Piecing Together Progress

Banking as a service is burgeoning—and with it, considerable challenges and opportunities.

Out of the ashes of the 2007–2008 global financial crisis emerged a new era of banking, one in which digital or mobile-only neobanks leverage cloud-based infrastructure to build out banking services as if clicking Lego pieces together. Nimble Application Programming Interfaces (APIs) enable savings, investment, mortgage and loan products to be added in weeks, rather than months or years.

Anne Boden, CEO and founder of neobank Starling, calls this “the Age of the API and Banking-as-a-Service (BaaS),” the latter a term for the end-to-end digital model that enables third parties to tap banks’ systems and infrastructure through APIs. “Think of it a bit like The Doctor in Doctor Who being regenerated as the first female Time Lord: it’s still all about banking—or in The Doctor’s case, intergalactic time travel—only now a traditional paradigm has been recast and unbundled to reflect advances in technology, culture, demand and practice,” she writes in a blog post.

In short, BaaS has become the rocket fuel for financial innovation. It has allowed fintechs to offer the kinds of services typically provided by a bank, without having to be regulated like a bank. It has given banks greater economies of scale and new channels of distribution, and brand names or big tech companies a means of increasing customer revenue and engagement by embedding financial services within the user experience.

The global BaaS market is expected to reach $43.15 billion by 2026, growing at a compound annual rate of 24.4% from 2019 to 2026, according to a report published by Allied Market Research. Though BaaS is already disrupting traditional banking business, it also provides opportunity for small and mid-size banks themselves to potentially gain market share previously out of reach.

Banks have always offered their financial products and services to other banks and non-banks, using different models such as agent banking, white-labelling or co-branding. The difference with BaaS is that it uses APIs. This allows any company, fintech or bank, to make their products and services available to a third party.

“BaaS has opened up a whole new world that didn’t even exist before,” says Louisa Murray, COO, UK and Europe at London-headquartered BaaS platform Railsbank. “Using legacy technology, you’d spend 12 months to two years getting a product to market. Now you can be up and running in weeks at less cost.” Using BaaS, Railsbank was able to bring new services like its LightningAid card for governments, NGOs and community groups, to market quickly during the pandemic so funds could be disbursed. “It took us 14 days from the initial idea to being available in the app store,” Murray says.

In this way, BaaS makes financial services available for everyone, not just the chosen few. Big name retailers or brand names are also getting in on the act. Swedish furniture giant IKEA’s owner, Ingka Group, recently announced it bought a 49% stake in its financial services partner, Ikano Bank, in an effort to offer more consumer banking services in-store and online. U.S. retail giant Walmart has forged a partnership with venture capital firm Ribbit to build a tech company offering financial services. “These brand names will need to find BaaS partners as they probably won’t want to get a banking license,” says Zac Townsend, an associate partner at McKinsey. “But it’s not going to be one of the big U.S. banks offering these services. It makes more sense for a regional bank.”

When retailers or brand names use BaaS to provide financial services at the point of customer need, it is called “embedded finance.” In the U.S., the banks behind these kinds of services tend to be smaller or medium-sized like Cross River Bank, which describes itself as “a state-chartered bank with the mindset of a fintech startup.” “[Using BaaS] to enable a bunch of fintechs to take market share from the number one and two banks makes more sense if you’re the third or fourth largest bank in the market,” says Townsend.

BaaS can help these banks gain a foothold in markets where their presence is small or non-existent. A good example of this is Goldman Sachs, which is the bank behind Apple Card. “It should be noted that neither Apple nor Goldman has much expertise in consumer finance,” Rick Chavez and Aaron Fine, partners at management consultancy Oliver Wyman remarked following the launch of Apple Card. “Apple makes hardware and software, and Goldman is mostly an investment bank. Yet their partnership represents the sum of all fears for financial services firms.” Goldman Sachs is not cannibalizing its own business by enabling Apple to get into cards. It is making a digital play to get into consumer businesses.

“Through BaaS, banks could also potentially learn from fintechs about how they design their customer experience,” says Val Srinivas, banking and capital markets research leader at the Deloitte Center for Financial Services. “These banks are looking at it long term.”

This was the thinking behind BBVA becoming in 2019 the first bank in the US to offer a full suite of Banking-as-a-Service via its Open Platform. “Big Tech companies in Spain and Mexico were consuming services through APIs,” says Marcela Zetina Manrique, Head of Open Innovation at BBVA Mexico. “We also thought if we deliver these types of services, we will have more customers.” In Mexico, BBVA is using BaaS to reach unbanked members of the population, distributing its financial products to workers in Mexico’s gig economy via third party fintechs using its APIs.

But BaaS is not as straightforward for banks as it is for fintechs. “The technology part is hard as banks are not used to providing these types of services,” says Manrique. “We’re used to consuming APIs from third parties. But to provide APIs for third parties, your customer service needs to be 24/7, not just between 10 a.m. and 6 p.m.”

BaaS banks also need to be careful about fraud and other regulatory issues, she says. “As a bank, you need to really understand what your motivation is for doing it,” says Manrique. “If you’re doing it out of fear of missing out or because of a regulatory requirement, you’re going to lose a lot.”

BaaS adds an additional layer of complexity for both banks and regulators. Under the BaaS model, the end customer consuming the cards, payments, loans, or mortgages as a service are oblivious to who is providing the underlying service. “The vast majority of customers don’t know the back-end payments rails that banks and credit cards rely upon,” says Srinivas of Deloitte. To the customer it may not matter, until something goes wrong.

“Railsbank delivers clients many of the services traditionally associated with a bank, such as providing direct access to the payment schemes ‘rails’ through Faster Payments,” says Murray. However, Railsbank is not a licensed bank. It has an FCA e-money license, which Murray says means client funds are always safeguarded. But the compliance regulations are complex. In Mexico, the fintech landscape is a blurry space, Manrique says. “They can operate and take a financial partner to their customer, but the customer doesn’t know there is a bank behind that service.” Mexico’s financial regulators are now looking at making BaaS more transparent to the end user, says Manrique, so they know who is behind the service.

With BaaS, there is a risk, ultimately, that banks could just become ‘dumb rails’—i.e., invisible go-betweens that offer commoditized products and services. “Everyone fears becoming dumb rails,” says Townsend of McKinsey, “but if a bank really jumped on this, they could build a profitable business providing services like KYC [know-your-customer] and AML [anti-money-laundering] at scale, alongside other things like payments and loans. However, that requires them to have undergone a digital transformation.”

The case for doing so seems compelling, according to a recent report on embedded finance by UK consultancy 11: FS. It cites research from a16z, a unit of US venture capital firm Andreessen Horowitz, which found that banks embracing BaaS experience two-to-three times above-market return on equity. “By offering their balance sheet, compliance and financial products via partnerships with BaaS providers, these banks are growing,” the report states. Thus, BaaS presents a mix of both risks and opportunities for banks. Having invested a lot in it already, Manrique says BBVA will stick with its BaaS strategy, despite the challenges. “We believe it’s part of the present and a lot of the future,” she says.