?? What's a brokered deposit anyway?

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Weekly Rant ??

Schrodingers brokered deposit.

Brokered deposits are confusing, and tightening their regulation is being proposed to solve issues like the banking crisis, Synapse, and "novel activities" like Fintech and Crypto.

This won't work.

Instead, it will create an even larger banking crisis as small banks struggle for deposits. Worse, it won't solve the issues we saw with ledgering or 3rd party risk management in the wake of the Synapse collapse. Nor will it solve the treasury management problems SVB and First Republic Bank suffered.

Why?

Let's look at

1. What is a brokered deposit?
2. Why deposit quality matters
3. The FDICs new proposal
4. We’re confusing separate issues
5. Fintech is a 3rd party but with very different incentives to brokers
6. Regulation doesn't have to be adversarial

1. What is a brokered deposit?

Great question.

Because it sort of depends.

On the surface, it sounds simple . Deposit brokers (third parties) often help consumers or businesses find high-yield rates by placing deposits at smaller banks willing to pay a premium for them. So if as a bank, I receive a deposit via one of these brokers, it's a "brokered deposit."

If you're a small bank or a savings and loan company, offer a higher deposit rate to attract customers to your product. Large and well-capitalized banks like JP Morgan or Wells Fargo don't need to fight as hard to attract deposits because they already have plenty.

This leads to a behavior where customers chasing the best rate may regularly switch their deposits between smaller banks. In turn "brokered deposits" can be considered risky because they're less likely to stick around than someone's paycheck.

In the 1980s, smaller savings and loans companies (S&Ls) were uncompetitive. Lenders could not take deposits and lend profitably in a market with high inflation but a cap on interest rates.

One solution was to lift the 5% cap on "brokered deposits."

Deposit brokers earn a commission to find the best rates on certificate of deposit (CD) products. Their incentive is to find more customers and earn more commissions. Their incentive is not to place that deposit in the most sound institution.

Brokered deposits were considered "hot money" (money that moves quickly) and were later cited as a major cause of the savings and loan crisis . More than 260 institutions failed, many of which make the top 10 bank failures of all time list .

Regulation is what happens when something must be done.

In 1989, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). FIRREA established a definition of deposit brokers and restricted banks from receiving brokered deposits if they were less than well-capitalized.

Sounds simple.

But there's a problem.

From '89 all the way through 2020 the FDIC determined that a deposit group was based on a series of interpretations and guidance that they issued … and if you had a question of whether or not your deposits were broker deposits, you had to check against these various opinions," he said.

In 2020, a new rule that 2020 included carve-outs beneficial to third parties partnering with banks was passed. If an organization primarily operated in payments (like a debit card program) or only partnered with one bank (like a debit card program), it got an exception from the brokered deposits rule.

Today, most of the largest Fintech companies, Crypto exchanges, and nonbank embedded finance programs rely on the exception of brokered deposits.

Changing this rule could impact

1. The deposits a bank can attract
2. The ability of Fintech companies to operate at all
3. The ability for new products and services to come to market

Smaller banks especially need a stable source of deposits and embedded finance; Fintech and credible Crypto businesses have proven to be exactly that.

If anything deposits at a Neobank look much more like consumer or commercial deposits than brokered deposits.

So if we change this regulation, we remove oxygen from the banking system.

2. Deposits are Oxygen - This rule would asphyxiate community banks

If you're a bank, deposits are oxygen. Banks can lend, generate income, and grow when they have deposits. When deposits leave, the banks lack the fuel to do business.

The first job of a bank is to remain solvent and ensure they always have enough liquidity. Deposits have historically been seen as the most stable source of liquidity. If a consumer or business parks their monthly operating income with a bank, they can be confident that it will not leave quickly.

If it leaves quickly, they'd have a problem.

• What we saw with the savings and loans crisis was that deposits would leave quickly, making banks insolvent.
• What we saw with Silicon Valley Bank is deposits left quickly, making them insolvent (alongside some treasury issues)

These banks lost their oxygen.

This is especially bad for smaller banks with smaller balance sheets. If you're JP Morgan, a few billion leaving is a rounding error, and you have time to adjust.

If you're a smaller bank, a missing $50 million is a crisis.

As Kunle explains in his piece?the amazing, consolidating US banking system , banks are a dying breed.

Over the past 40 years total US banking assets expanded?> 10x, from ~$2 trillion in 1984 to >$22 trillion in late 2023. During that same period the number of commercial banks in the US has?shrunk from ~14k to ~4k . The number of active bank charters has shrunk from ~18k to around 5k over the same time period.

If you're a regulator, these small banks look risky, but the US banking system is powered by innovation in its private sector. The giant mass-market banks provide stability, the regional banks provide a strong alternative, and the community banks provide specialism.

This dynamic unlocked embedded finance in the US in a way unmatched worldwide (except for perhaps China).

Embedded finance is the fastest-growing sector in Fintech and the single largest opportunity in financial services. It has proven lucrative for the smaller banks that have gotten this right. As I wrote in "Life after the consent orders "

In contrast to most of the industry, a relatively small bank, The Bancorp, announced that in Q4 2023, it delivered 31% revenue growth year over year, 26% return on equity (RoE), and a 41% efficiency ratio. Even if you exclude the rise in interest rates, that's exceptional performance for a small bank a year after the banking crisis.

But if we define everything a Fintech does as a brokered deposit, we risk throwing away the embedded finance opportunity.

We risk pushing more small banks out of business.

This is a rare case where the bank and Fintech lobby agree on the core issue.

Not all 3rd party deposits are brokered.

3. We're confusing separate issues.

Regulation is what happens when something must be done. Something must be done in the wake of SVB, Signature, Silvergate, Synapse, and other S words.

But we're confusing a lot of separate issues in the process.

If you look at the root cause of risk in each scenario, they're different. Some may overlap a little on a Venn diagram, but not much.

• Saftey and soundness in the wake of the banking crisis
• The Synapse shit show
• Brokered deposits

The FDIC has issued an RFI on Deposits to find better solutions for safety and soundness. The world has changed since the 1980s; we now have real-time payments and much more consumer choice, and with the new CFPB 1033 rule, we may allow consumer account portability. This means all money is becoming hot money.

It makes sense that, as an industry, we'd classify different risk-weighted deposits (liabilities), just as banks have to classify risk-weighted assets (loans) today . (h/t) Alexandra Steinberg Barrage for this suggestion.

The FDIC, OCC, and Fed have issued an RFI on bank-to-Fintech relationships to understand better solutions than the lingering mess we saw with Synapse and Evolve.

As an industry, ensure we have clear standards on where transactions are ledger, how BSA AML data is shared and monitored, and how resiliency is overseen.

If this were all it would make sense.

4. The FDIC Proposal doesn't address the issues

My gut reaction to the FDIC proposal on brokered deposits was

Let's Copy and paste 1980s regulation into 2024. This will make smaller banks less safe and sound while not solving any of the real challenges we see with bank ledgers or novel activities.

The reality is that it would repeal a 2020 ruling that dropped the cap on brokered deposits from 25% to 10% for "less well-capitalized banks" (the larger banks remain unimpacted by this rule).

So why are we classifying all Fintech deposits as brokered deposits?

That's a really great question. Sometimes, the ready-made solution is tempting, especially when agencies with long memories from the Savings and Loan crisis are involved. When that rule was repealed the dissenting voice in the room was the current FDIC chair .

But this isn't a solution.

It's like trying to eat a soup with a fork.

Futile and painful to watch.

5. Fintech is a 3rd party, but the incentives are different

If a deposit broker brings a bank a deposit, their incentive is to move it as quickly as possible. Brokers make money when banks pay them to attract the brokered deposit. More transactions create more revenue. Given that they're brokers, they can't ruin the relationships with their bank clients by moving deposits too fast, but the service is designed to chase the highest rate in the market.

If a Fintech company brings a bank a deposit, its incentive is to keep it there as long as possible. Chime, Cash App, Robinhood, et al. want to hold on to consumer deposits for as long as possible. Fintech companies have benefitted dramatically from a share of deposit yield in this interest rate environment.

This is not the same risk; therefore, it cannot possibly require the same regulation. A Fintech deposit is not, by definition, brokered because the party brought it to a bank. It's brokered if a broker brought it to the bank. Now, unquestionably, Fintech companies do look to partner with banks that offer higher yields, but bank-to-Fintech partnerships are nontrivial.

"Novel" is not the same as bad. During the pandemic, digital-only services offered by Fintech companies saved consumers and businesses. SBA loans were available in days because banks could partner with Fintech companies. Yes, the Synapse / Evolve mess is categorically bad for consumers and has a bad outcome. But let's keep this in context.

Banks remain the most heavily fined category of company in the world for failures. Banks are the most fined, highest impact, and highest consumer harm businesses operating in financial services. That is primarily because they also domainte market share. They're subject to regulation, have been fined BILLIONS, and things are still going wrong.

It's not Fintech that's wrong.

The market is moving faster, and digital technology has created a runaway freight train of new innovations in financial services. That's mostly good, but regulation has to adapt. Not by looking back, not by applying 20th-century solutions to 21st-century problems.

But by engaging.

6. Regulation doesn't have to be adversarial.

Does it every strike you as odd that the companies with the most regular contact with regulators are those with the most fines?

Regulation by enforcement doesn't have to be the answer. Intentionally making a rule damaging to a business to result in an inevitable court case, in turn forcing regulation by enforcement, is just daft.

This is a curse on all sides.

Jamie Dimon, Jane Fraser, and Charles Schaf have spent plenty of time with senior policy and regulators in the past 12 months. Has your unicorn's CEO?

Until recently, Fintech has been quite bad at engaging with Washington. I can name companies with $xxBn valuations that don't have a Government Relations person or team. There are exceptions to this rule (e.g., John Pitts at Plaid, folks like Klaros, AIR, The FTA, AFC, FS Vector, et al).

But it's time for Fintech to put on its big girl pants.

The 1033 ruling is one example of how Fintech got it right. Direct, persistent, multi-year engagement is how you get thoughtful regulation.

Regulation will always happen when something must be done.

Your job isn't to complain about how mean regulators are. They have a job to do (even if sometimes the easiest thing is to copy + paste or regulate by enforcement).

There is no downside to engagement.

It's not always easy.

But nothing worthwhile ever is.

ST.

4 Fintech Companies ??

1. Revenir - Automated tax recovery for travelers (UK)

Revenir helps travelers or businesses reclaim any VAT (sales tax) when for travelers or businesses who may have been exempt. Revnir offers an API for banks and Fintech companies to automate this feature for their customers. Travelers' VAT reclaim works automagically. A user can be notified 48 hours after a purchase that they've received the 20% sales tax refund.

?? This is really cool, I hope they expand from here. When UK citizens travel, they can get their VAT back on items they purchased in Europe. However, the manual process to reclaim is often only available at airports, leading to more than 80% going unclaimed. I want this so much that I will spam everyone I know at UK Neobanks and banks about it. My only worry is the company was founded in 2019 and recently re-branded. I wonder if this is actually possible or just mooted?

2. GeoWealth - Asset management for RIAs

Geowealth is an asset management platform for Registered Investment Advisors (RIAs). The product provides a platform for advisors to manage client relationships and portfolios and supports this with a client portal and app. The company also offers portfolio solutions, allowing the RIAs to build and manage more custom client portfolios.

?? As Gen X and Millenials age into wealth management, they expect a default digital service. The long tail of RIAs benefits from being able to manage that in a white-label way. Interestingly, Blackrock led this round, suggesting they see value in helping distribute more of their products by enabling the RIAs to be more efficient.

3. Walnut - Embedded insurance for Canada

Walnut allows platforms to enroll its customers in almost any insurance product. Platforms can add device protection or product warranties directly into checkout or commerce experiences. Lenders can also package loan insurance directly in their journey (e.g., balance protection or mortgage payment protection).

?? Embedded insurance has most of its growth ahead of it. The largest global e-commerce or Fintech companies have largely done this product, but there's a mid-market opportunity. Anything that can be embedded will be.

4. Punch Trade - Robinhood for India's Gen Z

Punch allows users to trade stocks, indexes, and options in NSI and BSI-registered securities. The mobile-only experience advertises the ability to trade options with "one-click protection," which translates to suggested stop losses.

?? I like its target generation, home market size, and default downside protection experience. Defaults are powerful. Most users want to reduce the friction to complete a trade rather than agonizing over how to position it. Baking that into the trade is smart design. The founders had a successful charting app, and India's Fintech darling Cred's founders have invested. This will be one to watch.

Things to know ??

1. Apple makes NFC available to all developers for a fee

Apple announced that it will make Tap-to-Pay available to all developers via its iPhone on iOS 18.1 in the UK and the US. Brazil, Canada, Australia, and Japan will follow shortly. This is significant because today only Apple's proprietary Apple Pay and Apple Wallet can access the on-device NFC chip that makes Tap to Pay available. Developers will have to sign an agreement with Apple and pay "associated fees" that have yet to be announced.

?? This unlocks incredible experiences and opportunities for Neobanks and Wallets. If you're Venmo, CashApp or Chime, you can now enable in store payments through your wallet.

?? We will see an explosion in apps and wallets that want to offer tap-to-pay. Apple Pay has a phenomenal lead for tap-to-pay in-store payments in the US, which will be hard to catch.

?? Heads Apple wins, Tails you lose. Regulators were going to force Apple to do this anyway. By opening up to the market, but keeping a take rate, Apple gets to monetize everyone just like they did with the app store.

?? Let the wallet wars begin. The future is wallets that hold your identity, loyalty, and payment instruments that work via any rail. Apple is in prime position, but they're not the only game in town. What's your wallet strategy?

2. RIP Tally - The Fintech that helped consumers with debt

Tally, a company that helps consumers out of problem debt, is shutting down after running out of cash. Despite raising more than $172m (of which $80m was in 2022) and reaching a peak valuation of $855m, they could not secure further funding to continue operations. Founded in 2015, the company helped consumers consolidate credit cards into a single lower-cost loan. After attempts to pivot to B2B failed, the company has now had to shut its doors.

?? Tally was always a company you could point to to say, "Here's why Fintech is good for consumers." Unfortunately, companies have to be economically viable to survive. While they may be gone as a business, they are not forgotten.

?? Thankfully, dozens of others are inspired by Tally taking the challenge to serve this segment. From giants like Chime and CashApp to the entire Earned Wage Access category, there is now active competition to help low-income populations improve their finances sustainably and ethically.

?? Building a sustainable lending business in debt consolidation is incredibly hard. The risk is high per customer, and the reward is often low. To be an ethical lender, you must balance pricing a loan to be a profitable business while ensuring you don't make the borrowers life harder. This means operating on razor-thin margins, something that technology helps with but doesn't solve entirely.

?? A lot of mission-driven talent with experience in the low-income segment just became available. Any Fintech or nonbank with a high user population in this segment should fight to get these folks. The word "community" gets thrown around, but Fintech really has one. Do your thing.

Good Reads ??

1. The FDIC approach to Brokered Deposits is Outdated

The industry is reacting poorly to the FDIC's proposal to widen the definition of "brokered deposits." This would remove the ability of nonbanks to apply for exceptions, which would put more work on the smaller banks desperately seeking liquidity as smaller and regional banks continue to be squeezed.

That's all, folks. ??

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(1) All content and views expressed here are the authors' personal opinions and do not reflect the views of any of their employers or employees.

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