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It may be hard for folks to believe, but not so long ago, a leading debate in U.S. politics involved how best to regulate reckless financial activity out of existence. As recently as the 2016 Democratic primary, financial regulation was a lead topic, with the two main candidates exhibiting starkly different approaches to dealing with Wall Street.
That focus was the natural outgrowth of the massive financial crisis of 2008, which led to millions of layoffs and millions more foreclosures. Problems like too-big-to-fail banks, excessive securitization, and proprietary trading with other people’s money were seen as among the biggest confronting the nation. But memories fade, thoughts turn to other priorities, and the pendulum begins to swing from tight to loose financial regulation.
That started in 2018, when Congress passed the biggest bipartisan bill of the Trump era, which deregulated large regional banks in a way that helped lead to the collapse of Silicon Valley Bank and a Federal Reserve–led bailout for its depositors last year. The tightening of capital requirements to make banks safer, which was supposed to kick in under President Biden, has stalled out amid an epic pushback from the industry and their allies in civil rights groups. The crypto industry has essentially bought itself a Congress and is working to install a hands-off regulatory structure for its house of cards.
Amid this period of deregulation and neglect of finance, around 200,000 customers of fintech “neobanks” have been cut off from their own deposit accounts, though the level of public outrage has barely risen above a whisper. Finance has become so invisible that even financial abuses that amount to separating people from their money don’t inspire much discussion.
In this case, the desperation of these fintech customers was wholly predictable, and even laid out in a Treasury Department report nearly two years ago. The fact that the risks were known at the highest levels and not acted upon reveals how inattention to the dangers of finance can be self-perpetuating. Without public awareness of finance’s inner workings, catastrophes can happen under our noses.
The chaos at Synapse, a bankrupt, defunct go-between that enabled neobanks to offer app-based deposit accounts, appears unfixable at this point. Jelena McWilliams, former chair of the Federal Deposit Insurance Corporation (FDIC) under Donald Trump, who has been brought in as Chapter 11 bankruptcy trustee for the company, stated in a court filing last week that Synapse’s partner banks are holding between $65 million and $96 million less than what fintech firms say is owed to customers. That’s a potentially bigger shortfall than the estimate given the week prior.
Worse, McWilliams said in the report, “full reconciliation to the last dollar with the Synapse ledger and Fintech Partner’s ledgers may not be possible.” The trustee does not even believe it has the authority to direct funds from the partner banks to customers. That means the standoff will go on unless the bankruptcy judge takes action.
Fintechs do not have capital or liquidity requirements, as we’re now seeing in real time.
The reasons for this failure to make depositors whole are obscure and complex. It could be anything from Synapse commingling customer money with operating funds, as has been alleged, or a bank partner extracting more from pooled accounts of customer funds than they were entitled to, as has also been alleged by the former CEO (who, in another case of failing upward, just got $10 million in seed funding to start a robotics company).
Either way, regulators find themselves stymied by the dispute. As Synapse is not itself a bank, there hasn’t been a bank failure, so the FDIC can’t step in. The banks at issue are small, removing them from direct oversight of the Consumer Financial Protection Bureau. The Federal Reserve, primary regulator to Evolve Bank & Trust, the partner bank most entangled in the mess, last Friday issued an enforcement action against Evolve over failing to have an effective risk management program in place to deal with fintech partnerships, as well as deficient compliance programs for anti–money laundering and consumer protection. But the Fed went out of its way to say that the enforcement action was “independent of the bankruptcy proceedings regarding Synapse Financial Technologies.” While Evolve cannot distribute any dividends or increase its debt without Fed approval, this gets end users no closer to their money.
Despite this paralysis, at least one corner of the federal regulatory machinery saw this coming. On November 16, 2022, the Treasury Department issued a report to the White House Competition Council about the entry of non-banks into the consumer banking space. The executive summary makes clear that, while neobanks succeeded in increasing competition for deposits, with potential consumer benefits, there was one problem: “They are generally not subject to the same oversight for safety and soundness or consumer protection … which raises various public policy considerations.”
Instead of becoming banks themselves, a costly practice that would confer all these regulatory compliance burdens, fintechs partner with banks that (allegedly) give consumers deposit insurance protections. This creates a situation where the banks are “both direct competitors and collaborators,” but more important, creates regulatory gaps.
Fintechs do not have capital or liquidity requirements, as we’re now seeing in real time. There is no ongoing supervision of their activities. They are subject to CFPB consumer protection laws and potentially state licensing regimes, but that’s a patchwork that doesn’t address the core banking practices. Partner banks do get supervised, as the Fed’s sanctioning Evolve Bank makes clear. But, the Treasury report concluded, “if the fintech firm … is providing the services to consumers, then the federal banking regulator’s ability to regulate and examine the consumer banking-related services provided by the third-party fintech firm may be more limited.”
That’s precisely what happened here. Synapse proved an unreliable partner for its fintech partners. Nobody on the fintech or bank side was prepared for the disorganized collapse of the middleman holding them together, and nobody on the regulatory side was monitoring Synapse, which stood in between the banks and the fintechs, for safety and soundness. And now approximately 200,000 customers, by the most credible estimate, are paying the price by being cut off from their deposits.
“When done responsibly, bank-fintech relationships can be beneficial for competition and consumers,” the report points out. “However, the increasing variety and complexity of these relationships highlight the need for a clear and consistently applied oversight framework to reinforce the bank regulatory perimeter and protect consumers.”
The report recommended coordinated and enhanced supervision for bank-fintech partnerships: “Regulators should robustly supervise bank-fintech lending relationships for compliance with consumer protection laws and their impact on consumers’ financial well-being.” What ensued, however, was less than robust. Last year, the top banking regulators issued guidance on how banks should interact with fintechs and other third parties, but they were quick to add that the guidance “does not impose any new requirements on banking organizations,” and was more like helpful advice for managing a third-party relationship.
While the guidance did say that banks were ultimately responsible for any deficiencies in third-party relationships, the regulators left it to the partner banks to decide whether to enter into business with fintechs, and how those banks could add compliance and risk management practices into any contractual agreements. The kind of supervision you would see in an ordinary depository institution is not present with fintechs.
There are still diligent financial regulators working to rein in finance. The Consumer Financial Protection Bureau is at the apex of its power, so much so that big banks are agreeing to its rules, such as limiting credit card late fees, even while they are still before the courts. The FDIC just failed Citigroup on its living will, which is supposed to provide a road map for winding down complex financial institutions and, if seen as deficient, could be used as a pretext to break up big banks.
But finance is a multiheaded hydra, always shifting and maneuvering to evade oversight and maximize profit. The depressing thing about this particular strain of financial innovation is that the perils of the fintech business model were completely visible to the same diligent regulators. The problem was that nobody else really cared to implement the recommendations until it was too late.
