Digital-only banks, or neobanks, have been a major focus for investors, and are gathering new customers by the boatload. But are they really banking’s future – or just a sophisticated fad for tech-savvy millennials?
Go to any advertising billboard or bus-shelter in the UK urban centres and you’ll see it: wave after wave of advertisements for neobanks, from Revolut to Monzo, Starling, OakNorth and, until recently, Germany’s N26. A similar consumer blitz is underway in the US and major European markets.
Data from these new digital-only players suggests consumers are liking their pitch: Monzo recently announced it had acquired 3.8 million customers to date in the UK, and expects to reach at least 5.5 million in the next year or so. Across the neobank sector globally, PwC predicts compound annual growth of 46.5{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} each year until 2026, when it says neobanks will be generating revenue – not profit, of which more soon – of $394.6 billion annually.
Growth of this magnitude is naturally attracting attention from investors and competitors. 2019 funding rounds by Starling and Monzo netted both organisations US$100 million, while Revolut’s February 2020 funding round raised $500 million and valued the company at $5.5 billion – three times what it was worth just two years ago.
After Goldman Sachs’ successful entry to the segment with its “Marcus” brand, which is picking up a billion dollars a month globally in deposits, JP Morgan announced its plans to launch a rival neobank later in 2020.
Neobanking displays all the characteristics of a new segment of economic activity: high company valuations, serious investment – and rapidly growing competition. McKinsey notes the number of neobanks worldwide grew from 2,000 in 2017 to more than 5,000 today; the consulting giant says new investment in the segment rose from $2.3 billion globally in 2018 to $3 billion last year.
Yet doubts about the long-term viability of neobanks persist – and the doubters are growing more vocal. For George Davies of Hambro Perks, “the jury is massively out as to whether neobanks can continue to grow at present rates. Fuelling this rate of growth is expensive.”
Adam Bialy, Chief Product Officer at OpenPayd, concurs, noting that “Monzo generated losses of £48 million last year, and £100 million over the last two years. There have to be serious doubts as to whether the firm will make any money in the next two years, either.”
If Neobanks are moving into a more complex development phase, then incumbent banks aren’t standing still: research from Tenemos for The Economist shows that 56{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} of traditional banks will partner with FinTechs to take on the neos – and another third say they’ll be setting up their own digital-only brands in the next 18 months.
Pick your yardstick
The debate about where neobanks go next depends, to some extent, on how you measure success. N26 CEO Valentin Stalf has famously gone on record to say profit is of less interest to him than customer acquisition – yet the low business volumes transacted via digital banks must be a concern for both management and investors.
Recent quarterly filings reveal the average Monzo customer has a mere £150 in their account with the bank, while estimates from payment processor Adflex suggest that just 19{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} of UK digital banking accounts are actively used by their owners.
And there’s no question of any of these banks making profits in the near term – although, as Laura McCracken, EVP at Wirecard reminds us, “Amazon was a non-profit business for its first twenty years. Digital banks are trying to build an entire sector. Consumer banking is the bit we see: but B2B services is where these banks will make most money.”
Hot and not
It’s not hard to see why digital-only banking looks like a good idea. Traditional banks are burdened with everything from expensive customer service arrangements such as the costs associated with maintaining a physical branch network, hugely complicated and often outdated technology systems and generous staff contracts and benefits.
Fairly or not, traditional banks are also often perceived by their customers to be slow, bureaucratic and expensive, especially in areas such as international money transfers, investment management and loans.
By contrast, digital banks claim to offer low costs, high rates of interest (up to 2.5{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} on standard savings products, compared to around 1{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} for most high street banks) and – best of all for the millennial generation – near-real-time services over mobile in for current and deposit accounts, payments and transfers.
In a finely-nuanced paradox, though, many of digital banking’s perceived advantages for the millennial generation are less attractive to other parts of the population.
Take the lack of branches, for instance: although a 2019 study from Javelin Research found that 50{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} of customers thought online banking was the most important thing a bank could offer, the other 50{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} said having a physical branch network was more important than internet banking.
Furthermore, the freshness that digital-only banks offer, including low or no-fee banking and fast service delivery, is arguably offset by their lack of experience, narrow product range and the regulatory and compliance difficulties they have encountered, such as mistaken account freezes, mandatory PIN resets and data breaches like the ones suffered by Monzo via Ticketmaster and Typeform.
Which way up – or down?
The standard business school model of market development suggests that neobanking is still in its infancy, with valuations soaring and new players proliferating. That said, there are signs that we may be near the end of this phase of growth, with differentiation between the various digital players’ offerings starting to occur as some pull out of or enter various market segments and geographies.
Berlin-based N26 recently caused much fanfare when it pulled out of the UK, citing uncertainty over costs and regulation post-Brexit as the reason.
However, several sources consulted for this article doubt that Brexit was really behind N26’s pull-out, noting that the firm had struggled to gain traction in a market rich with home-grown competitors such as Monzo, OakNorth, Starling and Revolut.
Conversely, UK-based Revolut, Europe’s most highly-valued neobank, announced its launch in Asia in October 2019. In February this year, Revolut began offering customers an aggregated overview of all of their finances from any institution over one platform in a bid to attract those keen on Open Banking via shared APIs, as permitted under the EU’s PSD2 regulations.
“The fastest declines in app usage for 2019 all came from traditional banks.”
In a way, Revolut’s move into aggregated accounts captures the essence of neobanking. It sounds funky and cool, some people say they want it – yet many others remain lukewarm, at best, to the products on offer.
Although bringing all your accounts together into one platform sounds like a great idea, a mid-2019 survey of UK consumers revealed that two-thirds of them had never heard of Open Banking – and only 8{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} thought it was a good idea.
High investor valuations but not a whiff of profit; huge numbers of accounts being opened, yet very little business being transacted – if neobanks are currently riding high on a wave of investor expectation, consumer enthusiasm and no small degree of hype, that doesn’t make it any easier to see a clear way forward.
Not i-deal
One of the more obvious suggestions for the future of neobanks is that they end up getting bought by traditional banks eager to acquire their customers, their glitzy user interfaces and faster technologies.
Yet given the high valuations placed on digital banks by investors, such deals would not be attractive to incumbent banks at present – which explains why players such as JP Morgan, Goldman Sachs and Canada’s CIBC have all chosen to launch their own digital banking brands, rather than purchase an overpriced upstart.
A more plausible future is market segmentation, product diversification, and scaling operations as much as possible. In plain language, that means getting bigger by selling more things to more customers in different places and standing out from the competition.
As skeptics have noted earlier, such ambitions don’t come cheap, and investors are going to have to be patient – and possibly have strong nerves – for longer than they might expect before they reap the rewards.
The race is on
It all seems to hinge on whether neobanks really are displacing traditional banks at the rate they claim. At some point, investor patience is going to wear thin, valuations will drop – and that’s when market share and profitability will start to matter.
According to some intriguing metrics published by SimilarWeb, an internet traffic analysis company, there’s evidence that neobanks are having a real effect on consumer’s bank preferences and making genuine inroads into traditional banks’ territory.
Although long-established incumbent bank Barclays remains the UK leader in online banking, Monzo’s active user base grew three times faster than Barclays. Overall, traditional banks’ web traffic for internet banking declined by 18{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} over the last two years.
While NatWest app installations declined from 8.8{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} of the UK population to 8.3{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f}, those installing Monzo rose from 2{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f}to more than 5{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f}. Likewise, Revolut’s installed base grew by 67{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} to reach 3.2{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} of the population by the end of 2019.
And the fastest declines in app usage – a better indication than installations when it comes to measuring user uptake – came from traditional banks, with Lloyds app usage down 25{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f}, HSBC down 22.5{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f}, and Halifax down by 19.1{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f}.
At its core, success in neobanking is not just about the ability to attract customers, but translating these customer numbers into active, profitable accounts. And that, in turn, means delivering on the promise of faster, better and cheaper services.
Whether the oft-proposed strategy of finding niche markets to exploit can be squared with growing customer volumes is open to question: there’s also some doubt over the extent to which consumers trust digital banks to deliver on their promises.
New research in the US from anti-fraud company OneSpan may give neobanking’s cheerleaders reason to pause for thought: their 2020 survey of 300 US digital banking customers and 100 bankers found that more than 50{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} reported having been the victim of fraud during the online account opening process – a staggering and barely credible figure.
Concerns about online fraud help to explain why 60{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} of bank respondents to the OneSpan study say they require new account holders to appear in person to verify their identities – something that’s about as “traditional bank” as it’s possible to imagine.
The end of the beginning
It appears the evolution of neobanking will be shifting gear in 2020, from the early days of proliferating competition and hype to the sober reality of making profits by serving customer needs.
As Lu Zurawski, Retail Banking Lead at ACI Worldwide puts it, “as they mature, digital banks will learn important life lessons about reliability, [and about] how consumers may prefer a bank that provides them with a great customer experience.”
One possible future for neobanks, however unattractive from some perspectives, is the emergence of a global giant to rival not just traditional banking giants, but also big tech companies like Google and Apple that have their own designs on the financial services sector.
At present, promising contenders for this role would be Britain’s Revolut or Chime in the US – though whether these firms can remain nimble and focused on profitability as they seek to realise their global ambitions is, for the moment at least, still unclear.
Whatever happens next, experience suggests that a degree of consolidation and reduction in the number of players in the neobank market is not far away – unless more neobanks can encourage customer usage, expand their product range, and move further down the road to making a profit.
PCM SAYS…
Clearly, not all of the 5,000 extant neobanks are going to survive the next five years of rapid change.
However, given the multiple challenges faced by large, incumbent financial institutions – including their expensive legacy technologies and branch networks – one can see the attraction of digital-only banking for investors.
Neobanks only look better from an investor perspective when the shift to purely digital person-to-person (P2P) and account-to-account transactions is factored in: in a purely digital world, much of the traditional bank’s payment infrastructures would become less significant.
Finally, there’s no denying that some major banks have been far too slow to change. A review of banking Annual Reports for 2019 would suggest the banks are keen to put that right, and that they are all investing heavily in new technologies.
All of that said, the longer-term prognosis for neobanks seems to hinge on whether they can persuade sufficient numbers of users to transact more business across more product lines quickly enough to satisfy their investors.
The fact that 50{3c4481f38fc19dde56b7b1f4329b509c88239ba5565146922180ec5012de023f} of consumers still prefer to use physical branches must be a concern in that regard; as is the data that Monzo’s average account balance was around the £150 per customer mark last year.
While neobanking has generated much heat and light, and held the big banks’ feet to the fire in terms of fees and customer service, there’s still a considerable road to travel before we can talk of a revolution in retail banking.
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