Banking On BaaS - Despite Regulatory Turbulence
Why recent regulatory scrutiny is symptomatic of growth.
Banking-as-a-Service (BaaS) is expected to grow to $22.6 Billion by 2032, according to a recent report. This can be difficult to believe with almost weekly news of BaaS providers rescinding their services or laying off staff amidst stringent regulatory action. Could this mean the end of BaaS or is this a key phase in this technology’s road to adoption?
Regulators in Action:
The end goal of the BaaS is to provide consumers with financial services within the context of their needs. For example: Tesla provides owners with the option of purchasing insurance directly from their app. This transaction involves multiple businesses - and therefore multiple opportunities for potential risk and compliance failures.
Regulators have been swift to act with BaaS banks accounting for 13.5% of severe enforcement actions issued to banks in 2023. These include:
Metropolitan Commercial Bank who was fined USD 30 million in Oct 2023 for failing to oversee a third party program manager. The bank has since shared that they will be winding down their BaaS division
Blue Ridge Bank was flagged by the OCC (Office of The Comptroller of the Currency) in August 2023 for having weak anti-money laundering controls. The bank has since started offboarding many of its fintech partners in an attempt to bring its operations back into balance.
Lineage Bank entered into a consent order with the FDIC (Federal Insurance Corporation) which required the bank to implement a risk management programme overseen by its directors, amended capital adequacy requirements and the severing of ties with certain fintech partners.
Working through these and other examples (like Vast Bank or First Fed Bank) we can see that the regulators are demanding enhanced risk protocols be followed, ownership of client risk and Board involvement.
At first sight it seems like the regulators have deterred some of the traction and popularity enjoyed by the industry - especially when looking at BaaS providers like Synctera, Treasury Prime and Synapse announcing recent layoffs. But this may be evidence of the priming of BaaS for wide scale adoption.
A Trusted Theory in Practice
When we take a moment to reflect, we can see that The Diffusion of Innovation is applicable to almost all types of financial technology in recent years. From blockchain technology to generative AI (and BaaS), each are in process with one of the core phases:
Innovators: These are the originators of new products or services. They are first-movers who bring to us disruptive innovations which we have not seen before.
Early Adopters: This group of businesses or individuals are secure and stable enough to take a risk on the new technologies shared by the Innovators. They are typically excited about these trends and actively seek them out.
Early Majority: This forms the majority of users. They are risk averse and rely on social proof from Innovators and Early Adopters in order to make new technologies a part of their day-to-day workflows.
Late majority: Not the last to adopt, but not convinced of the technology either, this group don’t rely on social proof - they want to see the technology in action and witness the practicalities before buying into it.
Laggards: This group tends to consist of resistant adopters. Those who use the new technology because their current substitutes are no longer available.
Image Source: https://sphweb.bumc.bu.edu/otlt/mph-modules/sb/behavioralchangetheories/behavioralchangetheories4.html
So where does BaaS fit in this framework?
Baas has been implemented by a few Early Adopters who are experiencing exactly what it means for a technology at this stage: they carry the burden of road testing this for the early majority.
It’s not uncommon for this to be the point at which regulators become involved - especially in an industry such as financial services. It is their job to ensure that the right guardrails are in place for consumers and other providers before the adoption becomes too unwieldy to control. But while these are banks with the inclination to take on the risk of this new technology, their ability to do so is being tested.
That’s why we are seeing hyped news on the pull back of different BaaS firms surfacing across the internet. Only, this is a natural response to the activities that BaaS firms are facing. In fact, layoffs and scale backs of BaaS programmes are arguably better for the sustainability of BaaS: It will provide easier, more viable operations during a traditionally turbulent stage of adoption.
What lies in store for BaaS?
There was never any question that BaaS is tossed aside: The ability for consumers to bank with brands and within the context of their day-to-day activities is a needed (and demanded) evolution of financial services. The recent regulatory action is merely a necessary but painful corrective action- not an indication to stop the pursuit of growth in the sector.
With any new technology, it will take time to find a balance in the regulations needed in order to administer it. BaaS is more complex than most, with its operations being anchored in a multiplayer ecosystem where accountability is not yet clearly defined. As these details are ironed out, it is easy to see why some project a CAGR of 19.3% for BaaS between 2023 to 2032 - all it will take is endurance.