In the annals of banking history the neobank movement is scarcely a blip — in terms of time, it’s only about a decade old. And yet this sub-industry has grown from a handful of companies to hundreds in one stage of development or another by the end of 2020. The movement’s influence has spread from Europe and the United Kingdom to much of the world now, including a growing presence in the U.S.
But neobanks’ exponential growth in population and customer base may be coming to a crossroads at the same time that the attitudes of the investors backing them are shifting. To date, neobanks have represented a blending of modern technology, a focus on specific customer pain points, key patents and “banking as a service” assistance, as well as willingness to forego income in exchange for growth. A handful are even attempting to evolve to chartered status, and one or two already have, notably Varo Bank.
In a white paper by Exton Consulting, “Neobanks 2021: Shifting from Growth to Profitability?,” the firm suggests that many neobanks, especially those passing their fifth anniversaries, have had their time to build scale and that investors want to see some return for their capital and their patience.
In fact, a combination of economic factors, hinged partly on COVID-19, is calling the tune as much as investors are: “In order to survive and grow their competitive positioning, neobanks will now need to play to their strengths rather than trying to be a jack of all trades. In order to prevail [neo]banks will need to focus on their core countries, their core products and their core differentiators and use their funding efficiently to grow in those selected areas. That may still include entering new markets and launching new products but not for the sake of putting a flag in more countries than the closest competitor without being able to subsequently digest that growth.”
There’s only one problem with this picture, according to the report: “Five years after the neobanking wave first gained momentum, the question of how these newcomers can develop a sustainably profitable business model remains largely unanswered.” Only a few — U.S.-based Chime being one of them — have even achieved operational break-even, the report notes. The usual income sources tapped thus far are insufficient.
And here’s a twist: Ten years ago, many traditional players were happily wishing the brash new competitors a swift demise. Now, with a growing portion of smaller banks making a business out of enabling neobanks, that’s not such an appealing thought for many anymore.
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COVID-19 Ignites Smoldering Neobank Challenges
Postponing profitability for growth isn’t anything new for tech companies. “Amazon, which reported significant gains for the first time in year 9 of its existence, serves as maybe the best example that investor patience during this growth phase may ultimately pay off,” the report states. In fact, in recent decades when de novo banks have been formed their investors have generally expected some return within five years as well. (Historically, in the traditional space, the exit plan for investors typically has been selling the de novo to another institution.)
“While lockdowns initially created a benign environment for digital banks able to remotely manage onboarding and key servicing processes, the extended crisis also highlighted the disadvantages for the new players.”
Exton suggests that COVID-19 has become an accelerant among neobanks, but not in the usual sense of hastening interest in their chiefly mobile-based services. Essentially, the firm believes that the coronavirus has exposed weaknesses in the neobank model that must be addressed as the industry turns to a profit motivation.
“While lockdowns initially created a benign environment for digital banks able to remotely manage onboarding and key servicing processes, the extended crisis also highlighted the disadvantages for the new players, often without their own banking license and less experienced in managing adverse scenarios,” the paper states.
In a sense, the cool kids of finance got a heavy dose of reality, especially early on in the pandemic when some leading neobanks had to announce layoffs and other cost-cutting measures.
Exton believes COVID-19 stepped up the speed of four other trends that together are going to cause neobanks to begin focusing on making money — or else. These include:
• Coming of age, and its implications: Many neobanks’ stated goal for scale was to build to a multi-million customer base. As those in the half-decade class hit that goal, the time is coming to “put up or shut up.” Over the last year or so some of the early leaders changed plans drastically because they couldn’t successfully hit profitability goals.
• When you dial a wakeup call, don’t be surprised if some folks wake up: Neobanks proved that traditional institutions weren’t always solving the pain points and providing the digital convenience that the new players could. The fact that the most successful neobanks signed-up millions of people got the attention of traditional players as well as direct banks. Some of them have now caught up.
• Rising regulatory focus raises the bar: Outages at Chime and Robinhood drew regulators’ attention to neobanks. And while Democrats have a reputation for being more innovation-friendly in financial services, they have rarely met an activity that they didn’t feel couldn’t be improved with rulemaking. Already, compliance expertise developed over decades of being regulated has been part of what “banking as a service” providers have brought to neobanks and fintechs.
As the report states, there’s no more “rookie bonus.”
• Multi-country players experience expanding complexity. A natural tendency of growth is to follow it with more growth, even over national boundaries. Some successful neobanks tried to export their models to other countries and Exton Consulting notes that time has shown that this is a bigger challenge than many thought.
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Impact of a Weakened Consumer Base
Beyond those four factors, COVID-19 has had a secondary but very important impact beyond that mentioned earlier: an erosion in consumer retail banking performance.
“COVID produced rising consumer credit defaults, which impacts those neobanks that make part of their money via lending. People spending less has shrunk interchange income and eaten into neobank income as well.”
The report points out that COVID has produced rising consumer credit defaults, which impacts those neobanks that make part of their money via lending. On the other hand, many of them depend on interchange income to pay for what they give away and for any revenue besides. Falloffs in transaction activity due to people spending less has shrunk interchange income and thus has eaten into neobank income.
This has hit neobanks serving small business and freelance and gig economy workers as well — their sufferings during lockdowns and slowdowns have reduced potential volume for specialized neobanks.
In addition, while Exton doesn’t see the growth in neobanks completely halting, the firm makes a case for a significant slowing — it sees this as a finite game.
Since 2010, roughly 319 neobanks have been launched, with many continuing, some going out of business and others being absorbed. In the decade-long life of this sub-industry, pioneers have filled in a good deal of the “white space,” as Exton calls the opportunity to meet needs traditional institutions have not. It’s not that demand is going away, but the firm contends that only so many firms can serve niche needs.
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How NeoBanks Can Make the Shift to Profit Orientation
Exton Consulting’s paper sketches out three paths to potential profitability by supplementing sources like interchange income that have been relied on up until now.
• Turning into a classic bank. A key angle of neobanking originally was breaking the link between loans and deposits. While margins remain tight for many credit types, the firm suggests going to a traditional intermediary model could help bring in the bucks. Neobanks could build on the digital expertise they started out with.
• Emulate big techs and others and build multi-product mobile solutions. Platforms that provide a range of products and services along with allied banking products can help feed the profitability of each other.
• Let neobanking go neobroker. Exton suggests that neobanks can reboot a strategy some direct banks used when they launched: offering inexpensive mobile brokerage along with banking services. Even where it is still offered among direct banks it is not talked about much anymore. However, the firm says, the newer players could use the strategy afresh.
“Being so close to the traditional neobanking model, the synergies between both businesses are striking,” the report states. “In particular, the advantage of sizeable customer groups that could be cross-sold a brokerage account should provide ample reason for considering the launch, acquisition of or partnership with a neobroker.”