Neobanks should find their niche to improve their profitability

The last 5 years dozens of so-called neo- or challenger banks (according to Exton Consulting 256 neobanks are in circulation today) have disrupted the banking landscape, by offering a fully digitized (cfr. "tech companies with a banking license"), very customer-centric, simple and fluent (e.g. possibility to become client and open an account in a few clicks) and low-cost product and service offering. While several of them are already valued at billions of euros (like Revolut, Monzo, Chime, N26, NuBank…​), very few of them are expected to be profitable in the coming years and even less are already profitable today (Accenture research shows that the average UK neobank loses $11 per user yearly). These challenger banks are typically confronted with increasing costs, while the margins generated per customer remain low (e.g. due to the offering of free products and services or above market-level saving account interest rates).
While it’s obvious that disrupting the financial market is a long-term effort and requires several years of losses and thus heavy VC investing, the LTV/CAC ratio should still be in good shape. Cfr. my blog "Customer acquisition cost: probably the most valuable metric for Fintechs" (https://bankloch.blogspot.com/2020/06/customer-acquisition-cost-probably-most.html) for more information on this ratio.
This ratio consists of 2 components, i.e.

• The LTV = the customer Life-Time Value, i.e. the average revenue generated by a customer in a 1, 3 or 5 year period. This should obviously be as high as possible, but remains an area of concern for many neobanks, i.e. on average around 15 EUR per customer per year. Many neobanks like e.g. N26 and Monzo seek revenue mainly from the low debit card interchange fees, resulting in very low LTVs (which has even worsened due to reduced travelling and small purchases following different confinement periods). The neobanks, like e.g. SoFi, offering lending services are far better positioned on this point, although this comes also with high risks, as incumbent banks still take the majority of high-quality loans, resulting in the neobanks having to find the best loans in the remainder.

• The CAC = Customer Acquisition Cost per customer, i.e. the total money spent on customer acquisition divided by the number of new customers. This should be obviously as low as possible. Most neobanks still achieve far better CAC values as the incumbent banks, with an average CAC of neobanks around 30 euros versus 200 euros for incumbent banks, but still too high compared to the average revenue generated per customer.

As a result and enforced by the recent Pandemic and its effects on the economy, VCs start to push neobanks to change their focus from growth to profitability. This leads to neobanks repositioning their offering, i.e.

• Seeking more profitable products and services. Today neobanks still take over predominantly the low profitability businesses of incumbent banks, such as payments or debit cards. The associated revenue streams of these neobanks, like payment transaction fees, premium account subscription fees or open banking commissions from brokering 3rd party services are in most cases insufficient to generate enough revenue for even an operational break-even, meaning new products and services need to be explored:

  • Expanding to more profitable existing services like investments and credits, although these markets are already very competitive with specialized Fintechs disrupting the market and require a lot of local (per country) customizations. Furthermore most neobanks don’t have the strong balance sheet to engage in long-term credits, meaning the focus will be mainly on credit cards, overdrafts, salary advances and purchase financing.

  • Expanding to more profitable customer segments like SMEs

  • Providing "Banking-as-a-service" services to other Fintechs or even banks

  • Positioning their banking app as a super-app, offering third-party non-financial services and taking a lead generation commission (cfr. my blog "From app to super-app to personal assistant" - https://bankloch.blogspot.com/2020/08/from-app-to-super-app-to-personal.html)

• Reviewing their pricing strategy, e.g. Monzo and Starling recently announced that they would begin charging fees for services they previously offered for free. This often results in a less transparent and more complex cost structure.

• Reviewing their international expansion strategy, i.e. already multiple neobanks have revised their expansion strategy or have even stopped pursuing certain markets they were trying to disrupt.

• Cutting on costs. While the operational costs of most neobanks are still considerably lower than the incumbent banks, quite a few neobanks have lost a lot of their initial agility and this due to the increased supervision of regulators, an application architecture showing the first signs of legacy and a workforce no longer as skilled, agile and motivated as in the start-up phase.

You could conclude that in their pursuit for a sustainable (profitable) business, many of these neobanks are starting to look more and more like the incumbent banks (but without the branch network) they initially wanted to disrupt.
The result is that many neobanks start to find themselves in a Catch-22 situation, i.e. their pursuit for profitability is starting to impact their strongest asset, i.e. their fully digital, very standardized, simple, low-cost and transparent offering, which allows them to operate with very low operational costs (around a fifth of an incumbent bank), scale very easily (to larger number of customers but also internationally) and attract new (typically young) customers.
It seems more and more that an exponential (international) scaling of revenues, while keeping costs relatively stable, is extremely difficult to achieve, due to the local regulatory constraints and the customer needs for local specific banking products and services. In this context it’s interesting to consider Starling Bank, which is one of the few profitable neobanks in the UK. This profitability is due to their strong focus on cost control, but it also came at the expense of growth, i.e. it has taken them 6 years to arrive at a million accounts.

And if this wasn’t concerning enough, challenger banks are also confronted with

• A lack of trust from customers, e.g. in the UK only 10% of customers place ‘a lot’ of trust in neobanks compared to 40% for traditional banks. This makes it hard for those neobanks to:

  • Position themselves as the primary bank of a customer

  • Have long-term relationships with the customers

  • Have high deposits of their customers, i.e. most neobanks only have on average a few hundred euros in deposits per customer, compared to a few thousand euros for incumbent banks.

  • Have high (meaningful) interaction ratios (e.g. daily/weekly use of the app) with their customers, which is important if they want to offer and monetize 3rd party services.

• Incumbent banks not standing still either, i.e.

  • Incumbent banks are continuing to invest heavily in their IT/Digitalization adopting new technologies (such as cloud) and new paradigms (such Agile, DevOps, Microservices, customer centricity…​)

  • Incumbent banks are closing more and more branches, which is even more accelerated by the Pandemic

• The threat of Big Tech (Apple, Google, etc.) venturing into banking. As Big Tech companies typically partner with incumbent players, focus on the same commodity services (like payments, debit cards, credit cards…​) as the neobanks and provide the same type of advantages (with regards to a digital, simple and fluent offering) as neobanks, this threat might actually be bigger for neobanks than for incumbent banks.

All this combined means many neobanks will have a hard time to flourish in the coming years. As a result, some might stop their business, others will get acquired (buy-out) by the major banks, while still others will reposition themselves, i.e. find a niche where they can excel and not fight head to head with the large banks.

This niche positioning will be according to 2 axes, i.e.

• Product and service range: currently neobanks position themselves with quite basic products, like foreign currency transactions (Revolut), credit cards (NuBank), debit cards (Chime, N26 or Monzo) or simple short-term lending (SoFi), but it might be interesting to come with more innovative products. E.g. in the credit space many opportunities exist for more flexible and personalized products. Cfr. Capilever’s blog "Are credits not too commoditized?" (https://www.capilever.com/blog-10/). Or in the account space, a fundamental paradigm shift could be implemented. See my blog "A bank account - A concept of the past" (https://bankloch.blogspot.com/2020/03/a-bank-account-concept-of-past.html).

• Customer segment: currently the biggest neobanks (Revolut, Monzo, Starling, N26…​) position themselves towards the general retail customers (obviously with a focus on the digital-native millennials) or SMEs (like VIVA Wallet), while some smaller neobanks focus on more specific segments like freelancers and independents (Mettle, Tide, Trezeo, Fyrst, Holvi…​) or other specific professions (such as lawyers, notaries, doctors, content creators…​), the unbanked and underbanked (cfr. my blog "Financial inclusion - A word with many meanings" - "https://bankloch.blogspot.com/2020/02/financial-inclusion-word-with-many.html"), women (e.g. Elas, First Women’s Bank…​), the elderly (e.g. Longevity Bank) or the mass affluent or high-net worth individuals. It’s clear that banks that can provide well-adapted services for a specific customer group might be better equipped for the above described upcoming challenges.

While a buy-out by a large incumbent bank can be a very valid exit-strategy of many VCs, I would personally regret that the innovations and disruptions brought by these neobanks would not continue to thrive. As such I hope many neobanks can soon reinvent themselves into banks, with a more specialized digital offering, where customers don’t just go to for pricing and usability, but really for a value creation that is not offered by any other financial institution.