The model makes sense in theory but faces challenges in reality.
A common model for many neobanks is to develop a current account (or pseudo current account1), provide some basic (typically non-interest bearing) savings pots, and deliver this all through a well designed mobile app. Revenue comes from scale and profit comes from a marketplace.
First, let’s cover some of the basics about these propositions.
Hygiene factors for many of these now include:
- Instant spend notifications
- Free foreign transactions
- Free and instant bank transfers
- Simple dashboards and budgeting
- Freezing / locking a lost card
And the differentiating features come in many flavours; some examples include:
- Early access to your salary
- Stocks and crypto trading
- Aggregation of external bank accounts
- Metal cards
There’s sometimes an element of customer segment targeting, for example Monzo targeted travellers early on, but this usually doesn’t last long - the underlying product is ultimately a commodity.
The business model naturally becomes a digital-only, mass market current account. Join the club.
Back to monetisation and revenue - for these neobanks, this has two key levers:
- Returns from scale, and
- Monetise that direct customer relationship.
Without the two levers, the model fails. Fixed costs need to be spread across the largest possible number of customers and current accounts are not enough to acquire and retain such a customer base over a longer term.
Returns from scale
The more simple element of the two; you take a very small return from each customer (e.g. payment interchange fees, foreign exchange basis points) and multiply this by a large customer base. Voila, you’ve got yourself a profit as long as customer acquisition is cheap and your remaining costs are fixed and not variable.
We lose money on every sale, but make it up on volume.
This happens to be the case for most neobanks, where:
- their product development approach is to build once for all customers,
- customer acquisition is low cost and driven by word of mouth or feature virality (e.g. Monzo’s payment splitting), and
- their customer service is either:
- mostly self-service or
- sees lower demand because the product itself is better built.
(Still, in some cases, these don’t hold true and the neobank remains loss-making for years. This is leading many to thinking 2020 will be a year of consolidation and acquisition by the bigger banks.)
The math works as long as scale is achievable and sustainable. But this is a highly competitive environment and, as I said, a commodity product. Success breeds jealousy, which results in more market entrants.
Monetise that direct customer relationship
So the neobanks must the leverage the relationship they’ve built with the customer into other products and services. This is the traditional current account cross-selling approach; use the transactional product to make a profit in large, long term loans and cheap, sticky deposits.
The problem is many can’t, or don’t want to, have a large balance sheet. In some cases their regulatory status limits this and for others it’s a desire to avoid the burden of further regulation.
Enter the product marketplace. Sometimes built as a specific area within the app, sometimes found at the end of a product selection journey - the marketplace allows a neobank to offer traditional banking products (mortgages, savings, loans, insurance, etc.) without the in-house capability or regulatory risk.
Traditionally banks often want to get mortgages they’ve sold off their balance sheet by crafting tranches of loans, securitising them and offering them up to external investors. The marketplace approach is arguably a more direct version, whereby the bank never has the mortgage assets or savings liabilities on its book and leaves the messiness of liquidity management, tranche analysis, and potential securitisation to those more willing and capable.
Marketplaces currently exist in one of two states: open and closed (aka curated).
- Open marketplaces allow any and all third parties to advertise products, assuming they satisfy any minimum eligibility requirements.
- Closed marketplaces seek and select the most appropriate partners for their needs.
Either way, the neobank is able to earn a commission on the customer referral while further cementing their app’s role as the key financial hub.
The marketplace model is highly extensible and scalable too; additional product types require direct integration with the third party, typically requiring a fixed amount of time and cost, and instantly provide all customers with low friction access.
However the marketplace model’s theoretical success has faced some practical challenges.
Firstly, traditional banks would rather offer their customers competing products than risk losing the customer entirely. We now have companies like Raisin doing exactly this for any bank that wants to provide a savings marketplace.
Secondly, the quantity and quality of potential marketplace partners remains low. Some deposit takers, such as OakNorth, have built integration-friendly operating models and therefore feature regularly on closed marketplaces. Other choices include relatively new fintechs seeking growth, such as Mojo’s mortgage partnership with Monzo or Habito with Starling.
From a customer’s perspective, these partners can be frustrating. Many are relatively unknown brands and others are actively turning away customers as they reach their balance sheet capacity. So far, the large banks with household names and plenty of balance sheet capacity are reluctant to become secondary providers in someone else’s primary relationship.
The current account plus marketplace model was conceived at a time when Open Banking and PSD2 were destined to open up the sector and equalise the playing field. The neobanks failed to realise that the regulatory requirements can be fulfilled in one of two ways: at pace to the fullest extent possible or slowly and satisfactorily.
Now we must wait and see if the growth of new fintechs and neobanks (who typically build with Open Banking in mind) is enough to realise the full ambition of the model. Or if customer apathy and legacy bank responses will stunt the vision, leaving us with a small number of neobanks and an unrealised ambition.