The sums lost in Synapse’s debacle are small when it comes to the financial system as a whole.  But, as the American Banker described last week, small amounts of money judged in the grand scheme loom large to many households.  Who’s to blame for losses due to the latest fintech’s playing fast and loose with FDIC-insured deposits? The perpetrators of course, but also the regulators who didn’t stop banks from striking Faustian deals with fintech companies, deluding themselves that issuing supervisory guidance would stop ruthless, agile speculators from preying on vulnerable banks and the still more susceptible customers.

Synapse has a cool name, but it sported red-hot warnings well before its bankruptcy.  That banks were willing to do business with a firm this dubious is a sign of deep strategic trouble for many small companies.  This is sad, but corporate survival often forces high-risk choices.  That regulators allowed bets that endanger both banks and their customers makes clear yet again that supervisory agencies take far too long and then do too little.

Was Synapse a clear and present danger before it became disastrous?  Just for starters, Synapse’s founder had apparently never worked a day in his young life.  Banks are supposed to know their customers and regulators are supposed to be sure they do.  Thus, this deal from day one was a bad idea for banks that should know better or quickly be told so. Drinking from the devil’s cup of “accelerating innovation” may be bewitching, but it’s also very dangerous.

With no one apparently saying anything, Synapse joined the flock of fintechs exploiting the unique privileges of a bank charter by, as critics rightly assert, “renting” the charter to use FDIC deposits as bait.  Promising that a customer’s funds will be FDIC-insured, these bank “partners” in fact only put consumer-derived funds – or at least some of them – in an FDIC-insured deposit in their own—not the customer’s name.  Thus, the customer gets his or her money back only if the nonbank still has it.

As everyone reading this note knows, depositors only get insured funds back from the FDIC if the bank holding them fails.  The entity holding funds at an FDIC-insured bank has this right like all other depositors, but depositors into the fintech live or die by its hand.  The fintech’s deposits are part of its bankruptcy estate, with customers only getting their funds back if there is enough left in the bankruptcy after higher-priority claims to permit this and the trustee can figure out whose money is whose within the omnibus account.

This is the under-belly of the “banking as a service” or BaaS business model, where banks urgently seeking cheap funds happily accept what they can from fintech companies also promising to feed them other scraps of its customers’ business.  BaaS banks often turn out to be little more than fronts for fintechs which then, like crypto firms before them, use the cachet of insured deposits to pilfer consumer pockets.

Regulators should have known better long before Synapse.  It is far from the first example of a BaaS gone bad.

In early 2021, the FDIC became aware that Voyager, a hot crypto scheme, was using BaaS to pitch FDIC-insured deposits to consumers betting on the then-red-hot crypto sector.  It took the Fed and FDIC well over a year then to do anything about this high-risk construct, sending a bad-boy letter to Voyager in July of 2022 and following up with FDIC guidance to banks warning them about these high-risk alliances shortly thereafter.  Several enforcement actions also followed in hopes of quelling crypto misrepresentations about FDIC status.  Good luck to that.

Seeing little progress over a year later, the FDIC issued a rule reiterating that companies that aren’t FDIC-insured depositories shouldn’t say they are taking funds that will be insured by the FDIC.  By this time, Signature Bank, a BaaS-crypto acolyte, failed, forcing the FDIC first and then the rest of the banking system to back Signature’s risky status in hopes of averting systemic risk.

Signature’s depositors were lucky – the bank failed and most got their crypto-enthralled deposits back.  Now, here we are in the summer of 2024, over a year after Signature and Synapse depositors aren’t as fortunate.  The banks holding their funds haven’t failed, at least not yet, so FDIC insurance does not apply and all they can do is hope that something is left over after Synapse’s speculative endeavors and insider deals are sorted out.

It’s been over three years since the first Faustian bargain between a bank and a crypto company put the innocent at great risk.  It’s been happening over and over again ever since with crypto until Signature’s demise led bank regulators to block banks from enabling high-risk crypto schemes.  Better late than never for crypto, but fintechs were in this game then an – no matter the FDIC warnings – and they’ve been in it ever since.

Will it take another big-bank failure to lead the banking agencies finally to close this barn door?  Judging by Synapse, it might.