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

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

Supported from Andreessen Horowitz and other major Silicon Valley venture capital funds, Synapse has partnered with about 100 fintechs serving a total of 10 million end customers, the company said in a bankruptcy filing.

Synapse’s collapse is an example of 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 Synapse’s four partner banks. But they have no way to prove that the money deposited at Yotta — funds that passed through Synapse and ended up in Evolve’s accounts — were theirs because Synapse controlled the ledger, which disappeared after the company’s bankruptcy.

The BaaS business model “was a hard lesson learned: I have to have a more one-on-one relationship with a financial institution,” Dominguez, a 28-year-old from Sacramento, California, he wrote in an email to the bankruptcy court last month.

According to a June 7 report, there is an estimated $85 million shortfall in customer funds managed by Synapse and its fintech partners. status report by Jelena McWilliams, former president of the Federal Deposit Insurance Corp. named Chapter 11 trustee in Synapse case.

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

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

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

Synapse’s bankruptcy lawyer at Levene Neale Bender Yoo & Golubchik LLP did not respond to a request for comment.

New model

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

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

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

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

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

Instead of licensing the software, BaaS intermediaries enter into contracts with both the bank and the fintech partner. The BaaS company manages customer onboarding, conducts fact-finding and anti-money laundering checks, and maintains a register of customer accounts, among other risk management and compliance functions.

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

Banks were supposed to monitor Synapse for compliance with banking regulations, but the company itself was largely exempt from regulatory scrutiny.

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

Evolve is not at risk of going bankrupt, despite blocked 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.

This month the FDIC issued a consumer advisory warning Americans about the risks inherent in banking with a non-bank fintech.

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

“There was already a shadow in the sense of the stack of consent orders,” said Jason Mikula, a consultant and author of the Fintech Business Weekly newsletter who is closely following the Synapse case.

Consumer advocates argue that initial enforcement measures have not been sufficient.

Synapse’s failure was the “watershed moment” that made it clear that the BaaS model must change, said Adam Rust, director of financial services at the Consumer Federation of America. “You cannot have entities operating in the banking sector that are completely outside the banking regulatory perimeter,” he said.

Even before the Synapse calamity, banks were moving away from BaaS and striking more licensing deals with fintechs that provided compliance and other software, he said

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

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

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

Higher costs

Industry advocates say banks taking more risk functions in-house means higher costs and potentially less innovation.

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

Some community banks are abandoning fintech partners as banks deploy their own licensing tools or software, despite high internal costs, he said.

“What you’ve seen happen over the last 12 to 24 months is a lot of these good banks spinning off, dissolving, shedding some of those fintech relationships,” Potts said.

Banks reject more than 90% of requests for fintech partnerships, said Michele Alt, a Klaros partner who worked at the Office of the Comptroller of the Currency.

“Often the fintech is simply too small to work for the partner bank,” he said. “Or the fintech does not have a level of risk management and compliance risk that meets the partner bank’s requirements.”

Eliminating fintechs that can’t perform BaaS functions could ultimately protect consumers, Rust said.

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

“I don’t feel my best”

Even as banks and fintechs are adapting to Synapse’s failure, the bankruptcy court is struggling to figure out how to give people their stranded money back.

And those people are suffering.

For customer Yotta Harley Johnson, 22, of Myrtle Beach, S.C., frozen funds mean there isn’t enough money to buy food, pay rent or keep up with bounced checks and late fees that accumulate.

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

“I’m not feeling the best about life and this financial situation right now,” Johnson said.

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