The March 2023 banking crisis will test bank sponsorships.
The current banking crisis, which in significant part has been focused on regional banks catering to fintech companies, is likely to result in increasing regulatory focus on an industry already subject to regulatory scrutiny. For example, the U.S. Department of the Treasury has already recommended that federal financial regulators pursue a more robust regulatory framework for non-bank financial services. The failure of fintech-focused banks will put further pressure on those that remain to increase compliance requirements and reduce risk.
In this client alert, MoFo’s Fintech Team gives tips for fintechs looking to ride out the current crisis while maintaining or diversifying their bank relationships, protecting their customers, and remaining compliant.
Tip #1: Easy Come, Easy Go
Consistent with their own onboarding objectives, fintechs may focus on finding a banking-as-a-service (BaaS) sponsor bank with a streamlined underwriting process and flexible diligence requirements. During good times, this approach may seem like a feature, allowing the fintech to onboard and quickly stand up new products and services. However, in times of financial uncertainty and regulatory scrutiny this may actually be a bug. Be mindful that sponsor banks with the lightest diligence and compliance checklist may run greater risk of regulatory criticism and pressure to terminate programs or suspend new products.
Tip #2: Re-think Consolidation of Sponsor Bank Relationships
In the face of the recent bank failures, it may be tempting to consolidate your banking relationships by moving all, or more, of your operating capital and other financial services relationships to your sponsor bank. By doing so, you risk giving your sponsor bank significant leverage while increasing your concentration risk. For example, sponsor banks often require broad setoff rights not just against the collateral account required under the contract, but also against any account held at the sponsor bank.
Tip #3: Banking Crises Force Regulatory De-risking
In any crisis, regulated entities are expected to examine their operations to identify and mitigate risks. While the current banking crisis was not caused by BaaS or strategic partnerships with fintechs, regulators will undoubtedly be carefully scrutinizing many banks that serve as sponsor banks. We expect that scrutiny will move downstream to fintech partners. You should proactively “get your house in order” and be prepared to promptly respond to sponsor bank requests for information and/or update policies and procedures. The federal banking regulators have released guidance on appropriate due diligence of fintechs.
Tip #4: Ensure Proper Recordkeeping for FBO Accounts
Many fintech-friendly banks offer arrangements under which fintechs are able to request the movement of funds through pooled-funds accounts in the bank’s own name for the benefit of the fintech’s customers (i.e., FBO Accounts). Under these arrangements, the fintech is responsible for keeping accurate records of its customers’ funds maintained in or processed through an FBO Account. If you have an FBO Account arrangement and your sponsor bank closes, you may be expected to report the individual balances in the account and direct the return of those funds to the appropriate customers.
Tip #5: Disclose, Disclose, Disclose, but Be Accurate
Many fintechs with BaaS deposit account relationships with sponsor banks have touted the availability of FDIC-insurance—whether direct or pass-through FDIC insurance—as a customer acquisition tool. Even before the crisis, the FDIC was scrutinizing insurance representations. In the wake of the FDIC’s receiverships, and the public focus on insured and ultimately guaranteed uninsured deposits, this scrutiny will no doubt increase. Fintechs should be aware that any disclosure of the availability of FDIC insurance for deposits held at sponsor banks must be clear, conspicuous, and compliant.
Tip #6: Be Mindful of Sweep Features for Your Programs
If your BaaS program involves a deposit sweep component, your customers should know which banks participate in the sweep program and have the right to opt out of certain banks in the sweep program. You should also be aware of how the sweep program impacts your representations regarding FDIC-insurance. Please reach out to MoFo with questions about sweep programs.
Tip #7: Take Caution with Expanded Offerings
In a banking crisis, fintechs may be inclined to “seize a market opportunity” based on client requests or try to expedite an expansion of product offerings with their sponsor bank (largely due to market slimming because other financial institutions are in financial distress). Taking on a new role or offering expanded services, especially in the fast-paced environment of a crisis, may unintentionally expose you to new compliance, licensing, notice, or other authorization requirements.
Tip #8: Exclusivity Can Limit Scalability
Agreeing to exclusivity with your sponsor bank, particularly in times of increased regulatory scrutiny or if your sponsor bank is undergoing financial stress, can significantly impact the growth and scalability of your BaaS program. Having multiple sponsor banks for your suite of financial products, and the ability to easily transition among your sponsor banks, helps to reduce the risk of growth and scalability concerns. You should consider the commercial impact of non-exclusivity, including whether there are volume discounts or other pricing tiers, as well as the treatment of program deposits as brokered or core.
Tip #9: Require Notice and Remedies for Sponsor Bank Financial Condition
Address potential adverse financial conditions of sponsor banks in your sponsor bank contract. Often times, sponsor banks are singularly focused on ensuring the financial stability of their fintech partners; however, it is equally important for fintechs to have contractual rights tied to the financial condition of its sponsor bank (e.g., bank should be at least adequately capitalized, and bank should provide notice if it fails to be adequately capitalized or of the occurrence of an adverse change in its financial condition).
Tip #10: It Is Critical to Have the Right to Transition to a Successor Sponsor Bank
It is critically important that you have the right to transition your BaaS program to a successor sponsor bank, and you should consider whether that right should be limited to termination scenarios or other events such as a material adverse change in sponsor bank’s financial or regulatory condition. Sponsor banks may try to limit fintechs’ ability to transition their programs to successor banks, both in terms of termination scenarios and timing to transition. But the time and resources invested by fintechs to build BaaS programs and the brand recognition should serve as significant incentive for negotiating strong transition rights.