As a CPA firm serving numerous VC-backed startups, we’ve noticed many of our clients keep their cash at fintech companies like Mercury, Brex, or Rho. These “neobanks” aren’t traditional banks, but they provide banking-like services by partnering with FDIC insured banks.
Recent proposed regulations from the FDIC could significantly impact how these fintechs operate and, by extension, how startups manage their finances. Since founders often turn to us to find out which startup banks are the best, and how to get extended FDIC insurance for their startups, we were pretty interested when we noticed that the FDIC released proposed regulations for neobanks on June 30, 2024.
We aren’t lawyers nor are we experts on politics, but these rules could possibly impact the startups that we work with, so let’s break down what’s happening and why it matters. And - again - these are only proposed rules, so there is no action to take at the moment.
If you take away one thing from this: it makes sense for most startups to have two banking relationships so that they can move money quickly if needed.
What’s a deposit broker, and why should you care?
The crux is that many neobanks might get labeled as “deposit brokers” So, let’s demystify a key term: “deposit broker.” Simply put, a deposit broker is an entity that helps place deposits with banks on behalf of others. This could include many fintech companies that help you manage your startup’s money.
The FDIC cares about deposit brokers because deposits obtained through them are often considered less stable and potentially riskier for banks. And, if they don’t have solid “know your customer” processes they can be a source of less-desirable/sketchy deposits (think money laundering, etc.) Those are a few reasons why there are regulations around “brokered deposits.”
What’s changing?
The FDIC is proposing several changes that could impact fintech companies and their startup clients:
- Broader Definition of Deposit Broker: More fintech companies could be classified as deposit brokers, even if they only work with one bank.
- No More Exclusive Arrangement Exemption: Currently, fintechs with exclusive arrangements with one bank aren’t considered deposit brokers. This exemption would disappear.
- Tougher “Primary Purpose” Exception: It might become harder for fintechs to prove they’re not primarily in the business of placing deposits.
- Changes to Application Process: Only banks, not fintechs, could apply for exceptions to deposit broker rules.
- Modified Sweep Account Rules: This mostly affects broker-dealers but could impact some fintech offerings. Sweep accounts are accounts that take a single depositor’s cash and spread it out to multiple banks to get a higher insured limit.
- Eliminating the “Enabling Transactions” Exception: Fintechs can’t avoid being classified as deposit brokers just because they’re primarily enabling transactions.
- More Scrutiny on Bank-Fintech Partnerships: The FDIC wants to take a closer look at these relationships.
Will neobanks have to become real banks?
This is one of the core questions that we are trying to understand from the proposed regulations. As far as we can tell, the short answer is no, but the reality is more complex:
- Tighter Regulations, Not Necessarily Full Banking Licenses: Neobanks won’t be forced to become full-fledged banks, but they’ll likely face regulations more similar to traditional banks.
- Operational Changes: Neobanks might need to restructure their relationships with partner banks and alter how they manage customer deposits.
- Increased Compliance Burden: Expect neobanks to face heavier compliance requirements, potentially leading to increased operational costs.
- Strategic Shifts: Some neobanks might pursue banking charters for more control, while others could pivot away from deposit-taking services.
- Partnership Model Changes: Relationships between neobanks and partner banks could become more complex, with increased regulatory oversight.
- Industry Consolidation: Smaller neobanks might struggle to meet new requirements, potentially leading to mergers or acquisitions.
- Innovation Impacts: While not halting innovation, these regulations could slow down certain types of financial product development.
Why this matters for startups
If your startup uses a neobank like Mercury, Brex, or Rho, these changes could affect you indirectly. Here’s how:
- Service Changes: Your neobank might adjust its services to comply with new regulations.
- Bank Partnerships: Your fintech’s relationship with its partner bank could change, potentially affecting your banking experience.
- Additional Regulatory Burden: You may face extra regulatory paperwork and headaches as neobanks pass down new compliance requirements to their end clients (that’s you, the startup).
- Increased Costs: Compliance costs could be passed on to you.
- Potential Instability: Some neobanks might struggle to adapt, leading to service disruptions.
- Diversification Needs: You might need to consider diversifying your banking relationships to mitigate risks.
Why the FDIC is proposing tighter regulation on neobanks
The FDIC’s proposed regulations on brokered deposit restrictions for neobanks come in response to several factors. We’ve seen some news about some of the neobanks closing accounts that are in countries where there are embargos and anti-money laundering rules, for example.
But, probably the biggest reason behind this newly proposed neobank regulation is the collapse of Synapse, a fintech company that provided banking infrastructure to other fintechs and startups. Understanding the context behind these regulations can help clarify why the FDIC is taking these steps.
The Synapse Fintech Collapse
Synapse’s collapse in early 2024 sent shockwaves through the fintech industry. As a company that offered banking-as-a-service (BaaS) solutions, Synapse enabled other fintechs to provide banking-like services without being traditional banks themselves. They were basically a middleware provider who sat in between the non-bank fintech player and the backend bank that provided the actual bank account. When they went under, something like $160 million in customer deposits were frozen (and hopefully not actually lost!).
You can almost think of one of their core products as being a bookkeeper, who recorded the transactions and kept the records of which end customer had money at which actual bank.
But… it turns out that bookkeeping is hard.
We only know what we know from press reports, but it sounds like Synapse had some issues scaling and keeping track of where the customers’ money was. Not good!
What we guess the FDIC’s is trying to do with their response
In light of the Synapse collapse and other issues in the neobanking sector, the FDIC is proposing these new regulations to address several key concerns:
- Stability of Deposits: By broadening the definition of “deposit broker” and eliminating certain exemptions, the FDIC aims to ensure that deposits placed through fintechs are subject to the same scrutiny and stability requirements as those placed directly with traditional banks.
- Enhanced Oversight: The proposed regulations seek to bring more fintech companies under the regulatory umbrella, ensuring they adhere to rigorous KYC and AML standards. This is intended to prevent the influx of high-risk deposits that could destabilize the banking system.
- Operational Integrity: By requiring fintechs to restructure their relationships with partner banks and comply with stricter regulations, the FDIC hopes to improve the operational integrity of these companies. This includes ensuring that fintechs have robust internal controls and compliance measures in place.
- Market Confidence: The FDIC’s actions are also aimed at restoring market confidence in the fintech sector. By imposing stricter regulations, the agency hopes to reassure investors and customers that fintech companies are operating within a secure and stable framework.
What’s next?
Remember, these are proposed rules, not final ones. There’s a 60-day comment period where fintechs, banks, and other interested parties can provide feedback. The final rules may look different from what’s proposed.
For now, there’s no need to panic or make drastic changes. However, it’s worth keeping an eye on these developments, especially if your startup relies heavily on neobank services. Consider the following:
- Stay Informed: Keep track of how your chosen neobank is responding to these potential changes.
- Contingency Planning: Have a backup plan in case your neobank significantly alters its services.
- Diversification: We pretty much almost always recommend that you have a backup bank - ie. funded accounts at least two financial institutions.
As always, we’re here to help you navigate any changes and ensure your startup’s finances remain on solid ground. Stay tuned for updates, and don’t hesitate to reach out if you have questions about how these potential changes might affect your startup’s financial strategy.
