💰 The Evolution of Banking-As-A-Service in Europe: The Shakeout Is Here

Growing up in a post-Soviet country slowly toddling towards market economy, I witnessed how people’s relationship with money and government plays a huge role in their well-being.

We didn’t have quality in either of them. Cash was king, having a bank account was uncommon; and “knowing someone” was key if you needed to get any government services.

At 17, I navigated the painstaking process of opening up a bank account and was perplexed with how complex the process was. Since then, I have been fascinated with innovation to change the government and finance sectors.

Now, I believe technology has a power to help maybe not with all but most of these challenges.

🙌 TL:DR — What We Will Cover In This Article

👉 Banking-as-a-Service (BaaS) is buzzing with activity: a lot of money has been invested during the last 3–5 years, but returns are not aligning as expected.

👉 The origins of BaaS and Embedded Finance can be traced back to Open Banking.

👉 However, Open Banking, BaaS and Embedded Finance are not the same. Each of them serve different needs but essentially complement each other.

👉 Now, it seems to be a shakeout stage for the European BaaS market.
- Regulators are getting increasingly interested in BaaS as a sector.
- BaaS providers need to show they’re worth the substantial investments made during the last “boom”.
- Those who navigate the shakeout successfully might have a chance to grab the biggest piece of the pie.

✏️ Intro — Why I Am Writing This?

If I say banking is the backbone of economy, I think almost no one would disagree. But do we still need traditional banks to do “banking”?

I asked this naïve question many years ago when I was just 17 years old.

My first experience with a bank was not that good.

I was 17 when I won a government grant for my youth project and had to open a bank account to receive the funding for project.

Long story short, I called/emailed several banks, all were slightly surprised and refused to open account because I was under 18. Then, I figured out that I have a right to open bank account with the written permission of parents; but offline — so we had to go notary office, then visit a bank branch…

The key — it took me 2–3 weeks to just open an account.

😤 I was frustrated: how is it that humanity aims to fly to the space, but we still have such problems on earth?

So, Then What? Why Am I Writing About This Now?

Because the way we bank has been changing.

Around the same time when I was struggling with the banks, a new trend was emerging in the banking industry — Banking-as-a-Service (BaaS).

✨ Imagine: the grant provider also offering virtual bank/e-money accounts on their own web platform — so I don’t have to go anywhere else and plus make project’s financial reporting easier at the end.

Good news, it’s technically possible now. 🙂 Read on to dive deeper.

I will provide an overview of Banking-as-a-Service in Europe: the market opportunity, the evolution of the industry and a summary of some of the challenges facing BaaS companies.

🚀The Evolution of Banking-as-A-Service

In this part, I’ll describe the evolution of the market and the place of BaaS in this evolution. I’ll also provide more information on the difference between BaaS from Open Banking and Embedded Finance.

The roots of BaaS can be traced back to the implementation of open banking. Once Payment Services Directive 2 (PSD2) was introduced in 2015, it was a game-changer for the industry. Although there were a few discussion on BaaS-type business models earlier, PSD2 created an environment for collaboration between incumbents and fintech innovators by mandating banks to share customer data.

Since the introduction of PSD2, the space started getting crowded. As seen from the chart below, the number of players entering the market has been steady over the last few years with a slight decrease during COVID.

Note: The graph is based on publicly available data and so may not be exhaustive. In reality, we can expect the number of companies operating in this area to be slightly greater.

Timeline | BaaS providers in Europe | By the author © Gasim Khasmammadli

The main hype after introduction of PSD2 was open banking. PSD2 mandated European banks to open their APIs to third-party providers, allowing them to access clients’ data upon request. This in turn empowered clients to have more visibility and ownership of their data.

Following this change, new players emerged — Account Information Service Providers (AISP) and Payment Initiation Service Providers (PISP). It meant a lot for banking and finance innovation. For instance, AISPs made account aggregation possible by enabling users to gather all their accounts from different banks in one screen. Likewise, several payment automation options became possible with the help of PISPs.

Although being revolutionary, the open banking had clear disadvantages:

1. Fractioned UX journey for end users.
2. Low process control from companies integrating solutions.
3. Benefits were limited to account aggregation, data sharing and categorization, leaving behind profitable products such as lending, foreign exchange, etc.

As a result, more complex, scalable and configurable solutions were needed. That’s where Banking-as-a-Service stepped in.

In contrast to Open Banking, BaaS enabled “third-parties” to go beyond mere data access and payment initiation. BaaS enabled connection to bank’s products and functionalities. With BaaS, companies could add banking products on top of their core offering, or build a neobank from scratch without becoming a fully licensed banking.

Value Chain Actors in Open Banking, BaaS and Embedded Finance | By the author © Gasim Khasmammadli

The benefits of BaaS were obvious: less regulatory burden, cost savings, and less of a need in building tech infrastructure from scratch.

It’s impressive — but there’s still more to the story.

Even though BaaS alleviated the need for extensive investments in licensing and core banking infrastructure, the cost of developing a user interface on top of it and integrating it with internal IT systems remained high. Additionally, for some use cases integrating extra APIs were needed — with each extra connection incurring additional expenses.

📌 In the end, BaaS proved to be a favourable choice for fintech startups that secured substantial venture capital funding, as well as for certain large corporations with surplus funds to allocate towards innovative concepts.

⚠️ But the market for BaaS goes way beyond fintech startups and large corporations. A significant number of businesses that don’t fall under either of these categories also need better financial provisions for their clients.

As a result, the concept of Embedded Finance came to light. The demand for even more cost-effective, streamlined, and rapid services pushed the market towards the Embedded Finance, a strategy previously employed by prominent brands through initiatives like loyalty cards, among others.

Again, it would be wrong to say that Embedded Finance emerged after 2020, but the widespread discussion started during last 2–3 years.

As someone who was following the market trends and participants, I remember how many providers started using “embedded finance” in their marketing efforts more and more since 2021.

Some companies, like Weavr, even marketed its difference from BaaS. Below is a screenshot from their website.

Weavr.io main page (note: text highlighted by the author, original is without highlight).

The heroes of this Embedded Finance age are middleware providers (or orchestrators). These middleware providers are platforms combining variety of financial and associated products within a one-stop-shop framework. By doing so, they streamline the integration process, replacing the need for multiple individual integrations with only one integration to their platform.

In a similar way to how BaaS integrators allowed for greater access to products, middleware providers allowed greater number of players to access those products. These one-stop-shop platforms have significantly reduced the cost & amount of resources needed to launch embedded financial services.

📌 As Lars Markull of Embedded Finance Review stated: “the most significant difference between the two providers (note: BaaS and middleware platforms) is the financial investment required to build an Embedded Finance solution”.

It’s also worth noting how some of these new middleware infrastructure providers have tackled the issue of divided user journeys. Certain middleware orchestrators also provide front-end solutions, often in the form of configurable white-label apps (e.g. AAZZUR, Toqio).

Common Confusion: isn’t BaaS and Embedded Finance same?

In fact, BaaS and Embedded Finance are used interchangeably. According to some experts, both terms refer to the same concept and are simply two different buzzwords.

However, I think this isn’t necessarily accurate. Without getting too deep, I’ll sum up a few points below.

Roles of industry players on the Fintech Spectrum | By the author © Gasim Khasmammadli

For me the key difference is in the value they offer:

• BaaS providers’ main values are their license and core banking infrastructure saving regulatory burden and unnecessary tech-stack investments. License is the key. Thus, BaaS providers possess a stronger financial and banking expertise in addition to tech infrastructure.
• Middleware providers’ main values are the single access point to the variety of services and if needed saving on front-end development as well. Middleware providers lean more towards a technological expertise, enriched further by robust UX solutions.

Now let’s see what benefits and opportunities BaaS market brings in more detail.

💶 The BaaS Opportunity

Banking-as-a-service propositions create opportunity for all key industry participants. The key here is the collaboration over competition. When banks, fintechs, and businesses come together and leverage their strengths, they can establish a value chain that benefits all participants.

📌 At the same time, this cooperative approach leads to provision of more comprehensive and valuable suite of services to end users. Research shows that there’s still a great deal of consumer demand when it comes to improved financial experience. According to Capgemini’s 2022 Voice of the Consumer survey, 75% of respondents have stated their readiness to use easy-to-use, available and seamless financial solutions empowered by technology.

• Non-financial businesses, ranging from small and medium-sized enterprises (SMEs) to large corporations, have the opportunity to broaden their offerings by providing financial services and gaining valuable customer data. This expansion can lead to an improved user experience. These businesses can accelerate their entry into the market, while also saving substantial amounts on technical development and compliance expenses. Plus, using BaaS solutions allows them to concentrate on their primary product, rather than diverting resources to areas outside of their expertise.
• Recent IBM research indicates that, in the light of a declining return on average equity (ROAE), incumbent banks’ investments into platform-based business models are rising.
  Acting as enablers and facilitators of financial services, the incumbent banks can also tap into new revenue streams, diversity their client base, reducing operational costs, and improve product strategy and marketing through access to enriched end customer data.

Source: Capgemini | Visual by Gasim Khasmammadli

• Neobanks and fintech companies play a crucial role in the BaaS industry. Many neobanks directly rely on BaaS providers since only a small fraction of them possess their own banking licenses. As BaaS clients themselves, they enjoy the same advantages as some of the other non-financial companies we discussed earlier.

However, there are also a few neobanks that hold their own banking licenses, allowing them to act as enablers. In this capacity, they have the opportunity to boost their earnings, diversify their customer base, and tap into new customer segments.

Fintech companies can achieve business growth by accessing a wider array of financial services with a comparatively lighter regulatory burden. This allows them to concentrate on excelling in their core offerings, instead of grappling with the complexities of providing banking services.

Benefits of BaaS for key stakeholders | By the author © Gasim Khasmammadli

Wait, where are the numbers?!

I will be honest: I don’t have the ability or resources to quantify the market opportunity accurately. Moreover, I think that obtaining precise numbers in this stage of the industry is almost beyond anyone’s reach.

“Half the truth is often a whole lie.”

Yet, to keep up with tradition, I will be sharing some numbers that you can see in almost every writing piece on this topic. :)

• According to Gartner, around 30% of banks with assets exceeding $1 billion are projected to launch BaaS by the end of 2024, with half of them not meeting their revenue expectations. We can already see some examples such as NatWest, SEB, etc.
• McKinsey reports that the total addressable market (TAM) for European (inc. UK) BaaS market is expected to reach an estimated value of €90 billion to €105 billion by the year 2030.
• Mordor Intelligence predicts the growth rate for BaaS in Europe to be threefold in the next few years; with the UK accounting for approximately 25% of the overall market share.

I am not pessimistic but still sceptic about these numbers. It might be more or less than showed in the above numbers — does it really matter right now?

I think there’s a huge market opportunity for BaaS but it’s still early to estimate it precisely.

To realize this opportunity, in my opinion, companies and investors would be better served focusing on finding the most viable use cases instead of getting lost in the numbers.

Once the market is established, with players finding their niche and real-life use cases yielding results (read as investor: make profits), we can start talking about where the market might be heading financially in the future.

With the potential opportunity now covered, I would like to explore the current situation.

🌡️The Shakeout Is Here

In 2023, with slowing down economies and rising inflation, investments in BaaS (like many other sectors) have been relatively lower compared to previous years so far.

According to Dealroom data, fintech startups got $7.4 billion in investment during Q2 2023, which is almost a five-fold decrease from the peak in 2021 and one of the lowest quarters recorded over the past six years.

Yet the industry is still alive: during the first half of 2023, quite notable deals have been happening in this space (See 1, 2, 3, 4, 5) further highlighting the interest in, and potential for BaaS.

Despite the slow down compared to the previous two years, BaaS providers have still continued to raise funds — with corrections to valuations:: Griffin raised £11 million in June, Solaris raised €38 million in July, Swan raised €37 million in September etc.

👮 Regulators also became more active, further amping up the regulatory requirements for market participants. The nature of BaaS service model, involving numerous companies in the process and the relatively simple setup of financial solutions, leads to the rise of financial crimes risks.

As LocalGlobe’s Tom Lambert said, in today’s fast growing fintech landscape, companies should navigate both improving financial experiences for customer and at the same time deal with increasing financial crime risks.

Two events that put oil on the fire in 2023:

• The Bank of Lithuania has revoked the EMI licence of UAB PayrNet, a subsidiary of Railsr. The situation affected not only Railsr and its clients but also other clients of PayrNet.
• Earlier this year, it was announced that Solaris will be able to onboard new clients only with the permission of German regulator BaFin.

Moreover, according to Dealroom, BaaS together with embedded finance is experiencing a growing trend of consolidation in 2023. Just a few example are the bankruptcy and acquisition of Railsr by its current investors, Contis fully retiring its brand and becoming a part of Solaris towards the end of last year, and Bankable acquiring embedded finance platform Arex Markets, etc.

This slowdown and consolidation phase is a turning point in the market which should in theory, result in only the most successful operators continuing to provide their services.

The BaaS providers able to navigate this shakeout successfully will define the future of the market. Or, to quote a famous song by Nas & D.Marley, “Only the Strong will continue”.

⭐Conclusions

BaaS is still a hot topic. In the last 2–3 years, it grabbed worldwide attention and a significant amount of investment. Now, the focus has turned towards profitability as investments should one day pay back and all eyes turned on BaaS players who struggle to make profits.

As a result, the market will continue to undergo a shake up in which only the strongest players will survive to claim a significant share of the market.

👉 In my next publication, I will share market overview of European Baas and Embedded Finance players.

Stay tuned, and feel free to reach out to me on LinkedIn and Twitter.

Thank you…

I want to thank Included.VC’s Nikita Thakrar and Anu Panesar. For inspiring, advising, and assisting me, but also for their unwavering commitment towards a good cause — to make Venture Capital more inclusive.