Why banks must reinvent BaaS

From 2018-2022, fintechs seeking access to digital banking services jumped (or were pushed by their VCs) to early Banking-as-a-Service (BaaS) models that promised frictionless launches and breakneck speed to market. These BaaS models prioritized speed over stability, making it nearly impossible for their bank partners to demonstrate sufficient oversight.

The regulatory scrutiny around this model should come as no surprise given the disintermediation experienced by the banks. Such a structure was doomed to fail primarily for three key reasons.

First, venture-propped, undercapitalized technology companies struck high-risk product deals with inexperienced startups. Secondly, these inexperienced players were connected with a network of community banks – many of which were new to the BaaS space. Third, the industry was using unproven technology to create a complex web of relationships with the intent (in some cases) of hindering oversight.

The structure allowed fintechs to operate without regard to appropriate controls, policies and conformance to regulations, arguably all but preventing even minimal oversight by the banks.

Consider the Synapse collapse, which checked all the boxes for inviting regulatory backlash: a nonbank developed a proprietary ledger to track consumer balances for pass-through deposit insurance. The ledger was incapable of accurately accounting for the complexity of the various programs, resulting in massive accounting irregularities known for months prior to the implosion, all of which resulted in catastrophic consumer harm. By prioritizing growth over stability, high-risk products were launched using models with systemic weakness and without regard for proper risk and compliance controls.

The time is right for a new model designed for stability and security to take back the reins and move beyond the challenges of BaaS 1.0.

BaaS 2.0: Reclaiming the role of banks

The emergence of BaaS can be at least partially attributed to the void left by traditional bank core processing providers and their lack of compelling, cloud native, API-driven interfaces. New, unknown providers emerged claiming to possess the desired technologies, but without the requisite experience and appreciation for oversight and compliance.

Banks are in the best position to turn this ship by recentering the model, consolidating the technology, and bringing forth the compliance infrastructure.  In this BaaS 2.0 model, the bank serves as the motherboard of the system, maintaining control of the ledger and the operational and technical switch. This repositioning ensures companies looking to deliver stable and scalable embedded payments solutions can do so through an experienced bank partner operating in a model capable of supporting both scale and scrutiny.

The benefits for everyone in the value chain are ample. Eliminating the middleman not only simplifies the structure but also preserves greater revenue shares for all parties. Removing extra complexity layers also allows fintechs to deploy solutions quickly and securely, as BaaS 2.0, in many cases, will require only one contractual relationship.

The blueprint for sustainable banking innovation

Eliminating model complexity and fragmentation is the blueprint for bank-led BaaS 2.0. Banks and fintechs can better collaborate to drive innovation while maintaining security and regulatory standards. Direct partnerships allow banks to appropriately serve as the hub for fintech relationships, fully controlling infrastructure and ensuring compliance at every step.

But BaaS 2.0 demands more than just technological updates—it requires a fundamental reimagining of how banks operate in the digital age. By doing so, fintechs can remove unnecessary middleware in favor of direct bank-fintech relationships. By seeking out cloud-native, API-first platforms offered by innovative, federally regulated banks, fintechs can finally build great user experience on a stable platform.

A sustainable, bank-led future

As the BaaS ecosystem matures, banks can lead by leveraging their foundational role and thereby help drive innovations. This shift from BaaS 1.0 to BaaS 2.0’s bank-led model can turn this ecosystem into a profitable, long-term opportunity for both financial institutions and fintech partners.

Restoring banks back to their central role can elevate the entire industry into a more developed financial ecosystem that balances innovation with stability to carve a sustainable path. This approach strengthens everyone’s business model without sacrificing quality and risk controls or innovation.

The institutions that succeed will be those that can balance innovation with their core responsibility: maintaining the soundness of the financial system while driving meaningful technological progress for the benefit of everyone.

Trent Sorbe is Chief Payments Officer at First International Bank & Trust.