The 2008 global financial crisis resulted in the loss of millions of jobs and trillions of dollars’ worth of financial capital. For many, the blame resided squarely with the banking sector and the individuals that got rich from laissez-faire regulations and speculative investments.
A new kind of digital-only financial institution known as a ‘neobank’ has emerged to capitalise on the resentment felt towards the industry’s incumbents
The wave of anger that the crisis unleashed continues to be felt to this day. The results of a YouGov survey last year tell the story of an industry that has failed to repair the damage caused a decade ago: in Italy, just 37 percent of the individuals surveyed stated that they trust their bank (see Fig 1). In France, a mere 27 percent of people believe that banks are a force for good; in Japan, the same amount think that banks act in the best interests of their customers.
With confidence in the banking sector at historically low levels, a group of upstarts have glimpsed a remarkable opportunity – one that may not present itself again for decades. A new kind of digital-only financial institution known as a ‘neobank’ – sometimes referred to as a ‘challenger bank’ – has emerged to capitalise on the resentment felt towards the industry’s incumbents.
To unsettle the leading players, these neobanks will need to do more than simply capitalise on the negative perception of long-established financial institutions. They will need to offer a positive alternative of their own that is more convenient, more secure and cheaper than what is currently available. Even if they achieve this, regulatory hurdles and a lack of market penetration could still prove to be their undoing.
Opening the floodgates
The banking industry has traditionally been one of the most impenetrable. Many of the market leaders, including the likes of JPMorgan Chase and HSBC, have roots going back more than 150 years and market capitalisations measured in hundreds of billions of dollars. For an entrepreneur or start-up, there are certainly easier markets to disrupt.
In recent years, however, the EU’s progressive approach to financial regulation has opened the sector up to greater competition. The original Payment Services Directive, which became law in November 2009, increased industry transparency and provided easier access for market entrants. Its successor, PSD2, went further still, mandating third-party access to banks’ application programming interfaces.
YouGov survey results (2017)
of individuals in Italy trust their bank
of individuals in France believe banks are a force for good
of people in Japan think banks act in the best interests of their customers
This more open landscape has meant new fintech firms have been able to securely access customer account data that was previously the sole preserve of traditional banks. This has allowed neobanks to thrive. These are institutions without physical branches, where customers organise their finances entirely via digital channels. Their lower overheads mean they frequently out-compete traditional banks regarding the fees they charge customers and in terms of their agility.
Sukhjot Basi, Co-Founder and CEO of Bank Yogi, told World Finance there were several advantages that were facilitating the rise of neobanks: “Neobanks have a lower barrier to entry, [which] means they can accept many more individuals who don’t qualify for a traditional bank account because they lack credit history or stable employment.”
Basi continued: “There are a large number of adults and households that are underbanked. According to the Federal Deposit Insurance Corporation, seven percent of households in the US are underbanked. Neobanks are also a great way for youngsters to learn [about] money management while their parents control an underlying bank account.”
Germany’s N26, a neobank that promises its customers a paperless sign-up process that takes no more than eight minutes, has already acquired more than one million customers since it launched in 2013. Competitors like the UK’s Revolut and Australia’s Xinja are also gaining traction. Collectively, Europe’s neobanks attracted $495.5m in funding across the first five months of 2018 alone.
A helping hand
The EU’s common standards have also proved to be a major help for neobanks: they allow a neobank to quickly expand its customer base, safe in the knowledge it is complying with regulatory standards. N26, for example, has already expanded into 17 different markets since it was founded five years ago. Another disruptor, Fidor Bank, offers its services to customers in more than 40.
In some ways, the rise of the neobank has been enabled by their long-established forebears. Traditional brick-and-mortar banks introduced customers to digital channels without really pressing home their advantages. Although mobile banking has been available for the best part of a decade, the apps offered by high street banks have been hampered by poor functionality and security concerns.
Late last year, researchers from the UK’s University of Birmingham found that a number of banking apps possessed security issues related to certificate pinning – a security mechanism that protects websites from impersonation by hackers – including software offered by NatWest, HSBC and Bank of America. More recently, in April this year, TSB customers found their mobile applications were displaying account details belonging to other users.
If the financial crisis damaged customer confidence in traditional banks, then subsequent security breaches have ensured that it has not been able to recover. Unburdened by decades of legacy architecture, neobanks have made the most of the opportunities presented by this breakdown in trust. For too long banks have taken customer loyalty for granted. Their modern-day challengers are beginning to show them what a mistake that was.
When neologisms first appear, particularly in the business and finance worlds, it is tempting to think of them as describing homogenous concepts. On the contrary, each neobank is unique and offers customers a range of different services. What’s more, not every neobank has taken the same route to arrive where they are today.
Not every neobank wants to rip up the rulebook: some of them have used relatively traditional methods to build their user base
For a start, not every neobank wants to rip up the rulebook: some of them, including the likes of Atom Bank, Tandem Bank and Starling Bank, have used relatively traditional methods to build their user base. While all three are mobile-only services, they also focused on acquiring a full banking charter prior to launch. This enabled them to offer customers a wide range of services, but it also increased their time to market. Being awarded a banking charter from the relevant financial authority can easily take between 18 months and two years.
Alternatively, neobanks can partner with financial firms that already possess regulatory approval in order to launch their products. This approach is not only quicker, it also grants them access to market and customer data that can be used to attract new clients. N26, for example, initially partnered with another German bank, Wirecard, while it was waiting to receive a banking charter of its own. Upon receiving its own licence in 2016, however, N26 began transferring customer information onto its own banking infrastructure. Apart from allowing N26 to offer a broader spectrum of services, receiving a full banking licence also meant the neobank could reduce its costs, as it no longer had to give a cut of its proceeds to its partners. For neobanks, lowering their outgoings is absolutely essential.
One of the ways neobanks have been able to attract customers is through the promise of lower fees. Because they do not have to pay the costs of running physical branches, they are able to offer services for free that more established institutions charge for, such as withdrawing money in a foreign currency. However, while neobanks are low-cost, they are also low-earning.
“Profitability is an issue, because these banks are offering their services below cost to attract new members,” explained Basi. “This is especially true if they are doing no-fee and no-mark-up international money transfers. Currency fluctuations that may occur every minute can further increase their operating costs unless the money changes hands only in the destination or originating countries. Their costs may also be increased by the fact that they have to share their revenue with the underlying banks that are supporting their accounts and transactions.”
The profit problem is perhaps best exemplified by the fact that earlier this year, Revolut claimed the distinction of being the first challenger bank to break even on a monthly basis. Most of the others are being sustained by investor funds and the belief that they will become profitable in the future. For the sake of comparison, Santander UK’s retail banking division made a pre-tax profit of £1.7bn ($2.16bn) in 2017.
Currently, it is not clear whether neobanks simply need to reach a critical mass of users before becoming profitable or if they are based on a flawed business model. Some of them make their money by charging for premium accounts and services, while others earn commission by cross-selling related products, such as insurance. Whether any of these approaches can provide the required long-term revenue streams remains to be seen.
Another problem facing neobanks is that customers can increase costs more than they increase revenue. In its annual report for the 12 months leading up to February 2018, UK-based neobank Monzo revealed that it had increased its user base to 750,000 customers, but across the same period its losses more than quadrupled from £7.9m ($10.05m) to £33.1m ($42.1m). Many of these new customers are happy to give neobanks a try, but are not ready to use them as their main account, meaning they are a financial burden instead of an asset. On average, for example, Monzo customers have less than £150 ($190.80) in their accounts.
Despite their rapid growth, neobanks are in a difficult position. While some are switching from a ‘freemium’ approach to a subscription model in the hope of improving their bottom line, this could result in customers returning to their tried-and-tested high street banks. The challenge, then, is to keep pushing for efficiencies that ensure profit increases in the same way customer numbers do.
More worrying than their long-term issues is the threat that neobanks’ recent successes could be undone. Customer acquisition remains difficult, with many consumers still finding it difficult to leave a centuries-old bank in favour of a new fintech start-up. Even with trust in traditional institutions at such low levels, old habits die hard. Neobanks are also operating in an increasingly competitive market.
“Customer acquisition is hard for all consumer businesses,” explained Will Beeson, Head of New Propositions at CivilisedBank. “Rapid development and deployment of scalable technology means there are lots of companies targeting the same finite pool of customers. Human nature dictates that a small portion of the population will be early adopters of new technologies and that the mass market will lag. Plus, it takes time to build trust, which is vital in financial services.”
Traditional brick-and-mortar banks introduced customers to digital channels without really pressing home their advantages
As well as battling it out among themselves, neobanks will need to hold firm against a renewed challenge from brick-and-mortar banks. Last October, JPMorgan Chase launched its own mobile-only banking offshoot called Finn. Other long-established banks are likely to follow suit. Far from destroying their predecessors, neobanks may inadvertently set them on the path to a new wave of growth.
There are also mounting concerns that neobanks are more susceptible to criminal activity than industry leaders are. Earlier this year, Revolut announced that it had discovered incidents of money laundering across its digital payment systems, something critics of neobanks and their automated compliance checks quickly leapt upon.
Although Beeson believes achieving compliance is “not a question of whether the technology is trustworthy, but a question of company culture”, balancing rapid growth and robust security is undoubtedly a challenge. In spite of the great strides made by many neobanks, there remains a perception that larger establishments can simply commit more personnel and money to compliance.
Becoming the norm
If neobanks can prove their security and regulatory credentials in the short term, then they might just buy themselves the time they need for public perceptions to shift further in their favour. As customers become more comfortable with digital banking, any aversion to using N26 instead of NatWest will fade. However, neobanks still need to do more to boost awareness among the general public. According to research conducted by Mastercard last year, just 11 percent of UK consumers currently use a neobank or said that they were “very likely” to use one in the next three years.
To ensure neobanks boost their uptake beyond digitally savvy Millennials, they will need to commit more of their income to marketing. This will, however, be a difficult battle to win, particularly as traditional banks can invest far more heavily in this area. A more fruitful approach could see neobanks adopting niche selling points, as opposed to competing on all fronts with the major established banks. There is already evidence of this taking place, with neobanks like Monese targeting “nomads, expats and migrants” and others, like Soldo, focusing on parents.
Consolidation is also likely to take place. The number of neobanks worldwide has grown substantially in recent years, and company takeovers are likely to prove the only way for some of them to achieve longevity. This, of course, is the case with any new market, and it would be wrong to dismiss these innovative new players simply because they haven’t toppled HSBC in the space of five years. However, it is clear that the recent success of neobanks is fragile. A greater focus on profitability must emerge quickly if these new kids on the block are to stick around for the long haul.