The digital bank piece in the embedded finance puzzle

WHEN paying for your ride on a ride-hailing platform, the app nudges you to round off your fare and put the extra cents into an investment product. A merchant on an e-commerce platform gets a notification that they are eligible for a loan based on their sales. These are instances of how embedded finance has crept into our lives.

On a quest for profitability, startups are inching into our online existence bearing offers of financial services via non-financial avenues - your shopping basket, your payment gateway.

Tapping on traditional banks, startups have gone on to offer everything from investments to insurance to loans. That’s not including financial services offered by companies themselves, such as payments and buy now, pay later (BNPL) facilities.

In markets like Indonesia or the Philippines where 51 per cent and 65 per cent of the population remain unbanked respectively according to a Bain and Temasek report, this could prove a lucrative opportunity. But rather than seeing embedded finance evolve to meet these needs, it seems that significant hurdles and barriers have appeared.

Embedded finance is top of mind for both traditional banks and the fintech sector, according to consultancy Bain’s South-east Asia financial services practice leader, Edy Widjaja. And the big trend for tech companies looking to further tap into this space has been in acquiring digital bank licences or even buying a traditional bank, shaking up the state of embedded finance which originated from banks or financial institutions partnering with disruptors to extend financial services.

“That’s the trend we’ve seen massively across the region in the last 18 months,” says Widjaja.

It was 2019 when the Monetary Authority of Singapore first opened the doors for digital banking licences, a process which drew 21 applications - 14 for wholesale banking and 7 for full banking licences. Four licences were given out.

Three years on, 2 of the 4 digital banks have just started operations, with Greenland Group’s Green Link Digital Bank and Ant Financial’s ANEXT bank opening their doors to register customer interest. The 2 wholesale digital banks cannot serve retail customers; instead they are focusing on small and medium enterprises.

Meanwhile, tech players Sea and Grab are readying to connect their digital banks to their own ecosystems and back ends. Sea’s Mari Bank and Grab and Singtel’s GXS Bank are the 2 remaining digital banks yet to begin operations in Singapore.

Part of the issue stems from who owns the customer.

The hurdles

The origins of embedded finance lie in traditional banks offering their financial services via non-traditional distribution channels such as platform apps like Grab. The super-app offers investment fund products by Fullerton and UOB Asset Management via its AutoInvest product.

Such partnerships have enabled access to insurance, loans and other financial products for a wider range of people. But there the question arises: Who owns the customer?

“If you wind back to even a year ago, there is always a debate. Am I helping them to eventually take away my business?” says Bain’s Widjaja.

Traditional financial players are wondering if products launched together with the tech players are just corroborating demand for tech companies to launch their own lines with their own bank. Furthermore, banks are just nominally providing the funding for some of these products, such as in Atome’s deal with Standard Chartered Bank for US$500 million in financing.

Then there’s also some lack of clarity in what traditional finance players can do with embedded finance.

“A key hurdle in embedded finance was initially lack of clarity on how licensed financial institutions can work with others to offer embedded finance,” said Michael Araneta, associate vice-president for financial insights at market research firm IDC.

This includes questions in risk management, credit decisions and key “know your customer” (KYC) issues with identity and fraud management - the key points in a life cycle of embedded finance propositions like BNPL. That’s also not taking into account questions around splitting of revenue between the traditional finance player and the distribution channel.

Then there is the issue of trust, where customers have to put their faith in the non-financial players as an intermediary of their financial transactions.

“Customers need to have the comfort that their personal information will be protected, similar to banks and other financial institutions,” says Liang Tzu-Chung, Asean financial services strategy and transactions leader at consultancy EY.

Then there’s the question of liability. There can also be some ambiguity on who is the originator of a financial product, when customers are buying it off an unrelated platform. In models where the distribution and manufacturer of a product is one and the same, should something go wrong, customers are clear on who to approach.

“Particularly as non-financial platforms do the distribution, it gets a little bit more grey, and therefore, the accountability needs to be clearer,” says Sam Kok Weng, markets and financial services leader at consultancy PwC Singapore.

Lurking in the background is the macroeconomic environment, which has stunted the growth of embedded finance. Economies moved out of a global pandemic and straight into rising inflation, making things harder for fintech startups to get funding to experiment with new business models.

“Since many of these services, such as more affordable and accessible loans and payment services, require significant rewards, subsidies, financial incentives and robust risk management systems, rich and solid funding from both public and private markets is essential,” Meng Liu, senior analyst at market research firm Forrester, tells The Business Times.

With leading platforms like Grab and GoTo having seen their hyper growth scaled back, this also poses a challenge to embedded finance in the region.

“Their platform business seems to have reached a ‘ceiling’ and it would be increasingly difficult for them to further grow. This is also reflected in their recent bad IPO (initial public offering) debut and stock share prices,” says Liu.

All of which makes owning a digital bank an attractive proposition for tech players to power their own embedded finance plays.

Buying the bank

It would seem that buying the bank would push past hurdles faced by tech players in partnering traditional banks. And many appear to subscribe to that view, judging by the flock of tech players buying stakes in Indonesian banks, and the initial 21 applicants for a Singapore digital bank licence.

“Such licences will enable technology players to extend their service offerings to customers on their platforms to include a full suite of financial services, and create a seamless ‘one-stop” customer experience on the same platform,” says EY’s Liang.

With a bank comes the opportunity to turn any loss-making payments business into sustainable ones with slim margins. There is also the trove of payment data that would aid tech players in credit scoring their customers as good or bad borrowers, and marketing products accordingly.

“Payments offer quite a lot of data about a person. If you are a person’s wallet, you can see what is going in and what comes out. That is one big source of data that tech players are interested in,” says PwC’s Kok.

Along with the licence also comes the capability to offer credit and potentially be complementary to the core business of a tech player. For example, encouraging customers to spend more on an e-commerce platform.

But it might not be as simple as plugging an acquired bank into the back end. Tech players will have to deal with essential tasks, ranging from updating the technology on the back end of a bank to cleaning up the loan book to a more manageable non-performing assets ratio.

“Some will require the acquirer to spend some time to rebuild the technology stack,” says Bain’s Widjaja.

Other factors might also dim the embedded finance efforts by tech players. The economic downturn has shrunk consumers' wallets, and will likely make consumers stick to their primary bank to reduce costs rather than try new embedded finance offerings.

“Facing decreasing spending power, fintech and tech companies will find it more difficult to scale up their embedded finance offerings,” says Forrester’s Liu.

There isn’t really an advantage of owning a bank compared to working with one, according to IDC’s Araneta, just a potential cheap source of funding for loans or potentially raising capital.

In the long run, questions about the sustainability of the business will crop up. Forrester’s Liu predicts that few of the digital banks can survive in the next 5 years, and some will cease to exist or be acquired. Higher interest rates might drive new customer growth, but retention will be tough.

“Acquiring the digital bank licences would drive some short-term customer acquisition and embedded finance early results, but won't have much sustainable positive impacts on their embedded finance efforts in the long run,” says Liu.