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

Four small US banks have some of the money. No one is sure where the rest went.

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

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 one of Synapse’s partner banks with an enforcement action that identified risk management weaknesses surrounding such partnerships.

Read more: What is a neobank and is it safe?

'Banking as a service'

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

In just a decade it became a major middleman between dozens of fintech companies 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 could offer their customers. It was able to do this by partnering with FDIC-backed banks that, in return, got a new source of deposits and fee revenue.

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

The largest was Evolve, which had roughly $1.5 billion in assets at the end of the first quarter.

The pitch that Synapse effectively gave to these smaller banks was "we’ll bring in the deposits; you don’t have to do much," according to Jason Mikula, an independent fintech consultant who publishes a weekly newsletter and has followed Synapse.

"This turned out not to be accurate, in my opinion," Mikula added.

The problems surfaced shortly after Synapse filed for bankruptcy in April when it could not 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 other partner banks to freeze customer accounts.

Both parties blamed each other as the culprit.

"Synapse’s abrupt shutdown of essential systems without notice and failure to provide necessary records needlessly jeopardized end users by hindering our ability to verify transactions, confirm end user balances, and comply with applicable law," Evolve said in a statement.

Synapse CEO Sankaet Pathak rebuked this claim, accusing Evolve of having 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 end result is that thousands of fintech customers lost access to their money.

“Synapse’s bankruptcy has left tens of thousands of end-users of financial 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 five federal banking regulators.

There was another problem: No one seemed to know where all of the money was.

In early June, McWilliams said there was a shortfall of $85 million, with the four banks accounting for only $180 million of the $265 million belonging to end 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 more than $100 million "has been distributed by certain of the partner banks."

Blind spots

Bank regulators have been concerned for some time about 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 discuss the potential blind spots for regulators as these relationships become more blurry.

“Banks and tech firms, in an effort to provide a ‘seamless’ customer experience, are teaming up in ways that make it more difficult for customers, regulators, and the industry to distinguish between where the bank stops and where the tech firm starts,” Hsu said in the speech.

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

These partnerships are not yet widespread across the entire banking industry, even though the use of this model is accelerating while banks of all sizes seek ways to attract deposits and earn more revenue.

Fewer than 2% of US banks used the banking-as-a-service model in 2023, according to 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, according to S&P.

In January, the FDIC issued a consent order to 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 come up with a plan for how to achieve an "orderly termination" with significant fintech partners.

The next month, New 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 in their banking-as-a-service business.

Then, earlier this month, the Fed issued an enforcement action 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 effective risk management framework" for its partnerships with fintech companies.

Regulators asked Evolve to improve its policies and risk management practices "by implementing appropriate oversight and monitoring of those relationships." They also noted that the action was "independent of the bankruptcy proceedings regarding Synapse."

A spokesperson for Evolve said the recent order was "similar to orders received by others in the industry" and "does not 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 in the past partnered with two crypto firms that went bankrupt, FTX and BlockFi, as well as Bytechip, a financial services firm had its accounts with Evolve frozen late last year on the allegation it violated federal law by laundering money for fraudsters.

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

"Evolve has engaged the appropriate law enforcement authorities to aid in our investigation and response efforts," the bank said. "This incident has been contained, and there is no ongoing threat."

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

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