Banking as a Service

Implications for Community Banks

Part Three Choose Your Partner Wisely

 

 

For a community bank that is considering developing banking as s service, there are several issues to consider.  While the overall public impression of banks and financial institutions took a major hit during the 2008 financial crisis, in large part, the damage was being slowly repaired.   However, it is obvious that the relationship between financial institutions and the public has changed forever.  Even before the coronavirus hit the economy, a broad wave of consumer distrust buffeted the banking industry's reputation.   Let's face it, the current times are not exactly the best for the image of banks.   In addition to the mortgage crisis, there have been several highly publicized scandals involving some of the larger and best-known banks. 

 

As pointed out in Bankshot^[1] banking journal- “What’s at stake? Customers have more choice than ever when it comes to where they do their banking, including from an increasing array of fintech competitors with arguably less cultural and emotional baggage than the traditional banking industry.   Now, more than ever before, there are real alternatives to banking.   

 

The need for nontraditional banking services is one of the main drivers of the financial technical “fintech” industry.  Many bankers seem to understand that fintech companies present the possibilities for significant change in the industry.  According to a survey conducted by PWC:

 

• FinTech is a driver of disruption in the market. Financial Institutions are increasingly likely to lose revenue to innovators, with 88% believing this already is occurring. The perceived business at risk trend has continued to rise, to 24% on average this year among all sectors.
• Incumbents are becoming more aware of the disruptive nature of FinTech, shown well by the fact that, in 2017, 82% of North American participants believe that business is at risk, up from 69% in 2016. Insights from PwC’s DeNovo also indicate that 30% of consumers plan to increase usage of non-traditional Financial Services providers and only 39% plan to continue to use only traditional Financial Services provider.  In addition, asset backed lenders have largely increased their share of lending (the lending club and other peer-to- peer business).  
•  

Fintech companies have been in the business of designing products that address some of the concerns raised by the unbanked or underbanked.  For example, speed of delivery, consideration of alternative means for credit underwriting and ease of delivery.

 

Despite the idea that fintech equals disruption, it doesn’t have to be a negative thing.  Disruption often results in improvement in efficient and better service.   In fact, there are several places where fintech companies and financial institutions, especially community banks have converging interests.

Community banks and credit unions have overall higher levels of trust and a better public image than their larger brethren.   Because community banks are smaller, they are nimbler and making changes to products lines can happen quickly and in response to customer needs.   The independent bankers association published the “Fintech strategy Roadmap in 2017” as a guide for the many opportunities that fintech companies can present.   A summary of these opportunities includes;  

• Increased Operational Efficiency and Scale
• Increased Access to Customers with a Younger Age Demographic
• Increased Access to Loan Customers in New Markets
• Enhanced Brand Reputation
• Enhanced Customer Experience

 

Disruption is simply that- it doesn’t necessarily have to be a bad thing.   In fact, disruption can result in greater efficiencies and more effective.  Some good news, these companies have done all of the research and development work with venture capital funds!   They have worked out a lot of the bugs that are usually part of delivery of a new product.   Some more good news, these companies are burdened by a regulatory scheme that really limits them.  That is that they are considered MSB’s and must get state licenses to operate in each state.  Because of this, many FinTechs are looking for a partnership with a bank- in this way they get around the need for licenses.  

 

Successful collaboration means having a risk assessment, strategic plan and most importantly, strong vendor management.    The FDIC, the OCC and the FRB have all issued guidance on the proper way to administer vendor management.   While the published guidance from each of these regulators its own idiosyncrasies, there are clear basic themes that appear in each.   All of the guidance has similar statements that address the types of risk involved with third party relationships and all discuss steps for mitigating risks.  

 

One of the considerations that are necessary is about what level of due diligence is required for a third-party contract.  The level of due diligence is heavily impacted by determination of whether the activity being considered is a critical activity.  The OCC guidance defines a critical activity as:

•      Critical activities—significant bank functions (e.g., payments, clearing, settlements, custody) or significant shared services (e.g., information technology), or other activities that could cause a bank to face significant risk if the third party fails to meet expectations;

•      Could have significant customer impacts require significant investment in resources to implement the third-party relationship and manage the risk; 

•      Could have a major impact on bank operations if the bank has to find an alternate third party or if the outsourced activity has to be brought in-house.^[2]

 

 

 

 

The steps that are necessary for the proper engagement of a third party for a critical activity are discussed in each of the regulatory guidance documents that have been released.  The OCC bulletin provides the most comprehensive list that includes: 

 

 

•      Relationship Plan:  Management should develop a full plan for the type of relationship it seeks to engage.  The plan should consider the overall potential risks, the manner in which the results will be monitored and a backup plan in case the vendor fails in its duties. 

•      Due Diligence:   The bank should conduct a comprehensive search on the background  of the vendor, obtain references, information on its principals, financial condition and technical capabilities.   It is during this process that a financial institution can ask a vendor for copies of the results of independent audits of the vendor.    There has recently been a great deal of attention given to the due diligence process for vendors.  Several commenters and several banks have interpreted the guidance to require that bank research a vendor and all of its subcontractors in all cases.  We do not believe that this is the intention of the guidance.  It is not at all unusual for a third-party provider to use subcontractors.   We believe that a financial institution should get a full understanding of how the subcontracting process works and consider that as part of the due diligence, however, it impractical to expect a bank to research the backgrounds of all potential subcontractors before engaging a provider.  

•      Risk Assessment:  Management should prepare a risk assessment based upon the specific information gathered for each potential vendor.  The risk assessment should compare the characteristics of the firms in a uniform manner that allows the Board to fully understand the risk associated with each vendor.  ^[3]

•      Contract Negotiation:  The contract should include all of the details of the work to be performed and the expectations of management.  The contract should also include a system of reports that will allow the bank to monitor performance with the specifics of the contract.   Expectations such as compliance with applicable regulations must be spelled out.   

•      Ongoing Monitoring:   Banks must develop a program for ongoing monitoring of the performance of the vendor.   We recommend that the monitoring program should include not only information provided by the vendor, but also internal monitoring including

•      Customer complaints:  Customer complaints are a direct indication of issues or problems within a program or product offering.  A system that tracks complaints and their resolution is a critical component of evaluating the overall effectiveness of a program.

 

•      Oversight and Evaluation:  There should be a fixed period for evaluating the overall success and efficacy of the vendor relationship.  The Board should, on a regular basis evaluate whether the relationship with the vendor is on balance a relationship with keeping.  

 

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[1] https://www.americanbanker.com/bankshot

[2] OCC BULLETIN 2013-29

[3] Ibid. 

Banking as a Service- Implications for Community Banks

Part Two- Technology is the Key

 

 

In the first blog in this series, we discussed the overall concept of Banking as a Service (“BaaS”).  A recent Cornerstone Advisors survey of bank executives found that one in 10 banks is in the process of developing a BaaS strategy and another 20% are considering pursuing a BaaS strategy.  This is only likely the beginning!  There are a couple of major factors that are driving the need for BaaS. 

 

First, as we noted in the first blog- cellphones are ubiquitous and as a result mobile banking applications are growing.   In addition to that, the number of unbanked and underbanked households presents an opportunity. There is a huge pool of potential customers for financial institutions.  This pool represents a large source of potential income that is untapped.   The pool we are referring to is the large number of unbanked and underbanked households in the United States. 

 

Who are the Unbanked and Underbanked?

 

The unbanked have no ties to an insured economic institution. Essentially, they have no checking or savings account and no debit or ATM card.   Meanwhile, the underbanked do use some of these services – often a checking account – but they also used alternative financial options within the past year.   This population has been estimated to be as many as 30 million people. Around 20 percent of Americans are underbanked, according to the FDIC, which means they have either a checking or savings account, though rarely both. Households are also usually given the underbanked distinction if they've used alternative financing options during the previous year, such as money orders or rent-to-own services. Around 67 million Americans are underbanked, or the equivalent of 24.5 million households, based on 2019 figures from the most up to date FDIC survey.[1]

 

Just as important as the number of people who are unbanked and underbanked are the reasons that they have limited contact with banks.   The most recent FDIC study on the unbanked and underbanked was published in 2019.  In the study, the main reasons for not having bank accounts included:

 

·         Do not have enough money to keep in an account”.    

·         Don’t trust banks”

·         Bank account fees are too high

·         Bank account fees are unpredictable”

·         Higher proportions of unbanked households that were not at all likely or not very likely to open a bank account in the next 12 months cited “Don’t trust banks” (36.2 and 31.5 percent, respectively) in 2019, compared with unbanked households that were somewhat likely or very likely to open a bank account in the next 12 months (24.7 and 21.0 percent, respectively).[2]

 

When we put this all together there is a huge market opportunity for banking as a service.   This is where the FinTechs and banking comes together.  And the way they do so is through technology; including API’s and BaaS infrastructure that allows for widespread adaptation of the products and services that are being designed and offered.  

 

 

API’s

 

These are software programs called application programming interfaces.  This is a fancy word for patches that allow different forms of data to recognize each other.  In the real world an API is like the adapter that you put on a three-pronged plug to make it fit into two pronged outlets.  

Financial API’s are specifically designed to allow financial data to be shared between entities that naturally would want to share data- for example, your bank account and Turbo Tax. 

 

There are three types of API’s

·          Internal – these generally don’t touch activity that is consumer facing.  They are designed to help the flow of internal information with an organization

·         Partner – these are API’s that connect to distinct businesses-organizations.  These are the API’s that are most often used by banks that want to offer specific products and services

·         Open- These are the applications that allow financial data to third party service providers.  These are the applications that allow a person to be offered direct pay for bills and subscriptions

 

The development of API’s has made it possible for banks to apply technology that was unavailable in the past.  

 

Infrastructure

 

These software platforms allow banks to take full advantage of API’s and to offer new and innovative products and services.  Reasons why infrastructure is necessary include

·         Costs of development

·         Resources and organizations that are not designed for software development

·         Technology that isn’t compatible

 

BaaS infrastructure providers have begun to ramp up their services – these will be needed partners as the industry develops.    We will discuss the aspects of vendor management in a later blog.  

 

 

 

 

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[1] FDIC National Survey of Unbanked and underbanked Households

 

[2] Unbanked versus underbanked: Who they are and how they differ.  Dec, 23, 2017 Waly Wojciechowski 

  

 

 

 

 

 

 

Banking as a Service- What it means for Community Banking

 

 

Introduction

 

One of the hottest topics in the financial service industry todays is the development of the are called “Banking as a Service” (“BaaS”).   Put in it most simple terms, BaaS is the combining of a financial services platform with digital access to a banking account.  Banking as a Service platforms allow non-bank financial institutions to offer all kinds of financial products.  You may have seen some of the products if you recently purchased an airline ticket, or large appliance.  When you proceed to check out, you get a notice that you can (on approval), finance the purchase and pay installments rather than paying the whole price right away.  

 

There are several firms that are no providing point of sale financing that allow for short term installment loans to pay for larger purchases.  This is a form of BaaS. 

 

For community banks, the growth of BaaS can present both an opportunity and a potential challenge.  As an opportunity, BaaS presents the ability to reach out to a much larger number of customers who have been unbanked and underbanked and offer services and products at a reasonable cost.

 

FinTechs as the Basis for BaaS

 

We hear a lot about fintech companies financial technology, also known as FinTech, is a line of business based on using software to provide financial services. Financial technology companies are generally, startups founded with the purpose of disrupting incumbent financial systems and corporations that rely less on software.

 

The overall goal of Fintech companies include:

 ·       Efficient and speedy delivery of funds

·        Development of alternate means of solutions for ongoing problems

·         Especially in the financial industry there are a lot of naysayers, but the fact of the matter is that there are structural reasons for the potential success of FinTechs.    Underbanked and unbanked people represents a huge potential market.   The FDIC produces a great deal of information about the unbanked and underbanked every two years. The study is called 2019 FDIC National Survey of Unbanked and Underbanked Households.   As of 2019, the combined number of unbanked and underbanked was almost 30 million people. 

 Fintech companies are pointed directly at the needs of the underbanked and unbanked

 

·         When thinking of a fintech, it is important to note that what they are trying to do is to get money to people is a manner that is both fast and cheap

·         FinTechs are also working on ways to meet the needs of a large group of people who are outside of the banking industry

·         Fintech companies understand that while not everyone has a banking account, mostly everyone has a cell phone or a similar electronic device

 

Using this technology, fintech companies are reducing the need for bank accounts. FinTech companies are really going after this population of people who for the most part are potential bank customers by providing solutions to problems that people have with banks.   One of the things that Fintech companies have focused on are the many uses of the smartphone.   For example, smartphones can be used for stored value.  That is, just like a reloadable debit card, the smartphone can be used to reload value repeatedly.  Fintech companies such as Zoom, Square and Amazon is making it possible to transfer funds and store funds.  Other Fintech companies are changing the way that credit is underwritten.  Fintech also has increased a small institutions ability to offer different products and services.  As traditional means for profit become scarcer, Fintech opens the possibilities for additional income streams. 

 

The 30 million people in the underbanked and unbanked populations are your potential customers!  The statistics show that this group is getting younger and more internet savvy.  The more that the customers use their smartphones, the less likely they are to rely on banks

 

Some examples of the many uses of a smartphone in the fintech industry includes the following:  

·        Stored Value  - A stored-value the card is a payments card with a monetary value stored on the card itself, not in an external account maintained by a financial institution.  Stored-value cards differ from debit cards, where the money is on deposit with the issuer, and credit cards which are subject to credit limits set by the issuer.

·         APIs - An open API is a publicly available application programming interface that provides developers with programmatic access to a proprietary software application or web service. APIs are sets of requirements that govern how one application can communicate and interact with another.

·         Nationwide Reach- Using data analytics, fintech companies can have access to customer behavior data and assist with marketing opportunities

 

For many of the unbanked, fintech companies represent a much-welcomed alternative to the use of high-cost check cashers.  In addition, there are companies that are taking on Payday lenders who up to this point have not had a great deal of competition. One of the other things that these companies do is give financial institutions the ability to offer products and services

Information is power and even for a small institution, if you are unaware of what your customers want and are going to want in the future, it is a problem.  The regulatory agencies that cover financial institutions have recognized this synergy and have issued guidance and taken steps that are designed to ease the process for relationships between financial institutions and Regtech companies.  These included:

 

·         Regulators are encouraging institutions to pool resources when it is feasible

·         Joint Statement on Banks and Credit Unions Sharing Resources to Improve Efficiency and Effectiveness of Bank Secrecy Act Compliance was issued in October of 2018

·         One of the main points of the statement is that there are ways that financial institutions can leverage what other banks or firms are doing

·         Fintech companies have the ability to help in a number of ways.  Some of these companies have developed programs that are help with analytics and security

·         The Office of the Comptroller of the Currency has initiated the Fintech charter program that was designed to allow Fintech companies to have special banking powers.  This charter has been called into question by a decision of a federal court that is now undergoing appeal. 

 

Regardless of the outcome from the appeal of the Fintech charter, the regulatory agencies have noted that fintech and banking are a natural combination that will continue to grow and in scope and activity.