The “banking as a service” strategy has quickly moved from a quirky niche play to a “golden opportunity” for a much larger group of players on both sides. There are several reasons for this shift.

Banks that have adopted “BaaS” in some fashion experience above-market returns on equity, in part because they are making much more efficient use of their technology stacks, according to Andreessen Horowitz. This is making BaaS more attractive to traditional institutions seeking greater profitability, especially community banks, that have been hit by troubles in the commercial real estate market.

“Commercial real estate is one of the great casualties of Covid, and commercial real estate has been where many community banks have made their bread and butter,” says Konrad Alt, Partner at Klaros Group. “A lot of community banks out there right now are needing to think harder about their strategy. As they look around for options, banking as a service is interesting and attractive. And they can see other community banks tiptoeing into the area. So, they are thinking, they can do it too.”

Ron Shevlin, Chief Research Officer at Cornerstone Advisors, says BaaS represents a $25-$50 million revenue opportunity these days.

The timing looks opportune because interest in BaaS and in the closely related concept of embedded banking is growing. This has increasingly brought in additional third parties interested in playing matchmaker and enabler between banks, which have the entrée to mainstream payment rails and all the other perks of bank charters, and fintechs and other companies that have innovative ideas but which lack the keys to the banking kingdom.

Bring On More BaaS Competitors, Says One Pioneer

You might think that a bank that has already established itself in BaaS might just as soon potential fresh entrants — competitors for deals, after all — would try something else. But Eric Sprink, President and CEO at Coastal Community Bank, which is a very active player in BaaS, says he favors more BaaS institutions.

“More banks in the banking as a service arena is healthy,” says Sprink. First, he says there are more than enough fintechs around who need bank partners to bring their ideas to market. Second, having more banks doing this “raises the education level of the entire ecosystem. Regulators will become more familiar with it. Trade associations will become more familiar with it.”

Banks active in BaaS already fall into two main groups. One consists of companies whose main business is banking as a service, including Cross River Bank, Bancorp Bank, Green Dot, and Meta. In some ways, they are really banks for fintechs, according to Sprink. The other group consists of active BaaS players that also maintain robust community banking operations, including branch networks.

The landscape for fintechs, banks and BaaS is changing and the decision to enter this activity from scratch cannot be taken lightly by either side, fintech and nonbank companies on one side and banks on the other.

The Field of BaaS Clients Is Expanding

As Konrad Alt likes to say, the classic BaaS user has been “two guys in a garage” who had an innovative financial idea in mind but who needed a banking partner. Typically they needed not only access to the banking system, but help with the byzantine world of compliance and other factors that banks have long since been initiated into. (Who knew that someday compliance would be cool?)

Other types of users have begun to explore BaaS relationships. Sprink says Coastal Community Bank has a partner that is a national consumer brand that is working with his institution to explore launching a buy now, pay later service of its own. Still a work in progress, this could be part of a “BNPL 2.0,” Sprink suggests.

Dov Marmor, COO for North America at Railsbank, says that retailers with enthusiastic fan bases are a natural customer for BaaS because they seek financial infrastructure to support new forms of commerce. For example, the ability of a sneaker store to provide financing from a salesperson’s tablet, or even to give away a pair in exchange for a signup, has strong appeal. In a report Deloitte Digital suggests that financial institutions enabling cashier-less shopping — akin to the Amazon Go stores — could become a ubiquitous application of BaaS as it becomes more the norm.

“You’re going to have more brands get into financial services and one way to do that is to partner with banks. Fintechs were the first big wave. But I think the next wave will be different. It will be companies with large, loyal followings that want to sell financial products to their customers.”

— Eric Sprink, Coastal Community Bank

In a way, the 2019 deal creating the “T-Mobile Money” account between T-Mobile and Bank Mobile was a forerunner of the trend.

Accompanying these broader trends is the commercialization of the growing fragmentation of American society. “The fractionalization of the larger community into affinity groups, or ‘community banking’ groups, for want of a better term, is very real,” says Peter Hazlehurst, Co-Founder and CEO at Synctera. His firm has some deals in the works that are highly specific, yet the sheer size of the American market makes them appear viable.

The New Middlemen

In just the last year or so, there has been a new wrinkle in BaaS. Traditionally BaaS arrangements were direct arrangements between the financial institution and the fintechs that needed them. However, as more players want to offer BaaS and more types of companies want to obtain some version of it, a new breed of middlemen, or matchmakers, have come to the fore.

“I call them ‘connectors,’ because that’s what the Federal Reserve calls them,” says Sprink. These are companies like Synctera, Treasury Prime, Synapse, Rize, and Nymbus that “curate” banking providers, help enable connections to partners, and connect the fintech and nonbank partners with some of the BaaS banks. (Sprink notes that Coastal Community owns a piece of Synctera.)

When Nymbus entered the BaaS fray in late 2021, it offered assistance with strategy, program management, operations, call center service, accounting, and compliance.

Sprink sees this “connector” movement driving increasing entry into BaaS by traditional players, by simplifying aspects of partnerships through the third party participation.

Need to Consider the BaaS Risks

The advent of the connector concept and its role in the future in helping banks and nonbanks find the right partners leads to a broader concern: Are BaaS enthusiasts on both sides looking under the hood enough?

Konrad Alt says that the views of regulators must be considered, and he believes that they will be taking a closer look at how well banks getting into BaaS are controlling the potential strategic risks of these arrangements.

He also points out some fintechs haven’t delivered on promises to “do great things for consumers,” says Alt, and some of those which have entered the lending business tend to charge very high rates.

“So you’ve got a portion of the public policy establishment that is very concerned about whether these companies are doing right by consumers,” says Alt. This makes for at least a yellow light as the Consumer Financial Protection Bureau shows increasing activism and other regulatory developments under the Biden administration follow this trend.

Profit Has A Price:

For any community bank launching into BaaS, a key matter is that they are taking on significant risk management responsibility for their nonbank partners, and not all newcomers seem to appreciate this.

Both banks offering BaaS and companies taking advantage of it must look at the full picture of what they are getting into. Alt sees issues that both sides must weigh.

“They need to be prepared to invest in and grow a really talented risk team,” beyond the team handling their own needs, says Alt, a former federal regulator who has worked in banking. (The latter includes time as Chief Banking Officer at Green Dot Corp.)

Another risk BaaS providers face can face is concentration and lack of diversity in their client portfolio, says Alt. “A community bank may be successful in getting a fintech partner that’s generating a bunch of earnings for them,” he explains. “But the bank is in kind of a precarious position unless it has several partnerships. Fintechs can move on to different partnerships if they want to and you don’t want to have too much revenue concentrated in a single partner.”

There’s a risk in success, too, according to Alt.

A fintech partner that goes from “two guys in a garage” to something really big can dwarf its community bank partner, potentially. This can be just as much a risk for the nonbank partner, should something happen to their banking system entrée. A regulatory order or worse can put a critical relationship in jeopardy, notes Alt, and BaaS arrangements can’t be unwound overnight.

For the nonbank partners, he adds, the opaque nature of the regulatory relationship can be a risk as well. Mandatory confidentiality regarding examinations, ratings and more mean that nonbanks don’t have the full picture. At least one major neobank has multiple BaaS providers and such redundancy could become standard at some point.

With risks for players on both sides, Alt believes there will be more regulatory attention to BaaS. This could possibly lead to a public example being made of some deal where the BaaS provider and their partner “are not on top of those risks as much as the regulators believe they should be,” Alt warns.