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Regulatory scrutiny of the bank-fintech relationship
intensified last spring after middleware provider Synapse collapsed, leaving thousands of online customers’ deposits in the lurch.

Last summer, federal banking agencies released an
interagency statement providing guidance for banks working with third parties
on deposit products, as well as a request for information related to the
bank-fintech relationship. In September, the Federal Deposit Insurance
Corporation (FDIC) proposed new recordkeeping rules for banks that take
deposits from fintech customers.

Several consent orders against banks concerning their partnerships with fintechs followed. In the first half
of 2024 alone, over a quarter of the FDIC’s enforcement actions were found to
have targeted bank sponsors involved in embedded finance partnerships.

Though the bank-fintech honeymoon may be over, it’s less
certain what will come next. Lumping all fintech providers together and placing
additional burdens on the smaller lenders that disproportionately rely on their
services isn’t the answer. Done wisely, fewer—and more effective—regulatory
bodies and rules would make for a more innovation-friendly environment.

Though much remains to be seen, this year may offer
something of a clean slate following the flurry of activity in 2024—presenting
an opportunity to develop smarter policies moving forward.

A New ‘Regulation-Lite’ Framework is Needed

2024 saw plenty of promising bank-fintech regulatory
developments. But we also witnessed overregulation and indiscriminate
application of rules that sowed further uncertainty.

Community banks, in particular, have suffered in the aftermath of Synapse’s failure, as regulatory bodies threatened to paint every institution with the same brush regarding their third-party partnerships.
At the same time, some FDIC field examiners have been interpreting rules
differently depending on the examination in question.

Before advancing any additional regulation, it’s critical that regulators focus their efforts on the real culprit rather than
placing all fintech-bank partnerships in the same bucket. In other words,
deposit-oriented solutions—and related consumer protection and money laundering
risks—should be prioritized, given the complexity of ongoing reconciliations and
the potential fallout for consumers (e.g., with Synapse).

Other functions, like
digital loan participation platforms, should be treated differently, as they
represent a healthy model of strong bank-fintech governance and partnership.

Once they’ve homed in, regulators should consider a
“regulation-lite” framework that encourages ongoing innovation and
collaboration while ensuring both parties meet appropriate standards. This
could take the form of a relatively simple checklist for both parties that
factors in relevant questions, such as:

Best Industry Practices

Several organizations offer useful blueprints for others to
follow. Banking-as-a-service vendor Treasury Prime fully integrates its ledgers
with its client banks’ core systems and holds its application programing
interface’s underlying code in escrow—so if the company went offline, banks
would still have access to the fintech’s database and could continue leveraging
its API.

Similarly, Chime Financial designs its relationships with banks to
protect its customers in case of failure.

“Not only does each of our partner banks have complete
access to the relevant ledger, they also each have full visibility into Chime’s
financial performance, enabling them to plan for and anticipate potential
disruptions,” Chime said in response to the federal agencies’ RFI last
year. “Consequently, our members would be protected in the event of an
operational disruption.”

On the bank front, a recent report from law firm Troutman
Pepper suggests that compliance teams should focus on “ledgering hygiene” that
requires fintech firms to have separate accounts that “more clearly delineate funds
for customers, operations, payment fees to third parties, contingency reserves,
and network settlement.”

More Collaboration Equals More Innovation

Fortunately, last year’s tumult stimulated more cooperation
and information sharing. This is a positive indicator of where the bank-fintech
relationship could be heading.

For instance, since launching in the fall of 2024, the Coalition for Financial Ecosystem Standards has worked among its members and alongside regulators to develop standards for third-party relationships.

Yet more can be done. As I’ve previously argued, bringing
back regulatory sandboxes in this area would allow fintech to gain needed experience in the banking world while fostering continued innovation in a
safe, monitored, and risk-averse manner.

Though there may be more twists and turns ahead, banks and
fintechs need each other more than ever. A regulation-lite framework that
fosters innovation, transparency, and proactive engagement among key
stakeholders can help both parties reach their full potential.

This article was written by Kelly Brown at www.financemagnates.com.

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