Regulator Proposal Could Reshape Third-Party Relationships

Federal regulators have turned their attention to banking as a service (BaaS) providers following the spring 2023 bank failures and the Synapse Financial Technologies collapse earlier this year.

In July, the Office of the Comptroller of the Currency, the Federal Reserve and the Federal Deposit Insurance Corp. issued a joint statement warning banks of the risks tied to third parties. The FDIC has since proposed new regulations for custodial accounts and brokered deposits.

If adopted, the proposed rules will change how banks use and oversee third-party vendors, fintech companies and deposit services. Bank directors need to understand how both rules could change their existing and future partnerships with those companies.

Fewer Deposit Broker Exceptions
In August, the FDIC proposed a new rule revising and expanding the definition of “deposit broker.” The proposal unwinds parts of a 2020 rule that created exemptions for certain types of deposit arrangements.

Under current regulations, banks that serve as the exclusive insured depository institution for a person placing deposits with the institution can classify those deposits as non-brokered. This exemption would go away under the proposed rule, and banks would have to reclassify more transactions as brokered deposits.

The proposed rule also narrows the primary purpose exception. Existing regulations exempt agents or nominees that placed less than 25% of their total assets under administration in a particular business line as brokered deposits. They also exempt agents or nominees placing 100% of customer funds in a particular business line into transaction accounts that do not pay any fees or other remuneration to the depositor. The proposed rule would (1) eliminate the general 100% exemption and (2) replace the general 25% exemption with an exemption only for broker-dealers and investment advisors registered with the Securities and Exchange Commission and placing less than 10% of assets under management for customers in a particular business line, with prior approval of use of third-party tech service providers.

This would change how institutions classify deposits arising out of third-party deposit placements, including certain fintech partnerships, with institutions that are not “well capitalized.” Such placements often are made with institutions that are in need of deposits to fund the bank. Under the proposed rule, undercapitalized banks would have fewer opportunities to partner with fintechs.

In October, the FDIC extended the comment period for the proposed broker deposit regulation by 30 days, which usually signals intense interest in a proposal.

New Recordkeeping Requirements
The FDIC has also proposed a new rule for custodial accounts, calling for more specificity in the records banks keep when partnering with fintechs and other third-party deposit services. The proposed custodial account rule seems to be a direct response to the Synapse collapse, with the FDIC referring to it frequently. In the recent Synapse bankruptcy, it became apparent that the middleware company, its bank and fintech partners and the end users did not agree on the master ledger regarding ownership of funds, and funds were allegedly missing.

Under the proposed custodial account regulation, banks would be required to maintain records identifying beneficial owners of custodial deposit accounts, allowing the bank and the FDIC to quickly identify end-user customers’ funds and pay deposit insurance claims if a bank fails. The rule generally would apply to custodial accounts through which beneficial owners may authorize or direct a transfer of funds through the third-party account holder, such a fintech or its partner, to a third party other than the account holder or beneficial owner.

Further, banks would be required to maintain accurate deposit account balances and conduct daily reconciliations against the beneficial ownership records, with additional requirements for recordkeeping by third parties.

Comments are due to the FDIC by Dec 2.

Conclusion
These proposed rules, once finalized, will pose new challenges to community banks in need of new deposits, as well as those looking to outsource deposits to other banks. Banks will have to reevaluate whether certain deals can be done and document their third-party arrangements in a compliant manner.