One would be forgiven for concluding that every bank, core bank and fintech developer on the planet is either building for Banking-as-a-Service (BaaS) or telling the market that they’re about to. Some have, in fact, already gone full circle by entering and then exiting BaaS.
With all the recent BaaS excitement, still strong despite regulatory headwinds, there are no real cross-jurisdictional platforms or service providers to be found. Certainly not one that spans across a big ocean. Global Embedded Finance (EmFi) customers, looking to build for a global audience, are facing the daunting task of integrating multiple providers across their main markets. This complexity impacts unit economics for the EmFi customer and is thus delaying global scale adoption.
To understand why no one is delivering BaaS on a global scale, we must look at the differences in market structures and regulatory frameworks. In this article, I wish to focus on the two biggest, established markets for banking as a service, namely the US and UK/Europe.
I will disregard the funding landscape because I think it irrelevant for this discussion. Good companies are still closing investing rounds albeit on lower valuations than in the frothy yesteryears.
Then there are the APAC and LATAM regions. Both hold much promise for BaaS and Embedded Finance but are still somewhat behind the curve. A big contributory factor to that are their fragmented financial infrastructures, both in terms of the ‘metals’ as well as the regulatory framework. There are indeed great signs of progress in Asia which, perhaps sooner then you might think, may help it leap beyond both the US and Europe in market adoption.
There are historical reasons for the unnatural (at least in my UK eyes) number of banks in the US. In late 19th century and early 20th it was illegal to operate a bank out of more than one building. Every little town in America had its own local bank. Over time, the banking system has consolidated from nearly 30,000 banks in the 1920s, to over 18,000 institutions in the 1980s to under 5,000 in 2022.
Small institutions saw their market shares erode as Tier 1 banks grew bigger and bigger, absorbing a growing share of local markets. This created a drive to secure alternative revenue generating models.
The large number of charters, and the growing local competition, increased the likelihood of a small number of those chartered institutions being that bit more adventurous and that bit more innovative in their business models. Weaker banks became targets for charter strip acquisitions, wherein the buyer would keep the charter but change the business model of the acquired charter. Consequently, there was never a shortage in institutions willing to dip their feet in promising new ponds.
The situation in UK and Europe was always very different. Markets were dominated by large national banks, and the tail of regional businesses was much shorter. Many of the smaller institutions are member-owned building societies and co-ops that serve their communities and are not under strong pressure to grow. It would also not be controversial to say that before the global financial crisis, and for a while after, European banks were in general less innovative than their US counterparts across all segments.
Due to this lack of effective competition in banking, the Electronic Money Directive (EMD) was introduced in 2000 and then amended in 2009 by the European Union, creating the concept of Electronic Money Issuers (EMIs). Smaller institutions, with lower capital requirements, were now able to offer some bank-like products and services.
In total, since 2013, the UK and Europe have collectively granted over 70 bank licenses and more than 350 Electronic Money Issuer licenses, while the US, in the equivalent period, saw an average of seven de-novo charters per year during that period.
As small US banks were looking for new revenue streams, fintech founders were in search of banking partners that would move fast. It was a match made in growth heaven. Both sides wished to strike the iron (aka the ZIRP high) while it was hot.
The Durbin amendment, which caps debit interchange rates for larger banks, also helped small banks offer better income share for the fintechs. Debit cards became table stakes for every consumer fintech in the US.
In Europe, EMIs provided similar value to the fintech customer. These smaller financial institutions, many of which founder-led ambitious organisations, were able to move quickly into the market, ahead of larger banks. EMIs were operating with a much lower cost base than traditional banks and were therefore able to out-compete traditional banks.
EMIs were not the only game in town for long. A very small number of newly licensed banks, dedicated to BaaS, emerged as an alternative to EMIs utilising their access to deposit insurance and central bank accounts as their main differentiators.
The BaaS ointment was not without its fly. Small banks with small compliance teams and small investment budgets faced an oversight challenge keeping up with the demand. The implications of that have been most vividly illustrated by Konrad Alt of Klarus Group, who showed the growing share of enforcement actions against BaaS sponsor banks relative to the rest of the US banking industry. The fate of EU BaaS providers was not much different.
For banks to win in BaaS, competitive pressures and an appetite for innovation (and perhaps, risk) are not enough. Technology drives BaaS adoption. Fast adoption, which fintech customers promised, required technology which legacy cores did not have. Large banks initially didn’t care enough to meet these requirements. Small banks were, with very few exceptions, unable to meet them and faced a build/buy decision when the market demanded speed.
Into this gap entered BaaS platforms. The connecting tech layer between the BaaS customer and the financial infrastructure, accessed via a licensed entity. Harvesting profit margins between licensed entities’ rigid pricing and their customers’ profitability pressures, platforms found the economics of this middle layer demanded cost mutualisation across many customers.
In the US, platforms had no prospect of becoming chartered banks and their only choice was a partnership model. In Europe by contrast, platforms could obtain an EMI license, directly onboard fintech customers and connect directly to the payment infrastructure, without needing a sponsor bank (except for safeguarding). Indeed, the first generation of BaaS platforms in UK and EU were all licensed EMIs or banks.
This created perhaps the most significant difference between the US and Europe – the ‘distance to license’. The US had a longer value chain. US license holders had to rely on two entities doing what they were supposed to do to be able to fulfil their regulatory obligations. Europeans mostly had one. EMIs who made extensive use of agents, who in turn had their own fintech customers, faced similar enforcement consequences of the longer distance to license as their US counterparts.
Distance to license also surfaced a critical question. Who was the platform’s customer - the bank or the fintech? In recent months pivoting US platforms declared their banks to be their customers (or else they’d risk losing all those relationships) and that they enable ‘direct’ partnership between their fintech customers and their bank sponsors.
The pivot to ‘direct’ relationships provided the death blow for the myth of bank sponsor migration, which US platforms marketed. Fintech liked the idea that if one sponsor decides to withdraw services then can just switch to another. On the surface, migration appeared like a technical challenge. In practice, it is extremely complex and as resource heavy as starting a new programme with a new bank. This is to be expected, since the new bank must onboard a fresh new customer, account number and cards must be re-issued, end users notified and much more. Licensed European platforms did not have to deal with multiple sponsors until they moved beyond their home market borders.
The evolution of BaaS followed a different path on either side of the Atlantic. Divergent business models, driven by the distance to license, on top of the usual challenges of new market expansion, meant few providers dared to attempt the crossing. The few who did, found they had to retreat.
Darwin said it is not the strongest species that survives, nor the most intelligent, but the one that is most adaptable to change. The BaaS, and Embedded Finance, market is amid a significant shift. Regulatory scrutiny is making some players take a step back and re-evaluate their strategic direction. Some players are consolidating, and others are exiting. Regulators’ attention is welcome as long as it provides clarity on the boundaries of, responsibilities of, and expectations from, each part of the BaaS value chain. Managed well, and we must all keep that as our north star, it should lead to overall better outcomes for end users of embedded finance.
Clear and better outcomes will in turn increase interest of non-fintech sectors in Embedded Finance. As global non-financial companies chase the revenue, growth and sometimes cost reduction opportunities afforded by contextual financial services to their own customers, they are currently facing a very fragmented value chain across their global footprints. When the regulatory dust settles, and business models grow close, we can expect a stronger BaaS sector emerging ready to deliver on a global scale.
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