When it comes to fintech, technology often overshadows the financial underpinnings. While there have been significant innovations in recent years, losing sight of these core financial fundamentals can have dramatic impacts on financial institutions—as evidenced by the recent failure of fintech company Synapse.
In his latest report, Banking-as-a-Service and Self-Inflicted Wounds, James Wester, Co-Head of Payments at Javelin Strategy & Research, examined the lessons learned from the Synapse collapse and its ramifications on the banking-as-a-service business model.
Under the Microscope
Fintech companies may operate under a financial institution’s banking license, but their mindset often differs from that of traditional banks. Many tech providers ascribe to the “move fast and break things” ethos, where speed and innovation are prioritized over risk management and compliance.
This philosophy does not align with financial services, where risk mitigation is a central tenet. Financial institutions have no margin for error—failure to meet customers expectations can lead to substantial repercussions.
The ramifications are more extensive when failures impact vulnerable segments of the population. These consumers, increasingly served by fintech companies offering lower-cost financial services, are particularly at risk.
Underserved markets have been overlooked by traditional banks because they are generally less profitable. In many cases, these markets include lower-income consumers who are mostly looking for a way to participate in the growing digital economy and manage essential tasks like paying bills online.
For consumers in these markets, losing access to their finances due to a dispute between a bank and its partners can be devastating. Therefore, financial institutions have an ethical obligation to vet their vendors and ensure that underserved customers receive a product that is reliable, relatable, and affordable.
“Ethical considerations aside, if a bank fails vulnerable consumers who aren’t equipped to weather a financial hardship, regulators are going to intervene,” Wester said. “Synapse is a prime example—they were trying to deliver financial services to an underserved population that is now out a substantial amount of money. It was completely avoidable, had they paid more attention to risk and compliance, and now the whole BaaS model is under the microscope.”
The Synapse Collapse
After the 2008 financial crisis, technology-driven financial services providers like PayPal proliferated rapidly. These platforms formed a digital front-end layer, handling operations outside the traditional banks’ reach, like peer-to-peer payments. As fintechs took on more financial functions, BaaS came to fruition.
For smaller banks looking to expand their footprint and compete on a national scale, partnerships with fintechs became a natural fit. This was one of the reasons that Evolve Bank and Trust chose to partner with Synapse.
Beyond extending their reach, Synapse convinced Evolve that it would take on the lion’s share of the bank’s financial services, including maintaining the ledger and managing customers’ debits and credits.
Unfortunately, Synapse did not hold up its end of the bargain. After losing one of its most lucrative customers, the company faced immense financial pressures that forced its eventual bankruptcy. It was later revealed that Synapse had not maintained the ledger for Evolve customers and instead commingled those funds into For Benefit Of (FBO) accounts.
The FBO accounts contained much less than what was in Synapse’s records—roughly $85 million less—fueling speculation that Synapse may have used Evolve customers’ funds to keep itself afloat.
For the bank’s customers, Synapse’s bankruptcy made it difficult to determine which funds in the FBO accounts belonged to which customer. In addition, the FDIC does not insure FBO accounts because it requires a customer’s funds to be held in an account under the customer’s name.
A Regulatory Reset
The Synapse failure drew the ire of lawmakers, and a group of U.S. senators said it exposed a “glaring weakness” in the banking-as-a-service model. Legislators have also called for Synapse’s partners to return the millions in frozen funds to their customers.
This heightened regulatory scrutiny is expected to prompt a reevaluation of the BaaS business model. Banks will need to place a much higher priority on risk and compliance, service-level agreements, and contract language when entering into partnerships.
“We created these words like neobank, digital-only bank, and fintech bank, but they are really just pass-throughs for various banking aspects,” Wester said. “We added an entire layer of technology and technologists, oftentimes without considering compliance. However, a bank is a real thing. It is a licensed institution that is regulated, and fundamentals like risk mitigation and ledger management should never fall by the wayside.”
“What happened with Synapse should not have happened,” he said. “It should never have escalated to that level because compliance should be baked into any financial services product. Unfortunately, in this case it was not, and there are many innocent victims. Now, regulators will respond in kind.”
