Banking as a service has steep risks as well as rewards

Banking-as-a-service is the fastest growing division at Evolve Bank & Trust in Jonesboro, Arkansas. Kristen Kines, business development officer at the $777.7 million-asset institution, says there is no shortage of use cases for potential customers, from consumer fintechs to card issuers to companies that provide disbursements.

This growth in BaaS is happening around the world. According to a 2021 report by Allied Market Research, the global banking-as-a-service market generated $2.41 billion in 2020. It is predicted to hit $11.34 billion by 2030.

“This fintech evolution is taking clients away from you,” said Mike Butler, CEO of Grasshopper Bank (center), during a panel discussion at American Banker’s Digital Banking Conference. “The digital demand from your clients is real and you want to find a way to participate.”

At a Tuesday panel at American Banker’s Digital Banking conference, panelists including Kines and Mike Butler, CEO of the all-digital Grasshopper Bank in New York City, detailed the importance of engaging with fintechs who want to provide banking services to their customers, but need the help of a chartered bank. 

“This fintech evolution is taking clients away from you,” said Butler. “The digital demand from your clients is real and you want to find a way to participate.”

But fraud and compliance are substantial concerns for financial institutions like Evolve and Grasshopper that support the banking aspirations of fintechs by providing a charter and underlying services.

“Half of my calls are legal meetings talking through this stuff,” said Kines.

One concern is that fintech clients have the correct controls in place to ensure proper customer service, compliance and Bank Secrecy Act and anti money laundering checks that will keep fraud at bay. Evolve tries to head off such problems by being proactive. 

“What is their ongoing strategy? What are their future marketing campaigns? When these guys are rolling out new things like cashback rewards or advertising to end consumers a new [annual percentage yield], we need to make sure everyone is on the same page and all the language represents the true construct of the relationship from a disclosures and legal, regulatory and compliance stance,” said Kines. 

The bank will examine the financial health of prospective fintech partners and how much money they have raised. It will forecast their burn rate and runway, and for fintechs that deal with lending or credit card issuing, whether they have a warehouse line and with whom.

Grasshopper considers its fintech clients subsidiaries of its business. “They have to think the same way and have the same mission,” said Butler. “Is the business plan real and viable and funded by great companies committed to them?”

If a fintech chooses to handle fraud itself, the $304.6 million-asset bank can conduct audits and request certain reports. With FBO, or For Benefit Of accounts, Grasshopper is responsible for fraud and underwriting. 

“We like that best because we use our methods,” said Butler.

Grasshopper is selective about which account applications it accepts. Butler says the bank’s approval rate is 40% for direct to business customers. The other 60% are declined either because of fraud or because of poor performance. It holds high standards for its fintech partners as well. Grasshopper cut ties with one client after noticing rampant fraud resulting from the company seeking inappropriate clients.

“From a brand perspective we were burdened by too much negative activity,” said Butler. “It was important for us to protect our brand.” 

Amit Parikh, the executive vice-president of banking platform services at Green Dot in Pasadena, California, noted that advances in technology are changing how easily banks can protect their customers and how fraudsters will have to adapt. For example, Apple and Google are beginning to allow government identification, such as driver’s licenses, to be stored in their digital wallets. “It’s more secure but an evolution. Fraudsters will figure out a way but there are signals from the device and that provisioning event that will make it more secure,” he said. 

Kines is encouraged by Mastercard’s work with biometrics and facial recognition in digital payments. “It’s nothing we are doing yet but being able to validate who your customer is when using facial biometrics is very interesting,” she said.

On a separate Digital Banking panel on Tuesday, Allan Rayson, chief innovation officer and chief technology officer at Encore Bank, which is headquartered in Little Rock, Arkansas, noted that Encore is in the early stages of a BaaS strategy. The goal is to increase core deposits and non-interest revenue, likely by focusing on commercially minded fintechs as partners. 

He pointed out another problem BaaS providers sometimes encounter: exponential growth.

“We’re $2.3 billion of assets, so we are well under the $10 billion threshold, but we are seeing banks bumping up against those thresholds and trying to manage that upside risk on the deposit side,” he said.

Finally, banks aren’t the only ones doing due diligence on their prospective partners, according to another participant on that panel. Mitchell Lee, the chief risk officer at Synctera, a company that builds fintech apps, says that his clients are asking questions about their prospective bank partner’s regulatory situation.

“Fintechs want to know who the bank is,” said Lee.

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