Embedded finance: The choices and trade-offs for US banks

Embedded finance: The choices and trade-offs for US banks

Over the past several years, major brands and tech platforms have partnered with banks to launch embedded-finance products that enrich their value and customer experience. For example, the restaurant management software platform Toast, in partnership with WebBank, launched merchant cash advance to offer short-term liquidity informed by card receivables data. Uber partnered with Evolve Bank & Trust and the accelerated pay company Branch to launch a debit Mastercard that allows drivers to get paid faster and earn rewards on fuel purchases. And several airlines have partnered with the buy-now-pay-later (BNPL) service Uplift and CBW Bank, to offer customers installment loans for flight purchases.

These are just a few products that contribute to embedded finance in the United States, which McKinsey research has determined to be worth $20 billion. In an earlier article, we defined embedded finance (EF) as the delivery of financial products, such as loans, insurance, and payments, by nonfinancial entities within the context of a broader nonfinancial offering. We outlined the emergence of embedded finance, the trends driving its double-digit growth, the ecosystem of players, and the opportunities we saw for firms to differentiate themselves.

At first glance, embedded finance offers banks an attractive opportunity to expand their distribution footprint with relatively low operating expenses. To lower the overhead typically required to sell and service financial services, banks can partner with software platforms, marketplaces, and retailers that directly access thousands of small businesses and millions of consumers.

However, EF also poses significant risks for many banks. Often banks must relinquish direct relationships with customers, so they run the risk of commoditization. Cannibalization of core products also is possible because banks have limited control over the distribution channels, which might include existing and prospective customers. These risks were minimal in early EF use cases, which primarily targeted underbanked consumers, such as those with neobank accounts and higher credit risk under traditional underwriting methods. However, in the past year, larger enterprises and technology platforms have offered a broader range of financial products to target customer segments more traditionally served by legacy banks.

Thus, incumbent financial institutions face a decision: to opt out of EF and cede market share to insurgent partnerships or to participate and give up revenue to their partners. To help banks weigh the pros and cons, this article looks at the various roles banks can play in EF and explores trade-offs and strategic postures to consider.

Different bank archetypes face different trade-offs

The risks and opportunities of EF differ depending on a bank’s size, distribution footprint, breadth of customer base, and product portfolio. It can be helpful to consider these variables in terms of three bank archetypes.

Durbin-exempt banks

Banks with less than $10 billion in assets have a structural advantage relative to their peers: the Durbin Amendment to the 2010 Dodd-Frank Act lets them charge higher interchange rates on debit transactions, which helps them outbid larger banks for EF distribution partnerships. As a result, many small banks (for example, Evolve Bank & Trust, which has $1.4 billion in assets) are the engine behind many checking-account-oriented fintechs and neobanks, such as Dave, Mercury, and Wise.

However, competing in embedded finance as a small bank can be challenging. Unlocking fully embedded use cases demands end-to-end digitized financial product journeys, such as account opening and know-your-customer, that are beyond many small banks’ tech stacks and capabilities. Moreover, the $10 billion ceiling for the Durbin exemption can cap the return on a transformative technology upgrade.

For small banks, EF can be a distribution multiplier with minimal risk of cannibalizing existing customers. But taking advantage of this opportunity requires rethinking technology, risk, and operations. Banks might solve this through partnerships and aggregators rather than internal builds. Still, the relative simplicity of basic deposit and debit products and the number of Durbin-exempt financial institutions—more than 9, 300 in the United States, or 95 percent of all US financial institutions —could commoditize this offering. Specialization (in lending products or risk services, for instance) and differentiation (perhaps in technology infrastructure or customizable compliance processes) through application programming interfaces can help small banks stand out.

Regional and segment specialist banks

Larger banks that compete in markets that are bounded—by geography, for example—have more opportunities. Because the risk of cannibalization is low outside their core markets, these banks display a greater appetite for trying to reach customers through embedded finance. With greater scale than the Durbin-exempt banks, they have more opportunities to invest in proprietary technology and can use their niche expertise to offer distinctive EF solutions.

For example, Citizens Bank, a regional bank in the Northeast, started its embedded-finance journey by providing installment loans to finance iPhone purchases from Apple, which gave it a diversified national consumer lending base. It extended that infrastructure to deliver on-demand installment finance to other e-commerce merchants, and now competes head-to-head with Affirm and other fintechs.

More broadly, commercially oriented banks can comfortably unlock EF use cases on the retail side, and those catering to midmarket and large enterprises can extend their offerings to small and medium-size enterprises (SMEs). Regional and segment-specific banks can generate incremental revenue with little downside by serving customers they would otherwise be unable to reach and those requiring a more comprehensive bundle of services. Their scale allows them to absorb the capital costs and fund the necessary expertise to serve niche segments and products through internal development, partnership, or acquisition.

Large, diversified banks

The country’s largest banks with diversified offerings and broad footprints face the biggest challenge in embedded finance. Cost structures and regulatory constraints made these banks less attractive partners for early EF use cases centered on deposits, savings, and debit interchange, and at their scale, almost any distribution partnership risks cannibalization.

However, the next wave of embedded finance will likely present an opportunity for larger banks. First, as EF players shift attention toward credit and lending use cases, they may increasingly value partners with hefty balance sheets, low cost of funds, and strong risk and regulatory controls. Amazon’s decades-long credit card partnership with Chase is an example; few banks have a balance sheet large enough to underwrite Amazon’s transaction volume.

Second, many large banks have niches within their product portfolio that they can transform into targeted EF propositions for distribution through third parties. HSBC, for example, recently partnered with the B2B fintech platform Tradeshift and with the digital logistics company FreightAmigo. Though HSBC is not among the largest banks in the United States, it is one of the largest globally and plays a major role in trade financing. Its strength in that area positions HSBC to develop trade finance products and distribute them at scale in third-party marketplaces and software platforms while maintaining its reputation as a leader in this space.

The largest, most diversified banks will likely face the highest cannibalization risk from third-party distribution. But where they can leverage differentiating capabilities, such as at-scale lending and credit or specialized areas of their product portfolio, the increased share may outweigh the margin loss.

Six strategic embedded-finance postures

In the face of embedded finance’s opportunities and challenges, banks may want to consider adopting one of six postures. The trade-offs facing each archetype will help banks narrow the choices (exhibit).

Embedded finance: The choices and trade-offs for US banks

Deliver EF-like experiences in-house

Embedded finance has raised the bar on customer experience in banking. Larger banks may opt to integrate the lessons of EF into their own banking experiences. Already, some are launching “challenger banks” to pursue clients with digital-led, EF-inspired offerings in segments where their current brand or operating model has less traction.

For example, Key Bank launched Laurel Road, a digital platform for healthcare professionals; its anchor product is student loan refinancing. Similarly, American Express’s Plan It option allows cardholders to pay for a standard credit card purchase with an installment loan repayment plan, mirroring popular BNPL offerings from would-be credit card disruptors.

These are not true examples of embedded finance, because they do not embed financial services in nonfinancial product journeys, but they are a viable competitive response. Part of what makes EF products appealing to customers is the tailored features and streamlined user experiences they offer. Mimicking these characteristics in an in-house challenger product reduces these points of differentiation. That said, an in-house product does not address EF’s primary advantage of bringing financial products to customers when and where they need them most.

Not every bank will succeed in replicating the customer experience of embedded finance. Still, the competitive environment is likely to motivate most to adapt EF’s lessons to enhance their customer experiences.

Acquire or build a distributor

Many fintech software players have made direct strides into banking: Square got a banking license in 2021, SoFi acquired Golden Pacific Bancorp in 2022, and Twitter Payments received its first state money transmitter license in June 2023. For the largest banks, a move in the opposite direction—building or purchasing a software player to distribute the bank’s financial products—might be appealing.

M&T’s Nota software is an example. Nota helps lawyers track and manage their clients’ funds and integrates with their practice management software. The bank has partnered with the Florida Bar Association to distribute Nota to its members. JPMorgan Chase acquired InstaMed in 2019 to provide a similar service to doctors’ offices.

Because of the capital required to build or acquire software to reach new customers, we expect this strategy to become more common among regional and national banks. The attractive economics of end-customer relationships will likely inspire some banks to seek growth this way. However, the cultural tension between risk-conscious banks and risk-seeking software start-ups may limit how many take it up.

Strategically partner with large enterprises

Many nonbank distribution partners, including major retail brands and other large employers with lower levels of financial and digital experience, see the benefits to their core business and the opportunity for new revenue streams from embedded finance. But they also recognize the significant operating complexity and risk in designing and distributing financial products. At-scale banks hold a competitive edge in the trust they built from blue-chip players, existing commercial relationships, and their ability to manage risk and regulatory compliance at scale.

These banks can differentiate themselves by building turnkey EF products, such as payroll, employee checking, earned-wage access, B2B payments, and CFO suite software. Embedded finance may soon become another off-the-shelf product, like financial management, that banks can offer to treasurers and CFOs.

Partnering with large enterprises may be the most likely approach for regional, segment-specific, and national banks. In the medium term, some commercial banks may differentiate by offering embedded finance as another commercial banking service. Although this poses some risk of cannibalization—for instance, distributing a checking account to an enterprise client employee who is already a bank customer—the distribution advantages and deeper commercial bank relationships will likely outweigh the costs.

Strategically partner with ISVs and marketplaces

Independent software vendors (ISVs) and marketplaces have led EF adoption for the past several years. Many of the largest, such as Shopify and Toast (ISVs) or Expedia and Etsy (marketplaces), offer various financial products on their platforms, including checking accounts, credit cards, and lending (mainly via merchant cash advances) through bank partnerships. Shopify has partnered with the payment facilitator Stripe and bank partners to include many of these products in its merchant dashboards, creating a customer experience that is different from that of traditional banking. With Stripe providing an EF platform for multiple players and other companies like FIS, Adyen, and Fiserv also developing payment infrastructures capabilities, ISVs and marketplaces will probably remain at the forefront of EF adoption.

For banks, ISV and marketplace partnerships present the highest risk of commoditization because of the many potential partners sitting between the bank and the merchant. ISVs, marketplaces, and payment intermediaries may seek multiple bank partners, offering deposit and lending products to the highest bidder, thereby squeezing bank margins. Banks will probably counter this trend by enriching their offerings with product, sales, and risk services to ISV and marketplace partners. Experts from the bank would work directly with an ISV to design attractive risk-controlled products and help create prospecting strategies and marketing materials to attract desirable customers in a compliant manner.

Partnering with ISVs and marketplaces may be a likely approach for regional and segment-specific national banks. The risk of commoditization will probably be too high for larger banks. And smaller banks may not have the resources to provide the level of product, sales, and risk service that at-scale banks can deliver; they may be more content to strengthen their balance sheets with low-priced deposit and lending opportunities. But in the middle, a few regional and segment-specific banks may forge strategic partnerships to deliver differentiated services and capture new SME markets.

Specialize in lending as a service

Many banks have expertise in particular lending products, from underwriting to compliance to servicing, and within specific verticals, but lack the distribution to reach every customer who could benefit from them. Fortunately, many distribution partners—particularly vertical-specific, software-as-a-service vendors such as Mindbody and Square—have at-scale access to customers with similar niche lending needs. Banks of any size with a unique product or vertical proficiency, or the wherewithal to build it, could use embedded finance to earn a potentially higher return with relatively low operating expenses.

For example, New Jersey–based Cross River Bank has played this role in BNPL and other forms of purchase-linked finance. It built credit underwriting capabilities and risk controls to orchestrate partner credit models that could serve the fast-growing fintech lending niche. The expertise it gained provided Cross River a competitive edge in serving a generation of lending-based fintechs.

The opportunity will likely be limited for smaller banks with fewer investment dollars and a smaller balance sheet, but Cross River has shown it is possible. Larger banks have many of the assets for niche lending within their existing teams and systems, and they may find lending specialization the most accessible way to engage with embedded finance.

Offer balance sheet and risk services

Banks that don’t have the investment capacity to participate in EF’s distribution opportunity can leverage banking-as-a-service (BaaS) platforms. Existing examples include Treasury Prime, Unit, and Bond. These platforms can already distribute deposit and lending products through their nonbank distribution channels; the banks get access to new revenue streams, and the BaaS platforms expand the deposit and lending capacity available to distribution partners. This marketplace model, supplied by a portfolio of banks, allows smaller banks to participate in embedded finance without major investments in IT.

While there will likely continue to be a market for large and midsize banks to play a sponsorship role, the balance sheet and risk services approach may be most attractive for small banks, especially those seeking to leverage BaaS platforms that offer a capital-light approach to entering embedded finance. In contrast, larger banks face two obstacles to joining these platforms. First, the standardization of products limits the extent to which larger banks can leverage their unique expertise, and second, the availability of Durbin-exempt banks on the platforms limits the attractiveness of larger banks as partners. As a result, this could be a strategy that investment- and deposit-constrained Durbin-exempt banks will pursue to broaden their deposit base.

Banks are at a strategic crossroads. Until recently, embedded finance primarily served costly and riskier customer segments. But with nonbank insurgents gradually moving upmarket to target core banking segments, incumbents must choose how to respond or risk losing market share. Customers want to bank online through nonbank channels. Banks that can help them do so could generate growth with embedded finance.