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Partner Bank Compliance and the Impact on Fintech
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Last month, Bancorp Bank, a U.S. bank that commonly partners with fintech companies via its parent company Bancorp, transitioned from a state-based banking charter to a national one. In parallel, over the past few months, the Office of the Comptroller of the Currency (OCC) — the federal regulator that charters and regulates national banks — has been more carefully reviewing the relationship between partner banks and fintech companies. Together, these recent changes signal that the role and responsibility of partner banks, as well as the cost of operation and compliance, is likely to evolve in the coming months.
As we know, the approximately 90 U.S. partner banks, in partnership with banking-as-a-service (BaaS) software providers, enable fintech companies to offer banking products like debit cards, bank accounts, lending products, and access to the national payments network, without needing to become banks themselves. Bancorp is one of the biggest and oldest BaaS providers, and Bancorp Bank is its subsidiary bank. They’ve typically focused on larger fintech companies and work with the likes of Chime and SoFi. Prior to getting a national charter, Bancorp Bank, like most partner banks, had a state-based charter along with FDIC insurance. Many partner banks have state charters (e.g., Evolve Bank, Coastal Community Bank, Hatch) and similarly are not under the scope of the OCC.
For banks that want to serve bigger customers with more complex needs, a national charter can provide additional flexibility. Traditionally, the preemption of state law by having a national charter (i.e., not needing to comply with requirements on a state-by-state level) was a benefit. That said, many banks have also shifted from national to state charters, primarily to save on costs and to get easier access to a local regulator (or more cynically, to go regulator shopping), especially post-Dodd-Frank.
The obvious tradeoff for Bancorp Bank is the additional regulatory scrutiny from the OCC, not to mention the upfront regulatory approval process, the high cost of switching charters, and ongoing operational review and examination costs. That said, Bancorp’s increased compliance costs are potentially balanced out by an increased confidence in their compliance procedures from their customers, especially given they target larger fintech customers.
This decision coincides with increased scrutiny over partner banks and disruptions in service. The OCC has been investigating the relationship between partner banks and fintech companies over the past year or two. For example, after investigation, Blue Ridge Bank, another federally chartered partner bank, agreed in August to increase its risk assessment, monitoring, and response to compliance, BSA/AML, operational, liquidity, counterparty, IT, and credit risk, among others. Blue Ridge also pledged to obtain a “non-objection” — essentially an approval — from the OCC prior to onboarding any new fintech partners, something it didn’t have to do before. Over the past few months, several other bank partners similarly stopped onboarding new customers or allowing their customers to open additional accounts.
In a recent talk, acting OCC Comptroller Michael Hsu said that the fintech-BaaS-partner bank relationships are “here to stay” and the “future,” suggesting the OCC doesn’t intend to end such relationships. He acknowledged that fintech companies have brought digitalization and expertise to the banking sector, and they will benefit consumers. That said, Hsu wants to “do the future right” and has indicated that the OCC plans to more closely monitor partner banks and require additional compliance reporting. The idea here is that the OCC wants to better understand where risk and stress lie in the financial system, who might fail, where payments are going, and the like, as it may have knock-on effects across the financial system and the economy overall.
So what do these changes mean for fintech companies? Increased compliance requirements for partner banks will likely leads to higher direct and indirect costs for fintech companies. Partner banks need more compliance staff and procedures to oversee their fintech customers. That means longer diligence and initial review processes, higher ongoing costs, and longer lead times for product launches. Smaller and higher risk fintech companies will likely bear the brunt: some partner banks may decide it is not worth the cost to serve them, leaving fewer options. Overall, we’re in the thick of increasing regulation that may trickle down to fintech — for example, new proposed Community Reinvestment Act (CRA) guidelines increase the assessment level banks face, and as result, may limit how and when banks partner with fintech companies.
Much of the idea behind BaaS providers was to make it easier for customers to start and manage a fintech company without needing the high upfront costs; by having the partner bank and BaaS provider handle the compliance, the fintech company could handle the software layer, customer acquisition, and servicing. These new developments may cement the opportunity for the BaaS providers, or even more so, for banks like Column and Lead Bank, who potentially can combine the bank with BaaS to streamline the process of getting a fintech product live.
– Seema Amble, a16z fintech partner
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Bridging the Gaps in Private Markets Software
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A few months ago, we wrote a piece — “Come for the Tool, Stay for the Exchange” — about a significant opportunity we see to enhance private markets liquidity. If you missed it, the TL;DR is that while many startups have attempted to broaden access to alternative investments through new marketplace products, we believe the most compelling way to sequence an offering in this category is to lead with software (the tool) before launching a multi-sided network (the exchange). Having now spent several months discussing this concept with many different constituents in the ecosystem, we feel even more strongly that there’s a big opportunity to build novel software solutions to serve private market stakeholders, starting with one initial focus group (e.g., general partners (GPs), registered investment advisors (RIAs), or limited partners (LPs)). In this post, we’ll define key industry workflows, discuss the status quo for software, identify specific opportunities for builders, and lay out some open questions we are continuing to explore.
To understand the different needs software could potentially address within an investment firm, it’s helpful to break down a typical firm’s activities into three different buckets of workflows: investing, capital raising and investor relations, and financial operations. Investing activities typically revolve around deal sourcing and execution, with associated tools providing CRM, market data, and data-sharing capabilities (e.g., data rooms). Capital-raising activities facilitate data collection and distribution between GPs and companies and between GPs and LPs. Tools in this bucket help with portfolio monitoring, LP CRM, LP onboarding, and ongoing LP reporting. Finally, financial operations activities encompass how dollars flow into and out of the fund, and the reporting associated with these transactions. Tools in this bucket help with fund accounting, waterfall calculations, capital calls, and distributions. For the purposes of this post, we intend to focus on the capital raising/investor relations and financial operations buckets, as we believe the stakeholders that populate these teams are not only underserved, but also act as central ecosystem nodes when it comes to potentially converting a tool to an exchange.
What we’ve learned
Having spoken to over a dozen GPs, RIAs, and LPs, we’ve boiled down our learnings to four main points. Most of what we heard tracked with our expectations, though we were somewhat surprised and particularly intrigued by our third and fourth learnings:
- Most incumbent offerings with significant scale are at least 20 years old, and they are typically owned by large incumbents or private equity firms. This means they aren’t necessarily motivated to move fast and break things or take big bets.
- Implementations are time consuming (multiple years), expensive, and extremely bespoke. This makes it challenging for any one software provider to create any sort of data-standardization requisite to eventually launch an exchange (like we have in public markets).
- While most scaled platforms offer the full range of capabilities, investment firms rarely consolidate their activities into any one provider because of concerns about business continuity or over-reliance. As a result of this, teams are using multiple tools for different workflows, which leads to a lot of duplicative flat file exports and email exchanges.
- Every large private markets investment firm is actively thinking about how to raise more capital from retail investors, as institutional LPs broadcast their “denominator problems” — the effect of public markets asset price declines inflating private markets portfolio allocations for institutional allocators — and retail promises more “permanent capital.”
The themes we heard throughout our discovery discussions highlighted several compelling opportunities for builders in this space:
Bridging the gap between user personas
There’s no reason IR and financial operations teams can’t share and work out of the same system of record, given that both teams’ relationship management strategies need to account for the same things: prospective investments (new potential LP dollars committed) and historical investments (performance, distributions, upcoming capital calls, etc.). Having one unified system that provides both teams with real-time visibility into the other’s activities benefits everyone involved, including the LP. This idea is made all the more compelling because relatively new but ubiquitous fintech infrastructure makes it easier for software builders to embed payments functionality (read: capital calls, distributions) into relationship management or fundraising software. This capability internalizes some of the activities that are likely done at the moment by a third-party fund administrator, which could enable more firms to potentially start doing their own fund administration and monetizing payments. Software that seamlessly bridges IR and finance teams will be incredibly sticky, financially prudent, and lucrative.
Building a modular product to initially solve for the most critical activities
Throughout our dialogues, we heard time and again that the central capabilities IR and finance teams are looking to augment with software are fund accounting, LP portals, and/or CRM. Budgets for LP portals in particular can be massive, since portals control such a crucial part of the LP experience with a given fund. Startups building in this space should eventually look to build an end-to-end solution, but in the short term, building a modular product allows prospective buyers to ease their way in building their own customizable experience over time.
Architecting a go-to-market motion that unlocks unique access to the “exchange” part of the equation
There’s an opportunity for startups to target ecosystem participants who have embedded relationships with large swaths of retail capital, e.g., wirehouses and RIAs. This is easier said than done, as there are compelling incumbents 100% focused on providing premier private funds with access to retail capital. However, many of these platforms are not focused on serving the funds in question with core IR software. We think there is an opportunity to do both. In fact, by doing the core software part well, we think it’ll make it even easier for funds to attract new sources of capital, given all the data a software provider will already have on the current LP base, fund performance, and ongoing investments. Having said this, the larger funds tend to have myriad existing systems and processes, many of which have been custom implemented over many years, so founders should expect the “rip and replace” sale to be long and hard fought!
Optimizing the product for network effects
One of the most compelling aspects of building in this ecosystem is the number and diversity of relevant participants who could benefit from better software tools. Successful builders in this category will create collaboration opportunities that naturally pull other ecosystem participants, such as lawyers, RIAs, accountants, and financial planners, into the orbit of the product.
While we’re excited about the thesis laid out above, there are still several key questions left to answer.
- Will winners in this market build deep vertical solutions for one asset class, or will they work to serve a broad audience across private markets? Are there enough GPs in any given asset class to support a massive standalone business? As an investor, do you need to believe that the financial services and payments components are essential revenue streams on top of SaaS, or is the market for software deep enough that the financial services revenue is all gravy on top?
- Can startups beat the behemoth firms without offering the five-year, fully custom implementation? On a related note, can they do it without becoming more of a services business? Fund administration and related use cases are known to be amongst the stickiest relationships in the industry today. While these represent a large revenue opportunity, when executed the traditional way, they rely on human-driven manual processes, which result in lower gross margin profiles than those in pure-play software.
With the rapid growth of alternative asset AUM and clear demand from firms for new sources of capital, we think this is an exciting time to build in this category. We look forward to seeing how founders can simultaneously solve pain points for multiple internal personas, like IR and finance teams, as well as for multiple external stakeholders, like GPs, LPs, and wealth managers. If you’re building something along these lines, we’d love to hear from you.
– Marc Andrusko, a16z fintech partner & David Haber, a16z general partner
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- Why we invested in The Coterie
- Why we invested in MVMNT
- Angela Strange and Flora Oliveira on Brazil’s surprising fintech tailwind
- Nathan Yoon, Melissa Wasser, and David Haber on launching a financial product: how to choose the right funding structure
- Alex Rampell’s tweetstorm on private-to-private M&A
- Anish Acharya, Alex Immerman, and Titan Co-CEO and Cofounder Clayton Gardner on how the fintech market is changing (podcast)
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