The Green Sheet Online Edition
July 7, 2024 • 24:07:01
Fintech compliance
A successful fintech aspires to arm a technology company with the requisite financial trust to disrupt federally insured banks and investment houses or to provide traditional financial institutions with the requisite technology and agility to outmaneuver a Silicon Valley startup (see t.ly/TAS0f).
But every fintech needs a partner bank. Every card network and ACH transaction has an associated bank sponsor. Only a bank may hold Federal Deposit Insurance Corp. (FDIC)-insured deposits, and unless the fintech holds a money transmitter license, a bank is necessary to pay out the end merchants and customers.
Regardless of the payment processor’s (ISO, ISV, payfac) size—a bank is involved in every transaction.
Nobody cares when a fintech fails. Did any of these carry a headline?
- Beenz.com
- Boo.com
- Wonga
- Powa Technologies
- Clinkle
- Habito
- Monitise
- Earthport
Oh sure, there is the occasional Wirecard, but by and large, fintechs start, take in investor money, and go big or go broke.
Banks, on the other hand, are too systematically important, too big or too socially responsible to fail. When one does fail, there are major implications far beyond the impact on investors. Depositor money is at risk. The ‘I’ in FDIC stands for insurance, which insures deposits up to $250,000. Regulators are called to task and board of director members may be personally liable.
Enter the cronut
Hence the dichotomy between how fintechs and banks view risk. A fintech looks at the upside. If it is successful, it will be worth many multiples of its initial investment. A bank looks at the downside, as its multiple, even when successful, is pedestrian. A bank’s probability for success is many times greater than that of a fintech, but the upside is muted. Consequently, while most fintechs are not directly regulated, many have partnerships with regulated banks, which require their fintech partners to adhere to the same compliance obligations as the banks.
Typically, this is done contractually; however, as I just shared, a bank is financially incentivized to be risk averse while a fintech is financially incentivized to embrace risk. Additionally, fintechs typically have much less capital and ability to absorb catastrophic losses.
This imbalance explains, in part, why, according to Alloy’s 2023 State of Compliance Benchmark Report, 93 percent of FinTechs find it challenging to meet compliance requirements (see t.ly/IqGm5). Even more curious, 55 percent noted that "lack of automation" is one of their biggest barriers to meeting BSA compliance requirements.
The fact that fintechs are struggling with automation, which, at the core, is what fintechs do, belies a deeper issue: they do not prioritize compliance.
What does this all mean?
Bank regulators are coming down hard on banks that are not managing their third-party risk. From a the FDIC's perspective: "Engaging a third party does not diminish or remove a bank’s responsibility to operate in a safe and sound manner and to comply with applicable legal and regulatory requirements, including consumer protection laws and regulations, just as if the bank were to perform the service or activity itself [emphasis added]. A community bank may engage an external party to conduct aspects of its third-party risk management. However, the bank cannot abrogate its responsibility to employ effective risk-management practices, including when using a third party to conduct third-party risk management on behalf of the bank" (see bit.ly/3zbSmga)."
Regulators do not care about the indemnity agreement a bank has with a fintech. To effectively manage third-party risk, banks need to either automate or raise their costs to their third-party partners.
Here’s where opportunity exists. If a fintech can work to align its processes with its partner bank and create a shallow footprint, the bank will be more apt to provide favorable financial terms. Moreover, some of the compliance work could be shifted to the bank—and banks have historically managed compliance better.
What does this look like?
To employ efficient compliance practices, partners should seek banks with existing offerings that are aligned with the near-term road map. If you are intending to make emergency loans funded through original credit transactions (OCT), source a bank that is experienced in both small consumer lending and OCT transactions. For too long, fintechs have sought banks that are willing to support their mission at the lowest cost, without conducting the investigation to understand the impact. Although it will take more time, vetting banks for their ability to assist a fintech in automating its compliance will shave time off every deliverable. Products will be innately less expensive.
Doing so is a process. Fintechs will need to undertake a full evaluation of a bank’s capabilities, security, third-party oversight and technical sophistication, but in doing so, the fintech will end up much further ahead on every subsequent offering.
Note: Please Join me along with fellow panelists, Peter Tapling and Vlad Sadovskiy, and moderator Dave Morris at the Midwest Acquirers Association's annual meeting, in downtown Chicago, July 24 to 25, 2024, as we take a deeper dive in regulatory trends and the impact on revenue. 
As founder of Humboldt Merchant Services, co-founder of Eureka Payments, and a former executive for such payments innovators as WePay, a division of JPMorgan Chase, Ken Musante has experience in all aspects of successful ISO building. He currently provides consulting services and expert witness testimony as founder of Napa Payments and Consulting, www.napapaymentsandconsulting.com. Contact him at kenm@napapaymentsandconsulting.com 707-601-7656 or www.linkedin.com/in/ken-musante-us.
Whether you want to upgrade your POS offerings, find a payment gateway partner, bone up on fintech regs or PCI requirements, find an upcoming trade show, read about faster payments, or discover the latest innovations in merchant acquiring, The Green Sheet is the resource for you. Since 1983, we've helped empower and connect payments professionals, starting with the merchant level salespeople who bring tailored payment acceptance and digital commerce tools, along with a host of other business services to merchants across the globe. The Green Sheet Inc. is also a proud affiliate of Bankcard Life, a premier community that provides industry-leading training and resources for payment professionals.
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