Embedded Finance: What Banks Need to Know Now

But let’s start from the beginning: In January 2022, we published a blog post bearing the headline “Open Banking: Taking a Wait-and-See Approach Can Get Expensive.” “Those who do not provide up-to-date programming interfaces in the future will not have a lasting business model in the long run,” we predicted at that time.

The term “open banking” denotes a standardized and secure exchange of data between banks and trustworthy third-party providers. Open banking works with the help of application programming interfaces (APIs). The objective of open banking is to harness standardization and efficiency to create added value and to foster innovation in the financial sector through new product and service offerings. Open banking, for example, today enables accounting software to automatically access a business’s bank data, eliminating manual work.

Open banking will make multibanking possible also for private individuals in the near future, meaning that clients will be able to access all of their bank accounts through a single interface even if they hold multiple accounts at different banks.

What’s clear is that open banking is by far no longer merely a vision of the future, but is already a reality today. Banks have recognized that open banking is absolutely essential to them being able to serve clients’ needs in the future. Many Swiss banks (including UBS, Zürcher Kantonalbank, and Valiant, for example) are already connected to the bLink platform, the open finance solution from SIX. Others are in the midst of the onboarding process as part of an ongoing multibanking initiative.

Open banking is the strategic and technological fundament for an exchange of data and services between banks and third-party providers. API connectivity and the secure integration of client data into software solutions from third-party providers are a major driver of innovation in the financial sector. The value chain for banks used to be a self-contained closed loop, but today that loop is opening: banking is being transformed into individual components that can be accessed separately and combined with other financial and non-financial services.

Specifically this means that banking is evolving. New players are coming onto the scene. More and more people are holding accounts at neobanks like Revolut or its Swiss counterpart Neon, which beckon with very low fees and rapidly integrate innovative services into their respective product lineups. Even Swiss retailer Coop just recently began to offer household accounts and debit and credit cards. There are also many international examples: think of Apple, Samsung, or Google Pay. Transportation service provider Uber has also joined in: it pays its drivers’ wages directly to their personal Uber accounts, which are also linked to a debit card.

Those companies all have something in common: they generally are not in possession of a banking license, but nevertheless provide banking services. However, they do not operate independently because in order to provide banking services, a licensed bank always needs to be involved. This means that behind the offerings by Neon, Coop, Apple, and the like, in the background there is always a bank that makes its services (compliance, technology, and know-how, for example) accessible to non-bank entities. This practice is called banking-as-a-service (BaaS) and embedded finance, and it is practically the next step in the evolution of open banking.

While open banking provides access to data and a certain set of services, BaaS enables access to a (nearly) complete suite of functions. In simple terms, this means that BaaS enables banks to allow other businesses to integrate banking services such as bank accounts, debit and credit cards, or loans, for example, into an existing product or platform. Several different actors are involved here:

• The BaaS provider is a regulated bank. It makes its services available to third parties via APIs.
  
  
• The (optional) BaaS partner is a client of the BaaS provider and acts as a distributor that integrates the banking services into its own platform. BaaS partners are often fintechs that possess the requisite technology, but lack sufficient licenses. Involving a BaaS partner is optional. If the bank possesses adequate technology, it can perform this function by itself. 
  
  
• The BaaS user is a business that utilizes the BaaS partner to integrate the banking services directly into its product. 
  
  
• The end client of the BaaS user are the last link in the chain. They consume the product supplied by the BaaS user while benefiting at the same time from the integrated banking services made possible by BaaS. Depending on contractual stipulations, the brand of the BaaS provider – i.e. the bank – might not even be visible to end-customers.

Embedded finance means the same as BaaS in principle, just from a different perspective. BaaS is the name given to the process by which banks make their services available to third parties. Embedded finance, in turn, denotes the banking services built into the offerings of a non-bank entity. Simply stated, embedded finance is the “what,” and BaaS is the “how.”

BaaS and embedded finance open opportunities for banks to develop new business areas, as you can read in our white paper titled “The Impact of Technology on New Business Models in Banking.” Outsourcing of their services provides access to new customers. Throughout Europe, there are already some established market participants that have made BaaS their business model. The list of the biggest players includes, for example, Germany-based Solarisbank (which counts Samsung as one of its customers), Railsbank in the UK (Amazon Web Services, Visa, and Mastercard), and the French bank Treezor, which was recently acquired by Société Générale, France’s third-largest bank.

In Switzerland thus far there is mainly one bank that is prominently positioned with a BaaS offering: Hypothekarbank Lenzburg. This regional bank founded a company called HBL Solutions in order to concentrate on BaaS, and it is the bank behind the neobank Neon, for example. Neon sources banking services from Hypothekarbank Lenzburg via BaaS. Hypothekarbank Lenzburg has gained around 200,000 new customers via Neon through this arrangement. That’s more customers than Hypothekarbank Lenzburg ever had before. Hypothekarbank Lenzburg is also the bank behind retailer Coop’s newly launched offering.

In a nutshell, BaaS makes it possible for the bank to penetrate entirely new customer segments that it most probably wouldn’t have reached the “traditional” way even with an enormous marketing budget.

But why is that necessary at all? Why should someone go to the trouble of opening an account at Coop in addition to or in place of his or her already existing bank account? The key lies in meeting customers’ specific needs. Coop currently offers savings and personal accounts, debit and credit cards, and Pillar 3a retirement savings accounts. In addition, customers can make cash withdrawals free of charge at all Coop stores. The fees are low, the credit cards are free, and Coop is the biggest provider of cash withdrawals in Switzerland.

Whether that alone is enough to win over the masses is questionable. But that may possibly mark just the beginning. The greatest advantage of the Coop brand is its emotional appeal. In Switzerland, people identify as a “Coop kid” or a “Migros kid” if they were “socialized” by one of the two big Swiss retailers. Coop in particular could optimally work the family theme angle. Things, for example, like special Superpoints conditions, children’s cards, or financial literacy offerings coupled with savings plans would be conceivable in the future.

In short, in order for embedded finance to work, it takes a strong brand with a certain emotional appeal, a sufficiently large number of customers that one can easily address, and a related banking services offering that meets the specific needs of that clientele.

Two things are needed to be able to offer BaaS: a banking license and the requisite technical infrastructure. It all starts with open banking. If BaaS and embedded finance are the PhD, open banking is the bachelor’s degree program. It lays the groundwork for BaaS and embedded finance. When banks integrate open banking, they acquire the necessary know-how via APIs and work together with corresponding partners. From there they can decide whether they want to go further.

BaaS and embedded finance are not absolutely vital to the future profitability of traditional banks, but they do present new possibilities and opportunities to tap new customer segments that are hard or impossible to reach the “old” way. Embedded finance is currently still in its infancy, but the market for embedded finance is projected to grow to almost 300 billion US dollars annually by 2033, according to a report from Future Market Insights. Banks therefore would be wise to take at least the first step and start to engage with open banking.