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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