The evolution of banking as a service is at an inflection point

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Despite recent industry shake-ups and a downturn in venture investment, banking as a service, or BaaS, is not going away, and demand for embedded finance continues to grow. Driven by a changing market, BaaS is evolving dramatically toward a new model, one where banks will have greater operational control and will be further solidified at the center of the embedded finance ecosystem.

This shift in the BaaS model is partly attributable to regulatory actions that have cemented existing regulations governing fintech partnership models. Other key drivers include the increased demand for embedded finance products and the maturation of partnership dynamics between banks and other businesses. What was once a market dominated by finance-focused applications that played in the same sandbox as neobanks and challenger banks, has now been opened to large brands, merchants, software-as-a-service companies and payment facilitators. This growth in demand is underscored by a Bain Capital study estimating that the transaction value of embedded finance will reach $7 trillion by 2026, a nearly 300% increase over just five years.

BaaS is having a measurable impact on the banking business, especially in the community bank space. Community banks (less than $10 billion in assets), many of which have seen declining assets as younger people flock to their larger brethren, are being bolstered by BaaS. In fact, those offering BaaS are seeing median deposit growth of more than 2% versus a near 1% decline among peers that don't, according to S&P Global Market Intelligence. Overall, banking is becoming more embedded, open, cloud-based and compliant. In Europe, BaaS is growing to what McKinsey projects will reach $100+ billion by the start of the next decade. This highlights the urgent need for a more robust BaaS model that can help sponsor banks grow while retaining their reputation as trusted and convenient financial partners. 

Bank leaders at the helm of sponsor entities can invest in BaaS business development and management functions to address compliance concerns as well as to compete in a growing market of sponsor bank options. BaaS still provides a great opportunity for many banks to scale, and the most successful will be those that operationalize all aspects of their BaaS function and invest heavily in the technology that is replacing the intermediary providers of BaaS 1.0 that have agitated regulators when it comes to ownership and responsibility of financial products. 

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An additional step in the BaaS revolution will be the new market opportunity for bank-focused software and tools that facilitate the softer elements of partnerships. Whereas older BaaS platforms controlled the relationship value chain for banks and fintechs, new BaaS tools will enable and enhance the banks' capabilities to find new nonbank partners, vet them based on target risk/return profile and implement them quickly — reducing upfront costs and time to market, and helping banks manage their partners over their relationship lifespan. 

In short, if the early days of BaaS were driven by market opportunity, the coming days of BaaS will be driven by the operational apparatus and software to acquire and manage that opportunity. 

The next evolution of BaaS will reverse the preexisting trend — from BaaS platforms commandeering the entire customer relationship value chain and all its complexities, to BaaS platforms being an enabler in the value chain that allows the bank to own and have oversight of the entire end-to-end relationship.

Banks will continue to support the growing demand for embedded finance capabilities, cultivating relationships with multiple fintechs just as fintechs cultivate multiple sponsor bank partnerships. The amount of banking licenses issued by regulating agencies has seen a reduction in recent years, and banks stand to benefit from this scarcity by commoditizing their banking licenses. By achieving this dynamic, these financial institutions will be able to unlock new value for end consumers as they continue to accelerate embedded finance adoption.