Banking-as-a-Service Evolves

The verdict is in: the paradigm-shifting Banking-as-a-Service (BaaS) evolution over the past several years is reshaping traditional banking. But in the midst of developments pioneered by many BaaS companies, regulatory and compliance fissures have emerged and expose a cautionary tale: the regulatory mechanism maintained by traditional charter-holders remains brittle. If the charter-holders aren’t technologically savvy, BaaS companies and the brands that leverage them risk violating their clients’ trust. 

In an article in Fintech Business Weekly this past summer, “As regulatory scrutiny of BaaS Grows, Rumors Swirl,” Jason Mikula writes: “With the explosion of consumer fintechs and ‘embedded finance,’ in which many non-financial companies began including bank-like functionality in their apps and products, a new market opportunity emerged: abstracting the complexity of partnering with banks.”

This is all well and good from a financial innovation standpoint, but it has also seeded these fintech grounds with issues that are now rearing their problematic heads, attracting the regulator’s attention. This BaaS evolution has taken place because of the desire of fintechs to innovate and, naturally, to profit handsomely in doing so. But there is a structural problem: many of the charter-holders don’t have the necessary tech know-how and are woefully unprepared for the volumes they are processing from these high-flying fintechs. This relationship is unequal in a key way: It is much harder for a traditional bank to become a technology company, than it is for a tech-centric startup to be on top of regulatory compliance. This dynamic is precisely what’s exposing the risks and blind spots—on both sides—that regulators are now focused on. And the consequence of running afoul with the regulator puts the trust relationship established by fintechs with their clients, at serious risk of fraying, or vanishing entirely.

The technical sophistication and complex processes of these fintechs means that traditional banks don’t have the needed level of visibility into their own accounts. And since they don’t speak tech, these old-school charter-holders are putting their reputations on the line with regulators. 

Commenting on Fed Vice Chair Michael Barr’s talk at Brookings Institution earlier this summer, Acting OCC Comptroller Michael Hsu raised these very pointed—and revealing—questions: How resilient are banking services to stress at fintechs? What happens when fintechs fail? How are bank and business fintech models changing and how are incompatibilities reconciled? Who is responsible for what happens when things break? Such questions are a red-hot stovetop for fintechs and their client banks. As reported in the Fintech Business Weekly article, two such charter-holding banks have already run afoul of just such questions. Blue Ridge and Evolve, which rapidly scaled their fintech client base, have run into “serious issues” with regulators. “The impacts of the increased scrutiny [has seen] many banks slowing or ceasing to onboard new BaaS clients altogether,” the article notes.

These regulatory concerns expose an opening for forward-looking fintech startups to chart a different path entirely by being both a tech company and a charter-holder. Two examples come to mind: Column, and Grasshopper; the former billing itself as “the developer infrastructure bank,” the latter as a “client-first digital bank serving small businesses, startups and investors.” The model that these banks are providing brings the charter-holder fully into the Banking-as-a-Service model. 

What Column and Grasshopper are saying is: From Day Zero, we’re going to own the charter, AND we’re going to build the technology middleware on top of it. For such innovative companies, the entire banking framework—compliance, risk management, financial crime (KYC/AML), payments, customer products, treasury, general ledger, customer products and their UI—is fully aligned with their bespoke, proprietary, cutting-edge technology.

There are analogous opportunities in other regulated areas of financial services, such as investment banking. FINRA-registered broker-dealer platforms that are digitally native from the get-go are able to provide additional services to their investment banker clients that significantly mitigate risks from a regulatory-compliance perspective. 

In the investment banking and broker-dealer space, the industry benefits greatly from charter-holders that truly speak tech. We see this as a tremendously positive development. This is evolving the banking industry and presenting unique opportunities for investment banking regtechs to truly advance the way things are done in it.

Charter-holders provide a fundamental and critical function in enabling innovation and the compression of the banking model by visionary fintech companies. This will always be the case. But those that speak tech with native fluency—and in fact who will themselves BE those very same fintechs—will win out in the long game, getting to redefine the industry from the ground up.