The proliferation of fintech start-ups over the course of the last decade has not only profoundly changed how the global economy consumes financial services but has given rise to an entire fintech ecosystem. Much to the chagrin of many fintech start-ups, the laws and regulations that govern financial institutions have not evolved at the same pace as the technology, leaving a gap that both regulators and industry leaders struggle to fill.
While many fintechs are experiencing tremendous growth through innovative new products, many of the constructs they need to navigate directly or through partnerships with banks evoke an antiquated vernacular that doesn’t accommodate growth and innovation. The struggle for regulations to keep up with the speed and depth of innovation is especially evident in the FDIC’s ongoing challenge articulating the rules on brokered deposits in the FDIC Act. This article will explore the origins of the brokered deposit rule and analyze what the new rule promulgated in December 2020 signifies not only for technology companies but for fintech and financial innovation as a whole.
What are Brokered Deposits v. Core Deposits?
Generally, a bank’s deposit liabilities are comprised of two types of deposits: brokered deposits and core deposits. Core deposits include checking accounts, savings accounts, and certificates of deposit that an individual holds at a bank. These types of deposits are considered stable because they are deemed to be more direct through a bank’s digital channels, typically have predictable costs, and are less susceptible to interest rate changes. On the other hand, brokered deposits are deposits made to the bank vis-a-vis a third-party deposit broker. Brokered deposits are deemed to be riskier, as they tend to be large denomination deposits that intend to improve a bank’s liquidity. The FDIC governs rules on brokered deposits which have impacted how fintechs partner with banks with respect to deposits.
While discussed in detail below, the brokered deposit rule has made it more difficult for fintechs to partner with traditional banks because of how deposits were classified. Specifically, bank partners were generally less likely to work with fintechs in the payment processing and electronic payments space because of the stringent requirements.
Nevertheless, the rule and specifically the lack of clarity continued to quash synergistic partnerships between banks and fintechs for over half a decade.
What is the Brokered Deposit Rule?
In the aftermath of the Great Depression, Congress enacted sweeping bank legislation and created the FDIC in 1933. The creation of the FDIC represented an effort to restore consumer confidence in the banking system and prevent bank runs that riddled the preceding decade. By creating a regulatory body tasked with maintaining and monitoring an insurance fund in connection with bank deposits, President Roosevelt and his Administration endeavored to discontinue the “under the mattress” savings practices that resulted in thousands of bank failures and incited economic chaos during the Depression. See Transcript of Speech by President Franklin D. Roosevelt Regarding the Banking Crisis, https://www.fdic.gov/about/history/3-12-33transcript.html
Experiencing tremendous growth and legislative activism, the FDIC amended the FDI Act in 1989 by adding section 29 on brokered deposits. Section 29 prevented a depository institution from accepting brokered deposits if it did not meet certain capitalization requirements. Section 29 does not define a brokered deposit; rather defines a deposit broker as:
“Any person engaged in the business of placing deposits, or facilitating the placement of deposits, of third parties with insured depository institutions or the business of placing deposits with insured depository institutions for the purpose of selling interests in those deposits to third parties”
See 12 CFR § 337.6
The broad definition of a deposit broker included nine exceptions including a catch-all exception where “the primary purpose” was not the placement of funds.
Why is the Brokered Deposit Rule Important to Fintechs?
Despite many attempts by the FDIC to provide guidance on what the brokered deposit rule means, the rule ultimately created a barrier for modernizing traditional banking practices. See FIL-2-2015; https://www.fdic.gov/news/news/inactivefinancial/2015/fil15002.html. The rule essentially applied to any fintech involved with gathering deposits; regardless of its role or whether it custodied assets. Specifically, in many instances, the brokered deposit rule prevented commercial banks from partnering with parties delivering electronic payment services to an end-user because of the onerous capital requirements imposed by the rule. Even as the deposit placement services industry took on a life of its own in the form of app-based fintech companies, the FDIC struggled with providing clear guidance on what it considered a brokered deposit in context of a third-party agent relationship.
Referencing third-party fintechs in a study submitted to Congress pursuant to the Dodd Frank Act in 2011, the FDIC again hesitated to clearly explain how to interpret the statutory rule in context of the emerging fintech ecosystem. See Study on Core Deposits and Brokered Deposits: https://www.fdic.gov/regulations/reform/coredeposit-study.pdf. Instead, the FDIC suggested that the primary purpose exception accommodates these types of use cases since participants’ primary purpose is not collection of deposits for a depository institution, but rather providing a product that allows payments to consumers or by consumers. Nevertheless, the rule and specifically the lack of clarity continued to quash synergistic partnerships between banks and fintechs for over half a decade.
How has the New Rule Changed the Game?
After analyzing hundreds of comments during the Advanced Notice of Proposed Rulemaking process of the new rule, the FDIC recognized the need to modernize the rule on brokered deposits to accommodate for collaboration and innovation between commercial banks and fintechs when it effectuated the final rule in December 2020. See 12 CFR Parts 303 and 337. https://www.fdic.gov/news/board/2020/2020-12-15-notice-dis-a-fr.pdf.
The final rule identified 14 specific business relationships that fall into the primary purpose exception: most of which are automatically applied. Beyond these designated exceptions, a fintech is allowed to apply for a primary purpose exception. The final rule is beneficial for fintechs in the following ways:
- The FDIC recognizes that any fintech that has an exclusive relationship with one bank is not placing or facilitating the placement of deposits and therefore does not meet the definition of a deposit broker.
- The final rule defines “facilitating” in context of how much control or influence a third party has over a deposit account after it is opened. A fintech that never takes custody of funds would not meet the definition of “facilitating”.
- The final rule specifically identifies fintechs (including software service companies) that place deposits into accounts that pay nominal interest or no interest or fees to customers as satisfying the enabling transaction designation under the primary purpose exception.
- Even if a fintech does not satisfy the enabling transaction test, the FDIC represents that it would approve the application if a fintech proves that providing software services, rather than placing deposits, is the primary purpose of the business relationship.
What Does This Mean if You’re a Fintech?
So, how does the new rule impact a fintech that is looking to bring deposits to a bank through its products and services? Simply put, fintechs will be better positioned to partner with banks now because banks prefer core deposits over brokered deposits, as they are more flexible for the bank and require less capitalization.
Significantly, if you are a fintech that primarily has a banking relationship with only one bank, the deposits at issue would clearly not make you a deposit broker based on the plain language of the rule. To the extent that a fintech has multiple banking partners and can’t invoke this part of the new rule, it can argue that it does not meet the definition of “facilitating” if the fintech never takes custody of any of the deposits, but simply provides software or technical services that integrate with a banking platform. This is the case for Banking As a Service (BaaS) providers like Synapse.
Furthermore, even if a fintech cannot argue that it does not satisfy the definition of “facilitating”, it can avail itself of the primary purpose exception. Under the enabling transaction exception, which is automatically designated (although the fintech has to provide written notice to FDIC), a fintech can be carved out from the rule if 100 percent of the deposits at issue are placed in accounts that do not pay any fees or nominal fees. Finally, even if the enabling transaction test does not apply, a fintech can apply for a primary purpose exception on grounds that its primary purpose is to provide software services, an exception that the FDIC acknowledges that it would grant in its guidance on the new rule.
The new rule is emblematic of not only acknowledging the valuable role that many fintechs play in the overall banking ecosystem, but an endorsement on behalf of the FDIC to foster and cultivate the collaboration between traditional banks and fintechs. Where the rule previously served as a roadblock to innovation, it now unlocks opportunities to deepen the alliance between legacy financial institutions and modern fintechs to the benefit of consumers, a truth that President Roosevelt would have envisioned only in his wildest aspirations.