Banking as a Service – embedded banking, regulation and how partners become competitors

Anyone who has looked into private financial investments in recent months has often become aware of various deposit offers with attractive interest rates. High-risk investment opportunities that can be classified as “high risk & high return”, such as in cryptocurrencies, are a thing of the past, as the current trading volume within Germany shows. Consequently, it has to be decided whether there is sufficient motivation to change and take up one of the time-limited lure offers of some local or international direct banks, or whether the deposits should be managed by the German blue and red banks, despite the fact that they are not quite willing to pass on the increased deposit interest rate to their customers.

Either way, it is clear that consumers’ appetite for risk and willingness to invest has declined due to anticipated uncertainties – inflation, war, increased raw material and heating costs, interest rate rises – and the visible real erosion of savings balances (on average 5.5 %). This is undoubtedly reflected in various sectors and, has at least some influence on the adjustment of the forecast for negative growth in the German economy.

But is it only consumers who yearn for security or can this be transferred analogously to the institutional world? In addition, the question arises as to how capital-intensive companies in the payment industry are reacting to this situation and whether there are Gallic villages like in the Asterix comics which, despite the challenging economic situation, are experiencing success with a product portfolio apart from “save now, buy later” products, while others are disappearing?

Wind of change for companies in growth

In July 2022, the European key interest rate was raised by the ECB for the first time since July 2011. But even before this increase and the ten subsequent corrections to the key interest rate, it was clear to many young companies that the investment behaviour of institutional investors would adjust. This assumption materialised in a decline in investments in risky sectors, such as venture capital. Secured financing rounds fell through, formerly celebrated “unicorns” had to lay off more than ten percent of their workforce, and private equity firms and venture capital funds declared that profitability, and not the ever-popular hockey stick that indicates new customer growth, remains the most relevant metric, even if it did not seem so in the past. Despite these fundamental changes in the business reality of many FinTechs, there have been companies that grew against the trend from venture capital investments to deposit investments due to their specialisation in services that were previously provided by classic banks. These companies can differentiate themselves because they often focus on a part of the entire product and value chain range of a bank and rent it out as a service to FinTechs and companies. The attentive reader will certainly have already thought that these are companies in the Banking as a Service (BaaS) sector. Nevertheless, the question remains why a market that is widely considered to be divided between infrastructure providers – FIS, Avalog, Sopra Steria or the young star Mambu – and banking providers – Solaris, Trezoor, Modulr or Raisin – regularly creates innovations and business models derived from them.

Why is Banking as a Service so attractive?

Banking as a Service is not a completely new concept, as popular providers such as Solaris Bank, currently supervised by BaFin, Banking Circle or TrueLayer have been selling precisely this service as a core product for several years. As the name already suggests, the acronym BaaS hides the provision of banking services from a fully licensed bank to unlicensed companies. In this way, the unlicensed companies are enabled to offer their customers products that were previously reserved for banks. Besides the provision of payment transactions within and outside the European currency area as well as an account, primarily companies that specialised in issuing a credit card in the corporate segment gained popularity in the past. By “lending” the banking licence, it is possible to gain a foothold in the market as a financial company quickly, without high equity capital and with manageable personnel.

The BaaS provider profits from the use of the software, as in addition to platform fees for the provision of the software, a fee for each transaction is charged to the FinTech. If the FinTech also decides to issue loans, an additional fee is charged for the provision of equity and the issuance of the loan, also known as fronting. The sum of the individual items makes it clear that the BaaS provider does not generate serious revenue by providing access on the core banking system, but by scaling customers on a transaction basis, regardless of whether it is a credit card payment, a SEPA transaction or the issuance of a loan. From this perspective, it is understandable why ADAC (Automobile Club in Germany, largest automobile association in Europe) or Amazon are so interested in terms of issuing processing. And if they are corporate cards with a corresponding surcharge, even better. The fact that many second-generation BaaS providers are strongly technology-driven becomes clear from the fact that the consumer does not always recognise who is operating the systems from processing to settlement in the background.

Embedded Finance enables the fusion between customer and core banking system

In addition to providing regulatory permission, BaaS providers enable their clients to build the services into their own ecosystem, making them invisible to the client and seamless from a process perspective. In practice, onboarding, account management, etc. are presented in the FinTech’s front-end, but the relevant data is managed in the BaaS provider’s core banking system via appropriate interfaces. This approach is called embedded banking and goes far beyond the widely known “white label”. Despite the fact that this model has gained popularity in the German market through intelligent marketing of BaaS clients as well as the establishment of their own brand, many of the companies acting as banks have found it difficult to follow the path to profitability via participation in the generated interchange fee or a booking item. One possible explanation for this is that consumers or businesses without access to credit lines at an established bank were targeted and they generate manageable transaction volumes. Finally, it becomes clear that BaaS users have the customer contact but act as intermediaries in the value chain.

Love it, leave it, change it

According to this motto, FinTechs are more and more interested in offering services themselves. The modular approach of BaaS providers is now being misappropriately applied to regulation and its limits. In concrete terms, this means that young companies, by being authorised as payment service providers or as e-money institutions under the Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz, ZAG), themselves take a place in the value chain that they have previously rented and in this way cut out the middleman. For example, e-money institutions in Germany can offer accounts, credit interest-free deposits, issue e-money, participate in the SEPA scheme or issue short-term loans under certain conditions.

Tasks that are not in the focus of these providers, cannot be secured with sufficient own funds or are too costly are in turn outsourced to competitors. For example, it is possible for a company to provide accounts but outsource the underlying payment transactions and clearing, issuing and credit checking, including fronting, repayment and servicing, to third parties. The end customer sees only one provider through which services are obtained. This strategy is interesting from many points of view, as the companies can offer services in their core business and also assess the need for, a full banking licence for themselves. We certainly do not want to take on the role of a trend barometer, but we still find the number of payment service providers and e-money institutions that are allowed to offer their services in Germany highly interesting.

More than 390 payment service providers and 200 e-money institutions are allowed to offer their services within Germany. To put this into perspective, it must be mentioned at this point that not all of them are active in the area of banking as a service. Nevertheless, it is relevant for the 590 licence holders that are allowed to operate in Germany to continue to be positioned innovatively and to have regulatory protection. The implications for payment service providers and e-money institutions resulting from the Payment Service Directive 3 (PSD3) and the associated merger of Electronic Money Directive 2 (EMD2) and Payment Service Directive 2 (PSD2) into Payment Service Directive 3 (PSD3) and Payment Service Regulation 1 (PSR1) will pose a particular challenge.

PSD3

The draft of PSD3 published by the European Commission in June 2023 creates further exciting use cases for regulated companies. The PSD3, supplemented by the PSR1, which will be directly implemented into German law as a regulation, takes another step towards the harmonisation of European payment transactions. Based on the current draft of the PSD3, e-money services and payment services are to be merged in the future and subsumed under the term payment institution. PSR1 aims to introduce changes to the existing open banking framework, remove barriers to the provision of open banking services and ultimately stabilise and improve banking and financial services. Account Information Service Providers and Payment Initiation Service Providers will in future have the ability to create custom interfaces and use them to connect with banks and other financial institutions. This interplay of Banking as a Service services, embedded banking and innovative regulation enables existing firms to grow and gives market entrants a raison d’être. This innovative power answers the question posed at the outset as to why a few firms in technology-driven industries persist, but a large proportion disappear through insolvency or through consolidation of many non-competitive firms.

Finally, the question remains about the outlook and what it may look like. Will BaaS firms be able to exist in their current form in the future, or will FinTechs seize the opportunity to map part of the value chain themselves and use BaaS providers to outsource less strategically relevant products? The influence of regulation on these questions in particular remains to be watched with interest and will show whether today’s partners will become competitors in the future.