The Next Waves in US Banking - Part 2: Embedded Finance
There's a lot of talk right now about embedded finance. Even though it has been underway in more primitive forms for several years, it is probably still on the upward swing of its "hype cycle". Still, it makes sense for incumbent banks to look now and decide on how they will position themselves to participate in this emerging reality.
Gone are the days when finance is something separate from normal day-to-day activities. Apps are taking the place of branches. Very few people write checks, bill pay usage will soon be going down, and bank accounts will become increasingly invisible. The standard embedded finance examples are Uber or Grubhub, in which we order and use our car or food while hardly being aware that there is a payment going on behind the scenes. But there are so many more, and this stitching of finance into the fabric of daily life will only increase.
This is something that emerging challenger banks have understood and are advancing. Mostly starting in Europe, players such as Monzo and Revolut have already launched in the US through partner banks and payments licenses, though in time they may seek their own banking licenses. Varo Money started in the US and now has a banking license.
One already common example is Buy Now Pay Later (BNPL) schemes, a modernized form of installment payment plans. With BNPL, payment is deferred and covered by a small line of credit almost without the purchaser's knowledge. Other examples include Square's Cash App, which adds small embedded consumer loans to Square's payment capabilities; Google Parking with embedded micro-payments; Salty's car insurance embedded into the sales process; and Unifimoney's aggregation of a range of financial services into a mobile app for up-market millennials.
This is the 2nd part of a short series of articles about Embedded Finance and how it is rapidly changing the US banking landscape. Part 1 examined how the role of banks is shifting and the emergence of "Partner Banks" in the US over the past 5-10 years.
This article expands on the theme, showing in more detail the different layers (and players) that make embedded finance work in practice.
The Four Layer Cake of Embedded Finance
Seamless embedding of financial services into everyday transactions requires different organization categories to work together: this is where banks' opportunities are to be found. I would categorize them like this:
1st Layer: Non-Bank Businesses
Function: Inclusion of financial functions to enhance their existing business offerings to their target customers
Examples: QuickBooks Cash, Shopify, Amazon BNPL
2nd Layer: Banking as a Service (BaaS) providers
3rd Layer: Financial infrastructure players
Function: Enabling connections between BaaS and servicing banks
Examples: Currency Cloud, Plaid, Finix
4th Layer: Partner banks
Some organizations may play more than one of these roles. For example, Greendot has acted both as a servicing bank and as a BaaS provider from the start. BBVA added BaaS services to its existing infrastructure.
Incumbent banks need to understand the new players, especially those who can help the bank expand into the new markets accessible through successful embedded finance offerings. They have the opportunity to be critical players in the ecosystem.
Note that this four-layer cake can be eaten in any order. An online retailer may approach their bank, who engage with their BaaS provider. Or a BaaS provider may attract a financial services app with services that need a partner bank. Or a bank may create a compelling banking delivery mechanism that the BaaS provider can sell to its base of non-bank businesses. You get the idea. As with any good ecosystem, each player helps every other.
The Ostrich Risk
Without a doubt, the biggest thing for banks to fear is inaction. As more and more lending opportunities, and fee-based revenues, are eroded through embedded finance scenarios, bank balance sheets will shrink, and equity holders will move away to more profitable opportunities.
The banking world is changing, and banks that hide their heads in the sand will pull them out later to discover that everyone else has left them behind.
Adjusting too slowly can also be a significant risk. Tweaking products to make them more digitally attractive, or offering a couple of new loan products, will not be sufficient to counter the shift in financial services from standalone to embedded.
On the other hand, it is essential that banks remain grounded in their strengths: community relationships, risk and compliance expertise, balance sheet, and trust reputation. They will mostly be ill-equipped to move into a pure technology-provider role, for example. Most of them will not have the technological expertise to build new infrastructure to deliver banking services into the new embedded finance ecosystem.
A New Kind of Partnership
The balance will be found in symbiotic partnerships. The new players in embedded finance – the BaaS and infrastructure providers who are primarily technology companies – need access to pure banking services. They also need the relationships that banks have with their existing customer base. Banks need access to the technology and agility of the newer players.
So this not a traditional software vendor relationship or point-solution Fintech relationship. It is a partnership in which BaaS provider and incumbent bank share revenue, are invested in one another's success, and introduce customers to one another.
While challenger banks have been increasingly successful in the UK and Europe, the barriers to full entry in the US banking system are very high. Incumbent banks, including mid-sized and smaller banks, have a great opportunity through partnerships to offer convenient, app-ready and embedded financial services.
How Can Banks Benefit?
There are several potential benefits for banks when supporting embedded finance. Here are a few ideas to leverage:
Delivery of financial services through embedded finance potentially opens up a hugely increased market, especially for smaller banks. Although a critical question will continue around who "owns" the customer, the fact is that transaction and loan volumes have the potential to increase greatly if the bank becomes an embedded finance enabler. For example, a BaaS provider like Railsbank enables a major retailer to offer specialty credit cards issued by a partner bank. Now there is a channel for the bank to offer additional products.
Acquisition and servicing of low volume customers will become far more economically viable since the expensive up-front activities will be done upstream from the bank. Smaller banks struggle with brand presence, marketing expenses, direct sales, and onboarding expenses (such as KYC). These costs mean that customers with low transaction volumes are not financially viable. When a retail channel or financial app takes on these expenses, the bank starts to be able to service them profitably.
When a bank's business customers want to embed banking services in their products and channels, a partnership with a strong BaaS provider enables the bank to meet their customer's needs, deepen their relationship and increase the cost of switching to another bank.
Existing and future consumers and businesses will increasingly expect to see banking services as an aspect of their daily activities. As Publicis Sapient's David Donovan puts it, they want "an 'invisible fabric' around [them], helping them feel that their bank is their personal CFO and there for them throughout their financial lives." Through its role in embedded finance, a bank will offer significantly increased convenience and accessibility by delivering products through customers other personal or business activities. The cost of revamping a complete product set around changing customer needs is one that many banks cannot justify. But by working with specialist BaaS and non-financial businesses, the bank can deliver services in entirely new and compelling ways.
In any good partnership, both sides have much to gain and much to contribute. A regional or community bank may not have the technological sophistication brought by a BaaS or infrastructure provider. But the banking license, balance sheet, credit underwriting expertise, compliance capabilities of a bank are invaluable in delivering effective embedded financial products and services.
Banks need to approach potential partnerships positively. They should identify strengths they can contribute, potential net income to be generated, and access to a growing (albeit different) customer base. At the same time, margins will diminish as more players share fees. And customer relationships may weaken as the bank is further removed from the point of access. But these challenges will happen whether banks participate in the new reality or stand back and continue business as usual. The important thing is to take action now to offset them by generating new customers and revenues.