Andreessen-Backed Fintech’s Meltdown Shows Bank Middlemen Risks

Joseph Dominguez and his wife have deposited more than $20,000 with Yotta, a financial technology startup that gamifies savings. Now they can’t touch any of it following the collapse of a separate fintech middleman, Synapse Financial Technologies Inc., in a case that underscores how a popular online banking model can fall through the regulatory cracks.

Synapse, which filed for Chapter 11 bankruptcy protection in April in the US Bankruptcy Court for the Central District of California, operated in a market called “banking as a service.” The company acted as a go-between for banks and their third-party fintech providers, maintaining a ledger of customer deposits and carrying out vital risk-management tasks.

Backed by Andreessen Horowitz and other top Silicon Valley venture capital funds, Synapse partnered with around 100 fintechs servicing a combined 10 million end-user customers, the company said in a bankruptcy filing.

The Synapse collapse is a poster child for holes in the fintech regulatory framework, bankers and consumers say.

Dominguez said he and his wife have account and routing numbers at Evolve Bank & Trust, a Memphis-based lender that was one of four Synapse partner banks. But they have no way to prove that the money they deposited with Yotta—funds that went through Synapse and into accounts at Evolve—was theirs because Synapse controlled the ledger, which has disappeared since the company’s bankruptcy.

The BaaS business model “has been a hard lesson learned that I need to have a more 1-to-1 relationship with a financial institution,” Dominguez, a 28-year-old from Sacramento, Calif., wrote in an email to the bankruptcy court last month.

There’s an estimated $85 million shortfall in customer funds handled by Synapse and its fintech partners, according to a June 7 status report from Jelena McWilliams, a former Federal Deposit Insurance Corp. chairman appointed to serve as Chapter 11 trustee in Synapse’s case.

The FDIC and the Federal Reserve told the bankruptcy court they can’t do much to help customers get their cash because the regulators’ authority is limited to banks.

Synapse’s meltdown is also likely to speed up changes already underway to the banking-as-a-service model, as lenders move away from farming out key functions to fintech intermediaries.

“Banks can’t outsource their responsibilities. Fintechs can’t step in to take on the responsibilities that have been there forever,” said Charles Potts, the chief innovation officer at the Independent Community Bankers of America, a trade group for community banks.

Synapse’s bankruptcy counsel at Levene Neale Bender Yoo & Golubchik LLP didn’t respond to a request for comment.

New Model

Banks have a long history of partnering with technology companies to serve a broader base of customers and expand their reach.

That has included purchasing compliance technology and other tools from core service providers such as Fiserv Inc., Fidelity National Information Services Inc., and Jack Henry & Associates Inc.

Today some intermediary companies such as Unit offer tools specifically tailored to the needs of community banks and their fintech partners. Those businesses operate largely by licensing software, or software as a service, to banks maintaining direct relationships with fintechs.

“The whole reason that this industry exists is the framework of partner banks to tech companies has existed for a very, very long time,” said Itai Damti, a Unit co-founder and the company’s CEO.

Synapse and other companies in the banking-as-a-service sector are different.

Rather than licensing software, BaaS middlemen contract with both the bank and the fintech partner. The BaaS company handles onboarding customers, conducting know-your-customer and anti-money laundering checks, and maintaining a ledger of customer accounts, among other risk-management and compliance functions.

Synapse created “for benefit of” accounts at Evolve and other banks, allowing the lenders to deposit fintech customers’ money into pooled accounts.

The banks were supposed to monitor Synapse for compliance with banking regulations, but the company itself was largely free of regulatory oversight.

In Synapse’s case, the Fed told the bankruptcy court it’s sidelined as customers try to unlock their money because it regulates only banks, not fintechs. The FDIC’s role is even more limited because it doesn’t supervise Evolve—that’s the responsibility of the Fed and state regulators—and the agency’s deposit insurance fund is only available when banks fail, not their fintech partners.

Evolve is in no danger of failing, despite the locked-up Synapse accounts, regulators say.

‘Watershed Moment’

Federal banking regulators, including Fed Vice Chair for Supervision Michael Barr, have warned banks to closely manage their relationships with fintech partners.

The FDIC this month released a consumer alert cautioning Americans about the risks inherent to banking with a nonbank fintech.

The Fed and FDIC have also entered into at least 16 consent orders since last year with banks for failing to properly manage third-party fintech partnerships and “middleware” relationships, including an action targeting Lineage Bank, one of Synapse’s partners.

“There already was a shadow in the sense of the pile of consent orders,” said Jason Mikula, a consultant and author of the Fintech Business Weekly newsletter who’s been tracking the Synapse case closely.

Consumer advocates say the initial enforcement actions weren’t enough.

Synapse’s bankruptcy was the “watershed moment” making clear the BaaS model has to change, said Adam Rust, the director of financial services at the Consumer Federation of America. “You can’t have entities that are doing banking that are completely outside of the bank regulatory perimeter,” he said.

Even before the Synapse calamity, banks were moving away from BaaS and into more licensing agreements with fintechs providing compliance and other software, said

Peter Dugas, executive director at consulting firm Capco and a former Treasury Department official in the George W. Bush administration.

Regulators will expect banks to have much more oversight of the fintechs they partner with, he said.

“Financial institutions have a core responsibility to mitigate third-party risk,” he said.

Higher Costs

Banks taking on more risk functions in-house means higher costs, and potentially less innovation, industry advocates say.

“The cost to deploy a new direct-to-consumer or direct-to-business solution is more costly. It’s inherently more costly,” Potts, of the ICBA, said.

Some community banks are ditching fintech partners as the banks deploy their own tools or license software, despite the steep internal costs, he said.

“What you have seen happening over the last 12 to 24 months are a lot of these good banks unhooking, unwinding, firing some of those fintech relationships,” Potts said.

Banks are rejecting more than 90% of fintech partnership requests, said Michele Alt, a Klaros partner who used to work at the Office of the Comptroller of the Currency.

“Often the fintech is just too small to make it work for the partner bank,” she said. “Or the fintech does not have a level of risk and compliance risk management to meet the partner bank’s requirements.”

Weeding out fintechs that aren’t capable of carrying out BaaS functions may ultimately protect consumers, Rust said.

“Maybe it should be expensive to run a bank,” he said.

‘Not Feeling the Best’

Even as banks and fintechs adjust to Synapse’s failure, the bankruptcy court is struggling to figure out how to get people their locked-up money.

And those people are hurting.

For Yotta customer Harley Johnson, 22, of Myrtle Beach, S.C., the frozen funds mean there isn’t enough money to buy food, pay rent, or keep up with returned-check and late fees piling up.

Johnson’s plans to buy a car are also on hold, the Yotta customer said in an email to the bankruptcy court.

“Right now currently I’m not feeling the best about life and this situation financially,” Johnson said.