Financial Institutions, Inc. (FISI) recently announced their Q1 2024 earnings, and amidst the headlines about a significant fraud event, a subtle but crucial detail slipped under the radar. This overlooked signal, hidden in plain sight within the transcript, suggests a much deeper underlying problem that could spell trouble for the bank's future.

While the $18.4 million fraud charge-off understandably dominated the conversation, seasoned analysts, myself included, were busy dissecting the numbers. We focused on the insurance divestiture, the loan growth projections, and the impact on capital ratios. But what we missed was an alarming shift in FISI's approach to their Banking as a Service (BaaS) program, a shift that reveals a growing aversion to risk and potentially signals a stagnating future for a key growth driver.

BaaS, for the uninitiated, is a revolutionary concept that allows non-bank entities to offer banking services through partnerships with traditional banks. Imagine a fintech startup, offering seamless payment processing or a budgeting app directly integrated with a checking account – that's the power of BaaS.

FISI, recognizing this disruptive potential, jumped on the BaaS bandwagon, albeit cautiously. Their initial goal of $150 million in BaaS deposits fell short, reaching $127 million by year-end. The bank attributed this to their deliberate pace of onboarding clients and natural fluctuations in partner balances. Fair enough.

However, within the Q1 2024 transcript, CEO Marty Birmingham offered a seemingly innocuous statement: "Our risk-adjusted process for evaluating BaaS partners, coupled with a control approach to transitioning them onto our platform has resulted in modest but sustainable growth in this line of business and a reduction in our partnership pipeline."

Let that sink in – a reduction in the partnership pipeline. This isn't just a slowdown; it's a conscious step back. While the transcript attributes this to prudence and focusing on existing partners, I believe something else is at play – fear.

The recent fraud event, a sobering reminder of the inherent risks in financial services, seems to have shaken FISI to its core. Their cautious approach to BaaS, previously lauded, has morphed into outright risk aversion. This retreat from a burgeoning market could significantly impact FISI's future growth trajectory, particularly as they project modest loan growth of 1-3% and anticipate continued disintermediation within their deposit base.

To illustrate the potential impact, let's look at some numbers. Assuming FISI maintained a moderate growth trajectory in their BaaS program, achieving their initial target of $150 million and adding a further $50 million per quarter, they could have reached approximately $350 million in BaaS deposits by year-end. This, in turn, could have provided a significant boost to their overall deposit growth, offsetting the anticipated disintermediation from lower-cost deposit products.

But with a shrinking pipeline, that scenario seems unlikely. Instead, FISI appears to be prioritizing capital preservation and short-term earnings, sacrificing potentially significant long-term growth.

While this risk-averse strategy might seem prudent in the immediate aftermath of the fraud event, it begs the question: is FISI becoming too cautious for its own good? The banking industry is constantly evolving, and clinging to traditional models while shying away from innovative opportunities could leave FISI trailing behind more agile competitors.

My Hypothesis:

FISI's reduced partnership pipeline is a direct consequence of the recent fraud event, indicating a heightened sense of risk aversion within the bank. This aversion, while understandable in the short term, could stifle long-term growth and hinder their ability to compete in a rapidly evolving banking landscape.

The Numbers:

Potential BaaS growth: $350 million in BaaS deposits by year-end 2024 (assuming continued growth).

Projected loan growth: 1-3%.

Anticipated total deposit growth: 1-3%.

Deposit Growth Trends

This chart shows the potential difference in deposit growth with and without continued growth in the BaaS program.

The coming quarters will be crucial for FISI. Will they embrace innovation and navigate the inherent risks of the BaaS market? Or will they continue down the path of caution, sacrificing potential growth for short-term stability? The answer could very well determine the future of this historic bank.

"Fun Fact: Five Star Bank, FISI's primary subsidiary, holds the distinction of being the oldest continuously operating bank in Wyoming County, New York, dating back to its founding in 1852."