A Federal Deposit Insurance Corp. rule proposal would end a common banking-as-a-service practice that allows banks to count deposits originated by financial technology partners as core and require them to classify the funds as brokered.

Regulators impose more restrictions on funds gathered with the assistance of a third-party deposit broker because they are viewed as riskier and less sticky than core deposits. BaaS deposits are viewed as brokered if a fintech program uses multiple bank partners. However, if the fintech program is partnered with one bank, the BaaS deposits can be considered core, thanks to an exemption referred to as the "exclusive deposit placement arrangement."

The FDIC's proposed rule seeks to eliminate this exclusivity exception, and it could have a far-reaching impact on BaaS practices given the broad use of this exemption.

"Many of those banks are using that exclusivity reason for these deposits not to be treated as brokered deposits," said Matt West, founder of Xenios who advises on BaaS arrangements. Although some of the fintech companies have seen the benefit of having a back-up bank partner, it is currently being discussed more than adopted in practices, especially for smaller BaaS programs, West noted.

A goal of the rulemaking is to address risks in bank/fintech partnerships, FDIC Chairman Martin Gruenberg said during a board meeting July 30. The risks were illustrated by the recent bankruptcy of middleware vendor Synapse Financial Technologies Inc., which Gruenberg called a deposit broker.

Synapse played a middleware role connecting four bank partners with a dozen fintech applications. As Synapse filed for bankruptcy in April, the parties had difficulty matching transaction records. It led to end users losing access to their funds for months as the banks worked to balance out the ledgers. There also appeared to be a deposit shortfall that left users worried.

The rulemaking has spurred a debate. Opponents say it mischaracterizes fintech risk as hot money and adds regulatory burdens to BaaS banks. Proponents of the proposal say the brokered deposit classification is necessary to reflect its higher risk.

Not clear-cut brokered deposits

Some argued that BaaS deposits do not have the same "hot money" characteristics of traditional brokered deposits that concern regulators.

According to the liquidity manual of the Office of the Comptroller of the Currency, banks pay up for brokered deposits to "raise large amounts of funds quickly," in part making the funds "highly rate-sensitive." But in a typical BaaS relationship, the selling point to depositors is rarely just higher yield as the fintech platform can attract end users by offering other services such as payments and an easy-to-use interface. Also, the economics are far more nuanced depending on how the bank and the fintech split revenues and responsibilities, and the fintechs are usually driven to build product niches to retain users and build a long-term relationship with the bank.

"I would say a lot of these fintechs deposits are actually the opposite of hot money," said Matthew Bornfreund, a partner at Troutman Pepper. "I think a problem with this proposed rulemaking is, the FDIC asserts that these are hot money and less stickier, more likely to run away from the bank than core deposits are, but they don't actually provide any evidence or data to support those propositions."

Classifying those funds as brokered deposits adds regulatory restrictions, which will only exacerbate the partner bank's stress when things go wrong, said John Popeo, a partner at consulting firm The Gallatin Group.

If a struggling depository institution is no longer considered well capitalized, they may not accept, renew, or roll over brokered deposits, unless they apply for a waiver from the FDIC, Popeo noted. This requirement would unnecessarily deprive a source of funding of the BaaS bank.

"Consider it like a de facto run, but it's a run by operation of law," Popeo said.

Adjusting to the change could create uncertainty for BaaS banks because there is no regulatory-defined brokered deposit threshold that banks are guided not to cross. If a BaaS bank would need to reclassify a large amount of deposits as brokered under the new rule, its examiners would require the bank to assess the impact on its liquidity in a relatively subjective manner, Bornfreund said.

For banks above the $10 billion asset threshold, a larger amount of brokered deposits will increase their assessment rates paid to the deposit insurance fund. But a large number of BaaS programs are managed by community banks under $10 billion in assets.

Not clear-cut core deposits

It is reasonable to expect BaaS banks to be careful of unusual liquidity strains. In the case of Synapse, countless end users became anxious to pull their money out of the fintech apps after the chaos. Those deposits will eventually leave the partner banks and weigh on the banks' liquidity.

A key factor making core deposits sticky is that money outflows are not necessarily correlated. But a large fintech partner could be in a powerful position to determine the destination of millions of deposits — or become a single source of stress triggering money outflows.

"When we traditionally thought of hot money back in 2008, 2009 with the liquidity crisis, we were thinking of large sums of money that moved in unison. Now, using that definition, how can we not think of deposits garnered through one particular partner brokered?" said Kirsten Muetzel, founder of KLM Advisory LLC who advises on BaaS partnerships.

While counting them as brokered deposits adds pressure when a BaaS bank loses the "well capitalized" status, building capital buffers proactively is important for BaaS banks with or without this exemption, Muetzel said. Recent consent orders showed that regulators have already raised their expectations on capital for BaaS banks.

"If you are in something that's new and you don't understand everything from an operational risk perspective, you should have a buffer in your capital to absorb those losses," Muetzel said.

A change in posture

Brokered deposit classification is only one of the many grey areas in BaaS. Many practices in BaaS seem to fit somewhere in the traditional banking glossary but can be interpreted differently.

So far, guidance on fintech partnerships has been a "disjointed approach" based on "piecemeal guidance," said Federal Reserve Governor Michelle Bowman in a July 25 statement. Guidance is being folded under the umbrella of third-party risk management, mixed with very different subjects such as how banks use software internally or handle cybersecurity incidents. Industry participants also must read between the lines of consent orders and regulators' remarks to decipher their expectations.

"That's the trouble," said Alexandra Barrage, a partner at Troutman Pepper. "When you're a regulator, you want to come out with principle-based guidance, and you don't want to be too specific, because you could inadvertently be cutting something off or preventing responsible innovation from flourishing."

Regulators now appear more willing to be specific. In an interagency statement July 25, they peeled through fintech partnership risks with much more granularity, Barrage noted. Also, this statement for the first time segments fintech partnerships in ways that are consistent with core bank activities, Barrage said.

The agencies also issued a request for information July 25, which many industry experts viewed as a positive step to collect knowledge about nuances of various BaaS models.

"There's a really tough balance," Barrage said. "How do you provide more rules of the road when the universe is already pretty diverse?"