Finserv Glossary

Open Banking

Table of Contents

What is Open Banking?

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Open banking is a system that utilizes application programming interfaces (APIs) to give third parties access to financial information. Consumer banking, financial data, and transaction history are three types of information that open banking transmits between third parties.

Consumers, financial institutions, and service providers can all leverage open banking to manage access, accounts, and information. Open banking is at the forefront of innovation in the financial service industry, promoting transparency and connectivity.

For example, open banking allows consumers to share their financial information with their accountant or wealth management advisor to give clarity on their financial position. In addition, open banking might be used to allow third parties to initiate transactions from your bank account on your behalf, like paying an insurance premium or monthly transfers to an investment account.

How Does Open Banking Work?

Open banking works based on APIs, which facilitate the transfer of information between two or more applications, like a bank accepting an electronic check from your insurance agent. Before the financial providers can initiate the transfer of information or monetary transaction, customers will need to authorize the movement through a check box or other form.

After consent is given, third-party provider APIs will then utilize the customer’s shared data and flow information between accounts. Open banking is most commonly used in the financial service realm, such as banks, wealth management businesses, and insurance companies. This is because these sectors deal with high levels of customer information and transactions. 

What are the Benefits of Open Banking?

Open banking presents various opportunities for both consumers and financial service providers. First, open banking promotes secure data-sharing between financial institutions and other financial service businesses. For example, transferring funds from one financial institution to another is more secure when networks are used instead of centralization.

In addition, APIs have the ability to data mine and find the financial products that best suit consumers. Maybe the data that financial service businesses find uncovers that they can benefit from a high-yield savings account or a separate investment account. Finding the right financial service products for consumers not only leads to increased revenue for companies that offer these products but can also benefit consumers who are matched with effective products.

Open banking also helps lenders accurately capture consumers’ financial positions and risk levels before making lending decisions. When lenders can see all of the different transactions and accounts that a consumer has, they can make more informed lending decisions that are in line with their institution’s risk tolerance.

Another benefit of open banking is the reduced time businesses spend completing online accounting and fraud prevention. For example, financial institutions can set parameters that detect when unusual transactions occur from third parties. When items are outside of the parameters, bank personnel are notified to follow up with the customer.

What are the Risks of Open Banking?

Despite the growing list of benefits that open banking leads to, there are some risks to consider. The top risk is abiding by financial privacy laws. The transmittal of consumer-sensitive information is a highly regulated area. All banks, insurance companies, and wealth management offices must follow the 1978 Right to Financial Privacy Act that limits what financial information can be accessed.

Breaking one of the regulations that your financial sector business is required to follow can lead to stiff fines and penalties by various regulatory agencies. This creates an added risk liability to consider before implementing open banking. Additionally, there are security risks present to the financial institution and consumers. Malicious third-party apps are becoming more prevalent, looking to wipe out funds from consumers’ accounts through the initial API link. This opens the door to added security costs and more expensive insurance. As data continues to become interconnected, financial service businesses will need to find effective ways to limit security hacks and attacks.

There is also a competition risk of open banking. There will be increased competition among financial service businesses that offer open banking compared to those that don’t. Consumers are constantly looking to go with businesses that prioritize innovation and convenience. A wealth management office that doesn’t give customers the ability to see their net worth from different sources or a bank that doesn’t track spending habits will be seen as a less competitive option.

Another risk of open banking is the consolidation of financial services. Big data can result in pricing power when many large financial institutions begin to buy out smaller companies and capitalize on the consumer data they are collecting. We’ve seen this happen in social media and online shopping. This gives an opportunity to misuse consumer data for alternative purposes, leading to the risk of non-compliance with privacy laws.

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What Does the Future of Open Banking Entail?

Open banking will force financial service businesses to adapt to new policies. Smaller banks will become more attractive and competitive to larger banks. One way large financial institutions can combat this is to reduce costs, increase convenience, and implement better technology for their customers. This may include overhauling existing processes to adopt new technology and innovating to the level consumers expect.

Customer relationships will continue to be a priority with open banking going into the next few years. Insurance agencies can provide customers a snapshot of their financial health, wealth management businesses can outline how much more money an individual can reasonably invest based on their current spending habits, and banks can provide transparency into different segments of financial data. Instead of simply facilitating transactions, financial sector businesses will need to take on a more personal relationship with customers.

How Can Financial Service Businesses Leverage Open Banking?

Before banks offered open banking, consumers would have to use outside platforms, like Mint or Personal Capital, to visualize their information from multiple sources. However, consumers are looking for this type of service from the bank or wealth management office that they use. This makes it important for your financial service business to uncover the different ways you can implement open banking. Maybe this includes adding a feature on a mobile app or creating a separate app that works in conjunction with your platform.

Additionally, financial service businesses can leverage open banking to improve current workflow and risk management. When there is more transparency throughout the lending, investing, and insuring sectors, businesses can make more informed decisions on how much to lend or insure a person for. This allows the business to reduce risks and simultaneously save on resources when APIs handle a majority of the data transferring burden.