The multi-tiered future of BaaS

A guest editorial by Alex Mifsud, chief executive officer of Weavr

If any fintech trend is painfully making its way through the archetypical Gartner hype cycle, it must be Banking-as-a-Service or BaaS. At its core, BaaS is an API-driven platform enabling third-parties – typically fintechs – to develop financial products that make use of the banking and payments capabilities and regulatory permissions of financial institutions that offer it. This means that non-regulated businesses can, in effect, make financial services available to customers without having a banking or financial licence themselves. The bank gets to monetise their licence efficiently, while fintechs bring ingenuity, market insight and usually, superior digital experiences to customers. It sounds wonderful in concept, but the reality is far more complex. The recent collapse of Synapse, a prominent BaaS provider, as well as the sheer number of regulator interventions across many developed world economies, has highlighted critical vulnerabilities in the BaaS model.

While no one, including regulators, seems to be denying the opportunity to create customer value, it is increasingly evident that the BaaS model as it has developed over the past 5 years or so will not survive in its present form. There are several evolutionary directions that are being talked about for BaaS, even if not yet established. Here, I would like to present a specific variant that the European regulatory model not only makes possible, but also presents a strong win-win opportunity for banks to collaborate with non-bank financial institutions like e-money institutions and payment institutions (I’ll use the acronym “EMI” to mean either of these). In this model, banks get access to the benefits of BaaS with minimal exposure to the now better understood risks, while EMIs get access to the powerful capabilities and economics that are the sole preserve of banks as deposit-taking institutions. These collaborations – in effect, a multi-tier approach to BaaS – should offer safer exposure to embedded finance for banks, and richer capabilities available to embedders, and ultimately, end-customers.

Antipattern matching

Recent announcements that Clearbank, a digitally-savvy clearing bank now promoting itself as an embedded finance platform, has hit profitability is a welcome tonic to investors despairing of the stream of bad news hitting BaaS players in the US and Europe. Even JP Morgan, one of the most respected global banks, has shown that size is no obstacle to ambitious, or even radical, innovation, as it also offers embedded finance. And at the other end of the size scale, Griffin announced earlier this year that, having secured a banking licence specifically to offer BaaS and embedded finance, it is now ready to start operating.

In the face of the mentioned challenges that EMI BaaS players have faced with regulators in Europe, some in the investment community have been proclaiming that​,​ to do BaaS effectively, a financial institution needs to have a banking licence. An e-money or payment institution licence simply won’t cut it.

While such pattern matching and extrapolation is understandable, it is not necessarily correct, and the rest of this article presents an alternative view: both EMIs and banks are viable financial institutions to support embedded finance, but each have strengths and weaknesses. Better still, by working together in a multi-tiered configuration, each type of financial institution can play to its strengths enabling the combination to deliver high capability, highly adaptive delivery models of embedded finance. 

Banks doing embedded finance

While a banking licence does confer specific advantages – mainly, that deposit-taking provides one of the most attractive financing models for financial institutions to raise funds for lending – there are also disadvantages to being a bank compared to being an EMI. In the UK, for instance, banks need to hold more capital than EMIs, and perhaps more importantly, banks are supervised by both the Financial Conduct Authority (FCA) and the Prudential Regulatory Authority (PRA), the latter of which does not supervise EMIs.

Navigating innovative operating models like embedded finance with two regulators can create greater risk aversion and therefore slow down or even discourage the experimentation that is required to find the right risk-value formula that works. We know from recent experience that getting the balance right between great customer value and sustainable compliant operations can be a delicate balance.

One way to square the circle is for banks to provide wholesale financial services to EMIs which then serve end customers on their own licences in turn. While this doesn’t completely insulate the bank from censure in the event that the rules are broken – for instance, if money laundering occurs – it does place the biggest share of the burden of the customer on-boarding and monitoring compliance on the EMI. Given that EMIs were created initially to support money-related activities for a digital world, it may be easier for them by working with a single regulator to achieve the right balance. It also allows large banks with cumbersome on-boarding processes designed for large corporations to get access, via the EMI, to a community of small- and medium-sized business customers that, in aggregate, represent meaningful business volumes for the bank.

There is a strong win-win in this kind of bank-EMI collaboration, especially for banks which are used to dealing with other financial institutions as customers. EMIs, in turn, can source a range of wholesale financial services from multiple banks: foreign exchange from one, and lending capacity from one or more others.

A new pattern: multi-tiered banking

The future of BaaS lies in collaboration. A multi-tiered banking model allows institutions to combine their strengths strategically. Such a model not only optimises the use of resources but also enhances the value proposition of BaaS by incorporating the strengths of various financial entities. EMIs, with their ability to offer commercial cards, credit lines, and foreign exchange services, reduce the risk for larger institutions and open doors for broader innovation.

Related news: Peanuds puts scalability first with Weavr partnership.

Image: Weavr

Guest Editorial This article was produced specially for Fintech Intel by an expert guest contributor.