of communication and responsibility.
The risks posed by each of these models, and thus the necessary controls, are different.
A regulatory overreaction to a situation like Synapse and Lineage risks causing a major disruption and setback for the entire fintech ecosystem. But the reality is, there is no turning back the clock to the era of the small town community bank.
Consumers’ financial lives are increasingly dispersed across multiple institutions and managed digitally, not at the bank teller counter.
While risks must be managed appropriately, a blanket clampdown on bank/fintech partnerships will hurt fintechs, yes, but it will also harm the consumers that use them and the banks that power them.
Representatives for Lineage and Synapse did not respond to requests for comment. Representatives for Evolve Bank & Trust and Synctera declined to comment for this story.
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