The report: 2024 State of Embedded Finance
Source: Alloy
Why we picked this report: The early promise of embedded finance and banking-as-a-service as sources of growth and new deposits for traditional finance institutions has been beset by operational snafus, regulatory skepticism and even outright fraud. Understanding current challenges and potential routes forward will be essential for banks who have embraced the model.
Executive Summary
The embedded finance sector is experiencing significant growth, with banks and fintechs collaborating to offer financial products through non-traditional channels. However, recent regulatory scrutiny has highlighted compliance challenges in these partnerships. A survey of 51 US sponsor banks reveals that while embedded finance partnerships drive substantial revenue and deposits, compliance issues are becoming a major concern. Banks are adapting by investing in new technologies and increasing oversight, but some are considering exiting the space altogether. The industry is at a crossroads, with successful players likely to emerge stronger and more compliant.
Key Takeaways
- 51% of sponsor banks’ revenue and deposits are driven by embedded finance partnerships
- 80% of sponsor banks find meeting compliance requirements challenging
- 39% of sponsor banks lost at least $250,000 due to compliance violations
- 94% of sponsor banks are investing in new compliance technology and increasing training
- 29% of sponsor banks are considering slimming down or shutting down their embedded finance programs
What we liked about the report: It asks the right questions at the right time (the underlying survey was conducted in early June). And the respondents are drawn from the sweet spot of relevant institutions: Larger entities of more than 1,000 employees who are nonetheless primarily local or regional banks.
What we didn’t: The number of respondents (51) could have been bigger.
The Changing Landscape of Embedded Finance
The embedded finance ecosystem is evolving rapidly, with sponsor banks increasingly opting for direct contracts with fintech partners. This shift reflects a growing desire for more flexible partnerships that can be tailored to manage the unique risks of each collaboration. The primary motivators for banks entering these partnerships include innovation acceleration (41%), customer acquisition (39%), and cost reduction and efficiency (37%).
These partnerships have become crucial for many banks, with embedded finance relationships driving an average of 51.3% of revenue and 51.4% of deposits. The majority of sponsor banks (61%) report having 6 to ten embedded finance partnerships, indicating a strategy of diversification across different fintech sectors or customer segments.
A Key Stat:
61% of sponsor banks contract directly with fintech partners, moving away from Banking-as-a-Service (BaaS) platforms.
Compliance Challenges and Consequences
Despite the opportunities, compliance has emerged as a significant barrier to the viability of embedded finance relationships. A staggering 80% of sponsor banks report that managing and meeting compliance requirements is challenging. The top challenges include lack of control over fintech partners’ policy controls, insufficient auditability, and ensuring consistent compliance across multiple jurisdictions.
The consequences of compliance violations are severe, with 75% of sponsor banks reporting losses of $100,000 or more. Beyond financial losses, banks cite reputational damage (20%), loss of business partnerships (16%), and suspension or revocation of licenses (14%) as the most detrimental outcomes of compliance failures.
Adapting to Regulatory Scrutiny
In response to heightened regulatory scrutiny, sponsor banks are taking decisive action. The vast majority (94%) are investing in new compliance technology and increasing staff training. Other key actions include conducting audits of previous transactions, adding staff to fintech partnership programs, and in some cases, limiting or shutting down their fintech partnerships altogether.
This increased oversight reflects a growing recognition of the need for more robust risk management in embedded finance partnerships. While 96% of banks report wanting at least a moderate degree of control over their fintech partners’ compliance programs, operational challenges suggest that achieving this control remains difficult.
Read more:
- How FinWise Bank Plans to Survive the Storm in Banking as a Service
- AI-Assisted Lending Could Boost Small Banks. But Regulatory Fear Stifles Innovation
The Future of Embedded Finance Partnerships
Despite the challenges, embedded finance collaborations continue to offer significant benefits, including more comprehensive coverage of financial services and improved customer experiences. To remain competitive, sponsor banks must balance their fintech partners’ needs for scalability, seamless user experiences, and competitive pricing with the imperative for stringent compliance measures.
Industry experts predict a consolidation in the market, with committed players emerging stronger and more capable of handling complex fintech partnerships. The development of standardized best practices and more sophisticated risk management strategies is expected, with banks investing in advanced systems and processes positioned to capitalize on the long-term growth potential of embedded finance.
As the embedded finance ecosystem matures, banks face a critical decision: invest in robust compliance solutions and fully commit to the space, or risk exiting the business entirely. Those who successfully navigate this transition are likely to build stronger, more compliant partnerships that drive innovation and expand access to financial services in the years to come.
Editor’s note: This article was prepared with AI language software and edited for clarity and accuracy by The Financial Brand editorial team.