These Digital Banks Help Fintechs to Offer Banking Services

Imagine that virtually any type of business you can think of could offer banking services to their customers, without having to apply for a banking license or directly bear the costs of regulatory compliance. While still few in number, there is a new type of digital bank on the horizon that is starting to make this a reality. There are reasons to think these “banking-as-a-service” (BaaS) providers could deepen financial inclusion.

A BaaS provider can be thought of as a technology company with a banking license. It offers tech-based solutions along with its banking license to financial services providers as a white label service. As the name suggests, BaaS is similar to the software-as-a-service arrangements that banks and other companies increasingly use to source technology solutions from external vendors. But BaaS bundles the license itself with the balance sheet and other requirements, such as compliance, reporting, staffing and risk management. This has profound implications for the business models of both parties and potentially for the structure of the financial sector. More importantly, it offers potentially powerful new avenues to expand and deepen financial inclusion.

The significance of BaaS is that it gives a whole new range of players a quick and frictionless way to enter financial services. Being a heavily regulated industry, banking historically has been a costly business to operate, due to the time and cost of the licensing process as well as the various prudential requirements placed on banks to safeguard the funds of depositors and the integrity, stability and soundness of the sector. By enabling virtually any type of business to offer banking services in record time and without these costs, BaaS providers can dramatically reduce the barriers to entry into banking.

This is particularly appealing to big tech players and other digital consumer companies that have large customer bases and a strong interest in financial services, but have been reluctant to get their own banking license. By partnering with a BaaS provider like Green Dot in the United States, a company like Uber is able to offer a bank account, debit card and credit card to drivers under its own brand without worrying about a banking license. It also is able to have those financial products seamlessly integrated with its technology on both the front and back ends.

BaaS is equally appealing to fintech start-ups and challenger banks that can leverage the BaaS provider to reach the market in a much shorter time with less up-front capital, regardless of whether they plan to pursue their own licenses over time. Well-known digital banks like Chime, Simple and MoneyLion in the United States and N26 in Germany have relied on BaaS partners. And besides facilitating new entrants, BaaS can power the digitalization of operations for incumbents, such as microfinance institutions, small banks and credit unions, that struggle with the limitations of legacy tech stacks in trying to keep up with consumer expectations.

Finally, BaaS also can help improve the unit economics of banking by embracing its commodification, creating basic versions of financial products and pursuing margins through scale by white labeling them to many other players. In a sense, BaaS can be thought of as creating shared infrastructure analogous to the tower-sharing arrangements commonly used by mobile network operators (MNOs) in developing countries. As cell phone services grew increasingly commoditized and end-user prices fell, many MNOs opted for tower sharing to strip out cost and defend margins. The model has been particularly important for serving low-income customers in remote areas, where the business case for creating tower infrastructure is weak. We believe the same may be true of BaaS models.

In short, BaaS can increase competition in banking, enable lower costs and end-user prices and bring financial products and services closer to customers by integrating them seamlessly into the digital environments where they are already spending time. All these forces should help to expand both the breadth and depth of financial inclusion.

It is worth noting that there are hybrid models in which a tech stack and license are not controlled by a single entity but offered through a partnership between a tech company and a bank (e.g., Banksy in Algeria). This variant notably makes BaaS easier to scale regionally or globally, since acquiring a license in each market is often more costly and time-consuming than working with a partner. However, it also complicates the technology and commercial aspects of the business model. We haven’t studied the net implications of this hybrid model, but it could be particularly relevant for small or heavily regulated markets where the cost-benefit analysis for the BaaS player to get its own license isn’t strong enough.

BaaS is still a nascent business model, with just a handful of examples worldwide, but we believe that its financial inclusion potential is big. By lowering barriers of entry, making access to cutting-edge technology cheaper and easier and promoting economies of scale and scope, BaaS players create an enabling ecosystem where diverse players can deepen financial inclusion without the need to acquire their own banking license.