Fintech is collapsing in one small corner of the banking world


Fintech upstart Synapse is unraveling in a small corner of the banking world, leaving thousands of customers without access to their money and the mystery of the disappearance of millions of dollars.

Four small American banks have some of the money. No one knows where the rest of the money went.

The story surrounding the bankruptcy of 10-year-old fintech firm Synapse highlights how the loose web of partnerships between venture-backed startups and FDIC-backed lenders can go the wrong way.

Regulators are scrutinizing these relationships more closely and warning various banks to tighten their controls when working with fintech firms.

Earlier this month, the Federal Reserve took an enforcement action against one of Synapse’s partner banks, identifying risk management weaknesses around such partnerships.

Synapse was part of a wave of new fintech firms that emerged after the 2008 financial crisis, when Silicon Valley-style digital banking companies promised to shake up the world of traditional finance.

In just a decade, it became a major middleman between dozens of fintech companies and community banks by offering “banking as a service.”

It gave digital banking organizations like Mercuryo, DAVE, and Juno access to checking accounts and debit cards that they could offer to their customers. It was able to do this by partnering with FDIC-backed banks, which in turn gave them a new source of deposit and fee revenue.

Traditional lenders that partnered with Synapse included Evolve Bank & Trust, American Bank, AMG National Trust, and Lineage Bank, all smaller banks compared to giants like JPMorgan Chase (JPM) or Bank of America (BAC).

The largest company was Evolve, which had nearly $1.5 billion in assets at the end of the first quarter.

What Synapse effectively offered to these smaller banks was that “we'll bring the deposits; you don't have to do much,” according to independent fintech consultant Jason Mikula, who publishes a weekly newsletter and has tracked Synapse.

“In my opinion, it didn’t come out right,” Mikula said.

Former Federal Deposit Insurance Corporation (FDIC) Chair Jelena McWilliams speaks during the Milken Institute Global Conference in Beverly Hills, California, on May 2, 2023. (Photo: Patrick T. Fallon/AFP) (Photo: Patrick T. Fallon/AFP via Getty Images)Former Federal Deposit Insurance Corporation (FDIC) Chair Jelena McWilliams speaks during the Milken Institute Global Conference in Beverly Hills, California, on May 2, 2023. (Photo: Patrick T. Fallon/AFP) (Photo: Patrick T. Fallon/AFP via Getty Images)

Jelena McWilliams, former FDIC chair, is the trustee in the Synapse bankruptcy. (Patrick T. Fallon/AFP via Getty Images) (Patrick T. Fallon via Getty Images)

The problems surfaced shortly after Synapse filed for bankruptcy in April after it could not reach an agreement with Evolve on the disposition of funds.

Three weeks into the bankruptcy proceedings, Synapse cut off Evolve's access to its technology systems. As a result, Evolve and other partner banks had to freeze customer accounts.

Both sides blamed each other.

“Synapse's sudden shutdown of essential systems without notice and failure to provide necessary records unnecessarily exposed end users to risk by hindering our ability to verify transactions, confirm end user balances and comply with applicable law,” Evolve said in a statement.

Synapse CEO Sanket Pathak refuted the claims and accused Evolve of delaying refunds to customers despite having the means to cover its losses.

“The debtor has been forced to play a perverse game of 'whack-a-mole' by making unreasonable demands on Evolve to unfreeze depositor accounts, while depositors continue to be denied access to their funds,” Pathak said in court documents last month.

The end result was that thousands of fintech customers lost access to their money.

“Synapse’s bankruptcy has left thousands of end users of financial technology platforms who were Synapse’s customers stranded without access to their funds,” Jelena McWilliams, the court-appointed trustee for Synapse and former FDIC Chairwoman, wrote in a letter last week to the heads of five federal banking regulators.

There was another problem: Nobody knew where all the money was.

McWilliams said in early June that there was an $85 million shortfall, and that the four banks held only $180 million of the $265 million owed to end consumers.

More recently, he said the shortfall was between $65 million and $96 million.

Some of the money has been returned to customers. McWilliams said June 21 that more than $100 million “has been distributed by some partner banks.”

Bank regulators have been concerned about partnerships between Silicon Valley-style digital startups and FDIC-backed banks for some time.

Acting Comptroller of the Currency Michael Hsu discussed potential gray areas for regulators in a September 2023 speech as these relationships become more blurred.

“Banks and technology companies are working together in an effort to provide a 'seamless' customer experience in a way that makes it difficult for customers, regulators and the industry to distinguish where the bank ends and the technology company begins,” Hsu said in the speech.

Last June, regulators issued final joint guidelines on how lenders should handle these relationships.

These partnerships are not yet widespread across the banking industry, although use of this model is growing rapidly as banks of all sizes look for ways to attract deposits and earn more revenue.

Acting Comptroller of the Currency Michael Hsu testifies before a Senate Banking, Housing and Urban Affairs Committee hearing in the wake of recent bank failures, Capitol Hill in Washington, US, May 18, 2023. REUTERS/Evelyn HocksteinActing Comptroller of the Currency Michael Hsu testifies before a Senate Banking, Housing and Urban Affairs Committee hearing in the wake of recent bank failures, Capitol Hill in Washington, US, May 18, 2023. REUTERS/Evelyn Hockstein

Acting Comptroller of the Currency Michael Hsu has raised concerns about the relationship between banks and fintech firms. (Reuters/Evelyn Hockstein) (Reuters/Reuters)

According to S&P Global Market Intelligence, less than 2% of US banks will use the banking-as-a-service model in 2023.

Yet regulators are becoming more aggressive in uncovering such relationships. Banking-as-a-service models accounted for 13.5% of public enforcement actions from regulators in 2023, according to S&P.

In January, the FDIC issued a consent order to one of Synapse’s partner banks, Franklin, Tennessee-based Lineage, identifying vulnerabilities related to its banking-as-a-service program and ordering the bank to create a plan to achieve “orderly terminations” with significant fintech partners.

The following month, New York City-based Piermont Bank; Attica, Ohio-based Sutton Bank; and Martinsville, Virginia-based Blue Ridge Bank received consent orders from regulators related to alleged deficiencies in their banking-as-a-service business.

Then, earlier this month, the Fed issued an enforcement action against Evolve, saying tests conducted in 2023 found that Evolve engaged in unsafe and unsound banking practices by failing to create an effective risk management framework for its partnerships with fintech companies.

The regulators asked Evolve to improve its policies and risk management practices “by implementing appropriate oversight and monitoring of those relationships.” They also noted that the action was “independent of the bankruptcy proceedings with respect to Synapse.”

A spokesperson for Evolve said the recent order was “similar to orders received by others in the industry” and “will not impact our existing business, customers or deposits.”

The bank counts Affirm (AFRM), Mastercard (MA) and Stripe among notable fintech partnerships on its website.

It had partnered in the past with two crypto firms, FTX and BlockFi, that went bankrupt, as well as Bytechip, a financial services firm whose account with Evolv was frozen late last year amid allegations that it violated federal law by laundering money for fraudsters.

In addition to its recent challenges, Evolve said last Wednesday that a “cybersecurity incident involving a known cybercriminal organization” had resulted in some customer data being illicitly spread on the dark web.

“Evolve has engaged appropriate law enforcement officials to assist with our investigation and response efforts,” the bank said. “This incident has been contained, and there is no ongoing threat.”

David Hollerith is a senior reporter for Yahoo Finance covering banking, crypto and other areas of finance.

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