Have you considered banking as service offerings or as service agreements? Over the past year, a lot of positive and negative attention has been focused on banking as a service offering to Fintech types of businesses. This blog will discuss how agreements can be put together and how risk and compliance can be managed to keep relationships between banks and Fintech partnerships positive.
For our purposes, we’re going to talk about banking services in the realm of embedded finance, and taking banking services and offering them as a suite of financial products,
A BANKING SERVICE AGREEMENT – OR FINTECH PARTNERSHIP WITH A BANK
First, it’s important to define and determine what the different parties are going to be doing because everything else in the agreement and the arrangement flows from that idea. Typically, a bank can offer certain services that other entities either cannot offer or find it very difficult to do so. These services are usually money transmission, lending, and taking deposits. In the service agreement, the bank agrees to take on deposits, make loans, or do some money transmission activities for the other party. The other party is taking on the heavy role of marketing and the customer services side in creating platforms to use in producing novel ways for the services to be offered.
The agreement needs to very carefully describe the services and activities the bank will take on. This Is to ensure that it is taking on the regulated activities. The agreement also needs to be very careful about defining what the Fintech partner can and can’t do and what might need to be done with the financial institution’s approval. Just by the nature of this sort of arrangement, some very interesting compliance risks arise, as well as other risk management topics that you need to cover.
COMPLIANCE
Regarding compliance, the bank and Fintech need to sit down and talk about the different types of compliance obligations that will exist in an arrangement. This is because the Fintech partner may or may not have a complete handle on the full extent of the compliance obligations that they’re taking on in their new role. Much of this needs to go into the agreement. Oversight also needs to go into the agreement to ensure that the Fintech partner and the bank are adequately implementing and monitoring their compliance obligations on an ongoing basis.
In this type of agreement, you’ll also see the bank having the ability to oversee policy and procedure, to see compliance audits and testing, and to require additional compliance burdens. You might think about it like a bank examiner coming in for a compliance exam and imposing the requirements on the bank. Except in this case, the bank is playing the bank examiner for the Fintech client.
Make sure everybody understands the full extent of the obligations, and then put some policies and procedures and monitoring governance in place so everybody can understand, see what’s happening, and ensure that it’s all moving forward and implemented on an ongoing basis. You also need to put some mechanisms in place to deal with regulatory changes where both parties are looking at how process procedures need to change in line with new regulations and new regulatory obligations.
RISK MANAGEMENT
Risk Management is a big topic. There’s no way we can fully cover this topic in this short blog, but there are a few things we can pull out. To begin with, it’s vital to understand the industry that you’re getting into. Early in 2023, we saw some major issues where deposits and funding sources that are typically stable, became very, very unstable for some institutions, resulting in some running off of deposits in very large amounts. When you’re looking at a relationship with the Fintech provider and bringing on deposits as a funding source, you need to test out your assumptions that traditionally bank deposits are very stable. If you change the environment in which they’re gathered, that stability assumption may not be valid. So, you want to be very careful how you’re looking at deposits and funding sources from this arrangement.
Another thing to consider in a Fintech or a BAS arrangement is that often the lending program is very low touch. There may not be human oversight over every loan that’s made. This is why it’s important to be very careful about setting parameters for the loan and writing that into the agreement. This ensures that the bank is controlling its exposure and the risk profile for the portfolio. You’ll want to control the overall exposures and watch the performance carefully. To assist in this, you may set some performance covenants and obligations between you and the Fintech partner in the agreement. That way, during the onboarding of the loans, the new lending relationships, and through the performance of the portfolio, you can see, monitor, understand, and control the overall risk.
One last thing on the risk management topic, in the payment space, if you introduce another partner between the bank and the customer, there tends to be less visibility for the bank on what types of customers are coming in the front door, and on what types of payments are being made. From a bank secrecy act and anti-money laundering perspective, you need to build in enough reporting and visibility into the relationship to be able to see what types of transaction activity you are really coming across, and to be able to monitor, to halt, slow down, or to control the aggregate volumes of payments activity that is coming across. This can be done through reporting. It can also be done through the way the relationship is set up between the bank, the Fintech partner, and the end user. The general idea is that you really want to understand who it is that you’re servicing and understand the flow of payments that are coming through the bank.
All of these protections can be written into a banking service agreement – usually in terms of representations. warranties, and compliance obligations. We can also add covenants and enforcement measures into an agreement.
CONCLUSION
If you’re considering a new bank service offering this year, we hope you’ll take a careful look at these aspects and consider what service offerings and agreements can do for you.
Farley Law specializes in working with both community banks and small businesses. If you are interested in learning more about these or any other income-generating activities for banks, please feel free to contact us at Farley Law, where we help our client financial institutions develop new products and financial services. Have a question or a comment? Send us a note at business@farleylawpllc.com, or set up an introductory call using our bookings service.