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Embedded finance is the placing of a financial product in a nonfinancial customer experience, journey, or platform. In itself, that is nothing new. For decades, nonbanks have offered financial services via private-label credit cards at retail chains, supermarkets, and airlines. Other common forms of embedded finance include sales financing at appliance retailers and auto loans at dealerships. Arrangements like these operate as a channel for the banks behind them to reach end customers.
What makes the next generation of embedded finance so powerful is the integration of financial products into digital interfaces that users interact with daily. Possibilities are varied: customer loyalty apps, digital wallets, accounting software, and shopping cart platforms, among others. For consumers and businesses using these interfaces, acquiring financial services becomes a natural extension of a nonfinancial experience such as shopping online, scheduling employees to work shifts or managing inventory. This more deeply embedded form of embedded finance is what has grown so significantly in recent years across the globe.
The evolution of embedded finance has been enabled by fundamental changes in commerce, merchant and consumer behavior, and technology. The digitization of commerce and business management has massively expanded opportunities to embed finance in nonfinancial customer experiences. As much as 33 percent of global card spending now takes place online with a large portion of small and midsize companies in the US relying on software solutions for managing their business. In addition, as digital natives came of age, they expanded the pool of consumers and businesses open to receiving all their financial services via digital platforms. Finally, open-banking innovation, supported by mandates has helped unlock latent demand by enabling third-party fintech players to access consumers’ banking data and even conduct transactions on their behalf.
In the strange economy where inflation strives with the recession, banks will assess their unique circumstances and decide whether to play defense or offense. Those favoring defense will tighten lending policies, adjust their outreach to customers and prospects, and possibly even exit some markets. Their more growth-minded counterparts will look to expand existing specialties or push in new directions.
One tactic those on offense are starting to pursue in greater numbers is embedded finance. Embedded finance is, broadly speaking, offering banking services through the platforms of nonbanking companies. This could involve offering loans, payments, cards or deposits, or a combination, in the name of the other companies to the customers of those companies, with the financial institutions providing the service essentially remaining invisible in the background. Some also might refer to this as a banking-as-a-service strategy.
Asset size is not a factor in whether a given financial institution can or should get into embedded finance. Very large banks have been very successful in embedded finance. There are also small banks that have been very successful in embedded finance.
Opportunities may not necessarily involve big names or big companies; they can come from any type of nonfinancial company or, in some cases, fintechs, that lack banking powers of their own and want to add them to their processes and platforms. Zell suggests that banks may find candidates for embedded finance partnerships as close as their commercial lending portfolio. Accounting software packages and business management software devoted to specific industries, such as operating restaurants, are other places where banks may find embedded finance tie-ins. One example of embedded finance is T-Mobile Money, offered by the namesake mobile carrier, which depends on Customers Bank and a fintech, to operate. If embedded finance represents a good fit for a specific financial institution, then launching and building on an embedded finance effort.
Embedded Finance and suitability: willingness to share the revenue for providing banking services- Embedded finance is a bit of a double-edged sword for banks. When a bank deals directly with a consumer or business, the revenue from a given service belongs to the bank. On the other hand, he adds, “if a bank becomes a provider of embedded finance and works with other providers, tech players or distributors to bring that service to end-consumers or end-businesses, then it will be sharing revenue with them.
Beyond sharing the revenue, the bank has another threshold to cross: Sharing the customer. As a provider of embedded financial services, you sometimes let other parties take ownership of customers that could have been owned, where it could have received 100% of the benefit. Understanding these two related shifts in perspective is essential to building a successful program.
To handle technological and distribution capabilities: By definition, “embedded finance” is embedded in something else, some other system or process. Otherwise, it would just call it “banking.” An example. “Let’s say I’m a bank,” he says. “I have a balance sheet and have the ability to make loans. But let’s say I decide to partner with a software vendor, such as a small-business accounting software company. Let’s say that our partnership is such that users of the accounting software can get a short-term merchant loan from my bank with a click in the software.” If the bank has the technological ability to connect directly with the software, it’s relatively straightforward. If not, the bank may need to develop that tech ability or, more likely, involve at least one tech partner, often beyond the company that is functioning as their distributor. Someone has to provide the relevant application programming interfaces, APIs, and other connective tissue.
It has seen some very large banks do this extremely well after investing a lot into it, and that’s why they’re succeeding very quickly. However, we’ve seen large banks that have not invested in the technology and as a result, they are struggling. And it has also seen small banks that have positioned themselves as banking-as-a-service or embedded finance banks that are focused on such technology enablement. They are doing quite well.
Third-party’s role in generating risk for the banking partner: A bank providing loans or deposit accounts through a distributor to end consumers or end businesses loses a measure of the risk control that they would otherwise have. This presents two questions. First, does the bank recognize the additional risk it is taking on, and, if so, is it willing to do so? Second, does it have the risk management capabilities in place to not only manage its own direct risks but those being generated through a third party? This isn’t a brand-new challenge for banks. However, even indirect lending through dealerships can generate credit issues and also, potentially, fair-lending violations.
Embedded Finance Appeal: It’s critical for a bank to first of all decide what they want to do in the embedded finance value chain. It has seen instances where corporate indecision has spawned programs that struggle to get off the ground. Generally, a bank can’t just take everything it does and simply replicate it in the embedded finance world. Part of gaining the clarity to move forward is honestly assessing the institution’s ability to handle what it would like to take on. A more advanced entrant may have a superior technology stack that will support credit card issuance through a partnership and this could support taking on both the tech and balance sheet parts of a credit-card-as-a-service program. Merely aspiring to a dual role, providing tech and credit, when the bank doesn't have the necessary expertise, is asking for trouble. A third party that provides the technology layer between the bank and the distributor can help. They typically need to develop those muscles before they start actually participating in the market, or, at least, they have to think about how they’re going to develop the muscles. It might not offer an extremely high return from the start, but once you get them out and build your capabilities, it’s easier to layer on products like debit cards, credit cards, and loans.
Embedded finance program to get started: The best way for a financial institution to initiate an embedded finance effort depends on its current activities. Banks that are working with fintech and software firms in other capacities can approach those companies to start partnerships. Usually banks that do this successfully start with one or two pilot partners. To keep the program quite small while they begin to understand what is actually required to be successful. It’s when they can start building those muscles. In some cases it’s been helpful to recruit people who have worked with fintech and business software firms before, to go into embedded finance with some hands-on experience.
Partnering with a Specialized Provider: Associating with providers of specialized business management software can be a good entrée to embedded finance, especially if the software serves an industry that the bank already has connections with. Examples include software for running healthcare practices, small grocery stores, and restaurants. Banks interested in embedding lending could offer short-term merchant advances through this type of partnership. There’s also an element of ‘like works with like’ to embedded finance. Larger banks typically work with larger, more established platforms and distributors. Smaller institutions may get a better start with smaller fintech and software startups. Active business lenders may find that their commercial relationship officers can provide leads to existing business clients who would be interested in some form of embedded finance.
Critical Matter to Clarify: No matter who the partner is, it is critical to know upfront what the prospective partner will need from the bank.
It has observed a lot of partners who don’t just need the bank’s balance sheet, but also a lot of help with day-to-day program management of the shared product. This may include needing to use the bank’s call center plus assistance in dealing with payment disputes and credit card chargebacks. Settling those questions early on helps avoid surprises later and can help produce a successful embedded finance effort. New entrants will have plenty of company.
It is observed from many of banking clients that they are looking for opportunities to drive growth in this uncertain market. The opportunity to extend the distribution of their products beyond their existing customers through embedded finance is quite attractive.
Concluding thoughts: Although leaders are already emerging, the embedded-finance market still has ample white space for new entrants; it is expected it to double in size over the next three to five years. The long-term winners are likely to be those that are already building the table-stakes technology, expertise, and relationships needed for a future leadership position. Financial services firms and fintech looking to stake their claims in the embedded-finance business would be well advised to commit themselves to implementing four initiatives: choosing a strategy, establishing a developer experience, building capabilities to support distributors, and developing support and risk services. For most banks with proprietary distribution, embedded finance represents a significant cannibalization risk. However, banks with limited footprints or localized relationships, such as community banks and regional banks, may see it as an attractive way to expand their revenue base. Some may be comfortable with growing deposits and earning revenues relatively passively, at least early on, but many will look for opportunities to differentiate themselves and boost revenues through more advanced products and support. At the moment, payments-focused technology providers are leading the charge on embedded finance, using their money movement capabilities to attract distributors and then expanding into products that have been the strongholds of banks, such as lending. Many banks and legacy financial services infrastructure firms are not yet equipped to externalize their processes and workflows to allow distributors to seamlessly integrate embedded-finance products into their journeys or distribution platforms. Distributors wanting to scale up quickly will need to build a modern developer experience, including the necessary technology to enable it. To do this, they should provide third-party developers with self-service access and well-documented APIs.
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