The banking and financial services industries are constantly evolving, and financial institutions need to embrace new technologies to both better serve their customers and stay competitive as innovative new approaches grow in popularity. One of the new trends attracting a lot of attention is banking as a service (BaaS). Here is what you should know about how banking as a service could help reshape the financial services industry in 2023 and beyond.
The Growth and Significance of Banking as a Service
BaaS has continued to grow in recent years given the unique opportunity this provides to both banks and to technology providers who are seeking to provide banking products and services as a neobank. Neobank providers like Chime, Varo, Affirm, and others have identified niche markets to whom they solicit their products and services, but since they do not have a license to operate as a bank, they need bank partners as a sponsor.
In the BaaS model, the neobank benefits from having the ability to offer their products and services and earn income on loan spreads, interchange income, and other fees passed to their customers. The bank benefits from holding the loan and/or deposit balances on their books by sharing the interchange income, and by receiving payments from the technology provider for having access to their bank charter.
Neobanks typically seek relationships with banks under $10 billion in assets as larger banks are subject to interchange caps by the Durbin Amendment, which limits potential profitability. And because neobanks work with banks under $10 billion, they seek relationships with multiple banks, as successful neobanks can quickly outpace the scale of any one sponsor bank.
Community banks who participate in BaaS have the opportunity to expand their ability to acquire new deposits, loans, and cards beyond their traditional acquisition channels. Additionally, by building relationships with neobanks, banks will expand their own technical capabilities and can often offset the cost of innovation by the increase in fee income.
Fintech: The Driving Force Behind Banking Development
Fintech companies have exploded over the past decade primarily because legacy bank technology does not provide a seamless client experience or efficient back-office operations. Most banks do not have the size and scale to build technology in-house and hence rely on partners to enhance their abilities.
According to Venture Scanner, there were over 3,300 Fintechs as of May 2021. Fintechs are building capabilities across categories of lending, payments, digital banking, funding, investing, regulatory compliance, security and more. While some Fintechs are focused on stealing business from the traditional banking ecosystem, many more are focused on partnering with banks to help improve their technology solutions.
Banks who partner with Fintechs are improving the way they onboard new clients, service existing clients, and operate the bank in a more efficient and scalable fashion. The innovation and expertise that these service providers bring have helped countless banking institutions expand their own business opportunities, proving that the relationship is a symbiotic one and that fintech companies aren’t all threats but potential business partners instead.
Cybersecurity Issues for 2023
While the coming year brings opportunities for the financial services sector to grow and develop through the application of BaaS and fintech, there are some gathering storm clouds on the horizon as well. The largest and potentially most damaging of these is undoubtedly the increasing number of cyberattacks and data breaches. In fact, there’s new evidence that shows smaller community banks are just as vulnerable to cyberattacks as their larger, more high-profile counterparts, which means the need for better cybersecurity will continue to grow at a noteworthy pace.
The most common type of cyberattack is social engineering where bank employees receive a phishing email in an attempt to gain the users security credentials or to implant malicious software on the user’s computer, which can in turn affect the entire network. Vulnerability attacks have also become very commonplace as well, where threat actors are able to gain access to the bank’s network through gaps in software or hardware where patches have not been properly maintained.
According to the 2022 IBM Cost of a Data Breach Report, the average data breach in Financial Services costs over $5 million. As an industry, Financial Services is only second to Healthcare as a top target for threat actors as the data gained in a breach is financially lucrative when stolen.
Banks must maintain a very strong security posture and invest in tools to detect and respond to security incidents quickly. Also, as banks can be impacted when their clients suffer a breach, so banks should ensure proper controls are in place to validate customers and to detect anomalous movements of money in customer’s accounts.
Emergent Trends in Mergers and Acquisitions
Mergers and acquisitions (M&A) have been especially prevalent in the community banking sector as demand in scale has increased, and community banks have been under ever-increasing pressure to keep up with the larger financial service providers and their deep pockets. This trend has slowed recently due to uncertain economic conditions and regulatory changes impacting valuation, like Accumulated Other Comprehensive Income (AOCI). However as macroeconomic factors normalize, M&A activity is expected to increase given the intensified competition.
M&A is not only occurring between banks, in some cases FinTechs are buying banks. In January 2022, SoFi completed the acquisition of Golden Pacific Bancorp, converting their business model from a neobank to a full-service, chartered bank. In other cases, banks are buying FinTech companies to enhance their technology capabilities.
It is clear that technology is driving consolidation. Community banks who wish to remain independent and grow must consider their strategic technology plans to remain relevant and competitive.
The Great Wealth Transfer
Finally, the latest trend, and potentially the most impactful, is that a massive multigenerational transfer of inherited wealth is likely to occur within the next decade. Being referred to as the Great Wealth Transfer, the event is likely to result in tens of trillions of dollars’ worth of assets migrating from the oldest generations to newer ones, with the majority of the wealth transferring from the Silent Generation to Millennials and Generation Z.
While the implications of this upcoming transfer of wealth are many, the first and foremost is that financial service providers will need to be prepared to provide for the needs of these much younger families and individuals, who are digital natives. Financial institutions need to build their digital banking tools to attract and retain these digital natives. As many legacy core providers have not maintained pace to help community banks compete in the digital arena, many banks are implementing strategies to stand up a parallel Digital Bank on a new technology stack that allows them to offer these capabilities without a major conversion or disruption to their traditional model.
Technology continues to transform the banking industry in very significant ways. Many of these changes provide significant opportunities for community banks to compete against the large national and regional banks as community banks have the ability to be more nimble and react to changes more quickly. That said, community banks must plan for and invest in technology that transforms the way they acquire and service new customers while also driving back-office efficiencies to be able to grow and scale for the future. When considering new models like BaaS, FinTech partnerships, or Digital Banking, it may seem overwhelming for bank leaders navigating this for the first time. Hartman Executive Advisors can help your bank evaluate which options are right for your organization and develop a plan and strategy to build new capabilities to gain traction quicker and more efficiently. If you are a bank leader who is looking for more information, please contact the banking experts at Hartman Executive Advisors to schedule a free consultation.