Embedded finance is a form of financial service offered by nonbanks that companies are using to retain customers and increase their so-called lifetime value. In today’s market, companies of all types and maturity levels-including retailers, telcos, big tech and software companies, car manufacturers, insurance providers, and logistics firms-is considering and preparing to launch embedded financial services.
Small businesses can open bank accounts through their accounting software, whereas consumers can pay directly through their retailers. To meet the burgeoning demand for embedded finance, financial institutions are increasingly offering BaaS (Banking-as-a-Service) bundled offerings that nonbanks can offer to their customers through white-labelled or co-branded services.
The BaaS Imperative
Although many banks are concerned that distributing their products through partners will threaten their client relationships, if end users begin adopting embedded finance in significant numbers, banks may have little choice but to launch their own BaaS businesses. For banks, enabling partners to distribute banking products can be a low-margin, high-volume business.
The market is still in its infancy, and it is hard to predict how it will develop. Banking-as-a-Service and API banking may become as ubiquitous as online or mobile banking, a channel that every bank must build and maintain. As a result, banks will continue to differentiate themselves through products, rates, reach, and other dimensions.
Another possibility is that the market will return to scale, much as cloud computing is dominated by big players. A few BaaS providers that are top-notch in technology, analytics, and cost structure will likely have insurmountable advantages in the space if this winner-takes-all dynamic continues.
Trends In The Embedded-Finance And Banking-As-A-Service Arena
- Customer Demand For Integrated Experiences: Customers are increasingly seeking simple, holistic, embedded, and direct experiences. According to our research, customers are flocking to these multiproduct customer experiences, known as ecosystems. The goal of ecosystem orchestrators is to offer as much integration as possible, so an embedded integrated financial offering fits in well with the model.
- Demand From New Fintechs And Beyond: To access bank accounts, make payments, and lend money, fintech companies require banking partners every year. However, big technology companies and other non-banking players cannot “become” banks in the United States and many other markets where the regulatory bar is very high. Fintechs have no choice but to offer customers embedded finance through banking-as-a-service. For these players to serve their massive customer bases, they require end-to-end Infrastructure as a service solution in conjunction with regulatory support and balance sheet or other funding sources.
- Rise Of Openness: Regulatory trends such as PSD2 and open banking promote the development of banking APIs and universal access. Due to compliance with these new requirements, often via IT modernization, some banks are considering new or expanded BaaS business models to recoup costs and take advantage of technological advances. Beyond regulation, Plaid and other aggregators are raising the bar for data portability, which is causing IT modernization and BaaS projects to increase.
- Search For New Revenue Models: Financial institutions are actively exploring alternative sources of revenue and product growth due to projected declines in banking revenue and profitability. Business models with scalable business models and fixed IT investments (e.g., distribution models) are especially advantageous.
- Adoption Of Technological Capabilities: As digitization accelerates, including automation and APIs, banks will be able to scale BaaS faster, making embedded finance more accessible for more companies. At the same time, those who seek to embed financial services view their digital experiences as a collection of modules built by others. Often, this is because they consider software engineering as their core competency, and credit, lending, deposit, or checking accounts as just another capability to add to the user experience.
It may well be a land grab to implement BaaS. In this case, banks will need to develop a BaaS strategy today that considers their cost structure and the route to transformation. They should also realize how a dramatic increase in customer demand for integrated banking experiences will affect their businesses.