What the embedded-finance and banking-as-a-service trends mean for financial services

More and more nonbank companies are offering financial services, such as bank accounts or wallets, payments, and lending. The companies’ embrace of embedded finance—banking-like services offered by nonbanks—aims to retain customers and increase their so-called lifetime value. Venture capitalists, such as Angela Strange at Andreessen Horowitz and Matt Harris at Bain Capital Ventures, have for years encouraged their companies to consider embedded finance as a key monetization lever, “making every company a fintech company.” Today, companies of all types and levels of maturity—including retailers, telcos, big techs and software companies, car manufacturers, insurance providers, and logistics firms—are considering and preparing to launch embedded financial services to serve business and consumer segments. For customers, the appeal is ease of use: a small business can get a bank account from its accounting software, or a consumer can pay via the retailer.

To meet the rising demand for embedded finance, financial institutions are increasingly offering banking as a service (BaaS)—bundled offerings, often white-labeled or cobranded services, that nonbanks can use to serve their customers. Making it work will require new technologies and capabilities, because BaaS is usually distributed to clients via APIs and requires strong risk and compliance management of the embedded finance partner. (Fintechs offering to intermediate BaaS relationships also have emerged; examples include Treasury Prime, Synctera, Unit, and Bond.) Banks will also need new business models, such as pay-for-use monetization, B2B2C and B2B2B distribution capabilities, and a careful consideration of branding.

The BaaS imperative

Many banks are concerned that distributing their products through partners threatens their client relationships, but if end users begin adopting embedded finance in significant numbers, banks may have little choice but to launch BaaS business lines. The good news is that enabling partners to distribute banking products can be a low-margin, high-volume business for banks. Banks often struggle with their cost structures, which are frequently based on legacy technology and enabled through manual processes and operations. To offer BaaS, banks must undergo digital transformations, but many already have. My work with incumbent banks suggests that more than two-thirds have undergone the digital transformation and modernization necessary to be competitive in BaaS.

It’s early to tell how the market will evolve. One possibility is that banking as a service and API banking become as ubiquitous as online or mobile banking, a channel that every bank must build and maintain. In that world, achieving long-term differentiation with BaaS will be difficult, so banks will continue to distinguish themselves based on products, rates, reach, and other dimensions. Another possibility is that the market will be prone to returns to scale, much as cloud computing is dominated by big players. If this winner-take-all dynamic prevails, a few BaaS providers that are ahead of the pack in technology, analytics, and cost structure will likely form insurmountable advantages in the space.

Six trends to watch

We see six trends in the embedded-finance and banking-as-a-service arena. Understanding and monitoring these trends can help banks, and those who hope to work with on embedded finance, identify opportunities and guard against threats.

  1. Customer demand for integrated experiences. The most significant trend is that customers increasingly seek simple, holistic, embedded, and direct experiences. Customers, according to our research, are flocking to these multiproduct customer experiences, known as ecosystems. By definition, ecosystem orchestrators seek to offer as much integration as possible, so an embedded integrated financial offering fits the model perfectly. Consider Walmart’s recent announcement that it is building a financial-services offering with financial-technology investor Ribbit or Ikea’s recent announcement that it is purchasing 49 percent of its banking partner.
  2. Demand from new fintechs and beyond. The many fintechs established every year need banking partners to provide access to bank accounts, payments, and lending. Big technology companies and other nonbanking players can build and offer financial services but are unable to “become” banks themselves in the United States and many other markets where the regulatory bar for doing so is high. That leaves banking as a service as the only means for fintechs to offer customers embedded finance. These players require end-to-end BaaS infrastructure solutions coupled with regulatory support and balance sheet or other funding sources to serve their massive customer bases.
  3. Rise of openness. Regulatory trends including PSD2 and open banking are promoting the development of banking APIs and universal access. The need to comply with these new requirements—often through IT modernization—is driving some banks to consider expanded or new BaaS business models to recoup costs and take advantage of tech builds. Even beyond regulation, Plaid and other aggregators are changing customer expectations for data and account information portability, which is increasing IT modernization and BaaS projects.
  4. Search for new revenue models. Considering the declines projected for banking revenue and profitability, financial institutions are actively exploring alternative sources of revenue and product growth. Particularly advantageous are sources that have scalable business models and fixed IT investments (e.g., distribution models).
  5. Adoption of technology capabilities. With the acceleration of digitization, including automation and APIs, banks can scale BaaS faster, putting embedded finance within reach for more companies considering it. At the same time, companies seeking to embed financial services increasingly see their digital experiences as a composition of modules built by others. This is often because they focus on software engineering as a core competency, seeing payments, lending, or deposit and checking accounts as just another product capability to add to the user experience.
  6. Changing trust levels in financial services. Our surveys show that in the United States, incumbent banks have lost the trust advantage they had over financial technology companies. At the same time, many other brands have higher trust levels, which they can leverage into offering financial services. Banks that enable white-label or cobranded financial services through partners can build on the increasing trust in other brands to distribute their products. Banks won’t necessarily need to white-label fully across all products and geographies; rather, they may identify markets or products where they can tactically leverage the growing trust in nonbanks.

Challenges and opportunities for nonbanks and banks

From discussing financial-services use cases with nonbank companies across varying sectors, I’ve found that many understand the benefits. To get it right, I suggest they consider three critical questions:

  • Does adding banking make sense within the user experience or journey we offer? Or is this just an innovation project without a strong brand or experience hook?
  • Do we have a right to win against competitors with a banking, lending, or payments offering? Will our embedded-finance offering ultimately reach the volume necessary to justify the expense of the build?
  • Do we have the technical and operational capacity to work with a bank to build on top of their banking-as-a-service offering?

On the bank side, I work with institutions grappling with what products to offer on BaaS platforms, how aggressive to be in white-labeling products, and how quickly they can build the required cutting-edge technology. As they consider these points, they should also debate the following questions:

  • Given the often-challenging history of IT and digital initiatives at banks, can we realistically transform ourselves to offer banking as a service? Should we partner with a BaaS provider? If so, what will that mean for our economics?
  • In what products and geographies should we offer BaaS? Where do we stand on white label vs. cobrand? If we are the dominant provider of a product in a market, should we be willing to disrupt our own business?
  • What advantage do we have against the integrated user experiences likely to emerge from retailers, big tech companies, and other businesses? If we do not pursue BaaS, do we have a realistic strategy to compete with digital attackers or defend against banks with larger digital budgets?

BaaS may well be a land grab. If so, banks will need to develop a BaaS strategy today, with a realistic understanding of their cost structure and the path to transformation. They should also clearly see the impact that a significant increase in customer demand for integrated banking experiences will have on their businesses.