EXCLUSIVE: “The €60 billion missed opportunity” – Albion Murati, McKinsey & Company ‘The Fintech Magazine’

Albion Murati, a Partner at McKinsey & Company and a leader in its Financial Services and Payments Practices, told TFM why embedded finance still has a long way to go

Embedded finance is the ultimate shopping experience, one where you can not only buy, but also optimise your borrowing, the delivery of your goods, even insure them, and all in that one, simple customer journey. More and more non-financial companies, such as merchants and marketplaces, are looking to integrate financial services into that journey. They see it as a way of building stronger relationships, trust and loyalty, with customers but also to increase the lifetime value of those customers.

There have been two fundamental enablers for them to do this. On the one hand, is regulation. Open banking and Europe’s revised Payment Services Directive (PSD2) forced access to data and made a lot of banking players think hard about how they were going to expose their services to third parties. And then we have a new tech paradigm, giving providers the ability to build modular components, hosted on the Cloud, and delivered through APIs. Now COVID has brought embedded finance to a tipping point by rapidly accelerating three trends.

One is consumer demand for digital financial services. We’ve seen growth rates in the number of digitally active customers doubling over the last few years, so that now roughly 55 per cent of all consumers globally are digitally active banking customers. The same trajectory can be seen for the sale of financial products; roughly a third of banking products nowadays are bought online.

The second trend is that fintechs have been gaining a lot of momentum. While that’s been true for the past five or 10 years, the most recent statistics are quite remarkable. For example, customer adoption of fintech services has radically increased. In the US, in a recent survey conducted by McKinsey, we found that 44 per cent of customers now have an active account with a fintech of some kind. And it’s not just consumers who are showing an interest; the investment community is putting record amounts of money into the fintech sector. In 2021, around €100billion of VC money was invested in these types of company; that compares to a previous annual average of around €40billion. Investors clearly believe there will be a market share shift, away from more traditional models, to new services, enabled by fintechs.

The third fundamental change that came with COVID, the one everyone is familiar with, is the digitisation of commerce. It’s not that just e-commerce penetration has increased; the more interesting fact is that we’ve seen new categories moving to digital commerce. Even the art world is moving to marketplaces and platforms.

As new verticals like this shift to digital sales, it will unlock new opportunities for embedded finance. And that will really challenge the status quo. So, are banks and payment businesses ready to take on these new opportunities and challenges?

We’ve seen some progress. To a greater or lesser extent, everyone, over the last few years, has had to renew their IT landscape, and, in many parts of the world, they’ve had to comply with a regulatory requirement to open up access to data. But while we estimate that the revenue pool for embedded finance could be €60billion globally, with the potential to grow tenfold over the next decade, today, the sum of the revenues generated by all the players – banks and fintechs – active in this segment, amounts to only a fraction of that. In Europe, we’ve seen ING strike up a partnership with Amazon to provide SME lending. In the US, Citi, JP Morgan, and Goldman Sachs have been making similar plays, as have some of the payment fintechs, most notably Stripe. But, while the opportunity is huge, it is still largely untapped. Ultimately, a big portion of financial services could be accessed through embedded finance/API-based banking, but for that to become a reality, two things need to happen.

Firstly, you need new technology and new capabilities, and that’s not only modular services that you distribute through APIs. You also need to build strong risk and compliance; management capabilities that can operate in real time. Because, as the embedded finance partner to a non-bank, you’ll find they expect you not just to provide better financial products that they can embed in their journeys; they’ll also expect you to take care of all the risks that come with providing that product. This is where the banks should have a stronghold – but they have not built the products yet. On the other hand, fintech and payment players are starting to build the products, but don’t always have the balance sheet or risk management capabilities that will also be required.

The second thing that needs to happen is for banks to fundamentally rethink their business model, because more than 50 per cent of banking revenues are linked to distribution, and, with embedded finance that is, ultimately, what you’re giving away. There is a risk that banks could just end up as utilities, where they control the balance sheet, but not much more. Banks will need to build new distribution capabilities, adopting a B2B2C, or B2B2B go-to-market approach. In other words, they are no longer optimising for serving the end consumer and merchant, but serving these ecosystems, merchants, or marketplaces that can give them access to that customer base.

There are big benefits that accrue from this new model. Banks can massively lower their cost of acquisition, by leveraging the access that some of these platforms can bring. Banks can also leverage nonbank data from their partner, to, for example, make better credit decisions. In many other disruptions that we have seen in financial services, banks have struggled to gain the upper hand. But that’s not the obvious outcome from the disruption that we see within the embedded finance market, because, to be a truly effective player, you need to combine banking-as-a-service (BaaS) software or service capabilities (that’s a modular product, in a Cloud-based environment, accessed in a very easy and convenient way, that is easy to integrate) with very strong, classical banking, balance sheet, funding, and risk management capabilities.

Three categories of player are already emerging. There is the pure BaaS fintech, or infrastructure player, which provides very strong product components to a merchant or marketplace, but does not want to take on any of the risk in embedding a financial product. Then you have the banks. And, lastly, a provider (bank or fintech) that combines both. An example of the latter is Affirm, which delivers a buy-now-pay-later offering for, among others, Peloton, Walmart, and Amazon. It also takes full control and ownership of managing the balance sheet on behalf of the merchant. Another example in the B2B2B space would be Banking Circle, which is building an ecosystem of offerings to enable payment players to integrate payments and merchant financing solutions, while also being a regulated bank.

We will probably also see partnerships between pure BaaS services players and banks to meet the needs of merchants, marketplaces, and ecosystems.

Identifying opportunity

The embedded finance industry is still developing, but there are some clear gaps in service that need to be filled. Merchants tell us that is still hard to find one partner to solve a use case in the same way across multiple geographies. They can find, for example, a card-issuer that will give them a fantastic proposition in the big European markets or UK/US, but it’s really hard to get that same provider delivering a solution in France, where there might be local card schemes operating, or local requirements. Similarly, it’s difficult to find one buy-now-pay-later provider across markets. Another problem merchants have is finding one partner to take care of all their financial offerings: most face a choice between a bank, where they at least they have zero financial responsibility, and a more nimble player with better products.

In the main, it’s the more simple products, providing end-to-end automated experiences, embedded into broader customer journeys – payments, financing, accounts, treasury management – that are seen as very good candidates for embedded finance. Daily consumer lending, for example, naturally provides a much better customer experience if it’s embedded into an e-commerce journey, rather than residing in your mobile bank.

And this is a reality that we’re all accepting: your bank won’t necessarily be intermediating the relationship. That will result in a natural fragmentation of financial services, where a number of products will be orchestrated by embedded finance ecosystems, a number will be served by more vertical specialists, and we’ll still see a number of services orchestrated by banks.

Today, embedded finance is still very much limited to digital ecosystems around e-commerce and online marketplaces. Going forward, I expect to see it being integrated in other ecosystems, too – social media, travel and hospitality, energy, health and others. And there are technologies on the horizon that will start to play a bigger part – we’re already hearing about use cases developed on the back of IoT. The future of embedded finance is a fundamentally new way of delivering and integrating banking services through new customer journeys. And those journeys have only just begun.

This article was published in The Fintech Magazine #23, Page 53-54