The new Banking as a Service reality

Banking as a Service startups emerged as a beacon of hope to neobanks and other fintechs, but reality hasn't been kind to those dreams.

Why it matters: Rather than facilitating a shift in banking, BaaS companies find themselves as M&A targets of established banks and service providers.

What's happening: A global pullback in funding, a changing customer base and increased regulatory pressure are contributing to BaaS consolidation, prompting the remaining players to shift gears.

Context: Just a few years after BaaS rose to prominence as one of the most heavily invested sectors in fintech, consolidation has taken hold.

• Fifth Third bought embedded payments platform Rize Money.
• FIS acquired BaaS startup Bond.
• Visa snapped up Brazilian banking and payments startup Pismo.

Yes, but: Not all BaaS acquisitions are created equal.

• Pismo sold for $1 billion in cash — a sizable uptick from its $400 million valuation in 2021, as was first reported by Axios.
• Meanwhile, sources say Bond was sold at a discount to its last valuation.

State of play: BaaS players are being funded at a dramatically slower pace, and the check sizes and valuations those startups can expect have drooped.

• The last nine-figure funding rounds came when Pismo raised a $108 million Series B round in October 2021, and Unit pulled in a $100 million Series C at a $1.2 billion valuation in May 2022.
• More recently, Treasury Prime raised $40 million in Series C funding in February, and Synctera scored $15 million in strategic funding in March.

Zoom out: The pivotal differences between favorable and unfavorable outcomes are more than just superior technology or a better business model.

• They're also the result of shifting market dynamics and a given startup's ability to navigate a changing customer base and regulatory pressures.

A changing customer landscape

When the market was booming, many BaaS startups assumed that early customers would be neobanks or alternative lenders looking at embedded finance as a way to get to market faster.

Flashback: "[For] the first generation of innovators, the premise ... was that there's a clear need for younger companies, especially fintech-centric companies, to get started and piggyback on their infrastructure," Accel partner Luca Bocchio says.

• "If you look across the fintech ecosystem in general, you saw a lot of overfunding of each category," Redpoint partner Medha Agarwal says.

Yes, but: Now that funding has slowed and investors are being more selective, a lot of early fintech clients are churning out.

• "A couple of years ago, when there was a lot of investment in the space, there were a lot of use cases that, from a business model perspective, were not necessarily sustainable. There's now a bit of a correction taking place," says Rodrigo Suarez, chief banking and innovation officer at Piermont Bank.
• "Pure-play fintech companies are having a harder time right now because of the cost of acquisition and overall sentiment about funding these companies," says Unit CEO Itai Damti.

Meanwhile, vertical SaaS players and enterprise software companies have begun adding financial services to their offerings, meaning a new group of customers has emerged.

• "What has changed over the years is that more and more software companies and more traditional enterprise customers are embedding financial products within their platforms," Accel's Bocchio says.
• "What we're seeing is much more deliberate use cases where someone's already built a business doing something else and they want to add banking services to it," says Synctera CEO Peter Hazlehurst. "That's much healthier in many ways, because building a neobank is quite expensive."

Details: Those enterprise businesses have different requirements from those of pure-play fintech customers of yore, and they're looking for more of a full-stack approach to the financial services they can offer.

• "We see a lot of demand for ... a full-service banking relationship with the customer and not just a checking account," Hazlehurst says. "Platforms like ours have to have the full stack, including lending, lines of credit, and maybe a charge card or a credit card."

The big picture: "It's hard to see people starting the next Chime or Mercury or Ramp," Damti says. "It's more common to see people starting companies that combine financial services with software for a specific segment."

Regulators take a closer look

As bank-fintech relationships have grown, so has regulatory scrutiny of embedded finance — and that has raised the bar for compliance in the sector.

Threat level: The possibility of a regulatory crackdown came into focus last year after the Office of the Comptroller of the Currency (OCC) entered into a consent decree with Blue Ridge Bank related to its fintech partnerships.

• That consent decree put into focus the relationship between banks and their fintech partners, as well as the lax approach some financial institutions took to managing risk around the fintech's end consumer.
• "That was kind of the whole business model: 'I'm providing my underlying infrastructure, but the rest is on [the BaaS provider] to figure it out,'" Redpoint's Agarwal says.
• "You're doing the underwriting, you're doing KYC, you're doing AML. You're doing everything else, and I'm just here to collect a toll, and it's great revenue for me," she adds.

Yes, but: "Regulators hate it because a non-regulated entity is assuming too much of the governance over how banking is done," Treasury Prime CEO Chris Dean says.

Be smart: "The regulators who are leading the agencies you should care about all came up during the 2008 crash," Dean says. "All of them were on the front lines watching that disaster happen.

• "They have this image burned into their brains of the shadow banking system, which in some ways was the cause of the 2008 problems, and they do not want that to happen on their watch," Dean adds.

The latest: In June, the FDIC, the Federal Reserve and the OCC released inter-agency guidance on how banks should manage risks around third-party relationships — i.e., their fintech partnerships.

• "Fundamentally, it's the bank's responsibility to prove the customer is who they say they are," says Synctera's Hazlehurst. "Keeping track of bad actors, but also watching for money laundering and misbehavior around moving money offshore or whatever."
• Damti, Unit's CEO, observes, "Examiners in the big agencies are starting to pay a lot more attention to how banks and fintech relationships are factored and how they are operating."

The bottom line: Increased scrutiny is raising the bar for companies operating in the space, but it's also creating a moat for those investing heavily in regulatory and compliance functions.