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Embedded fintech versus embedded banking – a critical difference

Embedded fintech versus embedded banking – a critical difference 1

By Jennifer Geis, senior analyst at Jack Henry

As the economy recovers from the turbulence of the COVID-19 pandemic and behavioral shifts solidify, financial institutions are adapting their strategies and operating models. Technology will continue to be the catalyst for that adaptation and the transformation of financial services moving forward.

Jack Henry & Associates recently conducted its third annual Technology Capabilities Assessment. More than 130 bank and credit union CEOs responded, reflecting the strategic priorities for a wide range of community and regional financial institutions across the U.S. The supermajority, 78% of respondents, reported plans to increase investments in financial technology over the next two years, with over 30% of respondents in the $1- to $5-billion asset range planning to increase investments by more than 10%.

So, why the uptick in technology spend? In large part because innovation is critical to addressing new and emerging threats. Respondents cited net interest margin compression, fraud and security, and a failure to innovate as their top three concerns during the next two years.

These concerns spring from the overwhelming speed of digitization happening across the industry. Banking-as-a-Service (BaaS) has blurred the lines between chartered and non-chartered financial service providers. New categories of disruptors and competitors are multiplying with large budgets, growing market share, and jaw-dropping valuations.

Fintech and BigTech firms have become more significant, direct threats. In fact, when asked to rank their top three competitors, financial institution CEOs reported fintech firms first (70%), followed by BigTech firms (53%). In terms of addressing competitive threats, respondents ranked enhancing digital offerings, growing loans, and improving customer/member service as the top three strategic priorities during  the next two years.

Understanding embedded banking vs. embedded fintech – a strategic imperative 

While financial institutions must close gaps in digital products and services to retain market share and relevance, they must also address strategic gaps in their broader understanding of ecosystem disruption.

Let’s take open banking, for example. Even though open banking continues to quickly evolve in the U.S., almost half of respondents were not familiar with the growing use of open APIs (application program interfaces) and data exchange networks to enable accountholders to share their financial data with third parties of choice. Yet, among the minority of CEOs in the research-and-planning stages of open banking, 87% plan to execute on an open banking strategy by 2023.

To avoid strategic blind spots, leaders must develop a deeper understanding of the open banking ecosystem as well as its risks and opportunities. Open banking is often mistakenly equated with BaaS, in which a financial institution rents its regulated rails (payments, deposits, loans) to non-chartered third parties, embedding banking capabilities into external settings that the financial institution doesn’t control. Google Pay, Uber, and GrubHub all have embedded banking capabilities.

While BaaS-enabled embedded banking arrangements continue to proliferate, the end-user (customer) relationships belong to—and are controlled by—the third party, not the BaaS financial institution. The user sees and interacts with the third party, while the bank or credit union remains in the background as a utility player.

Given BaaS runs counter to most financial institutions’ relationship-based business models—and given many financial institutions mistakenly equate BaaS with open banking—it’s no wonder that 16% of CEOs in our study said open banking “didn’t fit” their strategy. What many fail to realize is that open banking is actually bi-directional, meaning financial institutions can either (1) embed their wares into external settings or (2) alternatively embed third-party innovations and data into the financial institutions’ own digital banking experiences.

This approach is known as embedded fintech: the integration of fintech products and services into financial institutions’ native product sets, digital channels, and business processes. For example, consider banks and credit unions integrating popular services such as fractional investing or financial wellness solutions. These financial institutions are levering open banking rails to bring home meaningful data and tools for their customers—and to maintain ownership of the customer relationship.

Embedded fintech is changing the game for financial institutions and enabling them to address the top three strategic priorities identified by CEOs in the Technology Capabilities Assessment. By partnering with established fintech players, financial institutions are enhancing digital offerings with enriched security, wealth management, and cryptocurrency services; protecting and growing payments and loans with new revenue streams and distribution models; and even improving customer service with real-time, personal connections inside digital channels.

Embedded fintech strategies level the playing field against Fintechs and BigTechs, empowering banks and credit unions to outpace the competition by curating differentiated digital experiences that also leverage the very thing community financial institutions are best known for: personal service, relationships and trust. Fintechs and BigTechs simply can’t beat the combination of differentiated digital experiences backed by personal service and trust at financial moments of need.

Embracing real-time and emerging payments

Faster-payment use cases continue to evolve and multiply, and more than half of survey respondents aim to enable real-time payments by 2022.

As a subset of BaaS, Payments-as-a-Service (PaaS) and embedded payments are the dominant and fastest growing forms of embedded banking—presenting a material threat to financial institutions’ payments franchises. Last year alone, BigTechs and Fintechs siphoned $250 billion in payments volume (and $2.5 billion in payments revenue) from incumbent financial institutions. These threats along with a pressing need to grow and diversify non-interest income in the face of shrinking net-interest margins, have made payments generally—and payment hubs specifically—a key priority for bank and credit union CEOs.

Money and payments now traverse a hybrid world of centralized (fiat) monetary networks and decentralized (cryptographic) monetary networks. A multitude of fintech and neobank competitors such as PayPal, Venmo, Square, and Coinbase are bridging these networks and capitalizing upon significant consumer and corporate demand. Recent studies indicate that 50% of American consumers would use crypto services if offered by their primary financial institutions. Yet, 80% of financial institution CEOs have no plans to offer crypto services.

Banks and credit unions can start small now by offering the ability to buy, hold, and sell bitcoin within their digital banking channels. Once crypto regulations mature, financial institutions will look to bridge and provide settlement across a broader number of centralized and decentralized monetary networks.

The Technology Capabilities Assessment points to a future that is open, bi-directional, and decentralized. So, what can financial institutions do?

Identify strategic gaps in understanding as well as gaps in digital products and services. Lean into technology investments that plumb your institution into the open banking ecosystem—so that you can capitalize fully upon embedded fintech strategies. And choose partners who will enable emerging payments and differentiate your user experience. Finally, to win against fintech and BigTech firms, prioritize investments that enable your financial institution to translate personal service and trust effectively and efficiently into digital contexts.

Banks and credit unions will need to decide – and soon – whether they plan to be front-line competitors, invisible utility players, or simply a regulated infrastructure. The important thing is to make a deliberate choice rather than have that choice made for you by the forces of ecosystem disruption.

About Author:

Jennifer Geis is senior analyst at Jack Henry, a leading provider of technology solutions and payment processing services primarily for the financial services industry. She regularly contributes to Jack Henry’s blog, FinTalk.

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