OBSERVATIONS FROM THE FINTECH SNARK TANK

There’s a pall hanging over the banking as a service (BaaS) space as one partner bank after another has hit regulatory snags and BaaS platform providers have ceased—or cut back—operations over the past year. What’s the outlook for BaaS?

As Monty Python would say, “I’m not dead yet” or “it’s only a flesh wound.”

New research from Cornerstone Advisors and BaaS provider Synctera helps points to banks’ growing interest in BaaS and the path forward for banks and fintechs.

What’s Going On In BaaS?

According to Bain Capital, embedded finance—the integration of financial products from licensed or chartered financial institutions into the products and processes of non-financial institutions—accounted for 5% of all financial transactions in 2021, and will grow to 10% of transactions, valued at $7 trillion, by 2026.

The underpinning of embedded finance is banking as a service—the delivery of financial products from licensed or chartered financial institutions through non-financial institutions (typically fintechs).

Despite the rosy embedded finance forecasts, the BaaS space has taken a black eye in the past year resulting from a seemingly endless set of regulatory warnings, fines, and other actions against some BaaS banks.

It isn’t impacting banks’ plans to get into BaaS, however.

More Banks Are Getting Into BaaS

According to Cornerstone Advisors’ 2024 What’s Going On In Banking study, 9% of mid-size banks* already provide BaaS services, a similar percentage to the number of banks in the space according the consulting firm’s 2023 survey.

The percentage of banks in the process of developing a BaaS strategy has nearly doubled year over year, however, from 3.7% in 2023 to 7.0% in 2024.

Established BaaS have grown sizable businesses.

On average, today’s BaaS banks support roughly four partners, more than 300,000 consumer accounts, and 3,500 small business or other commercial accounts.

A few larger players in the space support 12 or 13 partners, more than 1 million consumer accounts, and between 25,000 and 50,000 commercial accounts.

The Opportunities For New Entrants

It may seem daunting for banks to get into BaaS with more than 100 well-established partner banks already in the space, but many of the current entrants aren’t taking on new fintechs.

At a Fintech Meetup conference dinner, attended by a virtual who’s who of BaaS bankers, the CEO of a long-established partner bank said his bank wasn’t taking on new partners and that, if he were first getting into the space today, he wouldn’t partner with some of the fintechs that he sponsors today.

He isn’t alone.

This is just one reason why the door to BaaS is open to new entrants. Another big reason: Fintech dissatisfaction with the current crop of BaaS banks.

Consulting firm Levvel conducted a survey of fintechs and found that more than six in 10 are somewhat or very likely to find new bank partners. Why? The long list of reasons is topped by platform integration issues, inability to scale, unresponsiveness, and expensive pricing.

Compliance Is Not A Competitive Advantage

There’s a popular meme propagated by one of the big venture capital firms that compliance is a competitive advantage in the BaaS world. Don’t believe it.

Regulatory compliance is table stakes. The best compliance in the world isn’t going to help with platform integration issues, scalability, and response time (it’s actually the other way around).

That said, Michele Alt, a former regulator at the OCC and co-founder of advisory firm Klaros Group, offers sage advice to banks in—and planning to get into—BaaS:

  • Board governance is a huge issue. At the board and management levels, risk governance needs to follow the large bank model. That means a board risk committee, chief risk officer, enterprise risk management, and appropriately qualified directors and executives.
  • Regulators expect clear and exacting controls. According to Alt, “in multiple enforcement actions, regulators have imposed exacting controls around the establishment of new fintech partnerships. The FDIC is showing increasing willingness to take responsibility for new partnership approval away from institutions that don’t meet these standards.”
  • The bank owns the customer (as far as the regulators are concerned). This is true from a regulatory perspective, but not from the fintech partners’ perspective (more on this at the end of the article).

Technology: The Key Differentiator In BaaS

There’s simply no way for BaaS banks to differentiate themselves in the space through compliance. The key to differentiation is a technology platform that enables: 1) ease of integration; 2) program (product) customization; and 3) speed to market on new product development and changes.

Easier said than done. Banks in (and getting into) the BaaS arena must overcome a number of constraints that plague most mid-sized financial institutions:

  • Scalability. Banks on small, old core systems often have no migration path to create scalable capacity and don’t know the threshold tiers that trigger hardware expansion.
  • Response times. Banks processing on a nightly batch window may not be able to meet the real-time processing requirements of their partners or consumers’ expectations for real-time (or near real-time) payments processing.
  • Core connectivity. Many existing core systems are not API-compliant and/or the full transaction set is not available through the existing API set, resulting in costly and time-consuming data integration initiatives.
  • Operations. Few mid-size banks have the development capabilities to address BaaS-related upgrades and additions and lack the technology architecture skills and resources to manage an ongoing BaaS operation.
  • Product creation/configuration. Many banks can’t create configurable, parameter-driven products to support fintechs without time-consuming product development cycles and extensive programming resources.
  • Cybersecurity. Partner banks typically need stronger cybersecurity capabilities to expand their “DMZ” layers and pipes to provide outside services.
  • Data warehousing. Mid-size banks typically have not invested in robust data analytics or data warehouses. According to Lee Easton, President of iDENTIFY, BaaS requires an accelerated prioritization of data management because end user account information must be sent daily to a bank’s data warehouse for compliance audits and reviews.

Organizational Considerations

Overcoming the technological and operational challenges to a BaaS entrance is not going to happen by assigning Jimmy and Jenny from IT and Sally from Compliance to the new BaaS team.

A new study from BaaS platform provider Synctera give BaaS banks and their fintech partners insights into the operational and investment requirements for a BaaS bank.

The Organizational Requirements

A bank getting into BaaS will need a dedicated team—or better yet, a new business unit.

Although the perspective of Synctera’s report is from the fintech’s point of view, the analysis is pertinent to partner banks, as well. From a technology and operational perspective, eight teams are needed:

  1. Ledger and platform team responsible for building the core ledger that is used to keep track of all of the money flowing through the system.
  2. Card issuing and processing team for building the card processing engine that sits on top of your payment processor.
  3. Compliance team to build out KYC, KYB and CIP, and integration to various identity platforms.
  4. Transaction fraud team responsible for integrating a fraud engine to decide on transactional risk assumption.
  5. Payment team that builds out ACH, wires, FedNow, Zelle, push/pull from card.
  6. Core platform team responsible for maintaining the Google, AWS, or Azure infrastructure.
  7. Security team responsible for auditing, PIN Vaults, encryption of key documents.
  8. Data science team consisting of two to four data analysts and two or more data engineers responsible for maintaining pipelines and data models.

Operational Requirements

Synctera’s study advises fintechs to ask potential BaaS bank partners:

● What products and payment rails do they offer?

● Do they have funding requirements or upfront charges?

● Will they provide technical implementation support?

● Do they offer KYC and KYB?

● Do they allow you to offer FDIC insurance above $250,000?

● What interest on deposit is available to your customers?

● What are their requirements for compliance?

● Are you required to code to their APIs or can you operate standalone?

● Have they actually sponsored a program like yours before?

● What’s their testing strategy for your program?

● How do you handle daily reconciliation of payments that go to the bank directly but also need to make it into your system like ACH and wires?

● Do they have integration to the FedNow network?

● Can they process same-day ACH? How about wires?

● How do they audit your daily operations?

● What ongoing monitoring requirements do they have?

An aspiring partner bank that can’t answer these questions should go back to the drawing board.

The BaaS Outlook

The mood at the Fintech Meetup dinner wasn’t gloomy, but it wasn’t particularly optimistic, either. Coastal Community Bank CEO Eric Sprink commented that a hard part of his job is keeping his folks upbeat and focused on the future.

But what is that future? Here are some thoughts:

1) The BaaS space will move upstream. The level of compliance, operational, and technology resources need to get into the BaaS space and grow the business is going to prove too much for a lot of sub-$10 billion banks. I’ve predicted that a big-ish bank will acquire one of the existing partner banks in 2024 to accelerate its entrance into the space and throw a ton of compliance and technology resources at it. The big banks will get into BaaS.

2) BaaS becomes a new line of business for banks. Cornerstone’s survey identified a number of banks who’s primary BaaS objective is growing deposits for its core banking business. That’s a warning sign. BaaS isn’t about growing the core banking business—it’s about creating a new growth opportunity by helping partners—fintechs, vertical SaaS providers, and merchants—grow their businesses.

3) Operational decisions matter. According to Sarah Howell, Head of Partnerships at LoanPro, sponsor banks should architect their operating accounts based on program level funds flows. Establishing program specific FBO and operating account architectures that enable traceability, while allowing for deal flexibility, will make recon and settlement much easier, thus eliminating manual processes across the bank’s accounting and compliance teams.

4) Build versus buy becomes a strategic decision. Let me restate that. The critical decision—for both banks and fintechs—is determining the right balance between buy and build. Cost isn’t the only determining factor—speed and quality matter, to. And understanding that the more you buy, the more vendor management resources you need, and the more you may be required to integrate.

5) Specialization becomes critical. Today’s sponsor banks generally focus on either payments or lending, with a few offering both. That level of focus—i.e., “payments” and “lending”—will be too broad a categorization a few years from now. BaaS banks will need to come to the table with a track record of reaching certain segments of the population (whether that’s the consumer or commercial population) with specific types of payments (which could be both payment and lending oriented).

6) BaaS platform providers survive (and thrive)… Synctera’s recent $18.6 million capital raise wasn’t a last-ditch effort to save the firm from extinction. It was a recognition of its large and profitable partnerships outside the US and its future opportunities in the US.

7) …but need to shift business models. The current BaaS environment is forcing BaaS platform providers to shift their focus from selling to fintechs to selling to banks—which is where their focus should have been from the start.

To download a complimentary copy of Synctera’s report The Build vs Buy Guide for Embedded Finance, click here.

*Cornerstone notes that the survey sample isn’t representative of the entire base of 4,500 US banks, but of the roughly 1,500 banks with more than $500 million in assets. In addition, although the Cornerstone study only includes 16 BaaS banks, that number represents more than 10% of all banks in the BaaS space today.

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