BaaS is dead, long live BaaS 2.0

Banking-as-a-Service (BaaS) has been hyped up by fintechs and their investors looking for big valuations that last several years, and consultants continually predict ever-loftier figures for the total addressable market (TAM) size.

BaaS is changing the relationship between consumers and financial services

McKinsey, for example, expects the European BaaS TAM to reach a value between €90 billion and €105 billion by the year 2030.

What is driving the hype?

It’s simple: consumer appetite. E-commerce companies seeking a competitive edge after the pandemic boom turned to BaaS to make their customer journeys better. Consumers, in turn, particularly Millennials and Gen Z, responded with their wallet, leading to increased conversion and repeat visits.

Aion Bank’s recent research found that 52% of 25 to 34-year-olds prefer using financial products and services from their favourite brands over traditional banks, while 50% will only stay loyal to brands offering embedded financial products and flexible solutions like buy now, pay later (BNPL) and cashback.

But BaaS is going through an evolution. The ‘fintech-led, investor-fuelled, growth at all costs’ version of BaaS is dead, or is dying a very quick death thanks to increased regulatory scrutiny. This is a good thing, because as the sector evolves away from the wild west of BaaS 1.0, it can enter its more responsible era.

Demand for embedded banking and the evolution of BaaS

Consumer behaviour toward financial services has shifted markedly in the past five years. Today, far more people trust the brands they use every day to access financial services. As BaaS adoption has increased, embedded banking products have become more common within the customer journey.

Consumers are offered choice with access to banking products at the point of need. In effect, BaaS puts the customer at the centre, delivering what they want in the way they want it – just as no one wants a mortgage, they want to buy a house, no one thinks I want BNPL, they think I want to buy a pair of jeans. In turn, businesses can attract new customers, increase basket size, improve retention and loyalty, and generate new revenue streams by embedding financial services into their customer journeys.

The problem with BaaS today is all BaaS providers are not the same. Some are strictly IT specialists, others hold EMI or payment licences, and a few others offer services based on a full banking licence. So, the BaaS you get might look very different from one provider to another.

In reality, the banking licence (if any) a BaaS provider has dictates the services they are able to offer just as much as their underlying technology. What’s more, the compliance and risk management credentials of BaaS providers are not consistent. Businesses considering BaaS must be aware of the importance of the regulation and compliance aspects of financial services, and they should not assume that every provider will take care of this for them.

This can be very confusing for companies considering BaaS, and regulators are now looking much more closely at the sector. In practice, regulatory compliance in BaaS should be table stakes, with banks – the underlying licence holder – owning the customer relationship from a regulatory perspective. But we are not there yet.

In order for this to happen, there is digital transformation that will be required in BaaS operations and compliance practices, with the need for investment in risk technology and automation to effectively manage the increasing complexity and risks associated with BaaS.

Additionally, regulators will want to understand where the risks in the BaaS model reside in order to manage them as regulators.

This is the defining premise of BaaS 2.0, which will be shaped by a few key factors.

Licensing and regulatory compliance to come to the fore

As we enter the next chapter of the BaaS story, businesses seeking a BaaS partner will focus on how the BaaS provider is licensed, alongside their technology solution.

Additionally, as BaaS matures, businesses considering opportunities in this space must be aware of the importance of the regulation and compliance aspects of financial services.

Compliance processes such as know your customer (KYC) and anti-money laundering (AML) are integral in the delivery of banking products. Adopters will seek out BaaS providers with demonstrable experience and expertise to handle this. Here, we may see artificial intelligence (AI) play a far greater role in automating processes, while also ensuring a smoother customer journey for the end user.

More bank involvement

BaaS 2.0 will also see more investment from larger banks. The appetite for BaaS and embedded banking is clearly there – both from businesses adopting the solutions and end customers using the products. And big banks are starting to believe in the BaaS model as a cost-effective path to acquire customers at scale via a B2B2C model.

I believe BaaS represents the future for banks – not as a separate entity, but living in parallel to traditional banking – with a fundamental mindset shift from solution led to customer led.

UniCredit recently announced its agreement to acquire Aion Bank and Vodeno. This is the first major European bank to recognise the BaaS model as a future growth opportunity and invest in its development, and more investment in BaaS will mean more innovation and more adoption across different sectors. We will likely see more interest from larger banks in the years to come.

What’s next for BaaS?

BaaS is changing the relationship between consumers and financial services, and BaaS 2.0 will do this in a more compliant and commercially sustainable way.

To date, embedded financial services and lending are the foremost BaaS use cases. The ability to offer a quick and frictionless experience when processing transactions is the foundation of any good customer experience. So, it is no surprise that giving choice when paying is a common starting point when companies engage with BaaS providers. We should expect to see a wider variety of use cases reach critical mass, including digital wallets, savings and investments, integrated directly into the customer journeys of the biggest brands. The goal: to create more value for the customer and retain loyalty.

Much has been said about BaaS impacting conversion, but the real north star of BaaS is to influence the browsing stage, with tailored financial products determined via data analytics, offered in a contextual way throughout the shopping journey.

This will help foster a better, more loyal – and long-term – customer relationship.

Ultimately, it will be the fully licensed banks, with their banking and regulatory expertise in partnership with the right technology platforms, that will shape how BaaS 2.0 will deliver this promise.