Banks involved in banking as a service will have to prioritize regulatory compliance in 2023 as scrutiny intensifies and opportunities in the segment grow.

Throughout 2022, multiple bank regulators have stressed that they are increasing their attention on banks' third-party risks. In one example, the Office of the Comptroller of the Currency entered into a formal written agreement in August with Blue Ridge Bank NA, the bank subsidiary of Blue Ridge Bankshares Inc., to enhance the OCC's supervision of the bank's fintech partnerships.

Regulators' messages are helping increase banks' awareness of risk management and not necessarily killing banks' interest in BaaS, industry experts said. Despite posing higher regulatory risks, the BaaS business model has yielded favorable financial results for the existing bank players compared to the industry average.

"Bank/fintech partnerships aren't going anywhere," Mark Chorazak, a partner at Shearman & Sterling in the financial institutions advisory and financial regulatory practice, said in an interview. "The nature of these partnerships will evolve, just given the increasing regulatory scrutiny, but also given the increasing sophistication of the parties that enter into these contracts on both sides."

Key areas of enforcement may include banks' compliance with the Bank Secrecy Act regarding anti-money laundering, how deposits are held and how the arrangement is being marketed to consumers, and credit underwriting standards, particularly for consumer loans.

"Regulators are going to spend time making sure that the institutions that are providing these kinds of services to third parties who are interacting with customers on their behalf are in a position to be as compliant as they would be in any other business lines," said David Sandler, co-head of financial services investment banking at Piper Sandler.

"That's going to have a profound impact on the space and the entrance into this space," Sandler said. "It already has."

Contractual rights to watch for

Some believe that the intensifying regulatory environment will prompt banks to tighten contractual terms on compliance practices to set expectations with fintech partners up front.

"I think that the battleground is going to be in these contracts," Chorazak said.

Banks could request more audit rights to inspect or monitor their fintech partners' operations. Banks should protect their rights to obtain sufficient information about how the fintech handles customer notices and how it resolves disputes or harvests consumer data, and they should not rely solely on what a fintech promises to disclose, but set up mechanisms of information flow as a contractual right, Chorazak said.

Banks should also consider the right to exit a partnership if the fintech is not performing, Chorazak added. Even if things may be going well, banks should assess whether a fintech partner is exhibiting a level of sophistication in compliance that is expected of the bank by its own regulators, Chorazak said.

"If there's a view that the bank isn't aware, or doesn't have enough answers to provide about the nature of the fintech's operations or activities, I think that's a red flag for the agencies," Chorazak said.

Banks are also using technology to automate compliance when managing their fintech partnerships, Greg Watson, CEO at Napier, a compliance software provider that counts State Street Corp. and Credit Suisse as customers, said in an interview.

"The neobanks that are coming out today are a little bit more sophisticated than what we've seen a few years ago," Watson said.

Long-term shift on debit programs

Doing business in a heavily regulated industry, banks are subject to regulation not only for compliance reasons but also for operational reasons. For smaller banks in BaaS, there is tension between pursuing growth and enjoying the benefits of remaining under the $10 billion asset threshold.

Banks with less than $10 billion in assets are exempted from the Durbin Amendment and eligible to charge higher interchange fees for processing debit card payments. The rule affects the strategy for smaller banks backing fintechs' debit card programs, where the partners typically share the interchange income.

"If your focus is retaining this banking-as-a-service or other fintech partnership models, you have to weigh that against the benefits or the economies of scale over $10 billion for your core lending business," said Cliff Stanford, a partner at Alston & Bird and leader of the firm's bank regulatory team.

Although many of the smaller banks in BaaS are choosing to manage their balance sheets to stay under the $10 billion threshold, they could opt to exceed it if they are swayed by the demand for scale.

"People are coming to the realization that business models funded entirely by interchange aren't necessarily going to be profitable," said Jonah Crane, partner at advisory and investment firm Klaros Group. "You might see a shift away from interchange-driven business models to begin with, which I think will make the $10 billion threshold matter less."

Credit card partnerships attracting larger banks

Larger banks are also taking a share in BaaS. Bigger players have the advantage of handling more complex programs at a significant scale, such as taking underwriting risk in credit card issuing. Goldman Sachs, for example, is the credit card issuer for Apple Inc., while Wells Fargo & Co. issues credit cards for a rent payment program designed by Bilt Rewards, an emerging fintech company that raised $150 million in funding at a $1.5 billion valuation in October.

"It's really hard to compete in the credit card space. It's kind of a scale game, and it's harder to differentiate yourself," Crane said.

First National Bank of Omaha is another credit card issuer backing fintechs through Bend by FNBO, an internal fintech venture launched in August. The platform announced its first fintech partner in November, Greenlight Financial Technology Inc., to issue credit cards aimed at parents using Greenlight's application.

First National Bank of Omaha entered the space in part because it has had an established team with a specialty in issuing co-branded credit cards for traditional industries and underwriting the loans, said Marc Butterfield, head of Bend by FNBO.

"Part of our mission is to disrupt that legacy business, but what I think is great is strategically, we look at that and we say, 'If we don't do it, somebody else will do it,'" Butterfield said.