The first wave of Banking-as-a-Service (BaaS) interrupted the financial services supply chain by disrupting the last-mile delivery of financial products. Where banks used to have complete ownership and control, fintech and retail brands started using BaaS to offer new products and services to a variety of customer segments—taking over the distribution to win customers and upgrading the efficiency of the financial system.
This expansion is known as last-mile delivery, where the bank does not own the last mile of the customer experience but is providing the content. BaaS created an opportunity for banks to collaborate with fintech partners who can better market, promote, onboard, and expand financial products to offer to customers. However, the first wave went too far by abstracting crucial aspects from banks’ regulatory practices and required customer due diligence, such as Know Your Customer (KYC) and fraud monitoring, leaving regulators concerned.
As embedded finance (EF) becomes more available, the Global Embedded Finance Market continues to grow and is expected to be worth around $384 billion by 2029; greater moderation will be essential to protecting banks, businesses and consumers. Let’s explore this next stage in banking’s evolution and what might be coming next.
In the past, HBO, Showtime, or Disney created original content and distributed it through their own network channels. Yet there was rapid evolution through last-mile disruption as agile partners delivered content more quickly and at lower costs. Roku, Netflix, and Amazon Prime became the last-mile delivery platforms, aggregating content from various providers into a niche offering that gained rapid customer adoption.
The banking industry is experiencing this last-mile disruption from fintech companies, retail brand apps, and enterprise applications providing the customer-facing experience. These fintech apps embed bank content and financial features and often bundle them with original content. With EF, banks will own some delivery mechanisms and also partner with fintechs for last-mile distribution. Simply put, EF will become a standard distribution channel that banks will accommodate—much like their online, mobile or physical channels they support today—allowing them to take back control of last-mile delivery.
Similar to the success of entertainment streaming services, the banking industry and consumers will see the benefits of banks providing their own products that can now be distributed across multiple channels.
One of the predominant use cases that fueled the BaaS movement was private branding of a deposit account with a debit or prepaid card. The non-bank program that owned the last mile of delivery would offer unique features that would attract customers to sign up. For example, a department store offers a debit card with its own branding, allowing customers who signed up to earn extra loyalty points when purchasing this specific card. The objective was to attract customers, increase deposits, and benefit from the debit card usage on the account due to the interchange fee sharing.
Currently, this setup remains a common use case as financial institutions seek additional avenues for growing their deposit base that go beyond basic deposit accounts and debit cards. But, as in all supply chain strategies, the more functions a company can take on within the supply chain, the greater its share of the economics.
Such is the case for interchange revenue in BaaS. Banks that own their own BaaS platform can directly power their deposit growth partners in a multi-tenant environment, utilizing technology to enforce compliance controls and create products and services tailored to their customers. With ownership over their digital ecosystems, banks gain more significant influence over the economics of the BaaS supply chain. As interchange potentially deteriorates going forward, the bank also mitigates risk by owning the customer relationship and ensuring their programs do not dissolve if the BaaS provider middleman disappears.
With new opportunities also comes the need to review regulations. On June 6, 2023, the Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System (FRB), and the Office of the Comptroller of the Currency (OCC) collectively released their Interagency Guidance. This contains their final counsel on third-party risk management within the banking industry and notes that banking organizations are ultimately responsible for any activities they undertake with external parties.
The current state of BaaS highlights the need for banks to control their delivery programs and not to outsource these to BaaS providers, as it facilitates too large a risk relating to data protection and compliance. The swing of Fed regulators requiring the bank to have greater control over BaaS/EF is a good thing—because ultimately, this protects the safety and soundness of the financial system.
The bank uses technology to provide automated and programmatic oversight, ensuring transparency in customer information, accounts, and transactions. The trend leverages the bank’s technology platform, allowing them greater control over their programs, risks, and outcomes.
Initial indicators, such as consent orders, show that regulators are requiring banks to perform their own KYC and manage their own third-party risk management. Banks in control of their own technology can manage these items digitally, while also providing tools for their EF partners to self-serve their own programs, such as managing fraud, Customer Identification Program (CIP), and money movement exception management.
The FDIC is also evolving when it comes to products like digital currencies and the delivery channels used to provide banking services. The FDIC recently announced it is seeking comment on proposed amendments to its regulations, creating a notable opportunity for banks that are leading the BaaS/EF market to advance forward.
The market will continue to evolve and is already going beyond basic deposit accounts and cards. Banks that extend their distribution channels and become proficient in bundling EF products and services together will be the banks that will be in the best position to deliver across any last-mile provider. Those are the banks that will have the greatest opportunity to advance and ultimately add the most value for customers.