The Concept of Banking-as-a-Service (BaaS)

Throughout this course, we’ve seen that incumbent financial institutions like the banks that traditionally provide capital to the vast majority of the population, have seen their businesses threatened on both the debt and equity fundraising fronts by new technology driven platforms that aim to bypass them, be it online lending, crowdfunding, or blockchain. In this module, we shift our focus from the challengers back to the incumbents and look at some strategies that incumbents could leverage to turn these threats into opportunities. As an exercise, I’d like you to reflect on what we talked about during this course and put yourself in the position of an incumbent bank like this full-service bank that we looked at in the series introduction.

You’ve now seen threats come in at all fronts consumer lending, business lending, investment banking and equities, and even deposit accounts. There are new platforms both regular and crypto-based and new technology showing up every day. On top of that, they’re now the so-called neobanks, which are fully digitized, fully branchless banks that specialize in a smaller segment of traditional banking functions, like only consumer lending and consumer deposits, or only business lending and payments. Examples, like Startling, N26 and Munzo, mostly from Europe are more nimble, have lower costs of operation and are poised to steal a large chunk of the younger more tech savvy customer base. So if you are the CEO of the incumbent bank, what will you do?

How do you go about addressing these threats? If you look at the history of competition, there are generally three ways that incumbents deal with threats of new entrants, with varying degrees of success. You can try to fight them, buy them or coexist with them. Particularly in the segment of creditech and fintech in general, as an incumbent bank fighting means really taken advantage of the barriers of entry that you already have, like the banking licenses and maybe try to lobby the regulators to create some new barriers as well. Buying the new entrants is another option which actually some banks like Goldman, Sachs and JP Morgan are pretty actively doing.

This means purchasing the innovators out right and try to either incorporate them into your own existing product portfolio or just shutting them down all together. The third option is to co-exist either waiting to see how the hype cycle would go, or maybe actively trying to find some ways to work with the challengers to grow the business together. And this option is the one that I’d like to talk about in this module, as it opens a really important concept called banking as a service or BaaS, which will see a lot more in the industry in the near future. And to see how BaaS could be done, I’ll go back in history and talk about well, not a bank but Amazon.

In the mid-2000s Amazon was already a dominant retailer. It had a good platform, good sales team, good logistics network, and a very solid tech infrastructure to support the enormous computational needs of these front-end functions. However, challengers rapidly entering the online retail space. Similar to the banking industry, you’re seeing more specialized more nimble players like Instacart, Gilt, Groupon, etc., coming in and try to wrestle away some customer segments from Amazon. So during that time Amazon was faced with a really tough decision, fight or accommodate. And what Amazon did next, it redefined the entire company and to some degree the entire industry.

To shed light on Amazon’s decision, I’d like to borrow a concept from choleric at Wharton, the concept of alpha assets. An alpha acid is a unique key component of the company that is number one hard to replicate, and number two give the company an unique competitive advantage. Around 2005/2006, when faced with the newly emerged challengers, the folks Amazon spent some time thinking about what Amazon’s alpha assets are, and what do you think? Well, it’s not the platform’s website, anybody can build that, it’s not the logistics network either because you can simply pay UPS more to deliver your packages faster.

If you think about it, it’s really the IT infrastructure, the back-end computing resources that enabled millions of transactions to happen simultaneously, as well as the host of software like optimization algorithms that route different transactions to the best warehouses for delivery, and the shear hardware to run these complex computational tasks with a lot of slack to spare. At the end of the day, it’s really the ability to compute faster that gave Amazon it’s edge. And this is really tough to replicate, and once you realize this Amazon’s decision will become clear. In 2006 Amazon Web Services, the AWS, was born.

It was Amazon’s Cloud computer that used it’s slack resources to do all kinds of computational tasks from web hosting, to supply chain optimization. And what did Amazon do with that? Well, it gave this for free initially, to the new competing retailers. Why would it do that? Well, the rationale is that it would take a long time for the Challengers to build up this alpha asset. And by providing it to them and eventually charging them for it, Amazon can bring these challengers into a say, quote unquote ecosystem. Let them compete with each other on the front-end. Once they use AWS to support their business, the more customers they bring in, the more they will use AWS.

And once you start charging for it because the hardware investment is already made, you don’t have to charge a high price to have it good profit margin. And the challengers will be happy to continue using it because it will still be cheaper than developing all that on their own. So essentially, by sharing the AWS with the challengers, Amazon has turned it into a platform of shared growth and prosperity with them, the better they do the better AWS. This strategy has really paid off, and now Amazon is the undisputed leader in the cloud computing space. And over two-thirds of Amazon’s recent profits came from the AWS. Now, with this story mind, let’s draw the parallel for the incumbent bank.

Similar to Amazon is now facing multiple type of threats from the new fintech challengers, it’s also facing the same decision. Now, let’s think about the incumbent bank’s alpha assets. Stuff that takes a long time to build, hard to replicate, and defines the unique competitive advantage. For banks, what are these? Well, the bank is really in the business of hosting a servicing the bank accounts, and I’ve spent hundreds of years making the account services as efficient as possible, from security, fraud, and risk management, to reputation. These are the core alpha assets and it’s really hard for a new challenger to replicate.

So the key question is, could the incumbent bank somehow leverage these alpha assets to build a platform such that, instead of fighting the challengers incorporating, them into a platform of shared prosperity. This AWS-like platform is called banking as a service.