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By Maosen Cai

Embedded finance generally refers to financial services integrated into non-financial internet platforms such as BNPL service available as a payment option on e-commerce platforms. The nature of the partnership among banks and tech firms may have blurred the lines in terms of who is accountable for the financial services being offered.

• Banks are exposed to asymmetric risk of accountability due to over-dependency on third-party platforms
• The powers of data and algorithms are yet to be fully tested across different economic cycles for managing credit risk of embedded finance
• Banks face higher bars of scrutiny as public expectations are uneven among banks and tech firms

The rise of embedded finance in recent years has seen big tech’s expansion into financial services. Big tech firms are on track to achieve scale rapidly as they benefit enormously from their large existing customer bases and from collecting and analysing their customers’ data.

On the execution level, embedded finance is usually provisioned in the form of a partnership between big tech and banks. Banks assume the regulatory responsibilities that big techs aspire to be free from. Big tech reaps the benefits of being a bank, such as access to cheaper funding including deposits and central bank funding.

This also makes strategic sense for banks given the scale of user acquisition originating from big tech ecosystem. By doing so, however, banks step into a substantially different role than that in conventional banking services. Consequently, banks are brought to new frontiers of risks calling for more prudence and new wisdom, especially on strategy, credit and reputational risks.

Banks are exposed to asymmetric risk of accountability due to over dependency on third-party platforms

From a regulatory perspective, a buy now pay later (BNPL) service is an instalment loan ultimately issued by the bank. But for customers, banks are less visible than the internet platform facilitating user acquisition and credit assessment. In this case, the question for banks is whether they can be accountable for such loans on the balance sheet without fully owning the customer relationship and risk management process.

Accountability asymmetry of this kind could potentially induce systemic risk to the financial sector if the partnership between the bank and big tech/fintech scales up to a more dominant role in the sector. This is especially the case for community banks and credit unions. Given the relatively smaller size of these banks, concentration on partnering internet platforms could expose a significant portion of the bank’s balance sheet to adverse events arising from these platforms and beyond banks’ control. Even when these threats are not imminent, the independence and sustainability of banks are still called into question due to disproportionate exposure to third parties.

The powers of data and algorithms are yet to be fully tested to manage credit risk

Despite market differences, lending is one natural extension of embedded finance, a space where tech firms like to boost their risk management capabilities upon big data and proprietary algorithms.

Ant Group, known for financial services embedded into Alibaba ecosystem, a Chinese e-commerce giant disclosed in its 2020 initial public offering (IPO) prospectus that it facilitated RMB 2,154 billion ($333.1 billion) worth of loans as of 30 June 2020, which is equivalent to 1.53% of total outstanding loans of China’s banking industry. Unlike other loans by banks, these are mostly unsecured loans but turns out to perform no worse and sometimes even slightly better than the banking industry average.

Credit quality performance above was quoted in Ant Group’s IPO prospectus to evidence the effectiveness of its risk management. Arguably, this can also be attributed to, at least to some extent, the sizeable unserved or underserved credit demand in China. One way to understand this impact is to look at credit registry coverage as a proxy for existing credit service penetration by banks.
According to World Bank statistics, credit registry coverage was 30.2% for China versus 100% for the US in 2013 (the year before Ant Group launched credit services). This offers two implications. Chinese tech firms like Ant Group can start with an untapped and larger market share of 69.8% while banks, due to reliance on credit registry data for underwriting, would focus on the smaller 30.2% market share.

Secondly, the sheer size of untapped customers creates greater potential for Chinese tech firms to employ big data and proprietary algorithms in identifying “good” customers among the population, than if they would in a crowded market already well served by banks.

 

These gaps may not last for long. Previously untapped population can gradually get covered in credit registry data when their credit performance is also reported by embedded finance platforms to centralised credit bureaus. By then, embedded finance platforms and banks would be on a more level playing field for the power of proprietary data and algorithms to be validated through different economic cycles.

Banks face higher bars of scrutiny as public expectations are uneven among banks and tech firms

Customers have higher expectations on licensed financial institutions like banks than on a tech firm.

Based on these expectations, when customer dissatisfaction is encountered in an embedded finance context, a complaint is more likely to be geared towards the banks involved rather than the tech firms. This can become even worse when disgruntled customers spread negative word-of-mouth across social media.

In 2019, Goldman Sachs was accused of discriminatory behaviour in its credit card services for Apple users (i.e. Apple Card), where some Apple Card customers claimed they received longer lines of credit while others did not. In follow-up, allegations that this is gender-based began appearing on social media and later got reported by mainstream media. Though Apple Card was co-developed with Apple, Goldman Sachs, as the licensed card issuer, seemingly took a bigger share of the blame.      

Embedded finance platforms to date are nowhere near replacing the role banks play today, nor are they willing to do so given the regulatory burden of being a bank. But banks would nonetheless be better positioned for the future if they are well-informed and organised to embrace embedded finance.

 

Maosen Cai is the head of audit analytics at WeBank, one of the digital-only banks in China.

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Keywords: Embedded Finance, Digital Bank, Big Tech, BNPL, Credit Registry, Data

embedded finance, digital bank, big tech, BNPL, credit registry, Data

Institution: Ant Group, Alibaba, Goldman Sachs, Apple, World Bank
Country: China, US

Guest: Maosen Cai

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