Keep up with regulatory evolution in BaaS

Banking as a Service (BaaS) has been a catalyst for growth in the fintech market. Sponsor banks play a critical role in this model, enabling fintechs to offer cutting-edge digital banking services to consumers.

Valued at $15.9 billion by some measures, the BaaS market is on an upward trajectory, with a projected CAGR of 17% from 2024 to 2032. The widespread adoption of BaaS initiatives by sponsoring banks can be attributed to two main factors: the proliferation of fintech companies and a period of regulatory silence to this day.

However, things have changed and the era of regulatory ambiguity is giving way to greater scrutiny of partnerships between banks and fintechs. At the same time, the rise of digital banking has accelerated fraud. Sponsoring banks must adapt to the evolving BaaS landscape to foster successful fintech partnerships in the future.

The changing fintech landscape

With new regulatory pressure, sponsor banks must demonstrate that they have demonstrable oversight of the entire operations of their fintech partners. A key component of this is fraud and compliance with long-standing regulations such as AML, KYC and CDD. Failure to comply with the rules exposes sponsor banks to the risk of sanctions, as demonstrated in 2023, when banks providing BaaS to fintechs represented 13.5% of serious enforcement actions issued by federal banking regulators – an outsized figure compared to the number of banks involved in such partnerships.

It is clear that sponsoring banks need to have greater oversight of their fintech partners. So what’s stopping them from taking more control over compliance and fraud protection?

The move from ad hoc compliance methods to full control has introduced significant hurdles. Sponsor banks will face a combination, if not all, of the common challenges described below in their efforts to align with the new regulatory landscape.

1. Fragmented data sources: Orchestrating data from different sources is a significant challenge for every financial institution. Within the BaaS model, the situation becomes even more complicated, with fintechs managing data collection and fraud management themselves and reporting directly to the sponsoring bank or through third parties. Sponsoring banks are therefore tasked with building a solid infrastructure capable of monitoring risk in real time. Many BaaS solutions rely on too many compliance solutions, fraud prevention tools, and data sources that can’t communicate with each other. This leads to silos and problems in detecting and making fraud decisions in a timely and accurate manner. When data is analyzed separately, anomalies or suspicious patterns may not be immediately apparent. For example, when a fintech sends a fraud report to the sponsoring bank and the bank doesn’t have the resources to interpret it effectively, it creates a vulnerability that fraudsters can quickly exploit. The attack can have negative consequences for customers, tarnish the reputation of the fintech and the sponsoring bank, and could culminate in regulatory fines for the bank.
2. Challenges in managing multiple fintech partnerships: Fintechs are diversifying their risk by partnering with a number of sponsor banks that specialize in specific areas such as deposits, credit, lending or international payments. At the same time, fintechs are prioritizing sponsor banks with robust risk and compliance programs and becoming more selective about which partners they collaborate with. With this change, not only will sponsor banks likely manage multiple fintech partners, but they will also be responsible for safeguarding customer privacy across various platforms. This requires them to separate sensitive information from various fintechs while ensuring that data integrity remains intact. Doing this effectively depends on a delicate balance between innovation, cost efficiency and robust data security, which can be difficult to achieve without detracting from the customer experience. And in today’s fast-paced world, a friction-filled CX can have significant implications, underscoring how important it is for sponsor banks to find this balance.

3. Real-time fraud detection and reporting: Fraud is moving faster than ever with attacks evolving in real time. It is impossible to adapt to new fraudulent attacks with outdated and non-dynamic prevention methods. These legacy solutions have slow, manual review processes that simply cannot keep up with the rapidly evolving nature of today’s fraud. The impact is significant. In 2023, consumers reported a record high 10 billion dollars lost due to scams, $1 billion more than the previous year and the highest losses ever recorded by the FTC. Both sponsoring banks and fintechs must be equipped to detect and respond to fraud real time. Sponsoring banks must prioritize real-time reporting and insights at the individual fintech level and at the aggregate portfolio level to produce real-time business intelligence and compliance and deliver services that meet all regulatory requirements.

A future-proof solution: centralized anti-fraud systems

Between fragmented data and broken lines of communication, emerging fraud and lack of modern infrastructure, all combined with the fact that sponsor banks may manage many fintech partners, sponsor banks are vulnerable to sophisticated fraud attacks that can result in serious regulatory fines.

The solution to these problems lies in effective, real-time data orchestration that can weave together scattered indicators and infinite fraud signals to create a more detailed picture of potential attacks. Sponsoring banks must be able to aggregate a wide range of information from multiple fintech partners effectively, while maintaining the highest data security standards to remain compliant and save valuable time, money and resources in the long run. Leveraging holistic anti-fraud technology that is adaptive, real-time and provides centralized intelligence can provide a future-proof regulatory solution.

Collaboration between sponsoring banks and fintech partners is key

Gone are the days when sponsor banks took a passive approach to fintech partnerships. Looking ahead, the most successful partnerships between sponsoring banks and fintechs will be those that collaborate with data and insights to ensure effective risk and compliance measures are in place.

Ideally, banks are working closely with their fintech partners to implement effective measures that protect customers and the financial ecosystem from evolving fraud. As a baseline, every fintech should have a holistic approach to fraud prevention and regulatory risk that breaks down silos so that all data can be analyzed effectively.

Brenda Banks is Vice President, Banking-as-a-Service (BaaS), for DataVisor.

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