As 2023 drew to a close, many banking executives and thought leaders threw up their hands in despair at the perceived death of Banking as a Service (BaaS). An anticipated white-hot market has failed to materialize to expectations, and innumerable financial institutions have seemingly thrown in the BaaS towel as the industry confronts the disruptive forces reshaping financial services on the path to Banking in 2035. The death knell has tolled. Or has it?
Rumors of BaaS’s demise have been greatly exaggerated. The BaaS model still holds enormous merit, but market turbulence and organizational and technical challenges continue to thwart financial institutions in their pursuit of building a successful BaaS offering. Redefining BaaS for 2024, and understanding the challenges at hand, can illuminate a path forward.
Redefining BaaS in 2024
The concept of Banking as a Service (BaaS) and BaaS models took root as banking digitally morphed via APIs, enveloped by the cloud. Popularity of the BaaS model and acronym hit the mainstream in July 2013, when Gartner published its landmark report Hype Cycle for Open Banking. It described open banking (aka BaaS and embedded finance) as “...the provision of services in the context of users through API platforms, app stores and apps.” More than a decade later, BaaS capabilities extend beyond new transaction channels to encompass complex financial operations, fraud and risk management, and regulatory compliance.
BaaS is the link between traditional banking and the tech-driven ecosystem. It’s a lucrative business model where banks provide white-label core financial products, through a few lines of code and APIs, to a myriad of payment frontends and industries — communications, hospitality, retail, airlines, energy, card processing and payments, among them.
BaaS, as I explored previously, has tremendous potential as a low-margin, high-volume new revenue business for banks. Critically, it could reverse the decline of the banking industry into a deposit and lending utility. The crux for banks is that they hold the banking license and, therefore, all of the regulatory obligations. Typically, the third-party partner never touches the customer’s money — it simply white-labels and delivers the bank’s products into the customer’s app. The bank is left holding the baby.
Steep odds from the top down
Financial firms, of course, face many hurdles that have hindered BaaS adoption. Difficulties in scaling fintech partnerships while retaining intellectual property — particularly amid a lack of technical competency on the bank’s part — is a distinct challenge. Realistically assessing the amount of time, money and resources required (while adequately preparing for the high level of operational and technical integration at hand) demands an array of hefty change management exercises and up-front investment. Without adequate capital at the ready, building a unique offering amidst 30,000 startups hitching to the fintech bandwagon will prove nearly impossible.
From the C-suite's perspective, BaaS initiatives require enormous commitment to the broader IT ecosystem and strategic alignment of business, technology strategies and ideologies. Add to that the difficulties behemoth financial institutions face with the recent plummet of fintech funding and a roiling macroeconomic environment. Leadership fights long odds in delivering what’s required to successfully mount a BaaS offering.
A BaaS pulse check
2023 was particularly testing for bank-fintech partnerships, as several banks found themselves in regulatory hot water. Among them, Evolve Bank & Trust and BaaS platform provider Synapse are in a dispute over responsibility for an alleged $13-million “deficit” in Synapse client funds being held in “for benefit of” accounts at Evolve. The partnership's breakdown led Synapse to lay off 40% of its workforce.
Increased scrutiny by U.S. banking agencies — outlined in the Interagency Guidance on Third-Party Relationships: Risk Management jointly issued by the Federal Reserve, Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC) in June — has placed further obligations on bank-fintech partnerships. The guidance emphasizes that a bank must align their risk management practices with the nature and risk profile of their third-party relationships, including partnerships with fintechs. This has bank executives thinking twice about leveraging fintechs.
Still, the many benefits of BaaS, and the potential of an anticipated (and tantalizing) $7-trillion market in coming years, means the stubborn question remains for banking leaders. How can an institution with a historied culture, focused on governance and risk management, adapt to a culture of innovation and focus on customer engagement, all while still shackled to compliance?
A recent U.S. banking study by CCG Catalyst showed that, among 122 C-level bank executives surveyed, 21% professed interest in leveraging fintech but weren’t sure where to start, up from just 3% in 2022. Those who said working with fintechs is an integral part of their business strategy slipped 4%, from 43% to 39% year-over-year.
This indicates that, although the sector is struggling to quickly tap its promise and potential, BaaS as a business strategy is far from dead. To the contrary. While banks still have much to consider about the model’s future in this shifting regulatory landscape, the benefits and opportunities remain — and they will likely be significant. They will merely be realized at a slower pace than once anticipated.
More haste, less speed — at least to start
Alluring as it is to pursue development of the next viral app, banks should consider BaaS as a longer-term strategy. They should work with partners to help build on existing relationships and increase capacity. Another salient option is also to look beyond fintechs to more established technology firms that are proven in AI innovation and execution. Whatever path they choose, success will entail doing the necessary due diligence and making data-backed decisions.
As for regulation, partnerships must foster a strong culture of compliance. Critically, that hinges on two things: the chief compliance officers must have 1) sufficient oversight of fintech operations and 2) sufficient decision-making power. Clearing these hurdles will require reports, reports and still more reports — all written for each stakeholder’s role and delivered in real time.
The BaaS model could prove a real gamechanger in financial services. The question remains, can traditional players rise to the occasion to make it a reality?
Author: Joan McGowan, Head of US Financial Services Industry Consulting at SAS