Managing New Recordkeeping Risks

By: Tyler Brown

OCTOBER 1, 2024

As events over the past six months remind us, regulation that covers Banking-as-a-Service (BaaS) sits in a gray area. Sponsor banks per se are well-regulated. But by and large, nonbank partners are not. That makes the bank ultimately and often solely responsible for compliance violations. When something breaks without the right controls, the bank is left holding the bag. It may not be equipped to handle the situation. The risk grows as third-party partners multiply.

A rule just proposed by the FDIC addresses some of that risk. A common arrangement in BaaS partnerships is for FBO accounts to hold deposits of multiple beneficial owners, in which a beneficial owner may initiate a transaction to someone else. A failure is when those funds “disappear” because of poor recordkeeping by one or more entities — a BaaS platform, partner bank, or a third party that owns end customers. The idea behind the proposed rule is that a licensed bank, as the regulated entity, is responsible for accurately keeping track of funds held in these accounts on its own ledger. If an entity fails, funds can be accurately distributed to customers.

“FDIC believes these circumstances [surrounding Synapse] have raised concerns about the accuracy and integrity of [account] records. These circumstances also raise questions about the completeness, accuracy, and integrity of custodial deposit account records for other [insured depository institutions’] arrangements with third parties to deliver deposit products and services.” — FDIC

If a third party fails and makes it impossible to reconcile funds with depositors, a problem with similar ramifications to a bank failure emerges — customers can’t access their funds. The crux of the problem is that recordkeeping and reconciliation for deposits and payments in pooled FBO accounts are not as easy as they sound. Each party’s records must be accurate and match up. When they don’t match up, there must be a source of truth to fall back on. That source of truth should come from the regulated entity (recordkeeping for accounts offered directly to customers are for the most part covered by preexisting regulation).

The “trust the third party” approach to partnerships is a liability (we’ve written about it in the context of enforcement actions). A third party’s operational failures are ultimately a partner bank’s problem and must be backstopped by that bank. This is particularly important for banks that want to be in the BaaS space.

What’s there for the partner bank to maintain, according to the proposed rule? Briefly, the account balance attributed to each beneficial owner, the ownership category in which the deposited funds are held, and other records maintained by the bank (if certain additional requirements are satisfied, a partner could also do it). We’ve argued before that sponsor banks must appreciate the complexity of third-party relationships — maintaining records well is just one more responsibility.

Prioritizing Products at Community Banks

OCTOBER 3, 2024

By: Tyler Brown

Deposits and Loans

Over 62% of respondents to a Conference of State Bank Supervisors study said that a community bank was its primary competitor for small-business loans, the highest proportion of any product reported in the results. Commercial real estate loans (CRE) ranked second, followed by?agricultural loans and?transaction deposits. In fact, at least a plurality of respondents saw a community bank as the primary competitor for all products except for payment services and wealth management/retirement services.

Respondents’ selections aren’t surprising, given the local focus and the distribution of services a typical community bank would offer. Community banks originate a disproportionate amount of loans to small businesses, as we’ve noted, and on average hold a relatively large volume of CRE loans. A community bank may be the most qualified or only bank to make agricultural loans. On the other hand, wealth management and retirement services are probably offered by a brokerage firm or a big bank and less of a concern for a community bank whose expertise focuses on deposits and lending.

Competition against community banks is more intense when it includes national financial institutions, digital-only banks, and nonbanks that sell most of their products and services online. In the survey, the largest perceived primary nonbank out-of-market competitors were for payments services (27% of respondents) — most likely, consumer payments apps (e.g., Cash App, Venmo) that compete directly with Zelle or pose a threat to legacy consumer payments methods — and mortgages from nonbanks with a large online presence (18%, e.g., Rocket Mortgage).

Key challenges for community banks then, suggested by the data, are to compete effectively with peers and larger in-market banks and adjust to the threat from some digital-first and digitally native players. How they do it is unique to their business strategy, and it should probably include their approach to channels. As we’ve covered, to compete successfully for customers, updating and integrating digital and physical banking is an imperative.

Big questions community bankers should revisit are: Faced with bigger rivals with large digital operations and fintechs with national offerings, how do I go from my current state — perhaps with a branch-focused approach to customer acquisition and servicing, dated technology, processes designed for local banking services, and siloed channels — to modern systems and operations? What products and services will generate loyal customers for the stickiest, most profitable offerings while I navigate head-to-head competition among peers? But maybe the most important question to ask is: What about my strategy anticipates the future?