Embedded Finance And The End Of Traditional Banking
Dateline New. York, 15th February 2023.
A market research survey of more than a thousand senior decision makers in the UK, Belgium and the Netherlands — commissioned by Polish banking-as-a-service (BaaS) platform provider Vodeno — found that two-thirds of them said that BaaS is transforming financial services for the better (I find it surprising that a third didn’t, frankly) and, more interestingly, half of them said that it will eventually make “traditional” banking obsolete.
That may seem a radical prediction, but I think it is entirely reasonable. Banking isn’t fun or interesting and most people (me included) don’t really want to spend any of their valuable time or attention on what is essentially a heavily regulated utility service. Most people (me included) would prefer to have their financial services delivered to them at point of need without interrupting their experiences. As Christina Melas-Kyriazi (a partner at the management consultancy Bain) observed, if you want to deliver financial services to a person then in some cases the best way to get to that person can be “via software, where they’re doing their work”.
Europe and the U.S are heading in the same direction here: Bain estimates that all kinds of financial services (not only banking) embedded into software accounted for $2.6 trillion, or nearly 5%, of total US financial transactions in 2021 and will approximately triple to $7 billion over the following five years.
(Note that point about this being all kinds of financial services and not only banking.)
While the market is currently dominated by payments and lending services, the upward trajectory will draw in adjacent value-added services as well. Bain suggest insurance, tax, and accounting as obvious candidates.
(Thomas Bravo’s recent acquisition of Coupa illustrates the market dynamics. Embedding payments functionality into other business management functions is of particular value. SaaS companies such as Avidxchange and Bill.com, as examples, obtained two-thirds and one-third respectively of last years’ revenue from such services.)
It is no surprise to see so much investment heading in this direction. An FIS global survey of 2,000 executives at firms across markets revealed plans to increase investment in embedded finance, environmental, social, and governance (ESG) frameworks and (rather interestingly, in my opinion) decentralised finance this year. Almost half of the financial services firms’ executives surveyed said that they will invest “significantly” in developing embedded finance products as consumers demand more convenient ways to transfer value in time, space and scale.
Fintechs and Techfins
What will this mean for fintech? On the other hand, the ability to deliver financial services inside consumer-centric experiences means better customer experiences but on the other hand, it means serious competition from the techfins. As Sophie Guibaud and Scarlett Sieber wrote in their 2022 book Embedded Finance: When payments become an experience (in the chapter on “Big Tech and Beyond”, pages 45-68) it makes sense for the technology players to move in this direction because these companies know their customers, have strong relationships with them and can use their data to predict their needs, offering the right products, at the right price and at the right time.
The techfins are more than happy to have banks, for example, do the boring, expensive and risky work with all of the compliance headaches that come with it. Big Tech does not care about the manufacturing of financial products, what it wants is the distribution side of the business. Given that they have no legacy infrastructure (e.g. branches), their costs are lower and the provision of financial services helps to keep their customers within their ecosystems.
It is easy to imagine a future where you use an Apple checking account (actually provided by JP. Morgan) and an Apple credit card (actually provided by Goldman Sachs) and use an Apple loan (actually provided by Wells Fargo) to buy your Apple glasses, then Apple will have a very accurate picture of your finances. A very accurate picture indeed.
It’s All About Data, Again
The business model here is clear. As I have written here before, what Big Tech wants isn't your money, but your data. The margins on money are shrinking, after all. According to McKinsey, “traditional" banks face stagnant or decreased revenue and profits. They note that the average global banking return-on-equity was around 9.5% in 2021. This is a sharp decline from 15% prior to the 2008 crisis and on the way to a projected 7% at the end of the decade.
One particular segment where this is having quite an impact is small business lending. A Bank for International Settlements working paper (no. 1041, September 2022) notes that fintechs (they look at Funding Circle and Lending Club) lend more than banks in areas where there would appear to be poor credit environment. The paper identifies the competitive threat to banks and concludes that such players can “create a more inclusive financial system, allowing small businesses that were less likely to receive credit through traditional lenders to access credit and to do so at a lower cost.”
Why? Well, as you might expect, this is about technology. The fintechs can evaluate credit risk using information beyond basic credit scores to emulate (and enhance) the local knowledge that used to be the domain of local banks. They cite the ability to access customer ratings and reviews as a good example of the “soft” data that can helpfully inform credit decisions. As Jonathan Katz comments about this over at The Financial Brand, banks that access such data stand to benefit from the business insight it provides, but note that it is insight that behemoths such as Amazon already have access to.
Imagine how much more accurate Big Tech’s decision-making can be when feeding the machine-learning algorithms with their hoards of data. If we want a better financial services sector then we must find ways to create a more competitive sector and that will mean moving on to some form of open data environment that delivers not merely financial services, but financial health, which is one of my favourite topics.
Powering Financial Health
There was a good piece in the Harvard Business Review a couple of years ago where Todd Baker and Corey Stone explored interesting ideas around the transition from individual financial services to integrated financial health. In that article they pointed out that the prevailing paradigm (of markets and choice) created a regulatory system that "largely places responsibility — absent the most egregious abuse — on the individual consumer" and argue for a radically different regulatory structure to more directly connect the success of financial services providers to their customers’ financial health.
(They draw an interesting analogy by comparing this approach with experiments in the American health marketplace that pay providers for improving patients health, "rather than paying them simply for treating patients regardless of the outcome of the medical intervention”.)
The incumbents have a problem here as well. Not only do they not have the data that Big Tech does, but according to findings from the J.D. Power 2022 U.S. Retail Banking Advice Satisfaction Study (based on responses from 5,177 U.S. retail bank customers who received financial advice or guidance from their primary bank in the past 12 months), overall customer satisfaction with the advice and guidance provided by national and regional banks has actually gone down over the last year.
What’s more, less than half of US customers use any form of financial health tool offered by their bank at all, which is a little disappointing considering how much banks invest in their digital apps, especially since research shows that customer satisfaction with how their bank supports their financial health rises sharply with the use of such tools.
with kind permission of Helen Holmes (CC-BY-ND 4.0)
So how can banks persuade people to use those tools? This is important, because customers need advice. Financial literacy is generally poor and the financial landscape is complex so you do have to wonder whether it makes sense to try and use tools to educate consumers at all, especially when a substantial fraction of those consumers have poor literacy and digital skills, never mind financial literacy and money skills.
(Credit card rewards are an ideal laboratory for exploring this topic. Here research shows clearly that rewards programs redistribute income from naïve to sophisticated consumers, supporting related studies that link heterogeneity in asset returns with measures of financial literacy.)
Maybe it would be better to instead provide consumers with intelligent agents to act on their behalf.
Why would customers trust the banks’ bots though? In the UK, I think this might be one of the unexpected consequences of an impending regulatory change. Last year, the U.K.’s Financial Conduct Authority (FCA) confirmed its plans to bring in a new “\Consumer Duty”, which will fundamentally improve how firms serve consumers. It will set higher and clearer standards of consumer protection across financial services and require firms to “put their customers’ needs first”.
What this means in practice is that companies will need to review their products (and their governance) to make sure that the best choices are made for consumers, not for the financial services providers. It’s a sort of duty of care, but for money, and it’s a real step forward in the delivery of integrated financial health rather than isolated financial products. Within this framework, it makes obvious sense for intelligent agents to act on the consumer’s behalf.
(I just spent several hours researching for, applying for and funding a new savings account and I’m still not sure whether I made the best decision or not. I’d much rather have had a bot operating under a regulated duty of care do this sort of thing for me.)
Refocusing the sector on delivering financial health, rather than financial services has implications that go way beyond choosing better credit cards or spending less on coffee and more on pensions but in order to do this, financial health providers will need a better picture of individuals and their circumstances. They need the raw data to work with. This is where the connection with open banking, open finance and open data comes from and when you look at trends in this context, the idea that people will access traditional banking services through traditional bank interfaces does indeed appear quaint.
Incidentally, as I was editing this article, I saw Shaul David’s comment on the news about Tesco considering divesting their bank. His point was that neither Tesco nor any other retailer needs a bank. What they need is a good embedded finance strategy, because there are many reasons why Tesco could be just as good a financial health provider to a great many people as a bank could. For one thing, Tesco knows what people spend their money on and for another it has distribution, brand and well-founded expectations of redress that are the potential foundations of a much better business than low-margin heavily-regulated core banking.
Dave, excellent post. Funny how our writing themes are aligning in 2023. My key points of difference: 1) banking used to be a community activity, now requires scale to manage the compliance and regulatory hurdles.. with bank margin driven by breadth of business and data economies of scale 2) Big banks work for most people.. they are adequate 70-80% of cases. 3) retail banking is a very low margin business with banks incurring a net loss on the bottom 30-40% of consumers (in US). 4) Agree on integration of banking into platforms that consumers use. V/MA are becomming the enablers here as they provide economics and agreements for QOS. 5) Other opportunities abound in specialist segments with unique needs (ex Gig workers).