Embedded finance is the new norm in payments and banking. A new, ecosystem-based innovation, embedded finance integrates financial services traditionally obtained via a bank directly into nonfinancial mobile applications, and business processes to offer fluid and superior experiences to customers. Think of an e-commerce marketplace store offering real-time, credit products in the form of Buy Now Pay Later, aimed at breaking down bulk cash outflows into low-cost EMIs to shoppers at the point of purchase, or a ride-hailing service enabling customers to buy travel insurance products whilst booking a ride to the airport.
Much of the initial excitement surrounding embedded finance has focused on the extent its development will enable TechFins (e.g. Facebook, Apple, Amazon, and Google) to enter banking. As in the consumer payments and banking space, embedded finance in the business-to-business payments space has tremendous potential. For mid-market businesses embedded finance can lower barriers to accessing financial services and products. A significant segment of mid-market enterprises operates in an environment of irregular cash flows and limited cash liquidity. For many navigating the financial landscape and finding the right financial support to address working capital gaps is difficult and time-consuming.
Traditional financial institutions are oriented towards larger businesses, discounting the needs of mid-level enterprises for efficiently managing cash flows. For example, the 63 million small and medium businesses (SMBs) in India form the backbone of the country’s economy. But they face a significant credit gap, and a mere 16 per cent of MSMEs have access to formal credit. According to an IFC report, Indian SMBs share of credit is a minuscule 6-7 per cent and the total credit gap is close to US$1.1 trillion. Long processing times, lack of transparency in timelines, and insufficient loan sizes remain substantive pain points, compelling many SMBs to continue to seek informal sources, often at significantly higher interest rates.
Why embedded finance?
Against the current backdrop, the rise of embedded finance can address and smoothen liquidity gaps. Previously, a business buyer may have spent hours on cumbersome paperwork to access trade credit. Rather than going to the bank, embedded finance provides the convenience of access by making these services an integral part of their day-to-day business activities. Companies such as Zaggle, for instance, aim to solve the biggest pain point for their target market, liquidity and cash flow management, by incorporating payments and credit into their business payables automation platform. Let us say a restaurant needs to purchase new kitchen equipment. Rather than wait weeks for the bank to process a loan, the restaurant can access embedded credit services to initiate and make payments toward the purchase.
Trends Influencing growth
The convergence of several factors is influencing the growth of embedded finance in business supply chains, beginning with an accelerated digitalisation momentum combined with several powerful government and regulatory policy initiatives and the rise of banking as a service.
Accelerated Digitalisation: In the post-Covid era swift digital transformation for increasing operational and business agility is vital. Several industry studies indicate that the adoption of digital technologies by businesses has sped up by 3-7 years. Companies are making technology investments across the enterprise and embracing digitalisation across various dimensions – refocusing efforts from predominant customer-facing experiences to core business processes and workflows including supply-chain interactions.
Favourable Regulatory Environment: Policy initiatives by the government and the central regulator to reduce access barriers and grow the share of formalised credit has provided a strong innovation impetus. In comparison with large enterprises, a major obstacle that SMBs encounter is the shortage of credit data, which prevents them from accessing traditional credit facilities through banks and other lenders. The Central banking regulator through initiatives such as Trade Receivables Discounting System (TREDS) ecosystem, is encouraging lenders to adopt cash-flow-based lending instead of balance sheet-based credit.
Over the last few years, many fintechs have stepped up to make financial services more accessible to enterprises underserved by incumbent financial institutions. This current challenge around data inequality is gradually being addressed via the identification of new ways to evaluate SMEs’ creditworthiness, which includes using alternative data. The digitisation of the economy, the constant upward curve in the adoption of digital payments and the introduction of the Goods and Service Tax (GST) has made available new data sources including GST returns, bank statements, cash flow transactions, and invoicing information to determine the line of credit a business should receive. Innovative lending service providers are also tapping into unstructured sources of data such as online social networks and mobile airtime recharge records to profile SMB lenders.
Rise of Banking as a Service: The financial services market is inexorably moving towards a more open, transparent, and interlinked model. Growing global adoption of open banking initiatives and the emergence of banking as a service (BaaS) are major enablers for embedded finance services. With BaaS, financial institutions are increasingly offering banking as a service (BaaS)—enabling nonbank companies access their services, typically using APIs. For financial institutions, BaaS offers a cost-efficient mechanism to enter new markets and capture new revenue growth.
Benefits of Embedded Finance
Embedded finance is a way of leveraging APIs and BaaS for creating financial services that are built into non-financial products. Although a range of services can be offered, popular initial use cases include embedded bank accounts or credit card offerings. In practice, fintech vendors such as Zaggle in partnership with banks offer free-to-open business banking accounts with high-yield interest on all balances and credit cards to customers to finance business spends.
With embedded commercial card offerings, SMBs have the flexibility to reduce the cost of payments. Embedded card offerings for instance can be backed by a fixed deposit enabling enterprises to earn interest rates on deposits and avail cashback on linked card transactions.
It also creates a virtuous cycle of formalisation by helping underserved enterprises to build credit ratings for future credit access. Leveraging transactional and other data, enterprises can gain immediate access to secured or non-secured credit which helps proactively manage working capital needs, make timely payments, and maximise cooperation with suppliers.
Businesses, like consumers, are seeking connected integrated experiences, seamlessly baked into the systems where they do business. Given the time it takes to switch back and forth between multiple systems and additional associated reconciliation overheads, finance professionals do not want to manage multiple systems. Further, connectivity between systems is complex and entails high integration and reconciliation overheads. The ability to initiate pay-outs using the payables software makes the process completely transparent and simple as payments are natively built into the application.
For incumbent banks—this marks the arrival of a major growth opportunity. This model strengthens the primary account relationship with corporates while expanding the base of new to credit customers. The collaboration with software vendors to embed offerings into relevant software platforms can shore depository accounts.
Another significant benefit is the operating cost efficiency associated with embedded credit models. Traditional distribution models are labour-intensive and characterised by higher operational costs. By our estimates, pure play embedded lending models built into financial management platforms can deliver between 40 and 70 per cent cost advantage over traditional models, enabling banks to serve enterprise segments they could previously ill-afford to reach.
It also helps banks to assess, measure, and manage the risks of extending financing to SMEs more effectively. With Fintech partners assuming the responsibility of performing initial Know Your Customer (KYC) checks, the costs of acquisition and associate risks are significantly reduced. Financial institutions also have an opportunity to play in this emerging sector by bringing new product innovations to leverage the platform’s user base.
Embedded finance is at an early stage but B2B enablement use cases will see significant growth over the next 12-24 months, with a real potential to revolutionise credit access for enterprises.