Lateral Thinking: Open Banking and Embedded Finance in Africa — Part 2
Samakab Hashi, Shreyas Mishra, and Njuguna Kamau.
This 3 part series will examine the emergence of open banking and embedded finance across the globe and how ultimately it will impact the African fintech ecosystem .
In part 1 we provided a high level primer to cover the basics of the trends and drivers to catalyze the emergence of open banking.
In this edition, we discuss the various business models banks can adopt and how ultimately the driving forces highlighted in part 1, opens the door to a world where every company is a fintech.
In the third post in the series, we will explore how the African fintech ecosystem participants (regulators, incumbent banks, digital banks, and fintechs) are responding to the changes.
Part 2: The impact of open banking on banks
“Incumbent banks should be “scared shitless” by fintech rivals. JPMorgan Chase CEO Jamie Dimon 2021
In part one we looked at some of the factors that were driving the adoption of open banking globally. In this post we examine how banks could respond to a world without a data moat.
Intuitively one can see how consumers and fintech’s can benefit from open banking, however it is not as obvious how incumbent banks benefit. Changes that allow the end user the opportunity to choose from more products and change providers will force the banks to compete with customer centric TPPs in a world where they have been robbed of their data moat. Taken to an extreme TPPs will usurp the primary customer relationship whilst leaving the retail banks operating as a low margin platform providing basic current account services. Bank CEOs are cognizant of the impact that Amazon had on retail.
Open banking provides just as many opportunities for traditional banks as threats. Banks still hold data on billions of transactions that can be used to create customer experiences that data-poor fintech competitors simply can’t match.
In addition, main street customers still trust banks with their financial data over newly emerged fintech rivals. A survey by Vocalink, a Mastercard Company, found that 73% didn’t want their personal data to be shared with a third-party provider. 51% of respondents thought the risks of using an open banking-enabled product outweighed the benefits. However crucially for banks 68% of respondents said they’d feel most comfortable if a bank was responsible for protecting their personal data.
Armed with customers historical data and trust, banks are ideally placed to partner with third party providers and fintechs to provide superior product offerings. There are multiple ways that incumbent banks could face the new world of open data.
There are broadly three business models that banks can adopt:
-a background utility play
-a marketplace approach allowing a bank to leverage its branding advantage,
-as a banking as a service provider which would see a bank lean into its data advantage
Banking as a utility
“The risk for the banks is that they turn into ‘dumb pipes’ and will become a place where you put your salary and out of that will come payments for leisure, utility and saving and they will go into different sorts of accounts run by much more progressive, value adding businesses.” Tony Craddock, Director General, Emerging Payments Association (EPA)2020
Before comparing the market-place and BaaS approach, let’s cover the most basic approach: the banks operating as a utility. In such a scenario, a bank would cede both product innovation and the consumer relationship to nimbler fintech competitors. Instead, the bank would focus on providing licenses, balance sheet, current accounts and basic functions. Bain & Company point out that similar disruptions in industries, such as music and travel, have seen incumbents’ profits fall by 10%-20%, often within five years or less. Whilst not an attractive outcome for banks, it is an option for banks with weak brands and product innovations.
When banks are choosing between adopting the platform model vs the BaaS model, they should ask themselves one simple question: do they aim to own the customer and compete in the distribution market to win the majority share of customer interactions or own the production through the creation of innovative products and services such as cardless ATM’s, Biometric verification or instant payments
In the platform banking model, the bank owns the customer and integrates services from fintechs. In the BaaS model, the customer is owned by the fintech/non-bank and integrates services from the bank.
Let’s start with the bank leveraging its brand to own the interface or the market place approach.
The banking market place
Uber, the world’s largest taxi company, owns no vehicles. Facebook, the world’s most popular media owner, creates no content. Alibaba, the most valuable retailer, has no inventory. And Airbnb, the world’s largest accommodation provider, owns no real estate… Kevin Kelly, The Inevitable: Understanding the 12 Technological Forces That Will Shape Our Future
Banks adopting this approach acknowledge that in an open banking world where they no longer have a data advantage, they can’t out innovate nimble fintechs that specialize in delivering niche products. Instead, this model would see banks integrate services from other fintechs to augment their existing offering and leverage their brand and footprint.
In this scenario the bank is a net consumer of APIs where a bank’s own product line up is enhanced by fintechs offerings. The bank offers the service, controls the UX and maintains the primary customer relationship. Such a model allows the bank to rapidly expand their product offering via third parties, cross sell and drive innovation on product development.
A practical example of this would be banks integrating personal finance management apps, credit scoring products, lending apps, insurance and more into the customers core banking interface. Ultimately the entire customer journey is integrated into a banking app. A customer could select a car, get a credit limit, obtain a loan and insure the car all in one app. Such an approach would be very much in lock step with evolving trends in customer preferences. According to the latest FinTech Global Adoption Index from EY, 60% of surveyed consumers would prefer to have access to their financial products from a single app or online portal.
BaaS
“Banking is necessary, but banks are not.” Bill Gates 1994
An alternative and potentially more disruptive business model would see banks adopting a SaaS model which in its purest form would see banks transition from selling banking products to selling software and non-banks becoming the customer interface to financial service. In essence banks would white label their products.
In the marketplace model a bank would become a distributor of fintech products and focus on holding the primary customer relationship, while the BaaS model enables the inverse, the bank would become a manufacturer of products and would work with non-banks to distribute said products. Or to put it technically, banks would become a net producer of APIs.
This approach is not unique to banking. Insurance firm AXA allows third party providers to connect to its core functionality through the use of APIs and offer their end consumers insurance as part of a bundle offering. Insurance as a service if you will.
To understand the potential transformative effect of BaaS, it is important to understand how the concept differs to open banking. On the surface the distinctions seem nuanced as both open banking and BaaS systems use APIs as a conduit to banks infrastructure. In reality the difference is significant as whilst BaaS is enabled by open banking, it potentially has a far greater transformative effect.
Open banking was shaped by regulation designed to liberate consumers data and is about opening banks APIs, to allow TPP to access consumer data. In short open banking only facilitates the most simple interactions such as limited data visibility and payment initiation.
BaaS goes a step further and non-banks use APIs to access banks core functionality to offer their customer bank functionality under their own brand. Functionalities that can be integrated in to a third- party offering includes payments, back-office operations, risk management, compliance and customer service
Such a solution can offer a win-win, BaaS allowing banks to significantly widen their customer reach and allow consumer facing brands to deepen their relationship with their consumer. All this is achieved by BaaS being the conduit to the world of embedded finance.
The path to embedded finance
“Every company will be a fintech company” Angela Strange, Andreesen Horowitz 2019
For consumer facing companies BaaS can change their entire value proposition. Previously it would have been impossible to offer banking services due to the need to obtain a banking license and comply with the myriad of banking regulations required to keep it. These barriers were so deep that whilst behemoths like Apple, Amazon and Walmart toyed with the idea of launching a financial service arm the idea was never implemented.
With BaaS much of that friction can be removed. Almost any consumer facing company including retailers, telcos, big techs and software companies, car manufacturers, insurance providers, and logistics firms; almost anyone could position themselves on top of the regulated infrastructure of licensed banks and offer any financial product without requiring customers to leave their ecosystem. Their consumers will be able to balance checks, make online payments or obtain credit without any interaction directly with the bank.
As such the brand can exploit its customer base for multiple new revenue opportunities for very little marginal cost. A good example of this is Shopify, the B2B firm makes over $500m per annum from financial services to its merchants in 2020 (growing at over 50% per annum).
“Take Shopify, for example, which provides website services for any merchant for a monthly subscription fee. Or Mindbody, a company that helps fitness studios like yoga studios manage their businesses, also for a monthly fee. Turns out both of these companies make nearly 50 percent of their revenue through financial services.” Angela Strange Andreessen Horowitz 2019
As can be seen in the chart below, the integration of fintech and embedded finance is the next step in the evolution of the SaaS business model. Fintech can unlock new verticals, drastically improve the CAC/LTV ratio and unlock new revenue streams.
Andreessen Horowitz noted in their piece on vertical SaaS and fintech, incorporating a fintech product could “increase revenue per user by 2 to 5x versus a standalone software subscription”.
A recent study by Lightyear Capital states that embedded finance will grow to $230 billion by 2025, creating a value of more than $1 trillion and is predicted to rise to $3.6 trillion in the US by 2030. Mat Harris of Bain Capital comes up with a similar figure.
Or, put another way, embedded finance opens up the opportunity — for investors willing to grasp it — to create businesses worth more than today’s software and platform firms in half the time it took them…or 10 times as quickly as it took the US financial industry to get to where it is today. _Simon Torrence 2020
Banks poised between innovation and irrelevance.
“If you can’t beat them, join them”_Senator James E. Watson 1932
For banks willing to move quickly, BaaS can deliver a host of benefits. According to VC firm Andreessen Horowitz, early adopter banks that have already embraced BaaS are experiencing a 2–3x above-market return on equity.
BaaS allows banks to outsource the distribution of their product line up, reduce marketing and operating costs and hyper scale customer acquisition. A study from Oliver Wyman suggested that switching to a BaaS model would see the cost of acquiring a customer fall from $100-$200 currently to between $5-$35.
Some three-quarters of respondents to the Equinix BaaS survey said they were now more likely to use BaaS as a route to market for new products, with the overwhelming majority (88.9%) viewing it as a productive way to bring products to market rather than building them in-house. BaaS also allows banks to reverse the flow of data giving banks access to consumer facing businesses customer data enabling further iteration and innovation of financial projects
Leading banks such as JP Morgan, BBVA, Goldman Sachs and Standard Chartered have realized that banks that create their own BaaS platforms now will not only get ahead of the open banking opportunity before their competitors, but also unlock a new stream of revenue by monetizing their platforms whilst at the same time slashing cost. Digital first banks will own the pipes and lease licenses, balance sheets, technology and products to an ecosystem growing at an exponential rate
Most banks are not ready
“The greatest challenge is that legacy tech was developed and procured in large blocks (a bit like buying a house that lasts forever) whereas the new paradigm is all about development and use of SaaS microservice based components (more like renting a room in a hotel)”. …getting a mix of houses and hotel rooms functioning well together is not that easy! _Michael Anyfantakis, Platform & Ecosystem Lead at Amsterdam Trade Bank
So how can banks ensure that they are insulated to avoid the risk of being intermediated out of the embedded finance opportunity? The first step is to ensure that senior leadership is committed to the transformation. Whilst the transformation to traditional banks will need significant resource allocation, leadership will also need to ensure that the culture of the business can evolve into one optimized for selling software instead of product. This will require bringing in senior leadership that can pivot in that direction.
The second challenge is to transform the banks’ technology stack. Most banks have stuck with more traditional systems and infrastructure and run the risk of being overtaken and left behind in the race to win new customers as non-interoperable legacy IT systems get in the way of innovation and create inefficient processes. The bill for decades of historical technological debt is now due.
The challenge banks face is to be ready to exploit the BaaS opportunity their tech stack needs to be outward facing, modular and scalable. In short, banks need to learn to play well with the wider ecosystem. Unfortunately, historically banks have built their tech stack for a value chain that was built to generate value from proprietary products and as such were built on monolithic architecture. This significantly limits the speed of innovation of established providers and leaves them trapped in an endless cycle of playing catch-up.
To fully adopt the BaaS opportunity, banks need to digitally transform their proprietary core banking systems to an open-source architecture or partner with fintechs that can provide the interface.
One solution is to partner with BaaS providers such as Railsbank that can enable legacy banks with monolithic infrastructure to seamlessly fit into the BaaS ecosystem. As can be seen in the chart below the BaaS provider sits between the brands and license holder (the bank) and allows brands to quickly and easily embed financial services — such as credit cards, subscriptions, wage advancing, disbursements, and more — directly into the brands apps or customer journey.
The banks’ role in such an eco-system is to partner with a BaaS service provider and rent out its license. Whilst this may be a suitable option for smaller banks, it will not be lost to many banks leadership that such a partnership would relegate them to being the dumb pipes of the ecosystem as discussed earlier. As such whilst BaaS players may not be competitors in the traditional sense (although some are seeking bank license) they may result in the banks being disintermediated from the customer experience. This in turn would leave banks exposed to the risk of being commoditized and give BaaS providers the opportunity to switch brands between banks seamlessly.
In order to avoid this fate many banks are looking to update their core infrastructure to allow them to directly integrate with the consumer brands customer interface. According to a McKinsey survey of 37 banking executives in May 2019 incumbent banks are increasingly concerned about the limitations of their own core architectures and their relatively slow pace of change. As a result, some 70 percent of banks are reviewing their core banking platforms.
A host of BaaS software providers such as Mambu,10x, Thought Machine and FinXact can help transform legacy stacks and McKinsey highlighted that by working with such companies, banks can radically modernize reducing cost, accelerate the time it takes to bring products to market manage data in a more holistic manner.
Conclusion
By 2030, 80 percent of heritage financial services firms will go out of business, become commoditized or exist only formally but not competing effectively.” Gartner, Inc, 2018.
For decades banks have only innovated around the edges of the business model, but the advent of open banking driven by regulation, evolving customer demand and new technology promises to open a host of new opportunities and threats. Bank leaders need to decide where they want to sit in the new banking ecosystem. Do they want to be a distributor of a product (market place) or embrace the world of embedded finance and BaaS?
At first glance the marketplace approach may seem more attractive; it requires less of a heavy tech lift and banks would not be required to give up the primary customer relationship with the end consumer. However, bank leadership should resist this option and wholeheartedly embrace the concept of embedded finance. Consumer expectations have been radically transformed by consumer centric tech brands, in the future the consumer will expect banking to take place in the background according to Citi’s head of technology for its consumer bank, Gavin Michael. “Customers will only think about banking ‘while they’re doing other things, like shopping, making travel plans, and talking to their friends,”
Banks do not have a track record of seamlessly integrating into their customers’ life and have spent decades looking at the world through a product centric lens whilst in contrast consumer facing brands have a customer centric philosophy and world class user interfaces built into their DNA. Banking-as-a- service will free banks to focus on other vital roles in the embedded finance ecosystem. The future of the banking industry may become the invisible rails and enable every other sector.
Whilst banks may have to accept one level of disintermediation with the brands sitting between the bank and the customer, they should not accept level two by allowing a BaaS provider to sit between them and the brand. The evolution to a world where the majority of bank transactions are made via embedded finance may be coming but it is not here yet. Banks need to partner with fintechs to gradually update their core platforms to embed directly with consumer facing brands.
We are at an inflection point, banks that focus on simply maintaining their current business model and customer base may go out of business together, some banks that partner with BaaS firms may exist as a utility type business but banks that embrace the new world rebuild their tech stack and switch to seeing the world through a BaaS lens will be well placed to thrive as part of a rapidly growing ecosystem.
We have seen some early movers in this respect BBVA have long been a pioneer in this, Goldman Sachs launched the new digital consumer bank Marcus and Standard Chartered launched a BaaS service. It will be fascinating to see which banks will make the jump into the new system before they are pushed out altogether.
“The best time to plant a tree was 20 years ago. The second-best time is now.”- Chinese proverb
Now that we have covered the basics, the third part of the paper will cover implications for emerging markets, particularly in Africa and we will share the perspectives of regulators, incumbent banks, challenger banks, fintechs and consumer facing brands.
