Coming into the 2020s, more and more people are embracing the digital era and incorporating the opportunities it presents into their lives. More specifically, a greater number of people are embracing the rapidly evolving and developing world of fintech, making their financial lives significantly easier than they have been for the better part of 30 years of dealing with big banks.
In part, this comes from the evolving nature of work and employment. Freelancers working in the gig economy now account for over 56 million people in the United States, with more Gen Z consumers launching their own side hustles and businesses while a maturing millennial generation incorporate more and more digital services in their lives. This is where neobanks come in.
What are neobanks?
As a quick summary, just in case you opened this article without really understanding the title, neobanks are also known as ‘online banks’ or ‘internet-only banks’ and are exactly what they sound like. They are banks that have no physical presence in the world - no ATMs and no branches. The exist solely on the internet, in the form of web pages and an app.
The term neobank was first used in 2017 to describe fintech firms that were challenging traditional banks and the market has since exploded. Noteworthy names (from a substantial list of alternatives) include Starling Bank, Monzo, MYBANK, Chime and Xinja. The term is arguably interchangeable with ‘challenger bank’ - that is, a smaller banking firm that challenges the well-established veterans that dominate the field. However, some challenger banks have physical branches while neobanks are exclusively web-based.
Neobanks have been helped, in no small part, by the shift towards ‘open banking’ policies by many world governments. New regulations have demanded that all banks, including the old staples, allow their data to be accessed by third parties when such is requested by the account holder. This has given tech companies the opportunity to insert their unique brand of innovation into an industry that has historically been extremely resistant to it, leading the a whole suite of new banking options that are able to compete on an equal footing with the well-established institutions.
Serving the underserved
One particular way in which fintech and neobanks have innovated in the world of banking is in providing greater degrees of customisation, helping to serve those that would ordinarily be missed by the cookie-cutter offerings of larger institutions. They, unlike their older cousins, are better able to meet the needs of the unbanked and underbanked, freelancers and small business owners, as well as digital nomads and recently settled immigrants.
Being outside of the typical customer profiles, such individuals have often been poorly served or have had to endure significant penalties just to have an account, including large monthly and annual fees due to low account balances or a lack of direct deposits. They would often also be unable to receive reliable and useful banking advice from institutions that do not train their advisors for such unusual circumstances.
Of course, the other significant evolution that has allowed neobanks to emerge is the ever-increasing rate of smartphone adoption and internet penetration around the world. Even extremely remote parts of the world, miles and miles from the nearest bank branch, are now able to get internet access. With a particular shift towards using apps over browser pages in the last 15 years, neobanks have been able to evolve to match their customers’ preferences.
The results speak for themselves, with 43 per cent of 18 to 24-year-olds and 40 per cent of those aged between 25 and 34 now preferring to bank through a smartphone app. Older customers are not far behind, with significant proportions each of the subsequent age brackets doing most of their banking online, either through their smartphone or their PC. Once you hit the over-65s bracket, it’s more than two thirds (67 per cent).
Adapting to serve
The famously agile tech world has proven to be better suited to adapting to the ever-evolving needs of customers and regulators than the old juggernauts, especially when it comes to sharing and utilising data. The best example of this is fintech taking the initiative to analyse data to show trends in budgeting, spending habits and long-term saving, offering clients advanced level of information and support for their financial health. Apart from being an extremely useful service that deepens the relationship with said client and their commitment to their bank, it’s also a premium service that can become an additional revenue stream for a neobank.
That’s not to say that neobanks have not faced challenges. The mobile banking revolution has yet to take the world by storm, as evidenced by the continuing dominance of traditional banking. The reason is that two essential components are missing that prevent the creation and development of neobanks - infrastructure and technology. However, even here, the tech world has found ways to adapt.
A Banking-as-a-Service (BaaS) approach to structuring neobanks has allowed the fintech sector to deliver customer needs quickly without needing to establish too much in the way of infrastructure. They bypass this need by instead utilising existing banking infrastructure through APIs (application programming interfaces), which take mere months to develop and launch and usually requires no monetary licenses or huge amounts of capital.
Through a series of APIs, user accounts can be created and transactions completed, with additional customisation like direct deposits, debit and credit cards and other typical banking services available on top of that core framework. The actual banking infrastructure is provided by a partner bank, which holds all of the accounts and funds. Synapse, Cambr, Bankable and Treezor all work in exactly this way.
The alternative to tech firms partnering with traditional banks in order to establish a neobank is for banks to partner with tech firms or even develop their own BaaS-style platform internally. Just as above, APIs are used as the customer-facing element of the system for customer-initiated onboarding, account funding and other banking activities.
The downside is that there is a greater responsibility on the part of the neobank for them to develop compliance, implementation and end-user support when they are partnering directly with a bank, meaning that the process of setting up the bank takes longer. However, successes have been seen in cases like BBVA, Fidor Bankand GreenDot.
The final and least popular approach to setting up a neobank is to go through the whole rigamarole of getting the appropriate licenses on their own, without working with an established bank. Effectively, they become an independent traditional bank with no branches. However, this is the most challenging approach and, as such, has seen the fewest success stories.
The issue with all of the above-listed approaches to starting a neobank is that they all depend on traditional banking infrastructure to do most of the work. The tech aspect is just a fancy frontage and, while it makes a significant difference to the user experience, the money is still going around in the same circles. Where does the neobank make its money if they are just passing requests through to other institutions?
Financial institutions have traditionally made their money through bank fees, deposit interest margins and loan interest income, none of which are available to neobanks using APIs to direct client requests through an established infrastructure. A more recent addition to the list comes from card interchange revenue, however, which neobanks can earn from.
When a customer uses a neobank-issued debit card, the merchant pays a processing fee. It’s automatically deducted from the total cost of the purchase, so it never directly impacts the customer (although some shops still add a slight charge if you want to make a small purchase with a card instead of cash to help them absorb this expense). This fee is perfectly normal - Visa, MasterCard, American Express and Discover all charge fees, as do traditional banks.
However, with this being the only one of the old revenue streams available to neobanks, they have obviously been forced to diversify and get creative. The result is that additional services are typically added, including high-yield savings, payroll advances, personal loans and credit lines. The goal is to encourage the customer to stay as a customer of the neobank instead of jumping ship at the first sign of a better offer - a habit that is growing among more recent generations. So far, it seems to be working.
How are traditional banks responding to neobanks?
So successful are neobanks at retaining customers that traditional banks have been forced to react in order to remain relevant. Fortunately for the customer, they have broadly decided to rise to the challenge and incorporate many of the lessons neobanks have been learning about how to be more relevant and effective.
There are, broadly speaking, three options for traditional banks to take when it comes to responding to this threat to their income and customer base. These are:
1. Develop similar products themselves,
2. Partner with fintech companies and get them to develop similar products,
3. Partner with a neobank and become the bank behind the BaaS solution.
Option 3 is an especially effective option, allowing banks to attract revenue from a broader array of sources by partnering with multiple neobanks. With minimal effort, they can accelerate their digital transformation and expand into new markets. However, the inevitable challenge they face is that of opening up their system to third party integration and working with the APIs neobanks use.
Concerns regarding security, especially where financial data is concerned, are both one of the greatest advantages traditional banks hold over neobanks as well as one of their biggest obstacles when it comes to partnering or expanding their own digital financial services.
Regulation saves the day
The world of neobanks is one of the very few occasions where new regulations are helping instead of blocking development. Many governments around the world are pushing for traditional banks to be more open when it comes to allowing third-party access to their data. Open banking regulations are especially prevalent in Europe, where the Payment Services Directive (and it’s second amendment) dropped almost all of the initial barriers for neobanks, spawning the likes of Monzo, Revolut, Starling Bank and many more.
By contrast, The US has so many regulatory bodies involved in banking at both state and federal levels that open banking has hit a lot of speed bumps. Other key areas like Asia, Canada and Australia are making progress to one extent or another.
One of the key drivers in the development of neobanks is Africa, where the vast unbanked population has created an urgent need for them. That being the case, Nigeria and other nearby countries have government-run associations to accelerate the development of the APIs needed for open banking.
The UK is probably the market leader in terms of creating an encouraging environment for neobanking. This thanks to transparent regulatory conditions allowing third-party access to bank data, along with clear ownership of personal information, all overseen by the Financial Conduct Authority.
What does the future hold?
Fintech firms have been slowly grinding down the dominance of traditional banking for years, even with non-bank brands like PayPal, Mint and Rocket Mortgage allowing independent financial services. As companies traditionally known for eCommerce start obtaining banking charters or partnerships, that process is only likely to accelerate.
In particular, neobanks will likely be targeting profitable yet underserved demographics - freelancers, small business owners, travellers and immigrants. They can generate revenue with innovative solutions and additional services beyond just deposit accounts, debit cards and payment processing. They can offer support for tax calculations, employee benefits, expense monitoring, global account access and simple account set-up, to name just a few.
In short, with continued innovation and a powerful push towards open banking, the future of neobanks is a very bright one indeed. And, with their development, the opportunities and options available for customers will only get better, too.
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