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Embedded Finance: What It Is, and Why Your Bank Needs It

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June 18, 2021


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.

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About the author

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Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. oXYGen Financial is not affiliated with Kestra IS or Kestra AS. Kestra IS and Kestra AS do not provide tax or legal advice.

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The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.

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Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. oXYGen Financial is not affiliated with Kestra IS or Kestra AS. Kestra IS and Kestra AS do not provide tax or legal advice. https://Bit.ly/KF-Disclosures

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