The Pros and Cons of Embedded Finance

There are roughly 200K emotional support animals registered within the US, according to the National Service Animal Registry. One of the most unusual emotional support animals is Wally Gator, a six-foot-long emotional support alligator. Wally’s owner, Joie Henney, relies on Wally as an alternative to depression medication. But Wally, who boasts more than 145K followers on social media, recently went missing during a visit to Georgia. News of Wally’s disappearance has spurred criticism due to the obvious risks of having such a wild animal as a pet. While the dangers of a pet alligator are fairly obvious, sometimes risks are more nuanced and subjective — which is the case with the banking industry’s embracement of embedded finance. The Appeal Embedded finance provides financial institutions a new source of revenue by enabling them to use application programming interfaces (APIs) to deliver financial products and services through nonfinancial offerings. With online and mobile app purchases now commonplace, embedded finance is an area that financial institutions should not ignore. Research from McKinsey & Company already values embedded finance offerings at $20B. The benefits are twofold. For financial institutions, embedded finance offers a way to strengthen ties to small- and medium-sized business (SMB) customers. Embedded banking can help enhance their payment options for SMB customers in a simple, secure way that also makes cash flow management easier. It is also a way for financial institutions to expand their distribution reach with minimal additional costs. Partnering with third-party marketplaces and software platforms provides access to countless small businesses and their customers. For retailers, such services are a means to provide customers access to the online and mobile payment options that they have become accustomed to, along with value-added services like the ability to track trends, buying behavior, and even rewards programs — without the need to install expensive payment systems. Risky Business The benefits of embedded finance and the extended distribution reach it provides make this integrated banking tool something that financial institutions cannot afford to ignore, but implementing it is not without risk. Embedded finance removes the direct relationship financial institutions currently have with customers, opening them to the possibility of being viewed as commodities interchangeable with their competitors. Limited control of distribution channels, coupled with enhanced banking activity among fintechs, also means the possibility of losing customers to these organizations. According to McKinsey, a financial institution’s size, distribution footprint, and the diversity of its product portfolio are major factors in the extent of risk that embedded finance poses. The smaller the financial institution, the lower the risks of cannibalization, but the greater the difficulty of adhering to things such as Know Your Customer (KYC) requirements. Getting the most out of embedded finance offerings necessitates revisiting the way organizations approach risk, operations, and technology and makes partnerships a more attractive avenue than building such capabilities internally for smaller organizations. As more and more nonbank organizations target banking customers, incorporating embedded finance could help financial institutions stay competitive, retain their customer base, and extend their reach. But those who do want to explore embedded finance will need to carefully assess both the risks and the benefits of doing so before they take the plunge.