The Slow Death of Neobank 1.0
We first wrote about neobanks (a digital, branchless alternative to traditional banks) back in February 2020.
It was a different era in which financial service apps were in high demand and the open supply of funding capital (from venture capital investors) propelled numerous founders to build all types of neobanks. Add to this mix the enhanced user experience from fintechs, and the majority of consumers & businesses were opening new accounts with nonbanks.
Neobanks all competed for the same monthly spend and wallet share from end-users with multiple accounts & cards, but who only used 1-2 regularly. As a result, numerous startups were unable to sustain consistent user growth and volume.
The VC flow of investment dollars started to dry up towards the end of 2021 and into 2022. A market consolidation started in which neobanks unable to raise another round had two options: to be acquired OR shut down.
The mantra of “growth at all costs” changed to “best path to profitability” by the end of 2022. The current neobank proposition (especially for consumer-facing firms) is too challenging to scale.
Let’s dive into key considerations (TL;DR):
Business model reliant on interchange revenue;
High upfront (user acquisition) and recurring (customer support) costs;
Ways to stabilize revenue streams;
What the next generation of neobanks looks like;
WHERE the neobank MODEL BREAKS
The predominant method for monetization with neobanks is interchange revenue, which is generated from card purchase transactions (made with the user’s debit card issued by the neobank).
Merchants accepting cards for payments must pay a transaction fee to card networks (i.e. Visa, Mastercard) and issuing banks for each purchase. Fees can range between 1% - 3% (in the US) based on merchant category. A net payment is made to the merchant (as sales proceeds) and issuing bank as revenue, of which a portion is then shared with the neobank.
Some ‘napkin math’ to illustrate this dynamic:
$100 purchase online of a pair of sneakers;
The merchant pays an interchange fee of 3% (or $3), receiving $97;
The card network keeps $0.25 as a processing fee for facilitating the transaction;
The issuing bank receives $2.75 as interchange revenue;
The neobank’s agreement (with bank partner) is 75% revenue share — earning $2.06;
NOTE: These are estimated costs & margins to consider. The type of card, how the card was accepted, merchant category, and revenue share % are all metrics that can have some variance. We can still see (in this example) how a neobank can become lucrative when each user starts spending $500+ monthly, on a recurring basis.
However, companies need to factor in critical program costs as part of their business model:
Cost of acquisition for that user, based on marketing channels & promotions (ex. $100);
Cost to onboard each user, such as collecting personal data necessary to run KYC (Know Your Customer) and sanctions screening checks (ex. $10);
Fixed servicing/maintenance costs per user, including bank partner, technology infrastructure vendor, payment orchestration, customer support, and program manager (ex. $5);
In the initial 12-month period, there’s $175 annual cost for a new user (based on the figures above). A user would need to spend $750 monthly in their first year in order to ‘payback’ the neobank — which is a high bar for customer activity.
This doesn’t factor the inevitable ‘churn’ in which a % of customers can close down their account and switch to an alternative banking provider at anytime.
The unit economics in the neobank model become unsustainable in an environment where capital is needed cover long periods of ‘cash burn.’
Fintechs need to find less expensive options for customer acquisition & support to increase the chances of profitability in the near term.
improving User acquisition costs
Even for niche-focused neobanks with a narrowed target demographic, acquisition requires a large, upfront investment.
Paid marketing (such as digital ads) leads to inbound volume, but the quality of these leads tends to be poor. The customers that do signup via ads have low (or no activity) on the platform.
Alternative, in-person methods have a higher success rate with quality, active clients. This can be through launch parties in metro hubs and event sponsorships (such as conferences).
However, gaining consistent ROI (return on investment) makes this difficult to scale as a long-term approach. Some events can lead to 100+ signups, while others deliver less than 20.
Realistically, most adults aren’t actively looking to switch their existing bank unless they had a poor experience. Fees (such as maintenance or overdraft), poor customer support, or losing a fraudulent dispute are top points of frustration. These incidents may be few and far between for the majority of bank & neobank clients today. The trigger for growth needs to come from product.
Which products & features most resonate with a target customer group?
Extra points for the neobanks that are doing something unique in the space as part of their core offering. This can be overdraft protection, cash advances, early wage access, subscription discounts (through partnerships), or customized insights for budgeting/investing/advising. Neobanks need to go beyond tablestakes (deposit account, debit card, payments) toward best-in-class program suites.
Another opening can come through teen banking (especially pre-college). Historically, teens first start their banking relationship where their parents bank OR at an on-campus event. Neobanks that can catch these students at this crucial time (on an ongoing basis) would gain significant traction.
quality customer support is expensive
What it takes to provide quality customer support in financial services often flies under the radar.
It’s a basic necessity that lacks the shine we see in other parts of fintech. A personalized experience that is dialed into unique financial situations and anticipates upcoming needs goes a long way. Similar to customer acquisition, many of the most promising efforts are difficult to scale.
The industry emphasis is for automated support in which users have self-help options through frequently asked questions and scenarios.
However, clients come to expect the ability to reach a ‘live person’ for any issue they have, in a timely manner. Once they connect with a support agent, their concern should be solved for in a few minutes — without the need to be transferred to multiple agents.
Live support is expensive for any company. Less costly options exist to outsource this to offshore contact centers, but this may feel off-brand for a neobank that delivers a specific level of engagement.
Chatbots became a popular alternative about 3 years ago due to their responsiveness and ability to automate.
Unfortunately, there’s a breakdown when it comes to understanding transaction history, deciding on exceptions for a customer issue, and detecting/responding to customer sentiment in an authentic way. Some of these items should be solved by the next generation of artificial intelligence (AI) models, which have improved data processing and recommendation capabilities — but this is still 18+ months away.
Stabilizing revenue streams
From the early example we highlighted above, a pure ‘interchange-only’ neobank isn’t viable.
Ultimately, platforms will need to charge a monthly subscription fee to cover recurring user costs and stabilize revenue growth. Ensuring there’s true value in a subscription is paramount. However, not all customer groups can afford to pay a monthly fee OR are willing to pay when ‘no-fee’ alternatives exist.
Only certain segments (typically not the underbanked or unbanked) would pay for banking services. To focus on the underserved (in a profitable way) requires high engagement and transaction activity per user, which is difficult to scale in today’s market environment.
The modern approach to building & launching a neobank from scratch should be flexible for multiple user groups through a tiered approach.
A ‘basic’ level of services should be available for customers avoiding bank fees. A wallet with budgeting insights, fee & subscription negotiations, reward programs, and affiliate discounts can all be included here. Neobanks would monetize off of affiliate partnerships (with merchants), deposit interest, and fee negotiations.
A ‘premium’ tier can also be created that provides a full deposit account and debit card, high-yield savings, cashback on card spend, no-fee ATM withdrawals, emergency cash advances, and early payday access. Interchange, deposit interest, and paid subscriptions would be revenue drivers.
With this path, premium clients can offset the costs for basic tier customers. The goal would be to convert more ‘no-fee’ clients into a paying tier over time. More subscription fees on a monthly basis increases the chances that a neobank will not only survive, but thrive.
The dynamic for neobanks has flipped: establish a product that customers would pay for, then build a program that supports one or more needs of the underbanked (without user fees).
ASKING THE ULTIMATE QUESTION:
Does my target customer need a neobank?
Many (newly launched) neobanks of today provide minimal to no differentiation — numerous no-fee alternatives exist for a deposit account, spend card, and payments. Lack of differentiation means no true value for the target customer. Without value, there’s no client engagement (e.g. deposits or purchases).
This will lead the neobanks that are still active to move away from providing an anchor checking account towards an affiliated financial product that’s in higher demand.
This can be lending, wealth management, or business management services for small & medium-sized enterprises. Once this non-deposit product gains traction, THEN a platform can add-on a full banking relationship.
In this path, there’s minimal customer acquisition cost because the client has an existing relationship. The monthly servicing cost can be blended with what the platform is currently paying for customer support (on their core product).
Neobanks may also get a boost from the new generation of partner banks and Banking-as-a-Service (BaaS) providers. These infrastructure players are finding creative ways to alter their cost structures to give new neobanks a chance at strong, net new growth in the first year through a lower floor of costs. The revised model would resemble more of a partnership (than a vendor relationship) in which banks & BaaS take a bet on new program in exchange for equity.
However, the main hurdle across all financial services in the next year is regulation. Regulatory agencies are pressuring banks to have better controls over risk & compliance of 3rd party platforms. Oversight needs to improve, but this can’t all be the responsibility of financial institutions. Neobanks need to shoulder some of this responsibility and cost in 2024.
what’s next for NEOBANKS?
There’s an overhaul of the neobank coming in the next 18 months.
Becoming the next Chime (for consumers) or Mercury (for businesses) is no longer viable (or as easy).
Traditional banks are becoming more experienced in developing new, digital offerings with the help of fintech infrastructure & program managers. This will lead to financial institutions acquiring existing neobanks that may be struggling to survive, and repurposing some of their products & features.
For founders & product teams starting to build now, the focus shouldn’t be on creating a neobank. Priority needs to center on what type of program a customer be willing to pay for. Once a startup finds this opening, fully commit to the product being as helpful to clients as possible.
The landscape is shifting towards ‘modular bundles’ with Embedded Finance. Infrastructure providers are building packages focused on payments, deposits, lending, insurance, and wealth management delivered through a platform’s portal. This is an easier proposition to start with (from a unit economics perspective), instead of ‘everything, all at once.’
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