In the wake of the Synapse fiasco and a number of other Banking-as-a-Service (BaaS) platforms selling at relatively modest prices to traditional players, many have been quick to write off the sector. One bank CEO remarked to us recently that the platforms have neither a charter nor distribution, and he expects eventually to be able to acquire a platform for free.
BaaS platforms aren’t the only players that can solve for these problems, but as we demonstrate in this article, they are well-positioned to address both of these issues. To understand why, it’s important to understand the history of how BaaS platforms arose and the challenges faced by the pioneers.
Over time, many BaaS platforms sought to provide additional value-added services that would otherwise need to be provided by the bank or fintech, such as customer identification and transaction monitoring capabilities, or integrations to other compliance solutions. The idea was to provide a one-stop solution for non-banks looking to offer banking products–a “bank in a box” accessible through a few easy-to-use APIs. Technically, the BaaS platforms abstracted away all (or large chunks) of the banking infrastructure behind their APIs.
Some BaaS platforms also sought to disintermediate the banks legally–fintechs would enter into a contractual relationship with the platform only, and the platform would manage key aspects of the banking relationship as well as the fintech’s compliance responsibilities. This model is workable as long as the bank oversees both parties, as the prepaid industry has shown. However, in some cases (often with good intentions) this led to banks relying on BaaS platforms to conduct oversight that should be done by the bank. As a result, some partner banks did not really oversee–or in some cases even understand–the risks they were running.
As regulators turned their attention to potential risks arising from bank-fintech partnerships, they identified heightened concerns with the indirect, or “aggregator” model, in particular. For example, Acting Comptroller of the Currency Michael Hsu highlighted what he saw as “the increasing complexity of bank-nonbank relationships” due to “direct banking relationships … being replaced with long-intermediated chains of discrete services.”
In addition, due in part to heightened regulatory scrutiny, banks no longer entrusted critical compliance responsibilities to the BaaS platforms–insisting on more direct oversight of their fintech partners.
With one or two notable exceptions, BaaS platforms have largely abandoned the aggregator model–describing their business as facilitating direct relationships between banks and nonbanks. As a practical matter, that is true. But it raises the question of whether the platforms bring enough to the table to justify their fees or the valuations at which they have raised capital.
For new fintechs looking to get to market, and sponsor banks without their own technology stack capable of supporting fintech programs, there remains a critical need for a software layer that abstracts away the hard work of integrating to banking infrastructure behind a few lines of code.
However, the supply of sponsor banks is likely to be limited, and some of those banks–like Lead or Column in the US or Solaris or Starling in Europe and the UK, respectively–have developed their own modern tech stacks to facilitate direct integrations. Others with well-established partner banking models (such as Pathward, Bancorp, or WebBank) are unlikely to turn to BaaS platforms for large parts of their operations.
Moreover, as fintechs mature they are likely to build out more of their own infrastructure–they are in the business of providing financial services after all, and owning more of the “stack” enables them to have more control over customer experience and product roadmap.
Does that mean there is no future for BaaS platforms? Far from it. But the opportunities for BaaS platforms will require them to understand their core competency and identify a broader range of areas in which to deploy it.
Their core competency is understanding banking infrastructure–ledgering, accounts, myriad transaction types, loans, interest accrual, etc. That core competency solves one of the biggest challenges banks face in innovating: Their core technology platforms are antiquated and monolithic, preventing banks from developing or partnering with innovative new products. Replacing an entire core system is time-consuming and risky–and often prohibitively expensive due to anticompetitive contractual terms.
The rigidity of the legacy core providers–both technologically and contractually–provides an opportunity for BaaS providers to help banks launch a broader range of new products and initiatives. Flexible, modern technology platforms that can integrate with banks’ legacy core systems, as well as modern risk and compliance solutions, can help banks of all sizes innovate and compete. Already, banks often build new applications on “side core” infrastructure, to support the desired functionality that is either impossible or uneconomical with legacy core systems, while syncing to the bank’s core for accounting and regulatory reporting purposes. In the US, this trend has, to date, mainly involved smaller banks, but elsewhere in the world we see examples of banks of all sizes pursuing this strategy. For example, in India many of the country’s largest banks have worked with service providers such as M2P to launch new digital products.
Could the proliferation of applications running on “side cores” eventually eclipse the legacy core providers altogether? Probably not. Banks will need to ensure the back-end systems supporting all of their products are interconnected. However, there is a significant market in helping banks and other traditional institutions launch new products. By focusing on their core competency of building flexible, modern, but robust and reliable bank infrastructure BaaS platforms can position themselves as the predominant alternatives to legacy core providers for banks launching digital services of all kinds–not just sponsored fintech programs.
The second opportunity is supporting the growing universe of nonfinancial companies who want to (or will realise eventually they should) embed financial services into their underlying product or service. The Embedded Finance opportunity is already large, and has the potential to become a significant share of the overall financial services market–while growing that market.
Embedded Finance has been pioneered to date largely by Software-as-a-Service (SaaS) companies looking to deepen their customer relationships, solve customer pain points, and monetise by embedding payments or other banking services directly into their software. Prominent examples include
This market has the ability to achieve significant scale. Most estimates of potential market size are not to be trusted, but as more and more businesses operate on software platforms that manage supply chains, accounting, payroll, and more, the opportunity to seamlessly integrate payments, lending, and insurance into those software tools is too obvious to ignore.
Moreover, BaaS platforms can realistically hope to scale with their customers in this market, rather than see most of them “graduate”. Most SaaS companies and large technology brands do not aspire to become primarily financial services companies, so a technology platform that offers pre-wired integrations to the spaghetti soup of bank infrastructure, packaged in modular pieces and delivered through modern APIs will likely continue to add value. Especially if that also comes with technology-enabled operational capabilities to take on processes such as chargebacks and returns that many non-financial companies would (rightly) rather not deal with.
By doubling down on the “boring” parts of their business–the core technology stack built to integrate nonbanks with banking infrastructure–and rethinking their business models, BaaS platforms can position themselves to take share from legacy cores and to power the growth of Embedded Finance.
About Jonah Crane Jonah Crane is a Partner at Klaros Group. He focuses on fintech, BaaS, Embedded Finance, digital assets, strategy and M&A, and policy and regulation. Jonah previously served as Deputy Assistant Secretary in the U.S. Treasury Department, policy advisor to Senator Chuck Schumer, and M&A lawyer at Milbank LLP. Jonah received a BA in Politics from NYU and a JD from NYU School of Law.
About Adam Shapiro
Adam Shapiro is a Partner at Klaros Group. He focuses on payments, digital assets, fintech, sponsor banks, & BSA/AML. Adam is a leading expert on financial innovation, with a particular focus on helping clients find solutions that meet their business objectives while maintaining strong regulatory compliance and risk management. Adam has a track record of helping clients successfully achieve difficult goals, such as gaining bank charters with non-traditional business models and scaling cryptocurrency businesses in the face of regulatory uncertainty.
About Klaros
Every day we send out a free e-mail with the most important headlines of the last 24 hours.
Subscribe now