- Technology
How banks can securely embrace embedded finance to boost revenue
- Tapping Banking-as-a-Service (BaaS) in regional and mid-size financial institutions can diversify revenue streams, bolster deposits and generate increased income.
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Last year marked a pivotal year for the banking sector, when the industry grappled with the aftermath of bank failures, including notable incidents like the collapse of Silvergate Bank, which was heavily involved in the cryptocurrency market. This tumultuous backdrop highlighted the pressing need for financial institutions (FIs) to adapt and innovate amid rising interest rates, deposit declines and intensifying competition.
In this context, Banking-as-a-Service (BaaS) has continued to present a beacon of opportunity for regional and mid-size FIs. By leveraging BaaS, these institutions might diversify revenue streams, bolster deposits and generate increased income.
BaaS, in essence, is the provision of traditional banking capabilities through application programming interface (APIs) by traditional banking institutions. This model empowers non-financial entities to seamlessly integrate and offer financial services, a concept known as embedded finance. According to Cornerstone Advisors, BaaS across financial services, including insurance and payments, is projected to generate a staggering $230 billion in revenue by 2025, a tenfold increase from $22.5 billion in 2020. For banks alone, the research points to a $25 billion opportunity in coming years.
However, seizing the potential of BaaS is not without its challenges. FIs must navigate the complexities of modernizing outdated technology systems, ensuring regulatory compliance and selecting appropriate integration partners. Plus, financial-crime risk must be contemplated.
The high abandonment rates in online account opening processes, especially among younger generations who prefer digital channels, underscore the urgency for digital transformation within the sector. Moreover, the banking industry’s landscape is being reshaped by a combination of well-established forces and recent developments, including the return of higher interest rates and the disruption caused by fintech innovators.
Building the right framework
For community banks, the transformation of legacy systems is essential for BaaS. Overcoming these outdated infrastructures, a task identified as a major challenge by banking executives, is crucial for scalable and innovative BaaS offerings.
Key to this transformation is the adoption of cloud computing, modern APIs and best-of-class fintech solutions. Technological advancements are pivotal in attracting fintechs for BaaS partnerships, leading to improved operational efficiency, better risk management and stronger customer relationships.
At the heart of BaaS is a robust and scalable API architecture, designed to seamlessly integrate with third-party systems and ensure compliance with U.S. regulations like the Bank Secrecy Act (BSA) and Anti-Money Laundering (AML) standards, alongside guidelines from the Office of the Comptroller of the Currency (OCC).
Revenue diversification is another critical aspect, achievable through models like transaction fees, subscription services and revenue sharing with fintech partners. This approach provides flexible and scalable revenue streams for community banks. Case studies of U.S. banks successfully implementing BaaS highlight the importance of technological agility and adherence to regulatory standards for sustainable success.
Navigating regulatory and compliance Frameworks
In the evolving domain of BaaS, FIs face the intricate task of ensuring regulatory compliance for embedded financial services. While fintech partners may contribute to operational aspects, the primary responsibility for managing regulatory risk lies with the FI.
A key challenge in BaaS is when banks outsource their fintech relationships to platform providers who control essential customer data. This can lead to limited visibility of customers, ineffective Know Your Customer (KYC) risk analysis, difficulties in profitability analysis of fintech programs, and insufficient analytical and reporting capabilities.
API solutions are critical in this context. They enable FIs to extend services to non-regulated entities while maintaining regulatory compliance through critical data. A notable regulatory consideration is the FDIC insurance limit. While the FDIC does not restrict customers from depositing over $250,000, it does mean that amounts exceeding this limit are not insured. Banks must therefore carefully monitor incoming funds to manage risk and inform customers about the extent of FDIC coverage. Without centralized data, monitoring customer deposits across fintech partner programs becomes a difficult, often manual, process.
The optimal approach for FIs is either to develop their own BaaS platforms or to partner with firms that can tailor a BaaS platform to their specific needs through integrations with key fintechs. This allows banks to directly engage with fintech partners, consolidating data within their core systems for comprehensive visibility and control. Such a strategy ensures that banks can scale services according to their internal requirements and risk appetite while maintaining full visibility of customer data.
By establishing their own BaaS platforms or working with customized solutions, banks can effectively implement robust KYC/AML processes, obtain full visibility of the customer, and manage regulatory compliance directly. This approach not only positions banks to comply with current regulations but also allows for agility in adapting to regulatory changes and leveraging data analytics for strategic decision-making.
Selecting the best partner for your journey into BaaS
As FIs navigate the intricacies of BaaS, selecting the right partner is crucial. The complexities of open banking, an increase in transaction volumes, intricate data sharing requirements and stringent regulatory demands call for meticulous partner selection and comprehensive due diligence.
When scouting for an integration provider to facilitate BaaS offerings and fintech partnerships, FIs should look for partners with the following capabilities:
The ideal partnership equips the bank with the means to integrate technology smoothly with BaaS offerings, ensuring comprehensive operational understanding, risk mitigation and control over data. Furthermore, such a partnership can streamline the bank’s operations and optimize revenue generation. These capabilities ensure that the bank can facilitate simple data exchanges with third parties and engage in BaaS offerings effectively, overcoming any limitations of the core banking system.
Looking forward
Embracing BaaS positions FIs at the forefront of innovation, enabling them to launch new products and tailor services to enhance consumer convenience. This strategic move not only secures a competitive edge but also catalyzes the expansion of revenue streams in an increasingly digital financial ecosystem.
As with any emerging technology, the path to secure BaaS adoption is laden with unique challenges, from integrating complex systems to navigating a maze of new regulatory requirements.
The cornerstone of success in this arena is the proactive development of a robust API infrastructure, which is the linchpin for scalability and seamless service delivery. Coupled with a steadfast commitment to regulatory compliance, FIs can ensure that their BaaS offerings stand on solid ground. Forging a partnership with a provider that aligns with an FI’s vision and operational goals is essential to streamline the complexities of integration and drive innovation.
These deliberate and strategic actions are critical for FIs aiming to capture the full potential of the BaaS model. By focusing on these key areas, FIs can enhance their stature as prominent players in the evolving BaaS landscape, ready to harness new opportunities and lead the charge in the next wave of financial services.
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