Embedded Finance Will End Traditional Banking? Actually… Yes!
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 t. wo-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.
This 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) observes, 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 in 2026. Note that point: this is about 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.
But what will this mean for fintech? On the one 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, it makes sense for the technology players to move in this direction because they are companies that 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
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 report 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 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
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.
In fact 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 use of such tools.
Given that financial literacy is generally poor and the financial landscape is complex so you do have 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.
Maybe it would be better to instead provide consumers with intelligent agents to act on their 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. 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.)
When you look at trends in this context it seems fairly clear than when a bot can access the relevant banking services via APIs and do all of the boring banking stuff that virtually no-one actually wants to do for themselves anyway, then the idea that people will access “traditional” banking services does indeed appear quaint.