Embedded Finance: What It Is, and Why Your Bank Needs It
Almost since its inception, the banking industry has been built largely on the principles of stability and conservatism. All else being equal, banks have demonstrated a natural preference for "the sure thing". Historically, banks look favorably upon investments with a relatively smaller return but which are almost certain to pay off, as opposed to investing in ventures that are higher risk but offer greater returns. This aversion to risk has resulted in the growth of the industry we know of today, with a total evaluation numbering in the trillions of dollars.
Unfortunately, this aversion has also
prevented banks from having the agility necessary to adapt to the changes of
today's digital, always-connected world and the consumers who have grown up in
it. Without sophisticated technology support such as virtual account management
and asset finance software,
traditional banks have not been able to keep up with the immediacy and variety
of choice that millennials have come to expect. Consequently, this valuable
market segment has seen fit to take their savings accounts and investment needs
to companies who operate in the embedded finance space.
If this seems to describe the situation your
bank is in, you've come to the right place. Here's what you need to know about
embedded finance and how your organization can meet the challenges brought
about by this new entrant into the financial services sector.
What Is Embedded Finance?
More and more companies these days have begun
to offer services that only banks could offer traditionally. These services
include savings or e-wallet options, internal investment and insurance
products, and even electronic currencies usable only for purchases within
specific brand ecosystems. These are all examples of embedded finance and are
efforts by companies to acquire and, more importantly, retain customers.
It's not hard to think of examples of embedded
finance, and given how successful it's been, it's only a matter of time before
small and midsize businesses start offering some form of it. Industry experts
have gone so far as to say that these days, every company is a financial
technology (fintech) company, implying that those who attempt to buck this
trend or ignore it will likely fail to be relevant in the future.
So what does this mean for traditional banks?
Will they be rendered obsolete?
That depends. Despite the rapid proliferation
of embedded finance and the almost ubiquitous nature of fintech apps,
traditional banks still have their role to play in facilitating a society's
economic life. However, for banks to continue to be relevant, they will need to
reconsider their position vis-a-vis fintech and will have to establish a
banking-as-a-service (BaaS) line of business to interface with fintech apps.
What Is BaaS?
Instead of considering fintech and all its
players as a form of competition, banks must seek to collaborate with them and
realign their operations accordingly. This is the essence of BaaS: creating
business units within banks that can interface with and provide backend support
for fintech apps and other user-facing components of embedded finance. By
adding fintech-ready API support to current banking IT infrastructure, banks
will be able to interface with fintech apps while also providing all the
services that users expect and require. This way, banks can refocus their
efforts on their core competencies of financial analysis and investment product
development while allowing fintech partners to deal with customer service,
marketing, and sales, as well as the development of optimal UX and UI.
The rationale for pursuing this strategic
direction is self-evident, as everyone else is doing it. An estimated two-thirds
of banks have already undergone some form of the digital transformation
necessary to integrate backend fintech processes into more traditional banking
operations. To not do so would seriously compromise a bank's ability to operate
further.
That said, fintechs need banks just as much as
banks need fintechs, and both contribute to the other's relevance. In most
countries, the regulatory bar that needs to be cleared in order to represent
oneself as a financial institution is very high and could take years to clear.
This is the reason most fintech companies would elect to pursue BaaS instead of
establishing themselves as, functionally, a digital bank. Traditional banks
provide an easy solution to the hurdle posed by regulation, allowing banks
space to operate while also allowing fintechs to focus on their own core
competencies.
All evidence suggests that embedded finance
and banking-as-a-service are here to stay. Customers, especially those in the
retail space, seem to want even more embedded and integrated experiences. As
such, they would rather remain within an app's ecosystem for all their
transactions rather than having to hop from app to app in order to transact.
Fintech continues its growth unabated, both as discrete lines of business
within established companies and as independent startups funded by a flood of
external capital. Banks can no longer ignore these trends and must buck their
conservatist tendencies in order to continue to operate in the future.
