Revisioning banking and BaaS last mile to safely deliver financial products
- The BaaS ecosystem has been evolving and that means different things for the banks, fintechs, non-banks, and middleware companies participating.
- On the Tearsheet Podcast, editor Zack Miller is joined by executives from Thread Bank, CCG Catalyst Consulting Group, and Infinant to discuss the last mile and where business models are headed.
Welcome to the Tearsheet Podcast. I’m Tearsheet editor in chief, Zack Miller.
We’ve got a great show prepared for you today. We’re going to be talking about "Reimagining the Last Mile in Banking and the BaaS Business Models that will ensure Safe and Secure Delivery of Financial Products." We’ve assembled a panel of experts that will provide valuable insights into the current state and the future of Banking as a Service business models. You’ll hear how these models are morphing to reshape the financial industry. As we explore where banking and BaaS has evolved from, we’ll also tackle BaaS Business Models in the future and the Path Forward for the different players in the ecosystem.
Joining me on the show today is
🔷 Kate Drew, Director of Research at CCG Catalyst Consulting Group: Kate brings over a decade of industry experience and is a renowned fintech thought leader. Her insights have been featured in publications like CNBC, The Fintech Times, and Business Insider, making her a sought-after expert in the field.
🔷 John Bearden, Chief Banking Officer, Thread Bank: John is CBO of Thread Bank. Previously, he served as President of the Middle Tennessee Banking Group at Renasant Bank. He previously led the Depository Fixed Income practice at Stifel Financial and Sterne Agee where he worked with depository institutions around the country.
🔷 Sarah Howell, Head of Partnerships at Infinant: With her background in card payments and fintech, Sarah is a key figure in the BaaS landscape. She has played a vital role in the launch of Apple Pay and has been a thought leader during her tenure at Visa. Her insights have been featured in publications like American Banker and The Financial Brand.
Tearsheet thanks our partner Infinant for helping make this conversation, and others like it, a reality.
Without further ado, here’s our show.
The following excerpts were edited for clarity.
The big ideas
Evolution of Banking as a Service (BaaS): The historical development of banking has evolved into modern BaaS, where financial products are offered through non-bank channels like fintech companies. BaaS has shifted from direct to indirect models and is now exploring more symbiotic relationships between banks and fintech entities.
BaaS Models - Direct vs. Indirect: There's a clear distinction between direct and indirect BaaS models. The indirect model often involves a middleman facilitating relationships between banks and fintech, but it's evolving rapidly toward resembling a more direct model. Banks are seeking greater control and oversight of their partnerships.
Tech Evolution & Bank Strategies: Banks are considering partnerships with tech experts rather than building their own tech infrastructure. This allows them to focus on their core banking services while partnering with fintechs or providing direct services. The strategy involves integrating banking services into various ecosystems like vertical SAS providers or other fintech solutions.
Revenue Streams in BaaS: BaaS opens various revenue streams for banks, such as generating deposits, monthly fees, interchange income, and offering additional banking services like lending and merchant acquiring. The revenue model is evolving, allowing for flexibility and opportunities for non-interest income, especially through SaaS models.
Customer Expectations & BaaS: The customer demand for financial services is evolving, shaped by on-demand services prevalent in e-commerce. BaaS aims to make financial services accessible at the point of need, aligning with the trend of "Amazonification" of banking. Fragmented financial lives of customers create opportunities for BaaS models to expand and cater to evolving user needs, especially among younger generations.
The following excerpts were edited for clarity.
Overview of the historical development of banking and its evolution into the modern concept of Banking as a Service
Kate Drew, Director of Research, CCG Catalyst Consulting Group: The way that banking looks and feels has been much the same for a long time. You go to your bank, typically to a branch or on desktop or mobile, and you'll access a range of financial products that could be checking accounts, savings accounts, loans, what have you. But at the heart of that has generally been this direct line between the bank and the end client. And that's what's really starting to change.
Now we're starting to see financial products delivered more and more in non bank channels. A major driver of that is the rise of Banking as a Service, which enables banking institutions to acquire customers by providing access to the financial system to non bank companies, which includes fintechs that want to offer financial services.
The origins of this date back several decades to the rise of co-branded cards, but it really catapulted over the last several years in response to a large influx of private capital into the fintech space. And that's precisely when we started to see some cracks in the armor -- everything hit headwinds related to that market contracting, first of all, and also due to a number of compliance-related issues. If you follow this space, you've seen headlines all over the place about these partnerships collapsing, and regulators coming in and issuing consent orders.
At this point, we're starting to see this evolution away from that original model, with a focus on different ways to maximize value and minimize risk. I think that's going to be the basis of our conversation today: how we're going about that evolution.
What are the key characteristics and components of the current state of BaaS and the business models that accompany that?
Kate Drew, Director of Research, CCG Catalyst Consulting Group: I tend to put Banking as a Service into two key buckets: indirect and direct. On the indirect side, you really have this model by which a sponsor bank or Banking as a Service bank is working with fintech or non-bank companies to help them provide financial services. There's a middleman in the middle. There's a whole crop of these BaaS providers.
And then within this indirect model, you can break that down into two further subsets. You have one Banking as a Service provider model that is really focused on abstracting away the bank-fintech relationship. I think we can all probably agree that this is very much a failed model. As an industry, we're moving away from that at this point. And then on the other side, you have Banking as a Service providers that tend to try and put a lot of emphasis on the bank-fintech relationship. They may be more of a technology facilitator, just trying to help everybody get up and running and maintain their program. That's really the indirect model: this three-pronged approach to Banking as a Service that usually involves a three way revenue split, for example.
On the direct side, you have banks that are working directly with their fintech clients. There is no middleman in the middle and the economics of that are a little bit different.
Passive vs. active sponsor banks
John Bearden, Chief Banking Officer, Thread Bank: I completely agree with everything Kate just stated. I would break down the indirect model a little bit more and say that the indirect model can be split into a passive approach and an active approach to working with these middleware providers.
If you look back a couple years and go back to the pre-pandemic timeframe, you saw a lot of banks that got into this business of sponsoring fintechs with these middleware providers. The banks were taking a very passive approach where the middleware providers stepped in with the premise that their technology and their approach to working with the fintechs was better than what a bank could provide directly. So the banks basically handed over their responsibilities to these middleware providers to both go out and procure that fintech relationship, but also provide a lot of the oversight of that relationship, in addition to providing the ledgering technology.
That model existed for several years and it prospered. A lot of the banks did very well -- they were early adopters of supporting fintechs in providing depository services. But like I said, many of those relationships were very passive, where the bank had very little knowledge of the end user, very little knowledge of the fintech and very little knowledge of what was going on with some of those programs.
I think that model is the one that's really been challenged over the past 12 months, specifically, post SVB. In the issues around the banking sector, back in the spring, we've seen the regulators really zero in on the space to make sure that the banks are really in tune with what's going on with these partners, and ultimately, the end user, which is a contractual legal client of the bank. They really want to make sure that the bank is taking an active role in how they work with their partners and the end user.
I think the other component of the indirect model that we've seen start to proliferate in the industry is a bit of a pivot from the middleware providers to say, Okay, we can't be the star of the show anymore. We really need to come in and support the banks -- they face the fintech and the end user directly. So it's more of an active approach to working with those middleware providers, where the bank has direct oversight, direct engagement with the fintech and the end user. I think that is the only model that will survive with these middleware providers that we've seen over the past couple years.
How banks chose to be active or passive
John Bearden, Chief Banking Officer, Thread Bank: There were some really early players, if you go back a decade plus, the early pioneers in this space included Meta which is now Pathward. They got into the business of prepaid cards and I think they took some arrows early on. They went through this consent orders and everything and they've matured. They've improved their internal controls and processes, and they were able to generate significant deposit growth and significant fee income.
I think a lot of other players saw an opportunity to partner with fintechs to get involved. I don't want to speak for everybody, but I think they probably thought we can get involved in partnering with fintechs in one way or another and attract those deposits and get the fee income in. And when they got into the business, they saw these middleware providers that allowed kind of a shortcut to get there faster than developing their own technology to provide these services. They were low cost deposits, pre-pandemic, and the interchange income or fee income that comes with that. But it was a way for them to amplify their business model.
And we've seen what's going on in the market. In general, I think the market is dictating that. There's better technology out there for financial products and services than the three primary core banking providers -- Jack Henry, Fiserv, and FIS -- allow. Most brick and mortar banks in the United States are tethered to these core providers. The marketplace is asking for something more. The banks that gravitated towards this marketplace early were the beneficiaries. I think they saw an opportunity to get involved, but it was a very passive approach where they handed over a lot of those responsibilities to the middleware providers. And I think those decisions are coming home to roost in the current regulatory environment.
I think it's the evolution of the business: the regulators have gotten more involved in Banking as a Service and trying to figure out what it means and what it means from the mechanics of running a bank. That kind of North Star, if you will, is that the bank needs to be in control. They need to be in control of the oversight of these programs and have direct relationships with the end user. But all that said, I think the middleware providers have added a valuable service in terms of technology and really assisting fintechs, helping them understand what some of the regulatory requirements are, from a compliance and BSA and AML perspective, to enter this space and to offer banking products and services to their end users.
Bank providing direct and indirect models
John Bearden, Chief Banking Officer, Thread Bank: I think the indirect model is evolving rapidly to look a lot more like a direct model. I don't think the indirect model is going to be allowed to exist the way it was two or three years ago. I think you're seeing several players in that space offering their software directly to banks, instead of being the the entity that goes out and acquires the fintech from a sales perspective and has the direct oversight of those programs. I think that model, as we said, is shifting pretty dramatically. So I think both a direct model and an indirect indirect in that context can work.
I think the the working with a middleware provider, even if it's licencing their software, you're beholden to their tech stack. You've got to like their tech stack and the products and services that they're offering through their channel to make that decision to continue working with a middleware provider. The economics and commercials that come with having three parties involved versus two. So there's a lot of considerations for smaller fintechs that are coming into the market that want to offer banking products and services. The middleware providers can still add some value, because they do kind of provide the training wheels necessary to help some of these smaller companies be prepared to offer these services to their customers.
Sarah Howell, Head of Partnerships at Infinant: I think whenever you're looking at this, this whole BaaS business model and industry, it's good to look at it from all angles. You need a processor, you need a bank, and then you need a distribution partner and embedded finance partner. Having the ability to have the chameleon perspective, where I can put my processor hat on and say, Okay, what needs to happen in order for it to be successful, put my bank hat on, and then my fintech or embedded finance customer head on -- I like to put that last hat on a lot.
John brought up a really good point, because these guys that are starting off, they need training wheels. They need to understand what they need to have from a compliance perspective. I'm going to embed financial products into my solution set. You should really only be talking to SaaS technology providers who have a different go to market strategy for embedding financial products into that to create a holistic offering, and not just a neobank at this point in the maturation.
That's just my little soapbox, but you want those guys to start off, and you want them to mature and you want them to get bigger. I think having step functions within the industry that allow them to do that is very thoughtful for banks to think about as they're building out their strategy, I want to put my little guys on a BaaS middleware provider, then I want to want to have a direct relationship with them once they grow up. And if I want to, if they're big enough, and they want to choose their own processor, I want to allow enough flexibility in my business model to win that business if I need to. Then also, I want them to grow up and and come straight to a tech stack that I'm powering. So now I can get both sponsor bank revenue, as well as tech revenue and processing revenue on behalf of the fintech, then I want to have that option. So optionality across the value chain, and the growth maturity of the fintech client is really key to keep in focus.
John Bearden, Chief Banking Officer, Thread Bank: A lot of it is product driven. So if a fintech is looking for a sponsor bank to purely offer deposit products, a DDA savings account, debit card, that's a pretty vanilla Banking as a Service offering that we could support through a middleware provider, with the caveat being that the bank really needs to be in control in this environment.
I think going direct allows banks like Thread the opportunity to offer more products and services, like lending products, payments, merchant acquiring, with other things that are going to help really build that ecosystem and that moat around those fintech relationships to better serve their customers. We want that flexibility and optionality to be able to do that through a direct model.
The importance of flexibility: direct and indirect
Kate Drew, Director of Research, CCG Catalyst Consulting Group: When I was doing the research for the report, Reimagining Last Mile in Banking that we published in collaboration with Infinant, in all the conversations that I had with executives, this idea of flexibility came up over and over again.
How do you balance the efficiency of a one-size-fits-all solution with the need to differentiate and customize in this new environment because as Banking as a Service evolves, just having a card program is not necessarily going to be the way of the future. It doesn't necessarily make sense from an economic standpoint or from a competitive standpoint. So getting that balance right is important.
A number of executives talked to me about having both a direct model and an indirect model. The direct model can serve some of those niche use cases that you cannot necessarily address with a tech stack that's built for the masses. But then having an indirect capability to help with some of those more simple use cases can potentially provide a pipeline of relationships.
Where bank-owned technology is headed
John Bearden, Chief Banking Officer, Thread Bank: If I go back to the founding of Thread in the spring of 2021, we recapitalized a small bank. We had this vision right from day one of providing embedded banking or embedded financial solutions to small businesses -- that was the core of what Thread was meant to be. And initially, we thought we're going to build our own tech. Or, we're going to build at least an integration layer above the core and plug in the required vendors to serve small businesses.
Then we got into the space and got in the business and quickly learned about middleware providers. The evolution of our thinking has led us to come to the conclusion that we want to refrain from building as much tech as possible. We want to really let the experts do that and partner with the good technology companies that they can provide best in class, world class technology.
This goes back to you what a lot of banks struggle with today: the legacy technology from the Core Three. They're all great companies, huge market caps -- they've obviously done very well. And they've been very acquisitive over time. But I think when you look at what the market requires today, it requires innovative, entrepreneurial minded fintechs that are developing software solutions that are specific to industries where they're solving a problem within a specific industry, and then plugging in banking products and services is just part of that solution. We think that is the future. So, at Thread, we're not going to go out and build that technology to serve different industries where we're solving a particular problem for different industries, but we're going to partner with companies that do and then have the infrastructure to be able to scale with those opportunities.
We want to create a stack where we can serve either fintech or direct customers with similar technology. One of the primary concerns we continue to hear about is this concept of a living will. What the regulators mean by that is if the fintech fails to raise additional money and they go out of business, what is the bank going to do with all these customers? At Thread, and I'm sure many of our peer banks are trying to achieve this as well, we want to have a tech stack where we can serve those customers and provide many of the same services, many of the same integrations with their ERP, whether it's AP or AR, working capital, software solutions, working with QuickBooks, Xero, etc. Being able to provide access to FedNow real time payments -- all the things end users are looking for through through their fintech relationships, we can be able to provide those directly, should that date come.
That's certainly not something that we want to happen, but as a backup, it helps us prepare for the future and also have a direct offering from Thread based on the technology we're developing with our work.
John Bearden, Chief Banking Officer, Thread Bank: We want to land and expand. We want to start with the core base banking products, deposits, then go to loans, then look at payments, and then partner with other vertical SaaS companies to solve solutions, whether we're wrapping around their software or vice versa. We want to be able to provide those solutions to to the SMBs that need both banking and software solutions.
Sarah Howell, Head of Partnerships at Infinant: Honestly, I think that's a phenomenal strategy. That's kind of the whole premise for the whole Infinant platform: we wanted to be able to make the bank platform. Whether you're embedding in your direct customers some non traditional financial services and some SaaS tech solutions or you're exposing out embedded finance capabilities, it doesn't matter with a platform banking model, you can embed in or you can embed out.
John Bearden, Chief Banking Officer, Thread Bank: I think what's different about Banking as a Service, as a revenue model, relative to brick and mortar banks, is that it allows the bank to partner within tech companies that are acquiring customers. So it lowers your customer acquisition costs, it creates a very efficient way for the bank to partner with other entities to reach a much broader audience. And so, assuming that you can get comfortable from a compliance standpoint with that audience, whether it's a specific industry, SMBs, or consumers, it allows you to bank a lot of folks.
The revenue opportunity is really generating deposits. So deposits create revenue for a bank -- it's cost of goods sold. So deposits are the fuel that allow for the investment on the assets out of the balance sheet, whether it's securities or loans. All banks need deposits, and the more you can generate the better, especially if they're lower cost. So deposits are the key revenue stream.
Then you've got monthly fees. You've got interchange on just the pure deposit place, whether it's debit card, charge cards, credit cards, there's the interchange piece. There's monthly fees associated with these programs. And then we want to go beyond that and provide other banking services, whether it be lending products, credit, and then merchant acquiring to help merchants, SMBs process payments, by providing an embedded finance product. Going back to this bundling concept, taking what you would normally get from going to a very large bank, and you want all these services as a small business, we want to be able to provide those through an embedded financial service offering.
So there's obviously fees and interchange on the acquiring side, as well. So it opens the door to a lot of different revenue streams, while keeping your customer acquisition costs very low. The flip side of that is the bank is investing heavily in compliance and operational support. So unlike a brick and mortar that may have far fewer BSA and AML officers, far fewer compliance officers, a bank like Thread or any other bank has to invest heavily in the infrastructure to be able to support these partnerships and work with these different fintechs to make sure that we're exporting all of the regulatory compliance requirements to our partners.
Banks: Build, buy, or partner?
John Bearden, Chief Banking Officer, Thread Bank: From the very get go, we talked about just trying to find the right opportunities where we can own the tech where it's bespoke and unique to Thread. And then whether we can sell that to other community banks that are looking for those solutions, or potentially to fintechs directly, as well.
How BaaS aligns with end customer needs
Kate Drew, Director of Research, CCG Catalyst Consulting Group: I think the way that customer expectations are changing and being set is happening first outside of banking. We talk about this all the time: it's happening in areas like ecommerce and on demand delivery of everything. We have struggled to really translate that into financial services. We've been talking about it for years and we have little bits and pieces of it here and there. Banking as a Service probably represents the most clear trajectory towards that. But we're definitely not there yet.
What it promises, though, is to bring into reality the ability to consume financial services at the point of need. To be able to access a loan product within an ecommerce checkout flow, for example, where I don't have to take a second step. And at that point, we'll really start to see the Amazonification of banking, but we've been talking about that for a very long time. It does still feel like we're very much on a journey to a point somewhere in the future.
Sarah Howell, Head of Partnerships at Infinant: A lot of us have very fragmented financial lives -- as business owners, you can have two or three commercial banks. And then as an end customer, you can have multiple financial relationships, some are direct with banks, and others are through an embedded finance model, like Venmo or Cash App. All of that fragmentation happening at the end user level will continue to still be evolving, which is good news for the industry and more opportunities for more banks to get into the BaaS model. Yeah,
John Bearden, Chief Banking Officer, Thread Bank: I would agree with all those comments. I think we're still in the early days. I mean, there's certainly been some early movers, and we're learning from the early movers in continuing to improve and work with our regulators. There's a lot of education that still needs to occur on that front.
I saw an interesting report that Cornerstone Advisors put out earlier this year: 47% of new checking accounts opened in 2023, through the second quarter, were opened through digital banks or fintechs. So 47% of accounts were not opened at a traditional bank. And then secondly, 72% of checking accounts open in 23, through the first six months, were opened by Gen Zers or Millennials. So if you start to look at the younger generations coming through and growing up and starting to take over businesses, this is what they're used to. They're going to be driving the marketplace, and they're going to require better products and services through technology.
I don't think you have that loyalty to the brick and mortar banks that you may see with the Baby Boomer generation, even the Gen Xers. This movement is here to stay. It's going to be a journey to continue to improve the way we do it, the way we interact with our regulators to make sure that there's proper oversight and safety and soundness of these different partnerships.