Banking as a service, or BaaS, can empower traditional financial institutions of all sizes to generate revenue without relying on shrinking branch foot traffic.
Through the use of application programming interfaces, or APIs, financial institutions can seamlessly embed what are regulated banking capabilities into digital activities that are happening outside of the banking environment. This is usually done through partnerships with fintechs.
An explosion in BaaS adoption has prompted federal banking regulators to issue guidance on third-party relationships. This has upped the ante in terms of the need for banks and fintechs to engage in mutually rigorous risk oversight.
In the following Q&A, innovation consultant Jason Mikula, who has worked as both a fintech executive and a banker in his career, provides historical context and perspectives on BaaS, conducting a deep dive into how this model progressed from its niche origins.
Mikula, who spoke with Jim Marous, founder and chief executive of the Digital Banking Report and co-publisher of The Financial Brand, also urges proactive compliance and risk management amid the uncertain regulatory climate.
The Origins of Banking as a Service
Q: Let’s start at the beginning: When and how did the initial concept of banking as a service first emerge?
Jason Mikula: I trace BaaS origins back to niche banks in the mid-2000s aggressively pursuing deep specialization. MetaBank, now known as Pathward, became laser-focused on prepaid debit cards as a core differentiated product. Other emerging specialists like Cross River were purpose-built around narrowly targeted lending activities.
At the time, this hyper-targeted approach seemed a risky deviation from the traditional all-in-one bank model. But in retrospect, these specialized pioneers laid crucial groundwork for what would ultimately become banking as a service. By excelling in a narrow sliver, they created ideal platforms to enable new fintechs through bank partnerships. Their focused expertise made them perfect collaborators for startups needing targeted banking capabilities.
Q: When did BaaS gain prominence as a distinct concept and recognized category?
Mikula: The model rapidly gained definition and prominence in the 2010s as converging needs supercharged adoption.
Small banks discovered lucrative new revenue streams by becoming fintech enablers. An explosion of venture-capital-backed fintechs desperately required licensed bank partners to bring disruptive ideas to life within regulatory confines. This perfect storm of symbiotic incentives vaulted BaaS from obscure origins into a booming, well-defined ecosystem almost overnight.
Once both sides realized the immense mutual value unlocked, the land grab was on.
The Explosive Growth of BaaS
Q: Just how rapidly has BaaS grown in adoption and market size over the past decade? What forces have fueled this hypergrowth?
Mikula: Adoption has exploded exponentially in a short timeframe as understanding spread regarding BaaS’s advantages. One study found the number of banks actively pursuing BaaS partnerships in the U.S. alone mushroomed from just over 100 in 2019 to around 500 by the end of 2022. And projected revenue growth is a hockey stick still in early stages. Goldman Sachs is forecasting global BaaS revenues to reach nearly $7 billion by 2030, after standing at just $2 billion in 2019.
Two converging incentives poured fuel on this hypergrowth. Fintechs rode a tidal wave of VC funding but desperately required bank partners to offer regulated services and get to market. Meanwhile, banks of all sizes realized BaaS could drive major revenue expansion by reaching new digital channels without costly physical footprint growth.
Fintechs needed licensed capabilities only banks could provide. And banks recognized BaaS as a new profit engine complementary to legacy models. This win-win unlocked BaaS’s massive growth potential.
Q: Which specific factors made BaaS adoption skyrocket for smaller traditional banks?
Mikula: For many, BaaS emerged as an enticing lifeline amid steadily declining branch traffic and fading legacy growth models. By unlocking new digital revenue channels without the need for geographic expansion, BaaS allowed smaller banks to monetize their most valuable assets — their trusted charters and risk management expertise.
If you’re a community bank seeing your branch business decline, BaaS offers a path to grow and diversify without doubling down on old distribution models. It presented an obvious way to replace fading branch-based revenues by leveraging existing capabilities in a new context.
Read more about the BaaS strategy at these banks:
Regulatory Whiplash and Expectation Inflation
Q: As you noted, regulators were essentially caught flatfooted and have been scrambling to catch up to the explosive pace of BaaS adoption. How exactly has this rapid growth fundamentally impacted the regulatory environment?
Mikula: The sheer scale and abrupt pace radically increased complexity under regulators’ purview, but supervision failed to keep pace at first due to lack of visibility. Where previously you had contained one-to-one bank relationships, now you suddenly have a complex web of fintechs and BaaS middleware partnerships to monitor.
This exponential rise in third-party relationships drastically complicated oversight demands on regulators. Banks migrating to BaaS found themselves managing myriad partners where previously they dealt with known customers directly. Most underestimated the systems, investments, expertise, and oversight required to properly govern risks in this new partnership paradigm.
“Where previously you had contained one-to-one bank relationships, now you suddenly have a complex web of fintechs and BaaS middleware partnerships to monitor.”
Regulators worry that banks have pursued BaaS revenue without adequate risk management capabilities. We’ve already seen cases like Blue Ridge Bank in Charlottesville, Va. In 2022, the Office of the Comptroller of the Currency required Blue Ridge to make several improvements to manage risks posed by its fintech partnerships, and the bank is now required to get a “nonobjection” from the OCC before it signs any new contracts or adds new products.
Regulators want assurances of proper oversight before allowing further growth. Regulators entered scramble mode to rapidly address blind spots and establish guard rails around newly visible BaaS risks.
Q: Can you expand on some major regulatory actions tied to emerging BaaS risks and sharply escalating supervisory expectations?
Mikula: Cases like the OCC ordering Blue Ridge Bank to exit BaaS in 2021 over deficient risk controls illustrate the new seriousness of purpose. The Federal Reserve’s $50 million penalty on Square’s banking arm in 2022 for oversight gaps that enabled major data loss provides another example.
These cases show regulators expect the same standards in embedded finance as traditional banking. Managing risk is still the bank’s responsibility as the regulated entity, even if done through partnerships. Regulators are still catching up but clearly expect licensed institutions to retain responsibility regardless of how offerings reach end consumers. Those hoping for shortcuts seem destined for major disappointment.
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New Imperatives for Banks Involved in BaaS
Q: In light of escalating regulatory scrutiny and expectations around BaaS, how must incumbent banks evolve their approaches moving forward?
Mikula: At a minimum, they must move quickly to transform back-office operations, risk management investments, and talent. Smaller banks with lean teams may struggle to build all this expertise internally at the required pace. This talent crunch makes prudent partnerships essential. Specialized providers can fill gaps more economically than attempting to do everything themselves.
Outsourcing and third-party risk management will likely take on growing importance. But exhaustive partner vetting is equally crucial with BaaS market consolidation accelerating. The next wave of shakeouts could separate resilient winners from undercapitalized losers across the BaaS ecosystem. Surviving will require proactivity and discipline on all sides.
Q: What advice do you have for both banks and fintechs contemplating partnership-driven BaaS models?
Mikula: For banks, ensure you can persuasively demonstrate risk management capabilities to regulators before pursuing partnerships. Expand deliberately based on experience rather than chasing volumes. For fintechs, carefully vet the strength and track record of potential bank partners.
Spell out responsibilities explicitly. Rushing into relationships without proper due diligence invites regulatory risk that could halt progress entirely. Patience and prudence will likely be separating virtues, with regulators taking a much harder line and market fortunes shifting. The next round of turmoil could aggressively weed out fragile players, strengthening the model’s durability.
The Outlook for Banking as a Service
Q: Even with the increased concerns around risks and regulation, what is your overall outlook for the future of embedded banking models like BaaS?
Mikula: The core growth trajectory remains highly promising if participants rapidly recalibrate to meet evolving compliance expectations. The most resilient players will likely be those proactively investing in deeply integrating rigorous oversight and risk management into BaaS operations and partnerships.
Forecasting any emerging field with precision is impossible. Risks tied to overexposure in areas like commercial real estate for smaller banks seem likely to reinforce the case for prudent diversification through BaaS rather than concentration. Spreading risk rather than magnifying it may strengthen the system, even if it slows headline revenue growth in the short term.
The future remains exceedingly bright for thoughtfully constructed BaaS models and embedded banking. Forward-thinking institutions on both sides that realize the immense promise while embracing evolved operating models can still unlock enormous opportunities. But sustainable success requires transforming to meet the increased two-sided diligence and complexity now clearly required in this approach by regulators and the market alike.
To hear the full conversation with Jason Mikula, listen to the Banking Transformed podcast here. The Q&A has been edited and condensed.