Many banking-as-a-service providers produced first-quarter profitability metrics that were better than the banking industry median for return on average assets, net interest margin and efficiency ratio.

Of the 18 select banks that offer banking-as-a-service, or BaaS, 13 banks generated higher ROAA as of the first quarter than the industry median of 0.87%, and 13 had higher NIM than the industry median of 3.00%, according to data compiled by S&P Global Market Intelligence. Twelve had a lower efficiency ratio than the industry median of 67.96%, meaning that these banks were able to generate higher net revenues with lower noninterest expenses.

The analysis included institutions that industry sources said are among the most well-known for providing BaaS. Banking-as-a-service typically refers to chartered banks providing depository, lending or payment services to nonbanks who would not have the authority to provide such services directly to their end customers. In this way, banks offer their specialty in funding, regulatory compliance and risk management, so that financial technology companies can skip the hassle of building a bank and focus on technology, product development and customer engagement.

The trend of embedded finance — companies adding financial solutions into their offerings — will continue to attract more banks and fintechs to BaaS.

"I think there's absolutely huge opportunity and demand for this because consumers are expressing huge interest in getting financial-related type of services from nontraditional players," said Ron Shevlin, chief research officer at Cornerstone Advisors.

No one BaaS model fits all

Although all the select banks are typically categorized as BaaS providers, their profitability metrics are dispersed on a broad spectrum depending on variables such as whether they focus on payment processing, credit cards, being the lender of record or providing federally insured deposits; whether they are native to a BaaS model; and the external competitive dynamics in their niches.

"You can't define banking-as-a-service as one product," said David Sandler, co-head of investment banking in the financial services group at Piper Sandler Cos. "There are several different legs to that stool."

Banks cannot assess BaaS opportunities in a generic way, Shevlin noted. Each of the banks has their own niche based on the bank's choice of growth areas, the risk appetite and their competitive advantage in regulatory compliance and the balance sheet. For instance, fintechs often turn to Bancorp Bank, MetaBank NA and Green Dot Corp. to add payments features or stored value cards. WebBank, Celtic Bank Corp. and Cross River Bank bolster fintech loan originators with their balance sheets.

The metrics of Cross River particularly demonstrated the strength of a successful, scaled BaaS provider, said David Jegen, managing partner of venture capital fund F Prime Inc., which does business as F-Prime Capital.

"[What] it comes back down to, is the bank fully committed to a new business model," Jegen said.

Barriers to entry

Several of the BaaS banks specializing in lending stood out with an NIM far higher than the industry median. In the first quarter, FinWise Bank had 13.43% in NIM, while Medallion Bank had 9.57% and WebBank had 8.40%.

Well-executed BaaS programs can be enormously profitable, but it is a special line of business that requires banks to think through how they want to address regulatory and credit risks, Sandler said.

"Providing banking-as-a-service and being a regulated intermediary for nonbanks can have significant tail risk," Sandler said. As regulators scrutinize banks' operations in periodical examinations, fintech programs that go off the rails could cause severe regulatory repercussions.

Omissions in fintech partnerships can also cause real financial loss to banks. In a recent example, Bronx, N.Y.-based Ponce Financial Group Inc. had to put back $17 million of loans to its fintech partner, Grain Technology Inc., because those loans were made to scammers using fake identities, according to a May 5 filing by Ponce. Grain, a startup that has not been profitable, intended to pay all amounts due upon the completion of a series A financing round, which Ponce warned in the filing "may not materialize."

Another characteristic behind successful BaaS programs is the banks' strategic vision to customize and differentiate their products and services in this increasingly competitive space. "There's still a lot of specialization, customization, product focus, target market focus that the bank has to bring to the table, as well as bringing some sort of technology integration capability," Shevlin said.

For instance, Green Dot has built strength with programs catering to low- to middle-income consumers. It is a good choice to distinguish itself from other banks that may not have the knowledge of that target market, Shevlin said. In addition, banks like Celtics Bank, Bancorp Bank and Coastal Community Bank have built their own technology early on to serve such partnerships, Shevlin noted.

BaaS market remains lively

The BaaS market continues to see healthy dynamics with established players growing and new players advancing innovation. The two banks with notably high efficiency ratios, Grasshopper Bank NA and Column NA, appear to be in the initial investment stage.

Grasshopper began operations in 2019 ,led by the former management team of Radius Bank, a digital bank acquired by LendingClub Corp. in February 2021. Grasshopper aims to bring the success of Radius Bank in personal lending into small business lending and uses its experience in digital banking to offer BaaS solutions to fintechs.

Column was launched in April by Plaid co-founder William Hockey and his wife, Annie Robertson Hockey. They were part of the investor group that acquired Northern California National Bank in 2021 for $45.1 million, according to press reports and Market Intelligence data. Column is positioned as a banking infrastructure provider. It is an example of the ongoing evolution in the approach to BaaS, Sandler noted.

Another source of innovation comes from fintechs that provide technology tools and commercial resources to help banks navigate the nuances of BaaS, Jegen said. Treasury Prime Inc. and Synctera Inc. are such businesses, Shevlin said.

For banks, BaaS presents opportunities to add new fee income or scale their digital distribution channels.

"More than anything else, it's the iteration of transactions that generally don't require balance sheet," Sandler said. "You don't have to dedicate a significant amount of assets or equity to the strategy, and you can have an outsized return on both assets and equity."