This subject has become quite prominent recently, and we want to discuss different types of relationships you might build between a bank and a fintech organization to offer or create a product or service, along with their advantages and disadvantages, and a few pointers on handling potential issues.
OBSERVED ISSUES
We’ve observed various issues arising from relationships between fintech companies and banks. Some relationships are more entrenched than others. The problems we’re seeing involve transparency, accountability, handling and marketing of services and products, delivery of these services, commitment to regulatory compliance, and technical capabilities. Surprisingly, issues with technical capabilities have emerged, which is unexpected from a technology firm. Another significant challenge is unwinding, exiting, or transferring these relationships to other institutions, especially when relationships are deeply intertwined and lack prior planning for smooth transitions.
“If you’re looking at relationships with fintechs, they are very doable but need to be handled carefully and prudently.”
BANK INVESTMENTS
Let’s start with something pretty traditional: investments. Banks can make investments in other companies, including startups. This might be news to some institutions, as banks do have limitations on their activities. However, a bank can invest in an organization engaged in banking services or the business of banking, supported by multiple statutory and regulatory authorities.
In general, if an organization provides a typical banking service or something related to banking, the bank can invest in it. However, the investment must be limited in scope. Banks can face unlimited liability with these investments, and the service being created must advance the bank’s operations in some way. There is a wide range of investments a bank can make, including in service providers and technology firms that offer software and services. This creates relationships with fintech organizations.
The advantages of this approach include the ability to define and negotiate the bank’s control over the organization and its economic interests. Economic interests can vary from providing a service to earning multiples on an investment or percentages. Banks can structure their investments in various ways. However, there is a risk involved: if the organization mismanages the funds, the money is lost. But if managed well, with capable people and a solid business plan, there can be significant returns. The bank does not need to be heavily involved in the service’s provision or development, but it can offer expertise and knowledge, ensuring transparency in how both organizations develop, market, and offer the service. This is one way to structure a partnership between a bank and a fintech firm.
You can also combine an investment in a fintech organization with a service agreement. The bank may use the services created by the fintech, which can also offer these services to other financial institutions or the public. This aligns incentives between the two organizations and provides managerial accountability. In terms of exit planning, if the investment goes well, it can be sold. If it goes poorly, the bank’s risk is limited to the investment and possible reputational damage. This makes the investment more entangling in some ways but also more standoffish than a service agreement, as the exit and limitations on liability and involvement are well-defined.
VENDOR AGREEMENTS
Another common approach is traditional vendor agreements. When a bank wants to offer a new service or a technology firm wants to introduce a new capability into the financial services market, they can do so through a traditional vendor agreement between the bank and a service provider.
For example, online banking technology platforms focus on providing robust services to financial institution customers while ensuring the service works well for the bank. The bank and the FinTech firm can define their relationship in a contract. Typically, in such a service agreement, you outline how the service starts, the compensation structure, the termination process, reporting mechanisms, and transition plans to an alternative service provider if needed.
In this contractual relationship, the bank usually takes the lead in providing services and opportunities to its customers, facilitated through an agreement with a third-party service provider. This could involve marketing, technology services, or referral arrangements. Such agreements enable the bank to offer its services and capabilities more effectively to the public, businesses, or consumers.
These arrangements have been around for a long time and can be highly beneficial and well-controlled. One potential disadvantage is that the bank often needs to be heavily involved in administering the program. However, this involvement can also be an advantage because it allows the bank to manage the relationship more effectively and ensure the service meets its standards.
PROGRAM MANAGER ARRENGEMENTS
Another set of relationships we want to discuss is a program manager arrangement, which often appears in payment services. In payment services like credit cards, debit cards, or merchant services, many parties are involved. These include finding customers, providing the payment service, offering the platforms where these services are accessed, clearing funds, and maintaining a payments network for everything to work together.
Typically, you’ll see a payment network involved, a sponsoring institution that ties into the payment network and oversees relationships, a technology firm, and marketing firms. A program manager often steps in to coordinate and manage the process, taking accountability for the various activities. The payment network, sponsor, technology firm, and marketing firm each play distinct roles, although sometimes these roles overlap, with one party holding multiple responsibilities or acting as the program manager.
Because payment networks and these arrangements have existed for a long time, the responsibilities and issues are well-defined and managed. Liability and responsibility can be clearly assigned, ensuring everyone knows their roles. There are also established methods for unwinding these service programs within the payment service framework.
In these arrangements, funds are not always embedded in the service. Often, the service only activates when a payment occurs. If the arrangement fails, payments stop, but customer funds are not typically held in limbo. This predictability is a key advantage, allowing for a more straightforward unwinding of the relationship. There are both advantages and disadvantages to this type of arrangement, but its predictability and established frameworks are significant benefits.
BANKING AS A SERVICE (BaaS) OFFERING
Let’s also discuss banking-as-a-service (BaaS), a topic that’s been in the news quite a lot lately. BaaS can be challenging to define because it means different things to different people. Today, we’ll focus on BaaS involving a financial institution—a regulated depository institution—that collaborates with at least one technology services provider. In this arrangement, the technology services provider primarily manages the customer relationships, handling marketing, technological capabilities, and customer interfaces.
In many cases, it appears that the FinTech provider is delivering the service, not the bank. This dynamic can occur in embedded finance, novel financial products and services, or a suite of financial services embedded in a community. The key issue is that someone other than the bank is taking on many responsibilities that typically fall under the bank’s purview.
This arrangement can lead to several problems. While the bank provides regulated services and maintains a direct contractual relationship with the customer, the relationship is administered by the provider, not the bank. Consequently, the bank may lack transparency and accountability in its relationship with the provider. It might not be able to veto actions taken by the provider or even be aware of them. The bank could struggle to oversee customer relationships and transactions, which could lead to unauthorized activities.
To address these challenges, the bank and the services provider need to establish a robust process for customer onboarding and offboarding, monitoring transactions, and understanding service delivery. The bank holds significant compliance responsibilities, especially in consumer transactions. If another firm handles most of the customer relationship duties, and the bank lacks a backup plan for compliance and customer service issues, it becomes overly dependent on the third party.
When entering such a relationship, it’s crucial to assess the third party’s capability and commitment to compliance. The third party should not launch new services without considering all potential issues. Reconciliation issues and technological capabilities are common concerns. If a bank relies on a third party for ledgering services, customer onboarding, or any technical functions, it must ensure that the provider can handle these tasks.
Errors are inevitable, but the technological capabilities and the system’s testing, maintenance, and monitoring must meet banking standards. Unlike other services, financial services failures often result in significant losses and actionable claims. For example, a consumer unable to access funds might struggle to pay rent or a mortgage, while a business might be unable to pay employees. These errors can cause a ripple effect, leading to further financial issues. Thus, when structuring a relationship where a third party plays a significant role, it’s essential to ensure that the party can deliver the intended services effectively and reliably.
UNWINDING A BaaS RELATIONSHIP
One issue we’re seeing is unwinding these BaaS relationships. Typically, if a bank fails and they have extended loans, they don’t have all their deposits in-house to hand out immediately to everyone who might approach the bank to be paid. The FDIC can step in and make the payment to the depositor, at least to the extent of FDIC insurance. Historically, the FDIC will typically ensure deposits past the FDIC insurance limit. There’s an existing backstop in regulated entities to handle many issues that come with providing financial services.
When dealing with money that’s being transferred, deposited, or lent, there’s almost always an inherent risk of liquidity and funds availability in that system. On the regulatory side, there are systems, checks, and balances to manage those particular risks. If you’re handing that sort of relationship to a third party and haven’t created a similar way to unwind the relationship or transfer it to someone else, you’re going to have a problem. Provisions need to be made to get the deposits back into the hands of the customer if the relationship fails.
It’s essential to track funds held in accounts appropriately so that everyone knows who has which funds. If you have lending, provisions need to be made for servicing. If a party goes away or has problems in service, it can be transferred to another institution, or there’s a way to allow the relationship to finish up. Payment services are typically easier to unwind because payments occur over a finite period, so remaining payments can be unwound.
If you’re going to do a banking service agreement, recognize that it’s more involved than other types of arrangements we discussed above. You need to ensure transparency and accountability, a strong commitment to regulatory compliance, strong technical capability, and exit planning. These are key issues that often crop up. Banking as a Service is not going away, but there is a painful learning curve for some institutions. If you’re looking at relationships with fintechs, they are very doable but need to be handled carefully and prudently.
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.