Chart 1

Global banks are increasingly looking to Banking as a Service (BaaS) as a means of growing their business, accessing previously untapped markets, and expanding their digital capabilities and distribution channels. While S&P Global Ratings expects BaaS to be a key element of banks' digital business offerings over the medium term, we believe a range of factors will dictate whether they can successfully bake BaaS strategies into their long-term business models.

BaaS And Embedded Finance: Complementary Ingredients

The term "Banking as a Service" is frequently used interchangeably with "embedded finance" (EF), and to a large extent, both serve the same purpose: they allow nonfinancial companies to offer regulated banking products and services. Yet there are key differentiating factors.

From the perspective of the acquirer, EF is the process by which nonfinancial companies add and integrate financial services to their existing product or service offering, by partnering either with banks that provide these directly or fintechs that enable this as intermediaries. For example, EF allows merchants to offer its customers credit from a regulated bank directly from its website.

For providers, BaaS allows banks to rent their infrastructure and regulated products to companies in various sectors so that they can offer financial services that usually require a banking license and are subject to strict regulatory scrutiny (see chart 2). Banking licenses are limited and expensive so BaaS provides an opportunity for banks to monetize them in a different way and earn a fee from acquirers. Beyond the economic advantage, BaaS is a way for banks to enhance their presence in the digital ecosystem and stay up to date with the latest digital trends.

In this article, we focus on BaaS, as we primarily explore the risks and opportunities for banks.

Chart 2

Until now, the BaaS concept has been reminiscent of the affinity partnerships between banks and corporates. These might include credit cards to an airline's customers or insurance to its employees--something banks and nonfinancial companies have been doing for a long time. Also, captive finance subsidiaries of car manufacturers have offered loans to finance car purchases for decades. What differentiates these examples from BaaS solutions is the underlying technology. BaaS is based on open banking models with data being shared through application programming interfaces (APIs). As a result, both providers and acquirers of BaaS can accelerate their integration with partners, business growth, and time-to-market. More detailed analysis of customer data is an additional benefit.

We believe that BaaS will play a greater role in both retail and corporate banking in the next five years, as banks scale up their technology and re-think their business cases. Initially, BaaS solutions mainly disrupted the payment segment, but that was only the beginning. The BaaS ecosystem is rapidly evolving to offer a wider range of products, such as consumer financing, insurance, or day-to-day workflow solutions for companies, including working capital, treasury, or transaction banking.

Open Banking: From Regulatory Gripe To Business Craving

Until recently, open banking was a regulatory imperative and banks in various jurisdictions--including the U.K., the EU, and Australia--were busy ensuring technical compliance. This involved developing APIs to allow third-party providers access to customer accounts. Initially, banks were concerned about increasing competition from payment providers and fintechs. Since then, the use of APIs has become more standardized, and banks have started to leverage them to drive additional revenues (see "European Banks Face Risks In Race To Implement PSD2," published May 16, 2019).

Most of the developments in BaaS have so far been linked to the payment segment (such as branded cards, wallets, and buy now, pay later [BNPL] products). However, a full, tailor-made, "as a service" ecosystem is gradually emerging from banks renting out their licenses. Once cross-industry data sharing is implemented more broadly, market adoption could be more widespread.

We expect faster adoption of BaaS by banks based in jurisdictions that have data-sharing frameworks--whether driven by regulation or market (see chart 3 for progress across geographies). Australia was one of the first countries to implement regulation to enable safe transfer of consumer data, but in doing so it introduced the "reciprocity" concept. This means that data sharing also applies to nonbanks, particularly Big Techs. This has resulted in a faster and broader adoption of BaaS partnerships across industries in the region over the past few years relative to other countries. For example, in Australia, two of the four leading banks have developed BaaS platforms to serve consumers (in the case of Westpac) or other banks (e.g., ANZ providing other banks access to their new payments platform).

Chart 3

BaaS Offers All Parties A Fresh Flavor Profile

While BaaS could be seen as a "white-labelling" or disintermediation threat to incumbents by nonfinancial brands, we see BaaS as another distribution channel for banks, adding to the more traditional routes. We therefore think that banks will choose to collaborate with third parties rather than become invisible players at the mercy of the corporations that are selling their products.

Meanwhile, to benefit from the extra-low-margin, high-volume revenue streams that BaaS enables, banks need to focus on investing in their technology to partly offset the heavy cost of banking licenses and other associated regulatory levies. This may be challenging for long-standing players with legacy noncloud native banking systems. However, we see numerous advantages for providers, intermediaries, and end-customers (see table 1).

Table 1

Varieties Of BaaS Feed Market Need

BaaS is slowly but surely increasing disintermediation between banks and the end-customer, whether that is an individual or a company. Financial services embedded into e-commerce and other software platforms accounted for $2.6 trillion (nearly 5% of total U.S. financial transactions) in 2021 and could exceed $7 trillion (10%) by 2026 (source: Bain & Company). The emergence of new economic business models--such as B2B2C, B2B2B, and pay-for-use--might mean that banks have less influence over distribution channels, the customer relationship, and the customer experience. New fintechs are stepping in to fill the gap, developing the technology needed and transforming the customer experience. For instance, U.K.-based fintech Bankable sits in between banks and corporates, offering a white-labelled API platform to deploy payment and card solutions in different currencies and jurisdictions.

Banks can operate as either a platform provider or service provider in the BaaS sphere, as follows:

Platform provider:  Banks would use their self-created one-stop-shop platform and might additionally partner with fintechs or other corporates to distribute their financial services or new products from third parties. Platforms may also offer value-added services, such as analytical tools or financial management. Banks own the customer experience and bear the risks of the financial products. For example, global leading incumbents such as JP Morgan, Goldman Sachs, Societe Generale, BBVA, SEB, or Westpac have developed their own BaaS platforms. These incumbents also compete with fintech platform providers such as Galileo, Marqeta, Bankable, or Railsr.

Service provider:  The platform or channel is owned by a third party and banks, through APIs, distribute their financial services onto these platforms, which then sell to the end-customer. Customer experience is owned by a third party, so banks lose customer engagement, but this model offers them the chance to lower customer acquisition costs. That said, the ultimate risk and liabilities lie with the bank. For example, Deutsche Bank has partnered with fintech Credi2 to develop a white label BNPL product for online retailers and e-commerce marketplaces. Also, German-based Raisin Bank--the servicing bank of German fintech Raisin DS--has launched its BaaS offering and migrated its existing customers to a provider-open API banking platform, allowing them to leverage digital solutions that require a banking license.

We see the benefits of both models for banks--choosing between them would depend on the bank's type and digital footprint. We believe that there is only limited room in the market for platforms and that these must appeal to customers by providing a frictionless experience. Banks that have sufficient scale, investment power, modern technology, and high-end innovation will be more likely to succeed in operating as a platform provider. In our view, only a few would fit into this category, particularly those with an advanced digital footprint and large customer bases, or potentially neo-challenger banks with no legacy core infrastructure. As the use of BaaS becomes more mainstream, we believe that most incumbent banks will at some point opt to become service providers. We think that even smaller, regional players might get involved, which could imply having some API-based partnerships with local corporates or regional public entities.

From the consumer's perspective, the accelerated use of smartphones across the world and the increasing time spent per day on mobile apps will likely drive further adoption of EF solutions (see charts 4 and 5). In addition, the trend toward outsourcing "as a service", combined with open banking and the use of API-driven platforms, suggests that BaaS is slowly changing the way in which customers interact with banks (see The Future Of Banking: Bank Cloud Adoption Goes From Blue Sky Thinking To Economic Necessity, published Feb. 8, 2021).

Chart 4

Chart 5

Seeking The Best Seat At The Table

In addition to the leading global incumbents that develop their own BaaS platforms, we expect banks owned by corporates to be a natural source of BaaS business (see table 2 for business cases where corporates are leveraging their bank subsidiaries or joint ventures to monetize and enhance customer loyalty).

Table 2

We also expect corporates to increasingly partner with banks or, in some exceptional cases, even purchase banks to develop a banking offer. For example, Southeast Asian superapp Grab and Singapore telecom group Singtel are in the process of launching Singapore-based digital bank, Digibank.

Similarly, Apple's recently announced launch of its own BNPL service in the U.S. is the latest example of a Big Tech expanding into financial services. While this is not the first time a Big Tech has offered financial products, it is the first time it has done this on its own. In 2019, Apple launched its apple card, a credit card for U.S. customers backed by Goldman Sachs and Mastercard. However, we understand that Apple will fully underwrite and fund its BNPL service, without the backing of a banking partner.

We could see Big Techs taking a chunk of the market for products and services that don't require a banking license, therefore having no need to acquire BaaS. However, we consider it less likely that Big Techs would be interested in becoming fully fledged banks considering the regulatory scrutiny involved. As Big Techs incorporate credit risk into their balance sheets, however, they will also face increasing regulatory examination, potentially leading to heavier regulation for the industry. On the other hand, Big Techs could become more serious competitors to incumbent banks, as they gather valuable customer data and are more digitally agile.

With interest rates on the rise, capital investment cooling down, and a potential turn of the economic cycle around the corner, some struggling neobanks could switch their business strategies and return their expensive banking licenses in a bid to lower costs. These banks might therefore find becoming a BaaS acquirer an appealing option. This was the strategy that Australia-based neobank VOLT initially envisaged in late 2021, though it shut its doors in June 2022 after it failed to raise funding to support its business. In addition, U.K.-based neobank Starling planned to expand into Europe with the launch of BaaS offerings in 2021. However, we note that it recently withdrew its application for an Irish (EU) banking license after a four-year process and that it now plans to offer software-as-a-service in Europe.

Could BaaS Tip The Balance For Bank Ratings?

We don't expect the emergence of BaaS to materially alter traditional banks' business models in the short term, because it will take time for those banks to scale up the new infrastructure and rethink the business application cases. In the medium term, however, BaaS will offer both increased opportunities and risks, and will therefore have a greater impact on banks' business profiles. In our analysis of banks' creditworthiness, we may consider implications from BaaS both at a systemwide and bank-specific level (see chart 6).

In our systemwide banking sector analysis, we would capture the impact of a regulatory-driven open banking framework in our assessment of industry risk. For example, we would assess whether supervisors are protecting a banking system from competition from Big Tech with the introduction of data-sharing frameworks that also apply to them. In addition, new regulations could emerge for BaaS, linked to its growing complexity and interconnectivity among companies, which could ultimately be a source of cyber and systemic risk.

We would expect to see the impact of BaaS on bank-specific factors in the following areas:

• The bank's business stability. This could be enhanced by revenue sources such as fees and commissions and supported by fee-sharing agreements with nonfinancial partners or distributors, as well as lower distribution costs. A bank's business and geographic diversification could also grow from new clients in unpenetrated regions because BaaS can offer innovative solutions and user convenience.
• Increasing access to customer data through banks' own BaaS platforms. This should enhance their ability to measure credit risk and therefore support a bank's risk management.
• A lack of direct influence on the customer experience, which might lead to reputational damage for banks in case of customer dissatisfaction. In extreme cases, this could lead to sudden outflows of clients and customer funds.

Chart 6

As the BaaS journey evolves and until we observe a more mainstream business application by banks, we will monitor developments on the regulatory front involving not only banks but also nonfinancial corporations, particularly Big Techs. We will also look for a wider customer adoption of platforms and increasing preferences for embedded financial solutions. Finally, we will keep track of collaborations between banks and nonbanks to productize this new digital distribution channel.

Editing: Alexandria Vaughan and Madeleine Corcoran. Digital Design: Tim Hellyer.

Related Research

• The Future of Banking: Bank Cloud Adoption Goes From Blue Sky Thinking To Economic Necessity, Feb. 8, 2021
• European Banks Face Risks In Race To Implement PSD2, May 16, 2019
• The Future Of Banking: Asia-Pacific Opens Up To Open Banking, April 11, 2019