Essential Guide to Open Banking

The banking sector has undergone a number of changes over the years. Due to the digitization of records and the use of mobile platforms to serve the masses, banking looks very different today than it did years ago. One major change that is sweeping the banking sector is open banking. While relatively new, open banking holds the promise of making the banking process better for both the customers and the banks they patronize. But what is open banking? Are there risks associated with it? And is it right for you as a user? In this guide, we delve into the topic.

Banking Challenges

While the banking industry is perhaps more evolved than ever, there are still certain challenges that users face. These challenges are about dealing with data and how this data is used. The biggest collection of information about the state of a customer’s finances can be seen in their bank transactions. This data includes how much money goes in and out of their bank accounts, where they spend their money the most, and so on.

The issue is that banks are not the only ones who could make use of that information. Third-party companies that offer financial services to consumers often need this information to tailor services to them. If a customer doesn’t have a credit history, access to banking information will make it easier for them to access whatever services they need.

However, sharing this information with third parties has always been very tricky. For years, the infrastructure simply wasn’t available to do so. When it was, issues regarding data privacy, customer consent, and others made it difficult for users to consent to sharing their data and for their banks to do so. This is where open banking comes in as it offers solutions to this long-running problem and very much appears to be the future of banking.

Open Banking Defined

Open banking is the practice of banks sharing customer information such as transaction history with other banks and non-banking third parties. This is done using application programming interfaces (APIs) and essentially creates a network through which different institutions can share the same data.

Say a customer wants to sign up for a budgeting app that determines how they spend their money and the ways that they can cut back and save more. To do this, the app would need to view and analyze their transaction history with their current bank. Open banking allows the bank to share this data with the app.

One notable thing about open banking is that all of these transactions take place with the customers’ consent. If you’ve ever signed up for a third-party financial service, you might recall being asked to grant permission for them to access your data. This would be an example of open banking.

Open banking is predicated on the fact that consumers will need to access many products and services outside of their primary bank. These services will need their data to do this properly and by leveraging open banking, everyone is better served.

Understanding Open Banking

As we’ve explained, the foundation of open banking is the APIs. But not all APIs are the same and there needs to be agreement between everyone in the open banking initiative. Because API is essentially a way to bridge different software, anyone can technically create one. But for safety reasons, the banking industry tries to restrict itself to only the tried and tested software.

Typically, the government, the banks, and the regulators will agree on certain criteria that guide the development of API. Once the API is built and deployed, businesses can begin leveraging and building programs on top of the API which solves various problems.

Take the issue we discussed about credit history. It can be hard to approve or deny someone a line of credit if there is no history to go off. But a look at their typical bank transactions in a month will give an idea of their financial situation. This way, people are not shut out of accessing credit facilities.

Open banking also gives customers a say in if and how their data is shared. By opting in to open banking, customers can decide if their banking data will be shared with third parties.

Third parties that want to enter the finance sector and share their products and services with the public will need past data. Through open banking, they can get just this.

Open Banking vs Open Finance

Within the banking world, it is common to hear the term open finance as well as open banking. On the surface, it can be easy to confuse one for the other. But while they are connected, they aren’t the same. In the simplest terms, open finance is a more complex version of open banking. In open banking, third parties can access account information and can enable transactions by a third party like PayPal Holdings Inc. (NASDAQ: PYPL).

Open finance, however, goes much deeper than this. Open finance allows third parties to access information not just regarding transaction history and customer identity but also investment history, pensions, and even mortgages. Using this, a wider range of products and services can be tailored to the customers’ needs.

While open banking sets the stage for what could be done with free and authorized sharing of customer data, open finance is building on this.

Benefits & Risks

Open banking offers a lot of benefits, some of which are as follows:

For consumers:

• Access to goods and services. Because open banking makes user data more transferable, consumers can access services like budget apps, lines of credit, and much more.
• Easy transferability. Creating new accounts with financial providers (e.g. moving their account from one bank to the other) is made significantly easier.
• Personalized services. By granting access to their data to third parties, consumers can get services tailored to their unique needs and tastes.
• Greater control of their data. At the heart of open banking is user consent. In other words, users can choose if their data is shared and to whom.

For Businesses:

• Healthy competition. Opening up user data to more businesses leads to healthy competition. As banks are not the only ones with access to user data, they will have to constantly improve their offering to maintain customers’ loyalty.
• Verifiable data. Businesses like loan companies rely on customer data to make decisions, and open banking offers access to verifiable and readily available information.

While these benefits are to be acknowledged, there are also some risks to consider:

• Risk of data compromise. While the existence of open banking means that third parties can access data, it also means that criminals might target this data for nefarious reasons. Banks and governments work tirelessly to ensure open banking safety but this is a risk nonetheless.
• Regulatory complications. Open banking and the speed at which it is developing poses a challenge for regulators who have to pass laws to protect all stakeholders and might not work fast enough to catch up with these developments.
• Update cost. At its core, open banking is a new technological development and this means that banks have to bear the monetary and time costs of implementing them. And depending on the bank in question, this might be very taxing.

Uses of Open Banking

Open banking has many potential uses, some of which are as follows:

• Providing transaction history. If a customer does not have a credit history for lenders and other service providers to verify, open banking allows them to look into their transaction history
• Account switches. Typically, moving your finances from one bank to the other can be a cumbersome process. But with open banking, customer data can be moved seamlessly and accounts can be migrated with ease.
• Account coalition. Consumers trying to have an overview of their finances do not have to log into multiple accounts to do so thanks to open banking. Instead, they can have all their information in a single interface.
• Instant transfers. Platforms like PayPal use open banking to approve transactions within users’ bank accounts, check balances, and recover transaction history.
• Marketing. By accessing data regarding customers’ transactions, businesses can better tailor and market services that are most relevant to them.

Open Banking Worldwide

Thanks to the many benefits it offers both institutions and individuals, open banking has found extensive uses around the world. Notably, different ways of regulating it around the world have also impacted those uses.

In the United Kingdom, for example, open banking is used to facilitate transactions using the payment processor Wise. With this third-party platform, customers can send and deposit money into their bank accounts. Banks like Monzo can also show the balances for all of a customer’s accounts, even those with other banks, in a single interface. Open banking is regulated in the UK by the Financial Conduct Authority (FCA). FCA allows customers to authorize third-party applications to access their data and facilitate transactions.

In the United States, an example of open banking is Capital One’s DevExchange. It allows users to open savings accounts on third-party applications and view their current balances inside applications like budgeting platforms. The Consumer Financial Protection Act (CFPA) guides regulating open banking in the US. Specifically, under the act, any business that offers financial products and services to consumers has to make such information available via open banking.

Bottom Line

Open banking is not just a way to facilitate information sharing. It is also an innovative practice that is on track to revolutionize banking as we know it. It can help not only develop better products and services and push them into the market but also allow customers to have a better view of their own financial situations.

Open banking as a concept comes with its challenges and is still far from its final form. Nevertheless, it is one of the most promising developments in the financial sector.