How the Banking as a Service market is evolving

Driven by its ability to democratize the provision of financial services, banking as a service (BaaS) is growing exponentially, with the market valued at USD 15.9 billion in 2023 and expected to expand to USD 64.7 billion by 2032.¹

Despite the strong projected growth, there are concerns that the honeymoon period for BaaS may be ending. Though these services have begun to mature and grow in popularity, BaaS remains a relatively new offering in relation to fintech clientele — and the current regulatory landscape reflects this.

Therefore, regulators are working closely with providers to ensure the right controls are in place to manage potential risks associated with these programs. For example, regulators are exploring ways to address concerns surrounding data, procedures, systems related to third-party risk management programs² and consumer protections.³

With these services under the compliance spotlight, providers and users are reevaluating the operational and financial structures that underpin BaaS, with a focus on risk management systems, compliance standards and integrated controls. Instead of being seen as detrimental to growth in the market, the increasing precautions being taken have the potential to guarantee a bright future for BaaS.

Understanding Banking as a Service (BaaS)

BaaS involves integrating a financial institution’s infrastructure and services into the platforms or systems of other financial or nonfinancial businesses. Businesses can then offer banking services under their own brand, allowing them to expand their offerings to their end customers.

These solutions go far beyond simple payment methods for online retail stores. For instance, businesses can receive BaaS products that provide dynamic investment solutions or ways to optimize liquidity management and strategies. By deploying BaaS products, financial institutions and nonfinancial companies can expand their offering for end customers and can also diversify revenue streams to help build a competitive edge in the market.  

BaaS products employ APIs and other digital channels to access their banking partners’ financial capabilities, which can then be leveraged in their offering to end customers. Without BaaS, these nonbank providers would be required to invest significant capital and navigate an unfamiliar and complex regulatory landscape to develop their financial products that meet customer needs. This can be both costly and a drain on internal resources.

Two sides of the BaaS market

The market has shifted over the past decade, resulting in increased competition between traditional banks and non-bank entities, as money services businesses (MSBs), fintechs and corporates are now able to offer financial services. As a result, opportunities for innovation and collaboration have also emerged. 

Within this evolving market, banks have uncovered an opportunity and need to approach financial services with more modularity, a welcome improvement on the traditional one-size-fits-all method. To achieve the level of flexibility needed to facilitate the new approach, banks are increasingly looking to collaborations with fintechs — focusing on rapid development, customization and an improved client and end-customer experience. At the same time, emerging non-bank entities have begun to appreciate the need for the scale, reach, capabilities and infrastructure of a traditional player, which protects the financial interests of their end customers. 

Through collaborative agreements, both sides benefit: banks can operate with more agility when reacting to changing customer needs, while nonbank entities gain access to the experience and regulatory know-how of banks, as well as their extensive networks and infrastructure. 

How BaaS benefits the client

BaaS capabilities have been embraced by businesses in today’s rapidly transforming economy, operating across a wide range of sectors where they can help improve the customer experience, retain and enhance competitiveness, and reduce operational costs.⁴ 

In recent years, for example, many broker-dealers (BDs) currently face both short- and long-term strategic pressures, driven by a combination of shifting market structures, the proliferation of data, evolving client demands, a new talent profile and regulatory headwinds. This has contributed to an ongoing decline in the number of BDs globally, with a reduction of approximately 25% observed between 2012 and 2022 — either through acquisition or closure.⁵  This has led BDs to look elsewhere for revenue opportunities, diversifying their business lines and entering new, often unfamiliar, markets. Within this context, BaaS products can help BDs expand the depth and breadth of their offering, such that they can potentially capture a greater share of the data and revenue wallet. 

By using BaaS products, businesses can also avoid large capital outlays as they do not need to establish and build their own products from the ground up. For example, neobanks, nonbank financial companies and fintech startups are leveraging BaaS products to expand their offerings into new markets, without the need to overcome regulatory hurdles — such as obtaining banking licenses to handle other businesses’ cash and execute their payments.⁶  

Choosing a BaaS provider: Regulatory compliance

Businesses have much to consider when selecting the right BaaS provider. Trust is an essential part of the puzzle, and it is important that businesses consider whether a provider’s capabilities are compliant with all relevant regulations. These considerations are being brought into focus as the BaaS market currently faces pressure from regulators; consent orders, legally binding demands issued by regulators to address regulatory violations, are being dispersed and enforced across the financial services industry to ensure that BaaS products adhere to relevant compliance standards.⁷  

Alongside regulatory compliance, businesses should also assess a range of additional factors when choosing a provider. Security should be high on the agenda, including the need for strong risk governance processes, robust know your customer (KYC) guidelines, anti-money laundering (AML) rules, fraud prevention and protection protocols, and extensive transaction monitoring systems. It is critical that a provider’s technology can seamlessly integrate with a business’ front-end systems. At the same time, the provider must also be able to offer business guidance, support and customizations to the technology.

The provider should also conduct its own due diligence before partnering with a nonbank brand. This includes deep scrutiny of compliance policies through assessing corporate structure, employee training programs, transaction monitoring systems and customer due diligence, as well as risk assessment, reporting and communication procedures.⁸

As part of these considerations, consumer protections are also a priority. In July, the Federal Deposit Insurance Corporation (FDIC) issued a statement on the potential consumer risks associated with third-party arrangements, stressing the need for banks to engage in a safe and sound manner that is compliant with applicable laws.⁹

Insufficient oversight of these arrangements can not only impact a bank’s ability to meet regulatory obligations but could also lead to end users being misled about the exact nature of the services being provided. Banks that offer services through third-party arrangements have a responsibility to put appropriate controls and guardrails in place to avoid misinformation and protect the end consumer. Providers should stay up to date with the developing regulatory landscape, as changes to laws and requirements will likely affect not just their practices, but also those of their third-party providers.

Innovation as a strength in BaaS

Beyond security and risk management, clients should examine the provider’s capacity to be at the forefront of innovation. BaaS is a rapidly transforming industry and requires banking providers to remain current. Businesses should look for an organization that has consistently positioned itself as a partner to clients — and potentially offers access to a cutting-edge suite of solutions. 

An innovative banking partner will also keep pace with market shifts, rather than letting the responsibility of reacting to such change to fall solely on the client. For example, real-time payment capabilities in the United States are rapidly evolving, with rails by both The Clearing House and the Federal Reserve now live. Navigating this changing landscape is complex, and the cost and effort associated with connecting to these new rails while also keeping up with future developments, are significant. 

To overcome these challenges, businesses can leverage the payment capabilities of large providers like BNY that have already made the requisite investments — helping to future-proof the offering to their own end clients. As an early adopter of real-time payments in the U.S., customers of BNY’s BaaS offering can also benefit from value-added solutions, such as the bank’s account validation service, designed to help mitigate the risk of financial loss while authorizing transactions more quickly through pre-validated transaction information to confirm if a receiving account is valid and in good standing.

This commitment to innovation is the final, and perhaps most important, consideration when choosing a BaaS provider. Businesses are looking for a provider that continues to seek out the latest technologies and partnerships to provide enhanced, flexible products that directly address the needs of businesses and their end customers, while also satisfying regulatory requirements. A commitment to innovation means that nonbanks and their clients can receive a best-in-class service aimed at helping clients grow, while also minimizing risk.