For months now, thousands of consumers have been unable to access money they thought was safely deposited in banks.

For months now, thousands of consumers have been unable to access money they thought was safely deposited in banks.

They are victims of the failure of a little-known venture-backed startup called Synapse Financial Technologies, whose closure is hurting not only consumers, but also the fintech startups that partnered with it, as well as the fintech industry as a whole.

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They are victims of the failure of a little-known venture-backed startup called Synapse Financial Technologies, whose closure is hurting not only consumers, but also the fintech startups that partnered with it, as well as the fintech industry as a whole.

The now-bankruptcy situation is placing additional regulatory scrutiny on fintech, highlighting risks for consumers who deposit money through non-bank financial service providers, and creating uncertainty for fintech investors and entrepreneurs.

What is Synapse?

Synapse Financial Technologies is a San Francisco company that served as an intermediary between fintech startups and chartered banks. Its fintech clients marketed financial products and persuaded consumers to sign up. Synapse sent consumers’ money to partner banks where it was deposited.

Since its founding in 2014, Synapse has raised approximately $50 million from Andreessen Horowitz, Core Innovation Capital, and Trinity Ventures for its banking-as-a-service business.

The company pioneered the banking-as-a-service model and helped make it faster and easier to build fintech startups. Partly because of the rise of banking-as-a-service, venture capitalists have poured billions of dollars into consumer fintech startups in recent years.

Synapse itself has provided services to more than 100 fintech companies, including many of its current lenders, such as venture-backed firms Juno, Yotta Technologies, and Yieldstreet.

In April, Synapse filed for Chapter 11 bankruptcy.

Why are consumers angry?

Beginning in May, banks including Evolve Bank & Trust and Lineage Bank froze access to accounts associated with Synapse, citing discrepancies in accounting records kept by Synapse.

Evolve Bank & Trust estimates that about 116,000 accounts across all banks are affected, said Thomas Holmes Jr., the bank’s senior vice president and director of marketing and communications.

The banks said they do not know who is entitled to what. There is a dispute between the banks and Sankaet Pathak, founder and former CEO of Synapse, over who is responsible for the irregularities in the accounting records.

Accounting reconciliation is continuing in the Synapse case, according to a trustee who manages the Synapse estate. But more than $100 million has not been distributed as of early July, according to the trustee’s accounts. Most of that is in joint accounts held by Evolve and Lineage, making it difficult to figure out how much equity is owed to whom.

According to the trustee, there is also a deficit of up to $96 million between the money deposited in the partners’ bank accounts and Synapse’s account balance.

The reconciliation is on track to be completed within a few weeks, Holmes said. Evolve “looks forward to returning the funds it has from that business to the correct consumer accounts once the reconciliation is complete,” he said. He added that Evolve cannot confirm the amount of the missing funds, if any, until the reconciliation is complete.

Evolve had previously provided payment processing services to the affected accounts, Holmes said. The accounts belonged to customers of Synapse Brokerage, a Synapse subsidiary, he said.

Consumers signed up for fintech services with the promise that they would be able to pay off their debts faster, earn high interest, or get rewards. The startups offered easy-to-use mobile banking apps. The apps claimed that deposits were kept safe at banks insured by the Federal Deposit Insurance Corp.

How are fintech startups that have partnered with Synapse impacted?

“We can’t serve our customers without the ability to transfer their funds, so our business has ground to a halt,” said Nick Sky, chief executive of Changed, one of Synapse’s creditors.

Changed helps people pay off debt and manage their savings. The company has raised more than $3 million from investors and has more than 100,000 registered users, Sky said. Changed has been working with Synapse since 2017. The company has been told that its customers’ money is held at Evolve, Sky said.

He said that Changed’s clients “have almost $2 million trapped in this bankruptcy limbo and that’s a small portion of the total, but it’s real and very significant.”

Several fintech startups that have partnered with Synapse find themselves in a similar situation.

Yotta, for example, has provided its customers with almost daily updates on its website, but many still can’t access their money. Yotta has an unsecured claim of $65.15 million in the Synapse bankruptcy case.

What do regulators say?

FDIC insurance kicks in when a bank fails. In the case of Synapse, no bank failed.

In a July 2 letter to Synapse’s bankruptcy trustee, an FDIC representative said the agency is “strongly encouraging the banks involved in this matter” to address the harm Synapse’s bankruptcy has done to consumers.

Federal Reserve Chairman Jerome Powell said in Senate testimony that the Fed is strongly encouraging Evolve, which the Fed oversees, to make money available to customers.

In May, the FDIC issued a warning to consumers about banking with what it calls “third-party apps.” Opening accounts on mobile banking apps that are not FDIC members carries additional risks, the warning said. “FDIC deposit insurance does not protect against the insolvency or bankruptcy of a nonbank,” it noted.

Why are fintech venture capitalists worried?

The Synapse failure highlighted the risks inherent in bank-fintech partnerships, a linchpin of fintech growth. Regulators were already cracking down on such partnerships, citing banks for poor compliance with anti-money laundering safeguards and other risk management issues.

Investors fear that, in light of Synapse, regulators will more forcefully censor partnerships between banks and fintechs, slowing or even making it impossible for fintech companies to take off.

“Running a fintech program or company is going to get harder and more challenging going forward,” said Salil Deshpande, general partner at Uncorrelated Ventures, a firm that is an investor in Juno, one of Synapse’s fintech partners. “This is likely to stifle competition in the space and further increase the market share of big banks and big tech,” he said, adding that it could hamper efforts to make financial services more accessible to consumers.

In June, another banking firm, venture-backed startup Unit, said it would lay off about 15% of its employees, citing slower-than-expected revenue growth as banks slow down in light of increased regulatory scrutiny.

In the long run, more regulation could help build consumer trust in fintech. Sky, CEO of Changed, said he thinks any fintech that moves money for consumers will eventually be regulated. “Which we wholeheartedly welcome,” he said.

Write to Yuliya Chernova at yuliya.chernova@wsj.com

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