By Ken Musante
Napa Payments and Consulting
A quarter of a century ago, I graduated from Pacific Coast Bankers School, a three-year credential program housed on the campus of the University of Washington. My banking background has served me well within payments and allowed me to successfully navigate both traditional banking and the innovative payments space. I long for embedded banking when BaaS is commonplace. Like most uncharted terrain, it will be difficult trekking.
We have all seen the headlines regarding the Synapse bankruptcy (see bit.ly/3Yq4R0D). Synapse provided APIs for other fintechs to integrate with to provide a customer-facing platform. Synapse had relationships with various FDIC-insured institutions and fintechs, but upon Synapse's bankruptcy, the banks could not access the information needed to confirm the deposits of the end customers. Worse, there is a $65+ million shortfall.
Customers were outraged. Some wrongly presumed their account was FDIC insured. The FDIC made all SVB and First Republic customers whole, surely they should do the same here.
Instead, as a consolation, the FDIC is working to permit future shortfalls by proposing requirements that would strengthen the recordkeeping and reconciliation requirements for custodial accounts so that beneficial owners (or end-customers) could be extended FDIC protection (see bit.ly/3YIJoBB).
If finalized, the rule would substantially alter the oversight, recordkeeping and reconciliation required by banks partnering with fintechs. I have previously discussed the importance of partner pairing, but these new rules amplify that importance (see bit.ly/40nXr0x). The rule would apply to any bank that maintains a deposit account with a FinTech and not just large banks.
The proposed rule does not apply to FBO or For the Benefit Of accounts. These accounts already require sufficient recordkeeping; no change is expected. FBO accounts are where payfacs, ISVs and ISOs maintain their settlement and merchant reserves.
But for entities seeking to enable embedded banking, this will alter the roadmap. Although the rule requires the bank to reconcile and identify each end user's deposit, that work may be done by a fintech, but in that context, additional rules would apply.
The additional rules would require contractual requirements clearly defining roles and responsibilities. I would expect that the final rule would also require some type of escrow database which would allow the bank to take over in the event the fintech became incapacitated. I expect prescriptions for vetting, controls, oversight and audits to be built out as well.
As mentioned, most ISOs, ISVs and payfacs would not be affected if they are only working with a bank for payment processing and maintain merchant monies in an FBO account. Payfacs that have their own money transmitter license and fintechs offering embedded banking through a bank will be impacted.
The proposed rule is an extension of recent attempts to better regulate the controls banks have over third parties. Regulators saw the ease and, in some cases, consequences from the offerings of non-FDIC insured entities through regulated banks and sought to prescribe specifics under which deposit accounts may be offered.
Further, many of the partner banks were smaller, and this proposal is specifically meant to apply to all banks, regardless of size. A bank maintaining accounts on behalf of a fintech would have to submit annual reports to the FDIC which would:
Embedded banking is coming. Unfortunately, not as fast as we would like. On Sept. 16, 2024, Five Star Bank announced plans "…to start winding down its banking-as-a-service offerings. ... The decision comes after an internal review that considered the contribution of banking-as-a-service (BaaS) to the Financial Institutions' core financial results, regulatory expectations and a proposed rule to reclassify BaaS deposits as brokered."
Regulatory oversight is, at times, necessary. I find it interesting, too, that one of the knocks against the card networks is the interchange "tax" and rule structure imposed. Yet those card network rules have long held that all funds, including reserves funds must be held by the acquiring bank.
The only exception is for payfacs that are large enough to obtain a money service business license. Those rules came about because of a similar instance, back in the 90s, when third-party ISOs were serving merchants and handling settlement funds. Unfortunately, those merchants faced the same fate as Synapse's end customers. The ensuing regulation is analogous and unfortunately, equally necessary. 
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.
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