(Bloomberg) — Over the past decade, dozens of financial technology companies have linked up with small and midsize banks across the country. The idea: The fintechs would create smart smartphone apps and offer new, useful services to lure customers, and the banks would hold onto the deposits, generating lucrative transaction fees. Notably, the deal allowed the fintechs to push for protection from the Federal Deposit Insurance Corp.

But now, as millions of dollars in deposits remain frozen months after the collapse of a company called Synapse Financial Technologies, that supposed FDIC protection has become clearer. And those partnerships are facing tough questions.

The reason customer deposits are on hold is because Synapse was terrible at keeping records. The company acted as a middleman between fintech apps, including Yotta and Juno, and their banking partners. When Synapse went bankrupt in April, it left behind a tangled mess: Synapse’s trustee said it was hard to make sense of its records, as the trustee was trying to resolve a $96 million deficit in its accounts.

However, the banks that were supposed to hold the deposits did not fail, so the FDIC insurance did not kick in. That raised concerns for consumers who bank through fintechs. How is a depositor using third-party apps supposed to determine whether their money is safe? “The short answer is: It depends,” the agency said in a bulletin issued in May. Its insurance covers the bank but not a fintech’s insolvency.

Nonetheless, banking regulators are taking notice and focusing their ire on banks. “To the extent that banks are partnering with fintech partners, they have a responsibility to manage risk,” Michael Barr, vice chairman of the U.S. Federal Reserve for supervision, said in a July 9 speech in Washington. “Unfortunately, we have seen examples of banks failing to effectively manage the risks of partnerships with other firms that support services to their end customers, and those failures have resulted in customer harm.”

At a Senate hearing the same day, Fed Chair Jerome Powell told Ohio Democrat Sherrod Brown that he oversees the banks but not Synapse. The conversation focused on Arkansas-based Evolve Bank & Trust, which had been one of the banks Synapse had worked with. “We are strongly encouraging Evolve to do everything we can to help make money available to those depositors,” Powell said. He noted that the Fed has hit Evolve with an enforcement action related to its risk management.

Evolve says it began winding down its business with Synapse in late 2023, and that some fintech end-user balances were transferred from Evolve to a different program run by Synapse. Evolve says it is still temporarily involved in payment processing and has withheld some end-user funds as a result. It also says only a small number of fintechs it works with were affected by Synapse’s failure, and that it is working with the trustee, other banks, and fintechs to resolve the issue.

Juno and Yotta aren’t much like traditional banks. Juno is aimed at cryptocurrency traders. Yotta, co-founded by Adam Moelis, son of billionaire investment banker Ken Moelis, makes savings a game by entering depositors into a lottery. But the fintechs’ troubles have shaken a basic assumption about any banking product: that once customers see the “FDIC” label, they can stop thinking about the safety of their money. And it’s exposed a weakness in the broader fintech banking model, industry observers say. “You realize this is something that’s actually a lot more fragile than it appears and it’s based on an area that very few people are really paying attention to,” says Hans Morris, a managing partner at Nyca Partners, a fintech venture capital firm.

Fintechs are awash with venture capital being pumped into banking with the promise of revolutionizing savings, with low or no fees and easy access. Big banks often have high fees and minimum balances that disproportionately affect younger, less wealthy people and have historically underserved segments of the population. But fintech entrepreneurs could also exploit a regulatory loophole: Smaller banks are allowed to charge merchants higher fees than big banks to process debit cards. That has allowed fintechs to work with those smaller banks to make money by splitting card fees. “It makes sense for small businesses and consumers to go with fintechs, because it helps improve the banking experience when it works,” says Todd Phillips, a professor of financial regulation at Georgia State University. “And when it fails, it fails catastrophically.”

Until Synapse, there wasn’t much focus on how to clean up after a fintech goes bust. Lawyers who advise fintechs say that needs to change. “Banks need to think not just about marriage, but also about divorce,” says John Geiringer, a partner at Barack Ferrazzano Kirschbaum & Nagelberg.

Synapse’s collapse is just one corner of a much broader industry. Among the most successful fintechs is Chime, which is preparing for an initial public offering and was valued at $25 billion in 2021, the height of the fintech frenzy. Chime stores its customers’ deposits at South Dakota-based Bancorp Bank and Oklahoma-based Stride Bank. Unlike the firms that have worked with Synapse, Chime says it has a direct relationship with its banks. “Chime’s model is the gold standard in digital banking: Customer funds are held in FDIC-insured accounts at OCC-regulated banks, with no middleware vendor separating people from their money,” says Mark Troughton, Chime’s chief operating officer. The OCC, or Office of the Comptroller of the Currency, is another U.S. banking regulator.

Current, a mobile banking fintech that caters to users who want to build their credit, changed the fine print on its homepage in May to more clearly remind consumers that they are not dealing directly with a bank, although their money is sent to FDIC-backed Cross River Bank and Choice Financial Group. Current says it has a direct relationship with those banks. Current changed the language in anticipation of an FDIC rule requiring fintechs to be more transparent. That rule won’t go into effect until January.

Some fintechs have chosen to become fully FDIC-covered banks. LendingClub Corp. and SoFi Technologies Inc. have entered the banking industry by acquiring existing institutions. But being a bank also comes with more regulation and oversight, and the Biden administration has been seen as taking a tougher regulatory approach. Applications for new charters have been on hold. “The inconsistency of this city has led to the growth of this ecosystem and the problems that come with it,” says Isaac Boltansky, Washington-based director of policy research at the investment banking and trading firm BTIG LLC.

For now, much of the burden of assessing the risk of fintech-bank partnerships falls on consumers. “It’s a real failure of public policy to expect consumers to understand the nuances of FDIC insurance,” says GSU’s Phillips.

©2024 Bloomberg L.P.

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