Who Will Step Away From BaaS?

By: Tyler Brown

AUGUST 20, 2024

Regulatory whiplash in Banking-as-a-Service (BaaS) threatens a business strategy relatively popular among community banks. Most at risk is the deposit-focused model common to the neobank era. Regulators have attempted to address risks common to BaaS amid over a dozen public regulatory enforcement actions on sponsor banks related to their BaaS programs — we’ve seen recent third-party risk guidance for community banks, and as we just covered, a statement on deposit products offered through third parties.

We appear to be on the road to regulatory normalization. But a new status quo could freeze out prospective BaaS banks, push others to unwind their programs, and change the nature of BaaS itself. By classifying nearly any deposits that came from a fintech or other third party as brokered — more expensive than core deposits — the FDIC’s proposed rule on brokered deposits, if finalized in its current form, could cause many sponsor banks to pivot to payment services and lending and make BaaS deposits the domain of super-regional and megabanks.

“The proposed rule would simplify the definition of ‘deposit broker,’ eliminate the ‘exclusive deposit placement arrangement’ exception, and revise the interpretation of the primary purpose exception (PPE) to consider the third party’s intent in placing customer funds at a particular [insured depository institution].” — FDIC

The FDIC’s current rule covering brokered deposits has enabled a crucial aspect of sponsor banks’ relationships with BaaS platforms, which often play a role in the distribution of deposits. As a result, it has also lowered the barrier to entry for sponsor banks. Under today’s regulation, contracts can be written to avoid the “brokered” classification, keeping the costs to a sponsor bank low for holding partners’ deposits. Under a final FDIC rule, exceptions that make those arrangements viable would disappear.

Sponsor banks and technology providers face uncertainty. One key question is: Would the proposal stay intact in revisions? It in effect seems a blunt instrument against BaaS, whose issues haven’t stemmed from brokered deposits per se. Top lapses in BaaS have been related to board governance, third-party risk management, and BSA/AML — and the proposed rule points to “forms of disruption such as the potential or actual insolvency of the third party” and gives Synapse as an example. A second key question is: What judgement calls would the FDIC make about brokered deposits within the narrow bounds of the new rule (what, for example, would happen to prepaid programs)?

Whether or not the FDIC rule goes into effect as written, the trend is clear: Dabbling in BaaS is over. The median size of sponsor banks will likely grow and small sponsor banks will specialize, consolidate, or scale as the costs becomes prohibitive for some. We wrote recently that, at its most basic, BaaS may help a bank gather deposits with a low cost of customer acquisition and earn platform fees, transaction fees, and interest. Much of that may suddenly no longer be the case. Bankers at sponsor banks should ask themselves what exactly the long-term BaaS strategy should look like for their institution, if they choose to continue at all.

Setting Priorities With Third-Party Solutions

AUGUST 22, 2024

By: Tyler Brown

Digital Banking, Onboarding, and Security

A sample of financial institutions (FIs) globally most often picked a unified digital banking platform for retail and small and medium-sized businesses when asked to choose the top solution they would partner with a third-party solution provider for. Security and fraud management and digital account opening came in neck-and-neck for second place. The results were based on responses to the 2024 Retail Banking Trends and Priorities Report.

These survey responses paint a partial picture of the modernization issues FIs face — in the US, outsourcing is common for FIs, but internationally FIs are less likely to do so. The first tactic, often associated with a single- or minimal-vendor approach to technology, leads to single-provider issues: Dealing with technology is relatively easy when it’s dictated by one or a few solution-providers. But a limited, vendor-dependent technology roadmap probably won’t yield the highest-quality options in the face of quickly evolving third-party solutions.

The types of third-party solutions FIs in the US choose points to where they are most likely to value core-agnostic, modern solutions — taking a best-of-breed strategy for the digital experience, customer acquisition, or security, for example. To compete effectively, bankers should keep in mind how other FIs invest in their technology strategies, including the use of third-party solutions:

• In the front office, enabling customer interactions across channels is important to retention and engagement amid a customer migration to digital channels and as mobile-first Gen Zers become customers. Digital account-opening and onboarding are equally important for attracting new customers through digital channels and setting them up for sticky digital services. FIs should use digital banking vendors to build a multichannel experience, ease the administration of digital banking across customer segments, and take advantage of a modern ledger. Better onboarding pushes targeted sales and cost-reduction measures.
• In the back office, better security and fraud-management tools are crucial as attacks become more sophisticated, regulatory demands grow, and tools emerge to satisfy those concerns. Several sets of tasks within this realm are getting more sophisticated, driven by artificial intelligence: Transaction monitoring and AML prevention based on complex patterns; biometric authentication, including “continuous authentication” within banking sessions; and the security and integrity of the FI’s systems to avoid tampering and data breaches. Old or sporadically updated technology in the end won’t meet FIs’ needs.

A robust understanding of third-party solutions and their use in the industry are crucial to effective modernization. As we’ve written, a best of breed strategy sets the foundation for crucial long-term evolution of a bank’s tech stack. But that strategy demands a carefully planned, internally driven innovation strategy. This approach, in which FIs are free to add, remove, or upgrade third-party features and services of their choice, depends on a composable core; middleware that abstracts a legacy core; or extensible “over the top” solutions.