Banking-as-a-Service: Should Banks Care?

It has never been easier to launch a new banking offering. A digital bank can be brought to market in a matter of months. A software provider can integrate an end-to-end banking workflow into their core offering, including checking accounts and treasury services. Similarly, on the demand side, the last 12 months have accelerated consumer adoption of digital-only banking services and small businesses’ adoption of vertical software. Terms like embedded finance and integrated payments are often used to describe these developments.

While these trends have been in play for some time, the rise of Banking-as-a-Service (BaaS) has accelerated them by making it easier for non-banks to participate in this space. We would argue that BaaS is effectively a mainstream development now.

Banks face a fundamental question on how to respond to the rise of BaaS. An instinctive reaction might be to view the development as a threat. If primary customer relationships migrate to non-banks and other digital natives, that poses an existential risk to banks. What often gets lost, however, is the opportunity this presents to banks to reimagine their customer experience, value proposition and tech stack.  

In this article, we will cover three topics:

• What is Banking-as-a-Service?
• Key market trends
• Implications for banks

What Is Banking-as-a-Service?

A BaaS offering can be typically characterized across four dimensions (Exhibit 1):

• Products which define the broad offering or solution or the problem being solved e.g., payments acceptance or lending
• Services or microservices which support the delivery of the broader solution e.g., know your customer (KYC) or compliance
• Delivery model which could be a full stack or partial stack offering, or just providing a banking license
• Segments for which you offer the solution — such as fintech, traditional banks, non-FI tech start-ups and merchants

Of the above four dimensions, services and segments are experiencing the most change today. We are increasingly seeing services or microservices being offered in a modular fashion, complete with flexible pricing models. Emerging players in BaaS are developing vertically integrated microservices or the packaging of microservices in a way which makes them relevant to a specific industry vertical. Exhibit 2 below shows the full range of BaaS offerings across a typical bank service and tech stack.

With regard to segments, the scope is continuously expanding with the entry of new players, most notably non-FIs which have various underlying motivations, such as strengthening their core offering, improving customer experience or creating an ecosystem.

In absolute revenue terms, we estimate that BaaS today represents an estimated revenue opportunity worth US$15-20 billion in the United States. The market is also expanding rapidly, at around 3.5 times industry growth rates. Effectively, the BaaS market is the size of an average US regional bank, or slightly smaller than the overall US merchant acquiring market. Certainly, BaaS now presents a high-growth and sizeable revenue opportunity. In Europe, we estimate this to be a US$6 billion market, and expect it to grow at 20% CAGR over the next five years, to US$15 billion in 2024.

Key Market Trends

A note on definitions. We identify three entities in the BaaS ecosystem:

• BaaS-enabled players are the companies that buy BaaS solutions. These include banks, fintechs, merchants and software providers.
• BaaS providers are the companies that provide BaaS solutions.
• End customers are those that use the financial services offered by the BaaS-enabled players. They are primarily consumers and small businesses, but increasingly larger businesses too.

There already exist a number of BaaS-enabled players that already are providing, or have the potential to provide, financial services as part of their value proposition, e.g.,:

• Digital banks (or neo-banks), such as Chime and Revolut
• Traditional banks that lack scale, such as credit unions and small community banks
• Payments service providers (PSPs), such as Square and PayPal
• Software / Software-as-a-Service (SaaS) companies, such as Intuit, Mindbody and Toast
• E-commerce retailers and marketplaces, such as Amazon, Shopify and Etsy
• Digital giants, such as Apple, Google and Facebook
• Consumer technology platforms, such as AirBnB, Uber, and Instacart.
• Traditional corporates, including mass retailers such as Walmart, automotive original equipment manufacturers (OEMs), electronics and equipment manufacturers such as Samsung and John Deere, and dining establishments such as McDonald’s

Put simply, any digital or traditional company or brand with a direct relationship with consumers and/or with small and medium-sized businesses (SMBs) has the potential to offer banking, lending, payments, foreign exchange (FX) and other financial solutions via Banking-as-a-Service. You could call it the great democratization of financial services. And while each player may have different strategic and economic reasons for entering the banking space, one thing is clear: their customers have significant unmet needs and are open to an improved value exchange.

Many small businesses are underserved by traditional banks in terms of lending and payments products and servicing, and are increasingly making use of vertical software solutions to help manage and grow their operations. This has created an optimal environment for PSPs, software companies, e-commerce marketplaces, and other such players with access to and trusted relationships with SMBs, to integrate retail and B2B payments solutions into their offerings. Many players are also embedding lending, FX, and transactional account solutions, having realized the direct and indirect economic impact of such products, and the scale of unmet demand from SMBs for better value propositions in the space. For a more detailed study of the small business banking space, please see BCG’s White Paper “Playing Offense: How Banks Can (Finally) Unlock the Small Business Opportunity”, published in September 2020.

Consumers’ growing expectations for digital and frictionless banking experiences are well documented, and the ongoing pandemic has only accelerated changes in consumer behavior. For example, 16% of US retail banking customers enrolled in digital for the first time due to COVID-19. In this context, the concept of embedded financial services powered by Banking-as-a-Service becomes very compelling for digital banks, retailers and other consumer-facing brands and corporates. Digital banks such as Chime in the US, and Revolut in the UK, offer an effective banking proposition – involving lower fees, simple and intuitive digital customer experience, and transparency – by stitching together a variety of BaaS solutions on the back end, from bank license provision to risk and compliance capabilities. 

Even established banks see value in BaaS solutions. For example, Goldman Sachs’ digital-only bank Marcus selected the Marqeta to power its card issuance capabilities. Some large banks are now using a Tokenization-as-a-Service solution to enhance usage of their existing card portfolio by enabling it to be instantly integrated into various wallet solutions. Embedded lending is also on the rise, with consumer and e-commerce retailers rapidly adopting Buy Now Pay Later (BNPL) schemes offered by fintech lenders such as Affirm, Klarna, and Afterpay, which are in turn powered by various BaaS solutions. For example, Affirm Plus financing is provided by Celtic Bank. Other players, such as Klarna, use Marqeta’s card issuing solution to strengthen their proposition at the digital point of sale (PoS).

Before Banking-as-a-Service, many of these players could never have entered the financial services industry. They don’t have a banking license. The costs for them to build the core technology stack and risk and compliance capabilities are prohibitive. They don’t have any experience with designing or managing financial products. The complex infrastructure in retail and B2B payments (such as clearing and settlement systems, and multiple different payment methods and instruments) can be daunting for even industry experts to understand. Moreover, traditional banks had no interest or ability to help, being weighed down by legacy technology, slow-moving culture and processes, and due to an understandable hesitance to assist would-be competitors.

In the age of digital when software is taking over the world and everything is available as a service, many unsurprisingly saw an opportunity to become a Banking-as-a-Service provider. As different as the use cases and business models of the various BaaS-enabled players may be, what these players need from their BaaS providers boils down to a few critical elements:

• Access to a wide range of financial services products (such as payments, lending, deposits, FX, insurance) and the underlying technology and regulatory licensing (regulatory licensing in Europe remains complex, given local market requirements in addition to the need for EU-wide licenses).
• Easy integration of those products and technology into their existing technology stack, with a low vendor management burden in terms of operational complexity and risk.
• Solutions-led approach by the BaaS provider, rather than a technology-only solution (i.e., a strong product such as lending, cards issuance, PayFac enablement; or a service bundle such as single-API-based onboarding, a credit decisioning engine, or a regulatory compliance suite).

BaaS providers compete fiercely to differentiate their products, services, and solutions. Many focus on a particular segment of BaaS-enabled players, certain use cases, and/or particular financial products. Some simply rent their bank license and regulatory compliance capabilities out “as a service”, often in partnership with multiple other BaaS providers that specialize in providing the financial products, customer operations, risk management and other capabilities that are necessary for a BaaS-enabled player to begin offering financial services to their end customers. 

Other BaaS providers – such as Green Dot in the US, Aion Bank and Vodeno, and Solarisbank in Europe  – offer end-to-end solutions for certain financial products that address every aspect of the BaaS value chain. This reduces the burden on the BaaS-enabled player which needs to stitch together different solutions and vendors, but also perhaps limits their ability to customize and embed the best point solutions available in the market. Please see Exhibit 2 above for a landscape of BaaS providers across the banking stack.

It is no wonder that BaaS is growing so quickly. End customers demand better. BaaS-enabled players (including digital and traditional banks themselves) have identified the opportunity to deepen their customer relationships and capture new profit pools. Moreover, BaaS providers (including some banks) are seeing ways to differentiate their value proposition, capture margin, and share in a fast-growing global market. We are still at the start of this tectonic shift towards the democratization of financial services. New BaaS start-ups, business models and innovations are being introduced into the market every quarter. 

BCG anticipates that the strongest BaaS providers will have other established businesses and revenue streams besides BaaS. This will allow them to subsidize their BaaS solutions in order to gain market traction and boost cross selling with their customer base. For example, Stripe had built a world-class payments business and produced competitive offerings in corporate card, lending and issuing, before launching Stripe Treasury, their BaaS API for marketplaces. 

Winning providers will also be versatile. They will bring strong technical depth and disciplined execution in their core BaaS use cases (Marqeta in card issuance, for example). However, they will also pursue an aggressive growth roadmap to expand their BaaS offerings, and introduce other financial products, solutions and verticals. This is important, as BaaS-enabled players are likely eventually to grow tired of integrating and managing best-of-breed BaaS providers for every financial product they want to offer.

Removing vendor complexity will be a significant factor in scaling this business. In order to capture significant revenue pools, BaaS providers might also need building capabilities and products which rely on risk taking. Merchant finance in Europe, which is taking off strongly, offers one example. Some of these products would depend to a great extent on a partner network (such as acquirers), so channel strategies would become increasingly important for BaaS providers  as they to continue to build scale.

Implications for Banks

The concept of embedded finance powered by Banking-as-a-Service is akin to an earthquake hitting the banking industry. Quite how high it will register on the Richter scale, however, is still uncertain, as the long-term impact -- and its severity -- are still hard to predict. One the one hand, banking profit pools are at risk, particularly in unsecured lending and payments acceptance. On the other hand, banks can also capitalize on new opportunities that BaaS creates. For example, they could upgrade their own technology stack as a consumer of BaaS solutions, or create new revenue streams by becoming a BaaS provider, independently or in partnership with other providers. One thing is certain: all banks should act now to assess their strategic context and plan their next moves (both defensive and offensive) in case the shockwaves catch them unprepared.

Several BaaS-enabled players are establishing relationships with banks’ customers and capturing their revenue. Banks therefore must work out how to avoid losing these customers. This will involve finding ways to compete with the likes of Stripe, Apple, Shopify, Square and Uber. One option is to be the embedded finance provider, such as Goldman Sachs and Citi in partnership with Stripe Treasury. However, this option is only available to a few banks, given the size of the market and the relevant considerations on cannibalization and risk appetite.

In order to compete with BaaS-enabled players, banks will have to improve their value proposition to their customers significantly. Beyond price, this involves enabling better digital experiences and product features in those areas in which their legacy tech stacks and ways of working become a significant bottleneck. This is where BaaS providers also represent an opportunity for banks to upgrade their capabilities. JPMorgan Chase’s partnership with Marqeta for virtual card issuance is a clear example of this thought process. In this way, even smaller banks can more easily digitize their key processes, such as opening accounts, and offer a digital experience on a par with the big banks. This doesn’t eliminate legacy tech stack challenges, but gives banks an elegant workaround to avoid lagging behind competitors in offering market-leading products.

Let’s do a deeper analysis here, first for consumers. Neo-banks – arguably the biggest beneficiaries of BaaS – enjoyed most of their early success with consumers who hated overdrafts and other fees, and valued transparency and simplicity in banking. Economically, they have also benefitted from Durbin interchange carve-outs in US which generate higher revenue compare to larger banks. Hence, the key question for larger banks is how they can win back this segment and serve them profitably.

BCG research reveals four key challenges that mass-market banking customers face:

• Lack of savings cushion
• Inadequate and / or volatile income
• High student debt levels
• Limited or poor credit history (thin files)

Neo-banks have addressed these challenges by offering features like early access and advances on paychecks, automated savings transfers, and credit builder loans. For many banks, it is difficult and time-consuming to embed these within their digital banking stacks. BaaS providers make this easier. For example, a bank can use a payroll API provider, such as Argyle, to verify a consumer’s ongoing employment, and use that information to underwrite them for a payroll advance. It is therefore a smooth process to add this feature for existing customers, which at least stems attrition. There is a similar argument, and other BaaS providers, available for banks when they seek to accelerate their product development efforts. As neo-banks expand beyond their anchor product to capture more of the banking wallet, banks will need to refine their game across the spectrum of customer needs.

Let’s consider small businesses next. The situation is bleaker here, as they have been underserved by banks, particularly in lending and payments acceptance. As more small businesses adopt vertical software to run their operations, payments acceptance and lending become natural workflows that can be integrated with software. Bank-owned acquirers have typically not been good at partnering with software companies for integrating payments, and this is now a crowded and well-served space. However, in the lending space, they enjoy strong structural advantages due to a lower cost of funding and the ability to understand and predict a business’s cash flows (from its checking account). A BaaS provider can help them digitize their application process, and create an anticipatory offering (such as pre-approvals based on cash flow forecasts) which is more compelling than something integrated with their software.

The way forward for banks is to make use of the rich BaaS provider ecosystem to develop winning plays for their customers. The same BaaS providers that are powering banks’ competitors can also help banks. This is an insight that must be immediately understood and capitalized upon.

About the Authors

Michael Zhang is a Managing Director and Partner in BCG’s San Francisco office and the Global Head of the FinTech sector in BCG’s Payments & Transaction Banking practice. Inderpreet Batra is a Managing Director and Partner in BCG’s New York office and the Global Head of the Acquiring and Processing sector in BCG’s Payments & Transaction Banking practice. Ankit Mathur is Global Manager of BCG’s Payments and Transaction Banking Knowledge and research teams, and is based out of BCG's New York office. Kunal Jhanji is a partner in BCG’s London office, leads BCG’s UK, Netherlands and Belgium payments practice, and a part of BCG’s Payments Practice leadership team. Dimitrios Lagias is a partner in BCG’s New York office, a core member of BCG’s Financial Institution practice, and a part of BCG’s mortgage segment leadership team.