Banking-As-A-Service is under fire — What’s next for Fintech’s hottest segment

Banking-as-a-Service was a major beneficiary of the recent fintech investment boom, but as we move through 2023 it is an area facing increasing challenges. Companies that self-identified as operating in the space saw round after round of funding as VCs splashed out the money, with a few even reaching coveted unicorn status.

But the good times may be coming to an end.

What BaaS is

First things first: BaaS is hard to define. Divergent regulatory and operational structures in Europe and the US result in “BaaS” meaning different things in different places. Subsequently, companies take advantage of this confusion to call themselves “BaaS” providers if their products and services so much as touch the area in an attempt to attract funding and media attention.

BaaS in the US (the simplified version)

BaaS in the US is the provision of core banking services to third parties by a company that has a full banking license. Notable examples include Cross River Bank, The Bancorp and Sutton Bank.

These banks are behind customer-facing fintechs, such as Stripe, Chime and Kabbage, and handle key operations such as loan agreements and holding customer deposits. Crucially by doing the latter, they offer customer protection in the form of FDIC insurance.

Another important point to note about the US system is that currently third parties offering the services directly to customers do not need to be regulated to do so.

On top of the core BaaS providers sits a subset of companies known as “program managers” who handle the operational side of the relationship. Among others, the likes of Nymbus, Galileo and Treasury Prime fulfill this role. They manage the network of providers behind the customer-facing brand, which includes, but is not always exclusive to, the core banking provider. These companies also bill themselves as “BaaS”, but they clearly fill different roles to the full license holders.

Another thing to note is that these companies often serve non-financial companies, enabling them to “integrate” financing into other propositions – Square issuing debit cards to customers is one such example, UberUBER offers them to drivers is another.

Regulatory headwinds are here

Regulators pose the biggest challenge for BaaS companies in the US. One, the Office of the Comptroller of the Currency (OCC), began taking renewed interest in the fintech industry as a whole in 2022, and BaaS, or rather “fintech-bank partnerships,” have been singled out for special scrutiny.

At the end of last year, it emerged that the OCC had taken action against Blue Ridge Bank, which had grown its deposit base rapidly throughout 2020 and 2021 by offering its services to a growing number of customer-facing fintechs. In doing so, however, the OCC argued that Blue Ridge had failed to maintain proper governance. The parties reached an agreement, more details on this can be found here, but suffice it to say that the OCC found many areas for improvement and Blue Ridge has a lot of work to do.

It is worth noting that the OCC only has control over nationally licensed (chartered) banks, while many BaaS providers are licensed at the state level. That said, these banks have their own federal regulators, who, while not beholden to the OCC, are likely to turn their sights on such a segment that has grown so rapidly and is responsible for such a large volume of consumer funds. The Consumer Financial Protection Board (CFPB) has also made its thoughts on BaaS known, for example, having creatively found a way to bring non-banks into its purview back in April 2022.

This activity means that BaaS providers need to be more careful in their growth strategies and partner selection, while fintechs should do extensive due diligence when it comes to finding a licensee to work with. Still, as has been pointed out, the Blue Ridge deal gives them an idea of ​​what at least one regulator wants bank-fintech relationships to look like.

The result is likely to be increased complexity and reduced growth for the segment as BaaS providers become more discerning and must dedicate greater resources to partnership monitoring. There will be fewer new customer-facing brands and banks that see BaaS as a quick way to increase deposits.

Overpopulation leads to mergers and acquisitions

Wherever the BaaS model has taken hold, it has proven popular. This has resulted in a multitude of players in the market, and even accounts for the loose definition of BaaS used by many.

But there are only so many new customer-facing brands and providers of each product or service that can be sustained across any market. This means that BaaS providers are competing ever harder for customers, and for the operational sustainability that VCs now demand.

One result has been that larger providers have started to acquire smaller, specialist organisations, creating more holistic propositions in an attempt to make themselves more attractive to customers.

In the US, overpopulation combined with increased regulatory scrutiny means we will see fewer banks enter the BaaS space, while program managers will become larger, offering customers fewer options in terms of provider.

The future is uncertain

The global BaaS landscape is set to change this year, but the need for BaaS services is not going away – the idea of ​​embedded finance that these companies facilitate has taken hold. People now want to be able to access financial services wherever the need arises, from buying a coat or a washing machine, to renting a car.

The question that remains is which companies will come out on top, and what will they look like? My money is on those who are paying the most attention to getting their houses in order so that they are cleaner than clean when the regulators come knocking, and those who have already started down the road towards acquisitions to strengthen their core offering. If businesses haven’t started doing any of these things, they are in for a very difficult time.

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