After several years of explosive growth, fintech companies are currently experiencing a reality check. Valuation multiples have dramatically compressed, investors’ priority has rapidly shifted from “growth” to “profitability,” and cash-burning startups are scrambling to adapt.
The truth is, they won’t all make it. Historically, 75% or more of all startups fail, per the Wall Street Journal. In fact, failure is so common in Silicon Valley, it’s a mantra (“fail fast”).
But what happens when a fintech that serves consumers fails? Users may have outstanding loans — which don’t disappear just because the company that originated them failed.
And, in the case of “neobanks,” end users have even more critical exposure: They may have balances in their accounts, have their paycheck directed into it, have automatic payments debited out of it and use an associated debit card for critical expenditures like food and transportation.
The risk is further elevated as neobank customers tend to be lower income and have lower credit scores. They may have few alternatives if their neobank abruptly shuts down.
What Goes Up:
More banks are eyeing banking-as-a-service as a profitable sideline. Due diligence should include a sober look at the risk of a neobank failure.
Virtually every neobank partners with a licensed bank to offer key aspects of their functionality, like holding customer deposits and issuing debit cards. For a time just a handful of banks specialized in these banking-as-a-service (BaaS) programs — entities like MetaBank, The Bancorp Bank and Green Dot.
But with the explosion of fintech in general — and debit interchange-driven business models in particular — community banks have gotten into the BaaS game in increasing numbers. There are now more than 60 consumer- and small business-focused neobanks operating in the U.S. That growth in demand has drawn names like Coastal Community Bank, nbkc, Stride, Blue Ridge Bank, and Evolve Bank & Trust into the banking-as-a-service business.
So, what happens to partner banks when a neobank fails, and what should banks considering BaaS be aware of?
Unique Challenges from Troubled Neobanks
If you’re partnering with early-stage, startup fintechs, it is likely a question of “when” not “if” one of them will need to be acquired or wound down.
Examples abound, both in the U.S. and abroad, of neobanks that have closed. BBVA acquired neobank Simple in 2014 – and shut it down in 2021. The account transition process went awry, as The Verge reported, presenting a variety of error messages to users and leaving many unable to access their account information.
Read More: Which Neobanks Will Survive In the Future?
In mid 2022, neobank Brex told tens of thousands of small businesses it would close their accounts, according to CNBC. While Brex itself didn’t shut down, it left customers about two months to withdraw their funds and find new banking solutions.
In perhaps the absolute worst case for customers, high-yield savings app Beam was forced to shut down by the FTC — leaving many users unable to access their money stored with its partner banks for several weeks.
As a result of several problem situations, bank regulators are wading in with tougher oversight of BaaS.
Regulators have made clear that disruptions that cause consumers to lose access to their funds will incur consequences. When customers of prepaid card provider RushCard — essentially a predecessor to today’s neobanks — lost access to their funds for an extended period of time, the company was fined some $13 million.
Then-director of the CFPB said of the incident, “Companies will face the consequences if consumers are denied access to their money. All of this stemmed from a series of failures that should have been anticipated and prevented.”
Blue Ridge Bank’s agreement with the OCC is another stark warning about potential risks of embarking on a BaaS business model without adequate planning. The agreement requires substantial remediation and improvements to Blue Ridge’s oversight of its fintech partners, including “contingency plans for terminating third-party fintech relationships in an effective manner.”
Also notable: The agreement requires Blue Ridge to seek the OCC’s permission before onboarding new fintech partners or offering new products and services through existing partners.
Partner Banks’ Responsibility Starts with Due Diligence
A partner bank’s approach to handling a potential neobank failure should begin before the bank even commits to taking on a fintech or neobank as a client.
The OCC issued guidance in 2021 for how community banks considering working with fintechs should approach due diligence. Suggested areas of diligence include examining potential partners’ business experience and qualifications, financial condition, legal and regulatory compliance, risk management and controls, information security, and operational resilience.
With regard to preventing a neobank failure, banks would be well-served to ask questions like:
- Does the fintech/neobank have adequate capital to build, launch, and run its program?
- What investors does the fintech/neobank have? Are they committed? Will they stand behind the company if times get tough?
- Does the fintech/neobank have a credible path to profitability, or is it focusing only on “growth” and planning to “figure out” the economics later?
It’s also worth determining if a potential neobank partner is committed to building the infrastructure necessary to protect its customers in scenarios other than “happy path” outcomes — or if they’ve only built an “MVP” (minimum viable product).
Also, does the neobank have a clear, documented idea about what it would do if the company runs out of money and must sell itself or shut down?
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Detect Problems Before They Put Customers at Risk
Once a BaaS program is up and running, of course the bank partner will be monitoring activity that is directly visible to them. This may include things like “for benefit of” (FBO) account balances, transaction activity and reconciliation reports.
Equally important is that a bank should also be monitoring its neobank partner’s financial health at regular intervals. How much cash does it have on hand? What is its burn rate? How much runway does it have? And if it’s in the process of fundraising, how are those conversations going? What does its pipeline look like?
Clear visibility into the financial health of their neobank partners can help banks detect potential problems in time to address them before they become catastrophic.
Read More: The World’s Biggest List of Digital Banks
How Banks Can Work with Troubled Fintechs to Protect Consumers
If a bank’s fintech partner appears headed for trouble, the two should work together to mitigate risk to the neobank’s users. Key steps include:
Provide timely, clear communication. Customers are likely to only be familiar with the name of the fintech/neobank, not the partner bank. Customer outreach should set clear timelines about what customers should expect to happen and when — particularly if any action is needed from them.
Ensure customer access to funds. If a neobank partner is shutting down, users should be given adequate warning to enable them to move their funds (via ACH or debit rails) to another account. If users do not move funds, funds must be returned by check if necessary — including making reasonable efforts to locate addresses of users who may have moved (i.e. checking the National Change of Address registry.)
Allow adequate time for transition. Lower income customers may have significantly fewer options than other customers and may be using the neobank product as their primary account. These users may need to open new accounts before they’re able to transfer funds out of a neobank that is shutting down — this may require extra time to ensure a smooth transition.
Be available to answer questions. Many neobanks emphasize “self-service” through digital account features and FAQs. But if a neobank is winding down, users will have urgent questions and want to speak to a live human being.
This is likely to entail additional staffing and systems work — making it all the more important that banks monitor and work with neobank partners to plan ahead and ensure there are sufficient resources and personnel to do handle a wind-down gracefully.