A fintech collapse is rippling through a small corner of the banking world

The unraveling of fintech upstart Synapse is rippling through a small corner of the banking world, leaving 1000’s of shoppers without access to their money and a mystery about thousands and thousands of dollars that went missing.

4 small US banks have a number of the money. Nobody is certain where the remainder went.

The saga surrounding the bankruptcy of Synapse, a 10-year-old fintech firm, puts a latest highlight on how loose webs of partnerships between venture-backed upstarts and FDIC-backed lenders can go so incorrect.

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

Earlier this month, the Federal Reserve slapped considered one of Synapse’s partner banks with an enforcement motion that identified risk management weaknesses surrounding such partnerships.

Synapse was a part of a wave of recent fintech firms that emerged within the aftermath of the 2008 financial crisis as Silicon Valley-style digital banking upstarts promised to shake up the world of traditional finance.

In only a decade it became a significant middleman between dozens of fintech corporations and community banks by offering what it called “banking as a service.”

It provided digital banking outfits like Mercury, Dave (DAVE), and Juno with access to checking accounts and debit cards they might offer their customers. It was capable of do that by partnering with FDIC-backed banks that in return got a latest source of deposits and fee revenue.

The standard lenders that partnered with Synapse included Evolve Bank & Trust, American Bank, AMG National Trust, and Lineage Bank, all small banks when put next with giants like JPMorgan Chase (JPM) or Bank of America (BAC).

The most important was Evolve, which had roughly $1.5 billion in assets at the top of the primary quarter.

The pitch that Synapse effectively gave to those smaller banks was “we’ll usher in the deposits; you don’t must do much,” in line with Jason Mikula, an independent fintech consultant who publishes a weekly newsletter and has followed Synapse.

“This turned out to not be accurate, for my part,” Mikula added.

Jelena McWilliams, former FDIC chair, is trustee within the Synapse bankruptcy. (PATRICK T. FALLON/AFP via Getty Images) (PATRICK T. FALLON via Getty Images)

The issues surfaced shortly after Synapse filed for bankruptcy in April when it couldn’t reach an agreement with Evolve on a settlement of funds.

Three weeks into the bankruptcy proceedings, Synapse cut off Evolve’s access to its technology system. That, in turn, forced Evolve and the opposite partner banks to freeze customer accounts.

Each parties blamed one another because the perpetrator.

“Synapse’s abrupt shutdown of essential systems all at once and failure to offer mandatory records needlessly jeopardized end users by hindering our ability to confirm transactions, confirm end user balances, and comply with applicable law,” Evolve said in an announcement.

Synapse CEO Sankaet Pathak rebuked this claim, accusing Evolve of getting the means to settle a deficit yet delaying the return of customer funds.

“The debtor has been forced to play a perverse game of ‘whack-a-mole’ with unreasonable demands from Evolve as conditions to unfreezing the depositor accounts, all while the depositors suffer lack of access to their funds,” Pathak stated in court documents last month.

The final result is that 1000’s of fintech customers lost access to their money.

“Synapse’s bankruptcy has left tens of 1000’s of end-users of economic technology platforms that were customers of Synapse stranded without access to their funds,” Jelena McWilliams, the court-appointed trustee to Synapse and a former FDIC chair, wrote in a letter last week to the heads of 5 federal banking regulators.

There was one other problem: Nobody appeared to know where the entire money was.

McWilliams in early June said there was a shortfall of $85 million, with the 4 banks only accounting for $180 million of the $265 million belonging to finish users.

More recently she said the range of the shortfall was $65 million to $96 million.

Some money has been paid back to customers. McWilliams said on June 21 that greater than $100 million “has been distributed by certain of the partner banks.”

Bank regulators have been concerned for a while in regards to the partnerships between Silicon Valley-style digital startups and FDIC-backed banks.

Acting Comptroller of the Currency Michael Hsu used a September 2023 speech to debate the potential blind spots for regulators as these relationships turn into more blurry.

“Banks and tech firms, in an effort to offer a ‘seamless’ customer experience, are teaming up in ways in which make it tougher for patrons, regulators, and the industry to tell apart between where the bank stops and where the tech firm starts,” Hsu said within the speech.

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

These partnerships will not be yet widespread across your entire banking industry, though using this model is accelerating while banks of all sizes seek ways to draw 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, on Capitol Hill in Washington, U.S., May 18, 2023. REUTERS/Evelyn Hockstein

Acting Comptroller of the Currency Michael Hsu has raised concerns in regards to the ties between banks and fintech firms. (REUTERS/Evelyn Hockstein) (REUTERS / Reuters)

Fewer than 2% of US banks used the banking-as-a-service model in 2023, in line with S&P Global Market Intelligence.

But regulators are nonetheless getting more aggressive about calling out such relationships. The banking-as-a-service model accounted for 13.5% of public enforcement actions from regulators in 2023, in line with S&P.

In January, the FDIC issued a consent order to considered one of Synapse’s partner banks, Franklin, Tenn.-based Lineage, that identified weaknesses related to its banking-as-a-service program and ordered the bank to give you a plan for easy methods to achieve an “orderly termination” with significant fintech partners.

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

Then, earlier this month, the Fed issued an enforcement motion against Evolve, saying that examinations conducted in 2023 “found that Evolve engaged in unsafe and unsound banking practices by failing to have in place an efficient risk management framework” for its partnerships with fintech corporations.

Regulators asked Evolve to enhance its policies and risk management practices “by implementing appropriate oversight and monitoring of those relationships.” Additionally they noted that the motion was “independent of the bankruptcy proceedings regarding Synapse.”

A spokesperson for Evolve said the recent order was “just like orders received by others within the industry” and “doesn’t affect our existing business, customers, or deposits.”

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

It has also up to now partnered with two crypto firms that went bankrupt, FTX and BlockFi, in addition to Bytechip, a financial services firm had its accounts with Evolve frozen late last 12 months on the allegation it violated federal law by laundering money for fraudsters.

So as to add to its recent challenges, Evolve said this past Wednesday that some customer data was illegally spread on the dark web because of this of “a cybersecurity incident involving a known cybercriminal organization.”

“Evolve has engaged the suitable law enforcement authorities to assist in our investigation and response efforts,” the bank said. “This incident has been contained, and there isn’t any ongoing threat.”

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

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