Banks and embedded finance – opportunities, risks and success factors

A brief clarification of terms to get started: “Embedded finance” refers to the integration of financial services directly into the purchase process of products and services by companies that are not themselves banks or financial service providers. The embedded service can come from a wide range of options such as payments – including “buy now pay later” (BNPL) offers or purchase on invoice – loans, accounts, credit cards or insurance. The principle is fundamentally not new; car banks or comparable dealer financing are often cited as “early” forms of embedded finance. However, it is gaining enormous momentum as a result of digitization and automation, as well as purchasing and consumer behavior that is changing as a result of these factors. The growth potential is assessed as correspondingly large. The consultancy Bain expects revenues for the total market in the U.S. to increase from $22 billion in 2021 to $51 billion in 2026. McKinsey comes to similar figures: Starting from total revenues of $20 billion, they forecast a doubling in the next 3-5 years. Similar developments at corresponding revenue levels can also be assumed for the DACH region.

The lending business as an important market segment

In addition to payment services, embedding loans is a very relevant option for banks. The segment can be divided into further sub-segments, which also brings new market players and competitors onto the scene. The “buy now pay later” segment is dominated by specialized providers such as Klarna, Riverty (formerly Afterpay) or Affirm. In addition to BNPL, the areas of point-of-sale and B2B loans should also be considered. Particularly in the latter, fintechs are active that specialize in providing loans for small and medium-sized enterprises. Growth opportunities through embedded offerings exist with regard to the predicted market growth for banks in all lending segments. We will now go into detail on the risks and opportunities to be taken into account as well as the success factors in technical implementation.

What are the risks and challenges of embedded finance?

The diversified market and competitive environment and the distribution of own offerings on third-party platforms and channels indicate this: Banks need to manage risks with integrated financial products. A major one of these is the potential loss of the direct customer relationship. Traditionally, lending in particular has been a product segment where banks have been competing for customers almost exclusively. These customer journeys took place at the banks’ own touchpoints. In the case of embedded lending, this customer journey can now also take place at any company or retailer that embeds financial services. This gives rise to the risk that existing customers will take out loans with other providers without the knowledge of their bank. The overall increase in the intensity of competition results in a further risk, namely shrinking margins. This further increases cost pressure for banks.

How can banks benefit from embedded finance?

However, the new market environment that is developing also presents banks with a number of opportunities. They can additionally leverage existing competitive advantages. First and foremost is the opportunity to expand customer acquisition. Embedded finance offers a wide range of opportunities, especially in terms of digital touchpoints, through which banks can position themselves as essential partners and enablers or even open up new digital business models. In cooperation with the front-end partner, they are ultimately the ones who, for example, take the loans onto the balance sheet. In this way, the financial product becomes a payment method. The bank thus has the opportunity to become more closely associated in the customer’s perception with the actual purchase and the satisfaction of a need than “merely” with the provision of money.

In the battle for the favor of customers, banks can rely on two competitive advantages over many newcomers and fintechs. The first is their own brand strength. Trust plays a major role in financial services, which banks have generally been able to build up through many years of business activity and specialization. Secondly, in banking, the area of regulation cannot be forgotten. Here, too, established players can leverage their expertise and experience in risk management and compliance when implementing and handling the necessary processes.

IT success factors in implementation

For an embedded finance offering, there are basically three roles to be filled, usually by one actor each. One partner provides the offering (e.g., the bank), the second sells it or embeds it (e.g., a retailer), and the third provides the technical basis. In this context, the central question for banks is: To what extent can and do they want to become a technology or software provider themselves?

Banks therefore have the choice of either providing their own technology or software together with the financial product (banking as a service) or working with an external specialist as a partner. In-house development requires a great deal of time as well as personnel and financial resources. However, it also opens up the possibility of building up a completely new business area in-house. With a technology partnership, this responsibility can be shared and expenses reduced, in some cases considerably, if it is possible to rely on already established solutions and expertise. If the software solution is designed correspondingly, technology partners also offer consulting and support for the process and workflow setup in order to further relieve internal bank resources.

Irrespective of this strategic decision, the following factors are particularly important for the successful technical implementation of embedded finance offerings for banks.

1. Automate processes as fully as possible: This aspect is particularly important for integrated lending products in the retail/B2C segment, as margins on these products are relatively low. An ideally fully automated credit application process, including credit decisioning, can reduce costs and thus enable profitable high-volume business.
2. Master interface management: Due to the typical constellation of three partners, handover points between the players and their systems are more numerous and tend to be even more critical than in traditional credit application processes. Reliable API-based interfaces are therefore critical, as is a high level of problem-solving expertise when individual elements in the process malfunction or fail.
3. Reliably meeting partner requirements: The banks’ distribution partners can come from very different industries. What they usually have in common, however, is a high level of expectation in terms of cooperation. Embedded lending offers in particular are an essential part of the purchasing process as a payment method with a direct influence on the partner’s key KPIs such as conversion rates. The interaction of the mentioned factors, automation and interface management, can make a significant contribution to the reliable fulfillment of such requirements, especially in terms of stability, performance and transparency.

 

As a bank, you want to establish or expand your business via embedded finance? With our BANCOS Onboarding solution, we can support you as a technology partner. We have special expertise in the integration of lending offers in demanding e-commerce environments. Feel free to contact us directly to discuss your needs!