When starting a new partnership with a financial technology company, Coastal Community Bank has realized the importance of thinking about a possible breakup.

In the past 18 months, Coastal closed about 10 fintech partnership programs for various reasons, said Eric Sprink, CEO of the Everett, Wash.-based bank. The closings did not cause any material effect on its balance sheet, in part because of the precautions that Coastal set up before the programs went live, Sprink added.

"Every time we onboard a new partner, we do a wind-down plan," Sprink said in an interview. "You hope you never have to use it, but you always have to be prepared as the partner bank."

The importance of wind-down plans for banks with fintech partners is becoming more apparent as the current funding dynamics and economic outlook are forcing fintechs to call it quits. A couple of the recent closures include neobank Daylight, incorporated as Be Money Inc., and payroll and benefits fintech Catch Financial Inc. The shutdown of fintechs can lead to sponsor banks losing sources of deposits and interchange fees.

With regulators keenly monitoring banks' third-party risks, banks are expected to think through their options in a scenario where their fintech partners could not survive the ongoing funding squeeze. "I think the banks are being required more to make sure they have the contingency plans in place as they enter those relationships," said Jim Perry, senior strategist at consultancy Market Insights Inc.

Reserving right to intervene

When a fintech winds down, a key accountability of the partner bank is to protect the end consumers and small business customers, Sprink said. The bank should ensure proper reconciliations, to reflect account balances correctly when the fintech is unwinding.

To be able to do this, Coastal often reserves the administrative rights to intervene if and when fintech partners are under stress, so that it can log into the fintech's systems to facilitate actions such as paying items or closing out accounts in due time, Sprink added. The bank gains such access by signing a tri-party agreement with the fintech and the fintech's core operating systems or payment systems providers.

Technology providers for banking-as-a-service providers such as Treasury Prime Inc. can also support banks to step in if a fintech partner has to close, said Jeff Nowicki, vice president of banking at Treasury Prime. In normal times, a bank keeps deposits brought in by fintechs on a separate ledger managed by Treasury Prime, so that these do not mix with the bank's core deposit transactions. When winding down, banks would have the option to transfer those deposits managed on Treasury Prime's ledgers to the bank's core system, or simply to mail out checks, Nowicki added.

"Your account is truly owned and ultimately managed by the bank, so the banks would absolutely step in," Nowicki said. "There are processes in place to get the money back to the end users."

Keeping fintech funding fluid

Still, banks need to consider the potential disruption to the funding and revenue streams they receive through the fintech.

For many community banks, a key attraction of banking-as-a-service has been landing the deposits brought in by fintechs and earning interchange fees on transactions going in and out of those deposit accounts. With the risk of fintech failure in mind, some banks opted to keep those deposits generated from the programs in highly liquid assets, even when the partners show no signs of stress.

For instance, BankProv, the bank unit of Provident Bancorp Inc., identified $91.9 million of deposits related to fintech or cryptocurrency customers as volatile, of the balance as of March 31. BankProv paired those deposits with short-term assets, such as cash, to mitigate risks that could be caused by potential withdrawals, according to a filing in May.

To reduce the concentration risk, Coastal typically sets a limit on how much in deposits each fintech partner can bank with Coastal, Sprink noted. It also sets covenants in contracts to get clarity on the risk and types of products that its partners can offer. In addition, Coastal limits the number of partnerships it enters. No matter how many fintech arrangements it exits, the bank only aims to onboard one to two new partners each year, Sprink noted.

M&A possible

One possibility to rescue a fintech under stress is for the bank partner to buy the fintech or certain pieces of the business such as technology, products or customer relationships. So far, these types of transactions have rarely come to fruition, but the combinations are logical considerations, industry experts said. The partner bank would have had experiences working with the fintech, and there could be better synergies considering the two parties have chosen each other from the beginning.

"I would guess that in the future, we're going to see more situations where those banks are trying to acquire that fintech and bring it underneath their umbrella," Market Insights' Perry said. "I have heard people talking around board tables in C-suites about that as within [the] realm of possibility."

For Coastal, its expertise in overseeing and running challenger banks would give it an edge in buying them, and it is evaluating opportunities to potentially purchase some fintechs that serve certain niches, Sprink said.

"We have a lot of expertise in working with partners in direct-to-consumer, direct-to-business, and we built that infrastructure to help with fraud, [Bank Secrecy Act] compliance, so I think that does enable us to do it with higher levels of synergies and competencies," Sprink said.