The revised Payment Services Directive (PSD2) was passed by the Council of the European Union in 2015, and widely implemented in 2017. The regulation ushered the banking industry to the Open Banking era of seamless data exchange. The implications of this regulation were not restricted to only Europe. We witnessed Open Banking being embraced globally – either market driven, or government regulated – across the key markets.
The advent of Open Banking allowed for new business model innovations. A key manifestation of open banking revolution is embedded finance – a business model that structurally separates the banking back-end operations from customer interface, making finance (payments, lending, banking) invisible and contextual for end users. Over the years, the embedded finance model has evolved (Figure 1), from banks being only the back-end rails to banks actively owning the CX and improving customer proximity through embedded finance.
Figure 1: Banks moving up in the embedded finance value chain to own the CX
Capgemini’s World Retail Banking Report 2021 indicated that more than 70% of banking executives agree that embedded finance helps to innovate banking products and services, expand customer base, reduce distribution and customer acquisition costs, and diversify revenue sources. As per an estimate, by 2030, nearly 50% of loan originations and payment initiations will shift to non-FS channels (like hotels, mobility, e-commerce sites, retailers, etc.). This will make embedded finance a prominent channel strategy for banks. For instance, Standard Chartered launched its Nexus BaaS platform in 2021. Since then it has partnered with an e-commerce company to launch a digital only bank in 2022 in Indonesia to offer embedded banking solutions to nearly 6.8 million merchants and almost 110 million users.
By 2030, embedded finance revenue potential for banks is forecast to reach nearly USD588 billion from just USD22 billion in 2020. Moreover, an analysis from S&P Market Intelligence also suggests that banks offering embedded finance could potentially witness up to 2x improvement over industry average on ROAA (return on average asset), net interest margin, and efficiency ratio. As the industry steadily moves towards Open Finance – allowing authorized access to a wider range of data beyond accounts and payments like insurance, investments, and mortgage – it will act as a tail wind for embedded finance growth and adoption.
Embedded finance is also a key growth driver for super app strategies. Combining financial products like credit, payments, savings, insurance, etc. with a wide range of non-FS services is unlocking new avenues of customer engagement. Brands such as Uber, Amazon, and Apple are already re-bundling their services with banking to orchestrate ecosystems. This is not limited to retail consumers only. We are also witnessing super apps and ecosystems orchestrated for SMBs where non-FS services like cash flow forecasting, tax services, bookkeeping and other services are bundled with working capital loans, payments, etc. Embedding financial products in super apps ensures customers or SMBs do not have to leave the app or exit the ecosystem to complete transaction – financial or non-financial. An example is NatWest which has created a new BaaS on its business banking app called Mettle. This allows SMBs to directly embed financial services into their workflows to create seamless client journeys.
As embedded finance presents a compelling set of opportunities, they are accompanied by risks. Embedded finance leverages network of APIs to connect with third-party service providers for data exchange. Banks need to protect the integrity of transactions and privacy of customer’s data within this ecosystem. Partnership complexities in the embedded finance ecosystem can also lead to counterparty risks stemming from one-to-many relationships, shared liability, and multi-tier relationships among service providers and banks.
Finally, banks continue to confront existing risks stemming from credit quality, liquidity concerns, volatile interest rates, and operations. To remain resilient, banks must build integrated risk management capabilities for embedded finance. One way to do this is by creating a separate Banking-as-a-Service (BaaS) unit, away from core banking operations, to isolate the primary business from undesirable risks stemming from embedded finance. For instance, SEB bank from Sweden launched a separate BaaS unit, SEB Embedded, to commercialize its embedded finance offerings. Banks can also consider forming a dedicated risk & compliance team for embedded finance to guard against evolving risks.
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