Banks that carry consent orders regarding their fintech partnerships are facing tough dynamics striking a balance between the benefit of growth and the rising compliance costs associated with it.

In recent months, an increasing number of consent orders have been issued to community banks that provide deposit accounts, loans and payment services to fintech companies' end customers. Even as banks face regulatory challenges, fintechs' interest in banking is only growing and becoming even more granular. The business case for banking-as-a-service (BAAS) remains strong, but banks should be wary of a fintech partner pursuing aggressive growth at the bank's sacrifice, industry experts said.

"Some of the fintechs have been so hot that they just don't negotiate," said Chip MacDonald, managing director of MacDonald & Partners LLP. They want the bank partner to "take it or leave it," even if the contract is unclear about key matters such as each party's responsibilities, expectations of service levels and corrective actions, MacDonald said.

Weak negotiations, vague language in contracts and lack of visibility into fintechs' growth plans could lead to serious compliance and operational issues for the bank, and the recent enforcement actions have reiterated regulators' message that the responsibility of compliance ultimately falls on the bank.

Resolving compliance issues under consent orders often means significant investments in personnel and procedures, a shift of priority to compliance, and in some cases, limitations on growth. It could erase the advantage of the BaaS business model, which attracted many community banks to drive fee income and deposit growth.

In 2023, the median return on average assets in a group of 59 BaaS banks was 0.85%, 10 percentage points lower than the median of traditional community banks, according to an S&P Global Market Intelligence analysis. The median of their net interest margins was slightly lower than that of traditional community banks, and the efficiency ratio was significantly higher.

Upside and downside of deposit growth

While deposit growth continues to be a bright spot for BaaS providers, there can be a gap between deposit growth and BaaS banks' capabilities to handle it.

BaaS banks under consent orders grew deposits in 2023 by 17.0% year over year based on the group median, significantly higher than that of traditional community banks, which was up 0.8%, and also higher than the 11.9% median of BaaS banks without consent orders.

The aim for deposit growth is aligned with fintech companies' ambition to deepen their relationships with customers. In February, payments giant Block Inc., whose banking products are backed by Sutton Bank, announced a new direct deposit feature enabling consumers to send paychecks directly to Block's consumer payment application, in a bid to make relationships stickier and increase the usage of other features in the app. Buy-now, pay-later platform Affirm Holdings Inc. also recently announced a direct deposit feature backed by its existing partner, Cross River Bank.

However, what typically comes with deposit influx is a large amount of compliance work, since the bank is required to identify each consumer and transaction. It could lift the cost of compliance and distract the bank from its other businesses.

Sutton Bank logged deposit growth of 26.4% in 2023, but it also received a consent order from the Federal Deposit Insurance Corp. in early 2024, requiring the bank to strengthen its compliance programs. Among other requirements, Sutton Bank needs to commensurate its resources for anti-money laundering and counterterrorism financing with its size, growth plans and the nature of its offerings.

The growth driven by fintech sometimes runs counter to traditional banking, where high growth could suggest risks with too much to handle all at once, said Brandon Oliver, a principal at BankTech Ventures LP.

"Hopefully over time, as banks and fintechs that join these partnerships get smarter — and again they walk hand in hand with their regulators, first, everything can be done compliantly, and then second, everyone can feel more comfortable with the pace of change," Oliver said in an interview.

Some BaaS providers exiting

Faced with the heavy lifting of resolving the regulatory problems, some banks chose to exit the BaaS business line.

In late February, Metropolitan Bank Holding Corp., the parent company of Metropolitan Commercial Bank, said it would wind down all its fintech partnerships, which would result in a loss of $781 million in deposits. The decision was made after it spent several months trying to pivot its BaaS unit since a cease and desist order was issued in October 2023.

Another recent example is Hulett, Wyo.-based Mode Eleven Bancorp., the parent company of Summit National Bank. The Federal Reserve Board publicized a cease and desist order to Mode Eleven, saying the bank holding company has voluntarily exited BaaS and is winding down all related activities after the Federal Reserve Bank of Kansas City found deficiencies in its pursuit of the fintech strategy in September 2023.

Still, regulators have recognized the benefit of BaaS when done correctly. While those recent consent orders may have created an inaccurate perception that compliance issues in BaaS have become an acute problem, it is not true that regulators are simply trying to squeeze the broader business model, said James Kim, a partner at Troutman Pepper.

"Appropriate third-party risk management isn't new. It's been around for a long time," Kim said in an interview. "Third-party risk management has evolved to include fintech partnerships over the years. I think that's the broader context."

Banks that manage to weather the current storm will come out stronger in a market with more rationality, Kim said.

"Some people may think that [prudential regulators] will be so strict that they will largely eliminate fintech partnerships. I don't see that," Kim said.

Fintechs, BaaS banks pushing back

It is increasingly clear that only the well-managed fintech-bank partnerships will last, but the marketplace is demanding more clarity as to what regulators would consider well managed.

"These activities are all permissible, lawful activities. But there is a subjective element to that — what I think is a good enough job is different from what you might think is a good enough job. So the regulators really are not using objective standards," Matthew Bisanz, a partner at Mayer Brown, said in an interview.

The American Fintech Council, an industry group representing fintechs and BaaS banks, has endorsed a bipartisan bill that seeks to provide greater transparency in bank exams, dubbed the FAIR Exams Act. It would establish a new appeals process for banks to resolve disagreements between their regulators. Rep. French Hill (R-Ark.) and Rep. David Scott (D-Ga.) introduced a bipartisan bill on April 18 in the House. A companion bill was introduced in the Senate in December 2023 by Jerry Moran (R-Kan.) and Joe Manchin (D-W.Va.)

"Federal regulatory agencies shouldn't be regulating via enforcement. They should create uniforms, guidance and structures to enable banks and fintechs who want to operate within the confines of a fair system to have the ability to do stuff," said Phil Goldfeder, CEO of the American Fintech Council.