Financial institutions are increasingly turning to banking as a service (BaaS) to distribute their offerings to non-banking companies. It’s a new development that is shaking up the sector and catching some by surprise. In a 2014 PwC report that explored the powerful forces shaping the retail banking industry, for example, executives predicted the 2020 banking landscape. Of the 560 executives surveyed then, 56% identified regulatory compliance as their key challenge for the road ahead.
In this one seemingly unremarkable statistic there’s a fascinating clue as to how challenger banks and fintechs were able to outflank the incumbents with new digital models, and why financial institutions are now feeling both threatened and excited by banking as a service. While traditional retail banks and credit unions were focused on the interminable challenge of compliance, the entire landscape shifted. In a matter of years, the relationship between bank or credit union and end user has changed almost beyond recognition. So too has the power struggle between established financial institutions and emerging fintech providers.
Seven years ago, financial institutions believed (with justification) that regulatory compliance would be the biggest obstacle to overcome. Today, their business model and potentially their survival are in question unless they can focus on other concerns. But as much as banking as a service may look like a threat right now, it offers the opportunity for many to thrive. Here’s what financial institutions need to know.
What Is Banking as a Service?
With an estimated market value of $138 billion by 2026, embedded finance is increasingly in demand among online businesses. Embedded finance allows nonfinancial providers to offer financial tools or services — traditionally the preserve of retail banks and credit unions — to their end users. Banking as a service is the structure that supports it.
Conventionally, unregulated and unlicensed nonfinancial institutions would not be authorized to offer financial services and products to their end users, nor would they have the technical resources to build the infrastructure required. Banking as a service provides the platform for them to do so, seamlessly and affordably. With BaaS, a business can potentially embed a vast array of modular services, from loans and payments to deposit accounts, into its offering by partnering with a secure, licensed bank or credit union.
The BaaS provider sits in between the financial institution (which provides the regulatory framework) and the fintech provider (which delivers the end-user experience). Here is the BaaS “stack”:
- The only connection to the end user is at brand or business level. This might be an airline or eCommerce store that wants to embed financial services into its offering using a white label solution.
- Products and services (credit cards, loans, buy now pay later) are developed by the fintech provider.
- The bank or credit union, as license holder, provides access to third parties through APIs.
How BaaS Originated
There is a misconception that open banking and banking as a service are synonymous, but there are some differences between the two. The introduction of PSD1 (2007) and PSD2 regulation (2018) in Europe unleashed the open banking era, under which banks and credit unions were obliged to share their data with third-party service providers. In turn, this allowed nonfinancial organizations to extend their range of financial services, carry out transactions and challenge traditional banks with faster, cheaper payments.
The end user might not have been too concerned with what had changed behind the scenes. From their perspective, there was just a wider range of providers offering lower fees and better user experience, from neo-banks such as Revolut and N26 to tech giants such as Apple and Google.
How BaaS Is Different
With open banking, banks and credit unions were merely opening up their data to third parties. With BaaS, they’re opening up their full suite of services, connecting through application programming interfaces (APIs) that integrate seamlessly with the bank’s core (regulated) infrastructure.
In essence, any business or brand can now behave like a bank or credit union. Retailers, insurance providers, software services, telco companies and more are now offering payments, deposits, loans and more through their own platforms. Instead of having to leave the business’s ecosystem to obtain these products or services, the end user can manage them all in one place. For the online company, the allure is complete control over the end-user experience and increased brand loyalty.
For its part, the bank receives a fee from the BaaS provider to make its API interface available. As Javier Rodriguez Soler, chief executive of BBVA USA, points out, “As long as this customer receives a good loan…I don’t mind if he thinks Target is giving him this loan.”
Not all banking as a service delivery involves a fintech partner. Many of the bigger banks and credit unions, such as JP Morgan and Goldman Sachs, are starting to develop their own BaaS platforms. Even the giants cannot afford to let the competition take the lead. With global sales expected to exceed $12 billion by 2031, banking as a service is simply too big a beast to ignore.
Is BaaS a Threat to Traditional Financial Institutions?
“For years, banks and fintechs have sparred over control of customer data,” notes American Banker. Now they must battle for end-user experience. In the sense that banks and credit unions are accustomed to owning that end-user relationship, banking as a service does pose a threat. Nonfinancial institutions can deliver a slicker, more user-friendly experience that traditional financial institutions — with their aging infrastructure, siloed decision making and regulatory burden — struggle to match.
But there is an opportunity too, which stems from the fact that financial institutions don’t have to rip out their core legacy architecture to partner with fintechs. BaaS is a cloud-based layer that sits on top of the core, so services can be integrated relatively quickly and scaled at speed. By embedding their products in other platforms, without having to invest in expensive technology upgrades, banks and credit unions can reach new end users more efficiently. Oliver Wyman Consultants estimates that customer acquisition costs could be up to 20 times lower through a BaaS stack.
Further Opportunities for Financial Institutions
Most of the interest in banking as a service to date has been around payments, with vendors searching for a more frictionless, lower cost way to integrate payments into their own wallet or platform. Any end-user concerns that nonfinancial institutions represent a bigger security risk than incumbent banks and credit unions have largely disappeared.
Younger generations, in particular, are likely to see a digital challenger bank as a safe option — more than 80% of Gen Z and millennials, for example, are already using a money transfer app — and the pandemic is accelerating the digitization of the banking landscape across the board. Online purchases surged by up to 25% in Europe in 2020 alone, and end users have become accustomed to end-to-end eCommerce solutions that banks must now emulate.
In that context, financial institutions should be bold in exploring new revenue streams that can be unlocked through banking as a service. By offering premium APIs in partnership with third parties, banks and credit unions can penetrate new markets, resonate with younger end users and integrate innovative solutions quickly without the need for major capital investment.
The Challenges of Banking as a Service
Before partnering with a BaaS provider, or developing a proprietary platform, banks and credit unions need to address some familiar challenges.
Any integration between a third-party API and the core invites a malicious attack or data breach. That means banks have to allocate already stretched IT resources to security, which is not something many will welcome. According to the CapGemini World Retail Banking Report, 39% of retail banking executives plan to decrease spending on IT maintenance.
Banks and credit unions have only just finished meeting the compliance demands of some far-reaching regulatory requirements in relation to personal data. For those operating in the U.S. or European Union, GDPR in particular threatens huge fines for any serious data breach.
Financial institutions have already implemented rigorous ”know your customer” (KYC) requirements to verify the identity of end users. These have to be consistent throughout the full BaaS stack, without impacting negatively on a smooth end-user experience.
For all the advantages of APIs, there are still data migration and data integration challenges to consider, as well as the potential for incompatibilities between third-party and legacy software. Not every financial institution will have the capacity to build on a BaaS offering.
How Banks Can Decide
As far as BCG is concerned, there is no question to debate. “If they are to survive,” the group wrote in 2020, “banks must start acting more like digital giants before digital giants — including Amazon, Facebook, and Google — start acting like banks.”
That might be easier said than done. For a start, banks and credit unions are understandably protective of the relationships they nurture with their end users. Distributing services through a BaaS partner puts that relationship at risk. In that respect, the most rewarding partnerships will be with fintech solutions that accentuate brand values. Examples include Bank of America unlocking more than $27 billion-worth of cashless mobile payments through Zelle and Wells Fargo promoting its green credentials in partnership with The Climate Service.
Traditional financial institutions can also expand their range of services with greater agility, offering insurance, rewards, foreign exchange and more without having to reconfigure their famously siloed infrastructure. Most banks and credit unions will admit that decision making can be sclerotic within the institution, with each department protective of its own workflows and financial objectives. By partnering with a BaaS provider, individual departments can get a service up and running fast without having to secure universal agreement, generating revenue and increasing efficiency across the whole organization.
Even more so since the pandemic, end users are looking for integrated, bundled mobile services that maximize speed and convenience. If banks and credit unions were to start innovating on those today, it would take years to bring a solution to market, by which time challenger banks would already have provided a slicker alternative. In that respect, banking as a service offers a fast track without compromising on the elements that matter most to financial institutions — security and regulatory compliance.
Oliver Wyman Consultants – The Rise of Banking as a Service
American Banker – Banking 2025: The Rise of the Invisible Bank
Insider Intelligence – Banking as a Service (BaaS) Explained & Industry Outlook 2021
McKinsey & Company – Financial Services Unchained: The Ongoing Rise of Open Financial Data
World Retail Banking Report – BaaS Platform Model Is the Way Forward – World Retail Banking Report
International Banker – Banking as a Service (BaaS): The Platform Approach to Banking