Digital-only “Neo” Banks – Are They Viable?

What are digital banks?

Digital banks, otherwise known as Neobanks, operate like regular banks and are Authorised Deposit-Taking Institutions (ADIs), and hence hold the necessary licences to take deposits, offer savings, mortgages, and loans to users. However, these banks have no physical branches and they operate solely online and generally interact with users through a mobile application. Although this reduces the personalisation of banking, Neobanks can leverage the vast amount of user data and use data analysis to provide a more personalised online banking experience. This can be done by recommending services that are tailored to the user, for example, recommending a low interest credit card for someone who makes regular purchases or a term deposit to someone with lots of savings.

Although Neobanks’ core business model still revolves around the interest rate spread between deposits and loans, many Neobanks also offer a range of other services. These services include stock/crypto trading, foreign currency exchange, insurance, and income & expenses tracking. Neobanks’ main competitive advantage lies in providing users with a superior user experience and lower costs without compromising the range and quality of services provided.

Who are the main digital banks in Australia and overseas?

Internationally, the top ten Neobanks have a combined valuation more than US$70 billion. The largest players globally include Nubank, Chime, Sofi, Revolut, Monzo, and Webank. Of these, Webank has over 200 million users in China, followed by Nubank with over 35 million users in Brazil and Chime with over 12 million in the US.

Neobanks entered Australia in late 2018, with the major players being Up, 86 400, Volt, Xinjia, Hay, and Judo.

• Up is backed by Bendigo and Adelaide bank, and provides users with a savings account and transaction account for everyday use.
  
   
• 86 400 was launched in September 2019 and has features including savings, transaction and home loans.
  
  
  • 86 400 was acquired by NAB in early 2021 for $220 million and is currently subject to review by ACCC.
  • At the point of acquisition, the Neobank had 85,000 customers, $375 million in deposits and $270 million in approved residential mortgages.
    
     
• Volt and Hay are offering similar services to Up, allowing users to manage their savings and transactions on their online platforms.
  
   
• Jodo is a Neobank focused on providing services to businesses as opposed to consumers with their main services being business loans, term deposits and business mortgages.
  
   
• Xinja ceased operations in early 2021 after World Investments cancelled their $433 million proposed investment as a result of Covid induced uncertainty.
  
  
  • This begs the question whether Neobanks are sustainable in the long run.
  • Nonetheless, Neobanks spend millions on marketing and sign up offers to attract new users and need significant capital to grow a sufficient size in hopes of achieving profitability.

Are Neobanks the next stage in the evolution of banking?

Many have argued that Neobanks are the next stage of evolution in the consumer banking industry. As digitalisation becomes more prominent in all sectors of the economy, it was only a matter of time before technology disrupted the way people access their money. Without the presence of physical branches Neobanks are able to significantly reduce operating costs and these savings are passed onto consumers, via a reduction in fees. Millions of people who are underbanked in developing countries, e.g., Brazil/India, or are working in the shadow economy can use Neobanks and their services to get access to a diverse range of low-cost financial services.

In Australia, the introduction of Neobanks have increased competition in the financial sector. Prior to 2017, over 80% of Australians bank with the large 4 banks as they hold an oligopoly in commercial banking. The subsequent deregulation increased the number of ADIs issued and allowed Neobanks to penetrate the market and foster an increased competitive environment. This increased competition, driven by the Neobanks’ ability to operate with a smaller cost-base, has forced the big four banks to redesign their mobile platforms and decrease fees for savings accounts. Nonetheless, despite the disruption that Neobanks have achieved in the commercial banking industry, they lack the ability to generate profit for their investors.

The million dollar question - long-term viability and sustainability?

The lack of profits has prompted many to ask whether Neobanks are self-sustainable as they can’t rely on venture capital funding in perpetuity. According to Deloitte, the three main challenges facing digital banks are:

1. Attracting customers
    
2. Diversifying revenue
    
3. Growing the business to large volumes

As evident with Xinja, Neobanks are heavily reliant on external funding when attracting new customers and scaling. However, can Neobanks generate sustainable growth to secure long term profitability?

Digital banks need to acknowledge the need to transition from a growing at all costs to a profitable and sustainable business model. According to a survey by Deloitte, there are six overarching insights.

1. Older and wealthier customers are more willing to engage digitally.
    
2. Covid has dramatically changed the way people manage wealth. Companies are also accelerating their digital presence, with 77% of CEOs claiming their digital agenda has been accelerated by Covid.
    
3. Younger customers are more willing to pay for banking services. On average, customers are willing to pay $13 for initiation and a $9 monthly subscription for banking services.
    
4. Customers prefer subscription services, which offer transparency and easy cancellation.
    
5. Loyalty benefits and reward programs are expected by most consumers.
    
6. Younger customers value social and environmental awareness with their digital banking experiences.

Deloitte concluded that customer engagement is essential to Neobanks as more engaged customers are more likely to sign up for additional products increasing the ARPU (average revenue per user). Neobanks can leverage their data collected to better predict consumer behaviour and recommend products and services to users. They should also target affluent customers, as research has shown that they generate more than two times the revenue from an average mass consumer. Leveraging higher engagement and targeting more affluent customers should allow Neobanks to secure diversified revenues and better margins generating sustainable growth and profitability in the long run.

The UK Prudential Regulation Authority expects start-ups to be profitable around 5 years after being founded. For existing Neobanks, the current economic conditions are favourable for private equity and venture capital funding and in Q1 of 2021, according to Bloomberg, global VC funding exceeded $125 billion and private equity investments and buyouts are forecasted to exceed 1.1 trillion. Furthermore, low interest rates and strong business confidence should allow most Neobanks to receive abundant financing in the short run and attract new users, especially affluent high net worth users. Nonetheless, the long run viability of Neobanks depends on management’s ability to incorporate sustainable growth within the business strategy. A potential consideration includes high user engagement to generate sustainable subscription income alongside interest income from loan products.

The takeaway

In summary, the current economic climate fosters financial innovation within the fintech industry and Neobanks in particular, will be able to absorb financing from the loose wallets of VCs and Pes. Albeit financing secures short term goals, management must recognize that the long run viability of their Neobank will depend on the company’s ability to keep users engaged when the sign-up benefits end. In the meantime, we should enjoy the fancy platforms and sign-up offers as they won’t last forever.