Is this the end of Baas?

Banks and people have a relationship solidified on trust. However, nowadays, people expect more. They want their money to work for them. They want it to grow, they want it to be easily manageable, and they want it to be part of their everyday experiences. Whilst a handful of fintech firms have managed to answer these calls by themselves, Banking as a Service (BaaS) emerged as a solution that could work en masse.

However, has the experiment of banks lending their technology and charters to fintechs been successful or is it set to fail? Let's assess the current state of play, what the future might hold for BaaS, and how it can continue to benefit all stakeholders for the long run.

Why does Banking as a Service work?

People now demand that their technology work within a seamless “ecosystem” according to McKinsey. With payments technology becoming hugely popular, it is no exception to this rule. In fact, 83% of institutions revealed to a survey that their customers expect an embedded finance experience.

However, banks are not a natural fit within ecosystems. Fintech distribution partners (nonbanking companies), on the other hand, can be seen as traditional banks’ sociable younger cousins that want to be in amongst the action.  

Yet wanting to make connections with others is different to being able to. For instance, just like how long-term contacts, know-how, and credibility are all more likely to be possessed by senior people rather than youthful ones in real life, the same is true in the financial sector amongst organisations. Sometimes a helping hand is therefore needed for fintech companies to become part of the ecosystem that consumers wish to see, and this is where banks come in.

Fortunately, banks providing infrastructure, products, and services to fintech companies through APIs – otherwise known as BaaS – works for everyone involved, fulfilling the wishes of every invested party. Here’s how:

• Banks gain a new revenue stream

• Fintechs are able to meet consumer needs

• Customers welcome their money and payments into a seamless ecosystem

For existing banks and financial institutions without sophisticated digital-first offering, BaaS provides a way to monetise existing infrastructure, regulatory licenses, and risk-management expertise by extending those services to customer-facing distribution partners in return for fees. This allows existing banks to reach new customer segments, diversify revenue streams, and generate additional income.

Akhilesh Khera, Partner
PwC UK

BaaS therefore works because it has demand and support from every direction, especially from those that make it happen – 70% of non-bank companies aim to spend greater funds on financial partnerships, including BaaS and 60% of banks and credit unions have forged a relationship with a fintech firm between 2020 and 2023. The impact of this is reflected in monetary numbers too – it is predicted that by 2030, BaaS is set to be valued at $7 trillion and will have helped tech companies realise $51 billion in new revenue by 2026.

Why does Banking as a Service not always work?

BaaS is evidently an enabler for what people desire when it comes to novel, user-friendly ways to utilise their money – just look at the origins of Monzo and Revolut for instance. However, just giving people what they want isn’t always the best decision.  

For example, children will often request fast food for breakfast, lunch, and dinner. However, they’re naive that burgers, fries, and the like lack beneficial nourishment. If they had this knowledge, maybe their wishes would be different. The same can be said for those who use fintech innovations powered by BaaS solutions.

If and how a bank is involved is key to understanding whether or not your money is protected by deposit insurance. However, in some cases, it is not always clear to consumers if they are dealing directly with an FDIC-insured bank or with a nonbank company.

Federal Deposit Insurance Corporation

This is because despite banks being highly regulated, fintechs remain relatively unscathed from compliance demands due to them being categorised differently to the former. Consequently, although they facilitate banking products and services thanks to BaaS relationships, they have a larger reign of freedom. In some instances, this means that actions that instill trust in financial services are overlooked such as reconciliation to safeguard client money and make sure that account balances are correct.  

Unfortunately, a lack of action has ramifications for everyone involved, even if no regulations are technically breached. Banks are scutinised for not engaging in enough due dilligence, trust in fintechs is lost, and in some instances, customers are even denied access to their funds.

Whilst none of these outcomes are desirable, some believe that it could have far reaching negative ramifications. For instance, Acting Comptroller of the Currency, Michael J. Hsu, believes that the presence of nonbanks in the regulated banking system, transfers risk to partnering banks. Strikingly, Hsu was quoted in 2022 stating that the increasing amount of partnerships between banks and fintechs have “a nagging familiarity” with the 2008 financial crisis.

What is the future for Banking as a Service?

It’s therefore easy to see that BaaS divides opinions. On one hand, it has helped turbo charge the development of financial technology. On the other, it allows banking activities to take place without very necessary banking regulations being imposed.

Arguably, customers’ and banking's appetite for BaaS has sustained its existence. After all, between 2014 and 2019, fintech firms ate into the share of the balance of unsecured personal loans from 5% to 39%, threatening a key revenue stream for banks. In addition, BNPL offerings by fintechs have “stolen” between $8 billion and $10 billion in annual revenues away from banks. It’s therefore clear to see why banks are looking for a new revenue stream and assistance in developing their digital offerings even if that means partnering with rivals.

However, in recent years, regulators are increasingly taking action against provider banks that do not take proper due diligence when forming BaaS relationships. From the creation of final interagency guidance by the FDIC, Federal Reserve Board, and Office of the Comptroller, to consent orders being issued to banks, it is clear that current enforcement is geared towards placing the onus on banks for making sure that their fintech partners are reputable.

Whilst this sees fintechs remain unscathed, it is already having an impact on the BaaS industry. For instance, on 17^th June 2024, Unit – a BaaS platform that helps provider banks and other fintechs bring new products to market quicker together – decreased their workforce by 15% because “banks in the fintech ecosystem have slowed down in the last year due to increased regulatory scrutiny”.   Evidently, as pointed out by a recent report by Deloitte, this “wave of change and regulatory development may force both banks and nonbanks to rethink their strategic goals and redefine their business models within the context of the regulatory perimeter and heightened supervision”.

Apart from the fact that BaaS partnerships might now be harder to come across, it indicates two other things:

• Regulators don’t want to end the premise of BaaS completely. They just wish for banks to enter BaaS agreements more responsibly.

• Further regulation could emerge in time so that fintechs are accountable too.

Ultimately, responsibility lying with banks is arguably not enough. After all, 76% of banks view FinTech partnerships as necessary to meeting customer expectations, and 95% of are focused on using partnerships to enhance their own digital product offerings. Consequently, conflicts of interest are likely to be rife. Instead, “the inescapable solution is to redefine the regulatory perimeter” when it comes to governing banking activities that include fintech firms according to Braeden Hodges, J.D. Candidate at Brooklyn Law School.

Prepare for change

The future of BaaS might be finely in the balance but murmurs of regulations becoming stronger and more far reaching suggests that it will be here to stay, even if in a new fashion. Given that banks themselves are already regulated, what the compliance measures might end up being for their fintech partners shouldn’t be too far from what already exists.

As a result, the following are all likely to apply to fintech firms engaging in BaaS partnerships, should new regulations come to fruition:

• Reconciliation – holding client money, forecasting, safeguarding, confirming balance totals, and more are all impossible without reconciliation. That’s why it is fundamental for banks and should also be for fintechs, especially when disputes - that hinge on reconciliation - between BaaS partners have resulted in accounts being frozen in the past.

• Capital requirements – BASEL III determines that banks must maintain sufficient capital reserves, yet for the time being fintech companies are exempt form this requirement.
  

• And more ...

Considering that 93% of fintechs already admit that they find it difficult to keep up with and abide by regulations, and as many as 82% of European fintechs have been built with BaaS, this might cause some trepidation. However, as pointed out at the G20 Summit in 2017, the upkeep of world financial systems is dependent upon the creation and enforcement of fintech regulation. Consequently, every firm must be willing to partake.

Play your part in preserving the reputation of the financial industry, maintaining trust in your services, and protecting client money by booking your Aurum demo today.