Fintechs know they need better compliance, but don't want to pay for it

Andrew Harrer/Bloomberg

Fintechs find meeting compliance standards challenging as regulatory scrutiny increases, but macroeconomic conditions are limiting their investments in those capabilities, a recent survey shows.

Banks are holding the fintechs they partner with to a higher compliance standard as bank-fintech partnerships and banking-as-a-service providers see more enforcement action, and more regulation in recent months, advisors said.

"Banks are being more critical of these partnerships," said Marina Olman-Pal, a corporate shareholder at Greenberg Traurig who advises fintechs. "A lot of these partnerships are structured in a way in which the bank pushes down certain regulatory compliance obligations onto the fintech partner … which the fintech company may not have had before."

Banks will also offboard fintechs that don't meet their compliance standards. Olman-Pal said this has also increased fintechs' appetite for third-parties that offer services like automated AML compliance. 

To handle the rising compliance obligations, most fintechs are using third-party risk platforms and AI or machine learning for at least some processes, according to a recent survey conducted by Alloy, a vendor that provides risk management products to fintechs like Ally, Marqeta, Brex and Petal.

Bank regulators are also offering more direction around fintechs and banking-as-a-service providers. In June, interagency guidance from The Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency offered more details for how banks should develop and manage relationships with third parties, like fintechs. The guidance puts the onus on financial institutions to evaluate and manage the risks of fintech partnerships.

"The trends that we're seeing are a maturation of compliance in fintech," Alloy CEO Tommy Nicholas said. "It's getting more regulatory scrutiny. It's getting more regulatory clarity. Regulators are paying more attention, they're being more prescriptive, and there's more action being taken."

Nicholas added that regulatory movement can help fintechs, banks and other parties understand what role they play in compliance. Ben Saul, a financial regulatory lawyer at Greenberg Traurig, said that most bank-fintech partners include indemnification terms, meaning that if a bank gets slapped with an enforcement action or fine, it can pass that to the fintech. Out of 202 fintech respondents to the Alloy survey, more than 60% said they paid more than $250,000 in fines related to compliance in the last year. 

In March, the FDIC hit Cross River Bank, a banking-as-a-service provider that makes loans through fintech lenders, with a consent order. The agency alleged that the Teaneck, New Jersey-based bank engaged in unsafe or unsound banking practices related to fair lending regulations in connection with a program it offered in 2021.

While traditional financial institutions are scaling up their investments around risk and compliance, nearly two-thirds of fintechs believe their organization is spending enough on compliance, and one-third said they are spending too much, per the Alloy survey. Venture funding, the main source of capital for many fintechs, has slowed. Public fintechs, like Dave and Upstart, are focused on piloting paths to profitability amid sputters in performance.

"Any way you can save money right now, if you're in one of these businesses where the macroeconomic climate is putting the squeeze on you, you're really remiss to your shareholders not to try and do that," Saul said. "Obviously, the challenge as outside counsel that we certainly make sure for our clients is, it can't really be at the expense of a sufficient compliance management system."

As regulatory obligations and the cost of entry around bank-fintech partnerships rise for banks, and the potential revenue opportunities in the current economic environment decrease, Saul said some banks are also pulling out of the banking-as-a-service ecosystem. 

Nicholas said he thinks the rate of banks entering the space has slowed, but is still bullish on bank-fintech partnerships going forward.

"We actually see more banks getting into embedded finance and sponsor bank-led activity," Nicholas said. "It's at a slower rate than it used to be, but it's still increasing. And I think the future is bright for embedded finance and fintech."