In this strange economy where inflation vies with 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 — a segment that hit $20 billion in revenue in the United States alone in 2021, according to McKinsey research. This figure could double somewhere between 2025 and 2027, the consulting firm estimates.
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, according to Jonathan Zell, a partner at McKinsey. “Very large banks have been very successful in embedded finance,” says Zell. “There are also small banks that have been very successful in embedded finance.”
Opportunities may not necessarily involve big names nor 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, is another place 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 BMTX, a fintech, to operate.
In an interview with The Financial Brand, Zell offered approaches to first, determining if embedded finance represents a good fit for a specific financial institution, and then launching and building on an embedded finance effort.
1. Is Embedded Finance a Suitable Strategy for Your Institution?
Zell, who has helped banking institutions in both the United States and Europe set up embedded finance programs, says the most successful ones have three characteristics in common at the start:
1. Willingness to share the revenue for providing banking services.
“Embedded finance is a bit of a double-edged sword for banks,” says Zell. 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 yours, where you could have received 100% of the benefit,” Zell explains.
Understanding these two related shifts in perspective are essential to building a successful program.
2. Ability to handle technological and distribution capabilities, or to cooperate with a distributor fulfilling those functions.
By definition, “embedded finance” is embedded in something else, some other system or process. Otherwise, we’d just call it “banking.”
Zell illustrates this point with 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, or APIs, and other connective tissue.
“We’ve seen some very large banks do this extremely well after investing a lot into it, and that’s why they’re succeeding very quickly,” says Zell. “However, we’ve seen large banks that have not invested in the technology and as a result they are struggling. And we’ve 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.”
3. A tolerance for a 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,” says Zell.
This presents two questions. First, he says, 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.
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2. What Aspects of Embedded Finance Appeal to Your Institution?
“It’s critical for a bank to first of all decide what they want to do in the embedded finance value chain,” says Zell. He 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, says Zell, and this could support taking on both the tech and balance sheet parts of a credit-card-as-a-service program.
Don't Let Embedded Finance Bury You:
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.
Often, says Zell, banks lack the “muscles” to take on everything they’d like to.
“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,” says Zell.
3. What’s Going to Be Your Embedded Finance ‘Beachhead’?
You can’t eat a 12-ounce steak in one bite. Zell suggests that a good way to begin a live embedded banking program is to start with a “beachhead” product or service, rather than a broader, more ambitious effort.
“The idea is to choose a product, get expertise selling it, and in that way create traction for that product,” he says. “That will allow the bank to build other products on that effort.”
Zell says McKinsey has found that offering deposit accounts through embedded finance makes a good beachhead.
“They 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,” says Zell.
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4. How Can an Embedded Finance Program 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 fintechs 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,” says Zell. “They 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.
Try Partnering with a Specialized Provider:
Allying 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 health care practices, small grocery stores and restaurants. Banks interested in embedding lending could offer short-term merchant advances through this type of partnership. (In late 2022 Amazon began to offer merchant advances to its third-party sellers through a new relationship with Parafin. In this case, Parafin, a fintech founded in 2020, funds the credit via equity financing and debt facilities with large banks.)
There’s also an element of “like works with like” to embedded finance. Zell says larger banks typically work with larger, more established platforms and distributors. Smaller institutions may get a better start with smaller fintechs 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.
5. What’s the Most Critical Matter to Clarify Before You Make a Deal?
No matter who the partner is, Zell says it is critical to know up front what the prospective partner will need from the bank.
“We’ve seen 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,” says Zell. 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, Zell says, and can help produce a successful embedded finance effort.
New entrants will have plenty of company.
“We’re hearing from many of our banking clients that they are looking for opportunities to drive growth in this uncertain market,” says Zell. “The opportunity to extend distribution of their products beyond their existing customers through embedded finance is quite attractive.”