Transcription:
Penny Crosman (00:03):
Welcome to the American Banker Podcast. I'm Penny Crosman. Banking as a service, a dynamic where banks provide products and services behind the scenes for fintech partners like neobanks and online lenders, has been under pressure for the past few years. Some banks have been hit with consent orders over their fintech partners' compliance failings. Some have struggled to service the millions of end users their fintech partners bring them, and the Synapse bankruptcy, which left hundreds of thousands of consumers locked out of millions of dollars that they may never get back, has given this category a black eye. But survivors remain, and for banks like Pathward in Sioux Falls, South Dakota, it remains a viable business model. We're here today with Pathward CEO Brett Pharr, who will share his views on how banking as a service is changing. Welcome, Brett.
Brett Pharr (00:52):
Thank you. I appreciate the opportunity to be here and talk about this important topic.
Penny Crosman (00:57):
Thanks for coming. How long has Pathward offered banking as a service, and who are some of the fintechs it works with?
Brett Pharr (01:05):
So we've been doing this since long before it was called banking as a service. I like to think about it as third-party delivery of banking services through partners. And in fact, our group that does this is, we call them partner solutions. And the interesting thing is we've been doing this with fairly large companies for a long time, companies that either grew up with us and are very much profitable and survivors through this, and many of them are even household names. So we do have fintechs meeting relatively recent entrants into this, but the bulk of our business has been with large longstanding financial services partners.
Penny Crosman (01:47):
Can you share a few names?
Brett Pharr (01:49):
Sure. Income, H&R Block, Blackhawk. There's some also newer names in the industry like Finix or Clair. And these are companies that we identified that we wanted to partner with, and many of them have been doing this as long as we have.
Penny Crosman (02:08):
And what kinds of products and services do you offer with them?
Brett Pharr (02:13):
In the early days, this was largely a prepaid, a card account, became a debit account, payroll cards, and often was a sort of single-threaded product approach. We're all familiar with gift cards that you can go and buy at a retail outlet. There's lots, millions of people in this country that do not have a traditional checking account, so they get their paycheck on a payroll card. And so that's been going on for a long time and for recent years because of the entrants and fintechs, both the fintechs, neobanks and many of our longstanding partners are broadening their product set. So now you have faster kinds of things. You have early wage access, many are mixing certain kinds of consumer lending into it. We're doing some merchant acquiring. So there's a lot of depth that's going on with the product set that wasn't there years ago.
Penny Crosman (03:15):
Now, early wage access has drawn a bit of attention from state attorney generals and some state regulators. How do you look at that? Are you concerned about that?
Brett Pharr (03:27):
There are different ways of structuring it and you take the more conservative approach to it where in essence the consumer doesn't pay for it, the employer pays for it, or the payroll company pays for it. It's a much better model. It's when it turns into payday lending that it's a problem.
Penny Crosman (03:46):
I hear you. What are some of the things you look for when you are considering a potential fintech partner?
Brett Pharr (03:54):
Well, the first thing to scale, scale, scale, we're going to have very few that are in early cash burn. If we do, they're going to have to meet some pretty high minimum. So you've got to have some scale. You've got to have a pretty good business opportunity already. Certainly we need somebody that understands the regulatory framework and will work with us, but we're also looking for innovation for people that are engaged in co-creation with us to find the products that hit a particular niche. Is there a story that makes sense and can we be a part of that story? So there's a number of things that go into that, but we're interested in long-term relationships, strong commitment and co-innovation.
Penny Crosman (04:36):
And how much due diligence do you do on a potential partner?
Brett Pharr (04:40):
A great deal, A key component of this is in fact third-party management. The way a bank has to think about this is if a third party is serving an end consumer, we are responsible for every interaction with that consumer, whether we're doing it or not. And so that requires a great deal of due diligence, close ties, monitoring, testing, inspection of the entire customer process in every aspect. Otherwise, we really are not doing our job as a bank.
Penny Crosman (05:16):
And that includes compliance. And
Brett Pharr (05:18):
Yeah, I mean it's everything from AML, BSA, fraud monitoring accounting, reg E chargebacks, things that, other things that have to do with general Reg Z compliance, the accounting that has to go on and certainly we can talk about reconciliations, all elements of that relationship that's being handled by that partner. We're responsible to be sure that it is done in a compliant and in a customer proper way.
Penny Crosman (05:45):
And it seems like at least until recently, regulators were kind of expecting banks to monitor their fintech partners on a daily basis. How is that feasible when you work with a lot of different fintechs and some of them, like HR Block, have a very large scale?
Brett Pharr (06:08):
Well, certainly there's technology that's involved, so that's a key piece of it. There's also sampling, monitoring kinds of things, mystery shopping, all kinds of things like that. You may not be able to do 100% full file monitoring in every case, but you definitely can have a view of what's going on with that customer by that particular partner. You have to have the tools in place to do that.
Penny Crosman (06:34):
So a big case that we've been following is the Synapse bankruptcy where a lot of fintechs have been kind of burned by this situation where their customer accounts were frozen and now a lot of customer funds just may never reappear. They've basically vanished. Do you have any thoughts on what happened there?
Brett Pharr (07:02):
Well, when this started probably five or six years ago, there was a theory that came into the marketplace that was a failure from the beginning, and that is that you can put a intermediary between the bank and the third party that's facing the customer sometimes called middleware. And that is a successful business model. We never thought it was, we never engaged in it. My relationships are directly with the third party that's facing the customer. It has to be in order for me to play the role as a bank. The idea was that you could go to the fintechs and say, oh, well, you don't want to have to deal with that slow, stodgy bank. They've got all these rules or they have poor technology, so we're going to hide you from all of that and get in between the two of you so that you don't have to deal with it, and then you can go off and be innovative, et cetera. We did not play, it would not play because it forgets the very basic premise, which is the bank has to have a direct relationship with the individual that's serving the consumer or it's a failed business model. So the whole concept of middleware in my mind is not a workable solution. Certainly there's a role for technology to play in helping to facilitate that partnership, but there has to be a direct contract between the bank and the one that's serving the consumer or it doesn't work.
Penny Crosman (08:33):
So the idea of a middleman should be limited to providing technology,
Brett Pharr (08:40):
Not anything else. It should be software as a service, but you certainly can't come in and interrupt that contractual relationship between the bank and the one that's serving the customer. We have some that participate in those things, but even then is tri-party agreements. We might have a processor, for example, but you have to have a direct relationship with the one that's serving the consumer.
Penny Crosman (09:05):
A really large problem in this situation was that Synapse had this ledger that had one set of numbers and its main bank partner Evolve has a whole different set of numbers and the numbers don't match. And there's this gap of $65 to $96 million. What do you think is the answer to that kind of reconciliation problem? The FDIC has said that banks and fintechs ought to reconcile at the end of every business day, and not everyone agrees with that. What do you think might be a good answer to that?
Brett Pharr (09:48):
Well, I think there needs to be reconciliation on a very frequent basis. Whether that can be done daily or not, that's something everybody may have to work through. There's some where that happens. There's some where that may not be able to happen, but it's got to be close. It's got to be close. There's even some are saying real-time balance in which we're probably not there yet, but could be in the future. So a very basic premise of banking is reconciliations. So you have to go through reconciliations and do the work. And the other very basic premise is you cannot do harm to the consumer. There may be a problem between the bank and the third party, but in no case can anybody cause harm to the consumer. And that's what happened in this case. And I found it rather unconscionable that the parties didn't eat it and whether it was the bank or the other one, they needed to cover the consumer and make them whole, even if it took a loss, because that is the role of banking to be the safety network, FDIC insurance or not. And that's what people rely on. And so it gives a black eye to the industry when you don't cover the loss that you created because you had this middleware layer between you.
Penny Crosman (11:00):
Yeah. And the CFPB recently said it's not going to be supervising fintechs anymore. And it wasn't supervising all fintechs, but it was going after certain ones that were, say, subprime lenders, accused of overcharging people. Does it worry you that fintechs don't really have a consumer watchdog?
Brett Pharr (11:24):
I think done right, the fintech's consumer watchdog is the bank, because it's the bank responsibility, both from a legal perspective, from the regulatory framework to keep the consumer whole. And if you are opening up your banking network to anybody, then you have to have robust third party management to be sure they're not hurting the consumer. That includes reconciliations, that includes AML/BSA, that includes Regulation E chargebacks, that includes Regulation Z requirements that are there, and there's a long list and the regulators are now drilling down and reinforcing this with the banks as they should. That goes back to my first statement, which is if you are in this business and somebody is serving a consumer on your behalf through your bank, you are 100% responsible for all those topics, whether you're doing it or they're doing it. And that's the whole premise and has been for two decades in the third party delivery.
Penny Crosman (12:34):
How do you get enough of a view into what your fintech partners are doing? Is there a technology that helps you to have visibility into exactly how they're handling compliance, how they're handling consumer complaints and so forth?
Brett Pharr (12:55):
Obviously, lots and lots of data, and so data feeds are critical. Certain kinds of tools like an AML/BSA, making sure you have the tools that because of the volumes that we have would be with a $50 billion, a hundred billion bank, you have to have the more advanced tools. And then earlier I mentioned, and you do complaint management, you do process checks, you do mystery shopping, you do audit testing of various things. You go and you look at what the consumer is seeing on their portal as their balance and looking to see if that's the balance that's on your records from the third party. I mean, these are the kinds of checks and balances that have to be going on all the time. And you'll certainly find issues, but then you work through it and you prove it and you make it better rather than just saying, oh, well, that's the fintech's doing. It's not my problem.
Penny Crosman (13:47):
That makes sense. So have any of the things that have happened over the last couple of years prompted you to change anything so far? And also do you feel like it's reshaped the landscape or anything that you're doing going forward?
Brett Pharr (14:07):
Well, first, from a positive standpoint, the introduction of the fintech topics like embedded finance, very much sort of a disintermediation of financial services, product distribution from traditional challenges to the channels to different places, it's a huge opportunity. It's a market size now that is growing double digits every year. So huge opportunity as more and more things get disintermediated from traditional bank channels, especially in the younger generation and the lower ends of the market, it's very exciting. It's growing, and our whole premise is financial inclusion for all. That's been the heart of why we're a banking-as-a-service only bank, and we have really sort of gone 100% into that market and that market is growing significantly. Sort of towards the caution side, we were already applying heightened standards to our risk framework well beyond a $10 billion bank because we knew the volumes that we were producing required that.
(15:25):
And so when I came in and started looking at it, that's the way we thought about it. We're making that even bigger now. We're starting to think about ourselves as a $100 billion bank even though we're not that size, but that's the kind of volumes that we have. And so we have to keep advancing that because if we're going to engage in all these different products in embedded finance and all these unique niches, we have to have a very, very robust framework for our risk and compliance so that regulators and consumers aren't aggravated with us.
Penny Crosman (15:59):
Do you have any advice for others, maybe smaller banks that are thinking of getting into this space?
Brett Pharr (16:06):
Well, we've often said it takes $50 to a $100 million dollars, three to five years of losses and a complete commitment from the board down to get in banking as a service. You can't make it just a side gig because you need some deposits. And I think that's what a lot of people tried to do. They said, oh, well, this is the easy way to get some cheap deposits. No, it's not. We sold our community bank a number of years ago and went a hundred percent in. It's very difficult to run a community bank and do this at the same time and stay under $10 billion. It's too much to keep up with. And so my advice is, if you get into this, you better expect to have a major investment and get a hundred percent in and expect the rest of your organization to not be able to do what it's done before.
Penny Crosman (17:01):
Well, Brett, far thanks for joining us today and to all of you, thank you for listening to the American Banker Podcast. I produced this episode with audio production by Adnan Khan. Special thanks this week to Brett Farr at Pathward. Rate us, review us and subscribe to our content at www.americanbanker.com/subscribe. For American Banker, I'm Penny Crosman and thanks for listening.