Embedded finance: Dutch Central Bank publishes analysis of inherent risks

The Dutch Central Bank (De Nederlandsche Bank, DNB) published in July its analysis on the scope and impact of embedded finance. The DNB analysis points out various risks that are associated with embedded finance models and provides preliminary views on the consequences of the increase of embedded finance models on prudential supervision of licensed entities.

What is embedded finance?

Embedded finance, also known as "banking (or insurance) as a service" or "white labelling", is a business model that allows non-licensed entities, or "white label partners", to integrate financial services, product and functionalities into their offerings and under their own brand name in partnership with a regulated financial institution – the embedded finance provider. White label partners leverage the financial institution's licence, enabling end users to access financial services more easily, most often without direct interaction with the financial service provider.

DNB acknowledges that embedded finance can encompass a wide range of financial services from banking and payment products to insurance and investment services. Regulated financial institutions provide their technical infrastructure to white label partners via application programming interfaces (APIs), which facilitate the integration of financial services into the partners' platforms.

Operational risks

Embedded finance products result from the interaction between systems of multiple parties, creating several layers between the financial service or product and the end- This fragmentation exposes financial institutions to operational vulnerabilities. For instance, a white label partner's insufficiently robust technical infrastructure could make the entire value chain susceptible to cyberattacks. Additionally, if a white label partner goes bankrupt, the financial institution may face challenges in maintaining the digital interface with customers and handling user claims, as the institution typically does not have a direct relationship with end-users.

Integrity risks

The potentially fragmented and complex nature of an embedded finance chain means that financial institutions do not have direct control over the entire process. They may rely on white label partners to monitor and identify integrity risks, which can lead to incomplete know your customer files and hinder the ability to detect suspicious transactions. This reliance can compromise the financial institution's ability to effectively manage risks related to money laundering and terrorism financing.

Financial risks

By outsourcing the underwriting process to white label partners, financial institutions risk encountering unexpected risks, such as credit risks or concentration risks that the financial institution is not able to properly monitor. Banks collaborating with non-banking partners for deposit collection may also encounter liquidity risks if these partners withdraw or fail to comply with policies or regulations.

Legal risks

Financial institutions remain liable for the services provided by their white label partners. Ensuring that these partners comply with all legal requirements is crucial. Non-compliance can lead to legal disputes and claims.

Reputational risks

A financial institution's reputation can be indirectly harmed by the unauthorised activities of its white label partners. For instance, misuse of customer data by a white label partner can reflect poorly on the financial institution.

Business model risks

In the embedded finance model, traditional banks or insurers do not have primary contact with the customer. Instead, the white label partner, who has better insights into consumer behaviour through data, manages this relationship. This shift means that traditional financial institutions lose ownership of the customer relationship, making them vulnerable if the white label partner decides to switch to another financial institution.

Looking ahead, financial services might become an anonymous, standardised, and potentially smaller part of the overall consumer purchase process on digital platforms, leading to price pressures that could challenge the business models of traditional financial service providers.

Financial institutions that choose not to adopt the embedded finance model might fall behind competitors. Due to outdated IT systems and a conservative stance, white label partners might prefer collaborating with foreign financial institutions, risking some institutions being left behind if this business model grows rapidly.

Consumer protection risks

Offering embedded financial services inherently involves behavioural risks, particularly the risk of mis-selling. Consumers might not fully understand the risks of the financial products and services offered by white label partners. Questions may arise about whether consumers receive the right product based on their needs, knowledge and risk preference, and whether they understand the applicable protection level, the identity of the underlying financial institution, the terms and conditions, and where to direct complaints.

Additionally, the embedded finance market might develop into an opaque market with non-transparent pricing and highly personalised premiums and conditions, increasing the risk of consumers overpaying. In a digital environment, where consumers can quickly purchase financial products alongside regular products, there is a risk of nudging and undue influence, leading to poor financial decisions or impulse purchases.

Privacy risks

The embedded finance value chain is inherently sensitive to privacy risks. Customer data (both financial and non-financial) is held and shared among multiple parties, increasing the risks of data breaches, misuse, fraud and unauthorised access to sensitive data.

Stability risks

In theory, embedded finance poses potential stability risks. A large e-commerce company could serve a significant share of financial consumers and become systemically relevant; and problems at such a company or its partner financial institution could significantly impact these consumers. Issues at a white label partner could also affect the financial institution if it heavily relies on the partner's customer base. However, these stability risks would require substantial growth in embedded finance over the coming years.

Resolution risks

The high degree of interconnectivity and dependencies within the embedded finance value chain makes the resolution of the licensed institution potentially more complex and time-consuming. The high level of automation and digitalisation might complicate the application of resolution tools, such as quickly freezing transactions.

Implications for prudential supervision

DNB states that embedded finance currently does not pose a direct risk to the safety and soundness of financial institutions involved in its provision. According to DNB, the scale of embedded finance in the EU and the Netherlands is not yet material compared to traditional financial services. However, DNB considers it crucial to keep an eye on developments and to anticipate a situation in which embedded finance players provide significant volumes of financial services and products that leads to increased risks.

While monitoring is crucial at this stage, DNB is of the view that several supervisory actions can mitigate the risks associated with embedded finance and extensive supervisory measures might not be appropriate or proportional at this moment. DNB foresees that possible measures include introducing reporting requirements for financial institutions involved in embedded finance, imposing higher risk management standards, increasing transparency about embedded finance activities (both by financial institutions and white label partners), raising capital requirements for embedded finance activities and, ultimately, bringing certain white label partners under supervision.

DNB recognises that several considerations are essential when contemplating further supervisory measures, such as the market's growth and size (in terms of volumes and number of parties involved), the resulting increase in value-chain complexity, the financial institution's ability to manage embedded finance risks and the specific responsibility distribution between the licensed financial institution and its white label partners regarding financial services. As the roles of white-label partners expand, the responsibility for risks and duty of care towards customers should also increase, making further supervisory measures more appropriate.

Finally, embedded finance is a cross-border phenomenon, requiring an international approach to ensure a level playing field and prevent regulatory arbitrage. A white label platform in Germany, for example, could partner with a financial institution in the Netherlands and vice versa. DNB is actively involved in the growing discussion within relevant international supervisory bodies.

Osborne Clarke comment

Embedded finance will likely change the financial landscape by pressuring traditional financial institutions' business models, leading to more specialised banking and insurance models and creating larger and more complex dependencies between financial and non-financial institutions. This is already on the radar of the European supervisors and is now also on DNB's.

We expect that DNB will increase its focus on embedded finance models, with the aim to obtain a thorough understanding of the various models, the complexity of embedded finance chains, and the distribution of the roles and responsibilities throughout this chain. Further interpretations and guidelines from DNB are to be expected.