Full-stack neobanks are taking the retail banking market to the next level

[This landscape is not intended to be exhaustive, there is an incredible amount of innovative Fintechs in Europe offering similar services]

The retail banking market is ripe for disruption

The fact that all incumbent companies, retail banks included, are facing a major risk of disruption has become common knowledge, but it’s particularly true for the banking industry as it gathers all the ingredients for disruption. Please note that this analysis will only focus on European retail banks for the sake of simplicity.

In order to cook a delicious banking disruption you will need the following ingredients:

1. [The disrupted] A 4,000 year-old market that has become a commodity since innovation, transparency and customer service haven’t been at the center of the value proposition: European retail banks

2. [The trigger] A macro-economic context and a new set of regulatory frameworks which challenge the incumbents and their business model: Low interest rates, Basel III, PSD2, GDPR, Regulatory “sandbox”…

3. [The disruptor] A technological shift in favor of new agile entrants with disruptive business models: Fintechs

4. [The catalyst] A high level of customers dissatisfaction supported by their behavioral change: Mobile-first

The retail banking market is one of the oldest and biggest markets in the world. For the European region, it represents a number that the human brain can barely figure out: 390 billion euros of annual revenue. Such a big market is also the beating heart of the capitalist economic system: it can’t get rid of regulation.

source: European Central Bank

After a successive wave of crises — subprime in 2008, Greece in 2008, and European Sovereign debt in 2010-, the macro-economic context has not really been in favor of banks and their business model, which is transforming deposits/savings into credits.

On the one hand, Basel III limits their leverage ratio. On the other hand, deposits can cost them money in a low interest context. Before the crisis, European banks regularly reported ROEs (Return on Equity) above 20%. In this new low profitability context, cost of equity could be higher than expected return in Europe.

Besides the pressure on profitability, European regulation aims at increasing competition in all markets, not sparing banks. Two major movements are converging: the Payment Services Directive (PSD2) and General Data Protection Regulation (GDPR). Both will help to regulate an open banking model in order to foster innovation and competition.

PSD2 is set to take effect before January 2018 and will force banks to open their APIs, enabling individuals to easily share their financial data. GDPR is complementary to PSD2 by ensuring that security will be uniformly enforced across businesses dealing with financial data. Thus, the line between banks and Fintechs or tech giants could shrink if they can easily build financial services on top of banks’ infrastructure and data (which will require an opt-in from the end user).

Furthermore, the regulatory cost of scaling a Fintech in Europe could drop with the EU’s intention of creating a unique digital market. It could allow Fintechs to beneficiate from a pan-European sandbox and pan-European licenses. For example, it’s already the cases in the United Kingdom, Singapore or Honk Kong and it’s not a coincidence if most of the full-stack neobanks are based in London.

The low-end disruption of the retail banking market

Thenceforth, favored by the macroeconomic context and the regulations, a low-end disruption is threatening the retail banking market. As defined by Clay Christensen in his book, The innovator’s dilemma, a low-end disruption is a simpler, cheaper or more convenient solution in a market in which customers are over served by existing products. By disaggregating banking services, Fintechs and tech giants are offering a better alternative to existing services, they’re redesigning the business models.

Moreover, the digitalization of the customer relationship increases the possibility of a low-end disruption. Nowadays, more than 80% of interactions occur through self-service channels. Mobile banking apps are top ranked in each app stores. Meanwhile, branches are becoming less and less economically relevant for banks. A recent study shows that in only 2 years more than 1000 branches have closed in the UK. The same trend is observed in France, where BNP Paribas recently announced that they will close 200 agencies before 2020. The personal relationship with a physical banker might disappear for the non-premium customers’ categories and a great example of this trend is Bank of America’s opening of 3 fully automated branches.

In the meantime, incumbent banks raise increasing customer dissatisfaction. Since banking services have become commoditized, prices are driving competition in a market where the churn rate remains low (around 10% in Europe). Getting a customer to switch from one bank to another is not an easy task. The epic battles between banks for earning new customers remain:

1. Millennials: to attract customers as early as possible

2. Long term products such as loans or mortgages: to lock customers as long as possible

If loans and mortgages are mainly a pricing game, acquiring millennials is now beyond pricing, 71% of Millennials would rather go to the dentist than listen to a bank’s message. They are heavy users of mobile services, used to well-designed apps with frictionless and instantaneous services. Although being aware of this sharp change, banks struggle to innovate as well as they would like to and it’s even more difficult for Tier 2–3 banks. Many reasons can explain this:

  • IT legacy system and verticalization of business lines (we will develop this topic later)
  • Decision process and governance: banks are running a successful business that is well optimized for short term profits and innovation could cannibalize a large chunk of revenue from the legacy services
  • Business lines friction: it’s always hard to reorganize your business when cannibalization occurs between offline and online banking
  • Innovation culture: banking has been originally an offline business where the tech culture isn’t obvious
  • Talent attraction: challenging to attract the best engineers compared to GAFAs or Fintechs if it is for IT maintenance tasks, which represent 80% of tech spending in a bank

In summary, European retail banks are currently strongly concerned about regulation, compliance and cost cutting. In this context, it’s hard for them to be at the forefront of innovation while the world is still waiting for a Facebook or Amazon of banking. Will it come from leading banks or new entrants? From our point of view, it will only come from newcomers.

Full-stack neobanks are paving the way of innovation for incumbent banks

To illustrate our point, we will focus on full-stack neobanks and use a recent investment that we’ve made in Monzo. At Orange Digital Ventures, we distinguish two kinds of neobanks: full-stack neobanks and front-end focused neobanks (cf. our mapping). Both are developing software that is efficiently addressing consumer needs with a lighter cost structure. However, there are two important differences between these two models: the banking license (regulation) and the full control on the core banking system (IT).

Monzo is designing the bank of the future, with a banking platform built from scratch that allows easy integration with third party providers. It wants to give everyone access to the best banking services in the world. Full-stack neobanks such as Monzo are very different from incumbent banks, since it is a banking platform. To define and analyze what’s a platform, we’ll use the definition of Sangeet Paul Choudary from his book Platform Thinking: A platform is a plug-and-play business model that allows multiple participants (producers and consumers) to connect to it, interact with each other and create and exchange value.”

Choudary sets out three platform layers that he illustrates for many different tech giants: [Infrastructure], [Data], [network/marketplace/community].

Several full-stack neobanks are built on this platform model:

1. [Infrastructure] They are built from scratch by talented software engineers coding with a lean approach. One of their biggest strengths is to own and have full control on their core banking system, which enables them to innovate without being restricted or slowed down by third parties.

2. [Data]They are operating banking model and services that leverage on unsiloed data

3. [Marketplace] They are questioning the banks’ business model which rely on leveraging assets

Full-stack neobanks: mastering most of the value chain from back to front in order to deliver the best customer-centric product based on a lean approach

Monzo has built its core banking system from scratch, whereas incumbent banks are having headaches dealing with their IT legacy systems developed in the 80s and 90s, which are a big barrier to innovation. You can’t easily deliver a modern customer experience if the engine is not suitable. Let’s take a feature such as instant notification on payment: it looks simple, but for a lot of incumbent banks, providing such a feature is a pain. Even if the banks are all currently working on the enhancement of their core banking system, it is expensive and can takes anywhere from 3 to 6 years to implement, according to Accenture. In the tech world, it’s way enough time to disrupt any market.

This flexibility given by the core banking system is a key asset to react to changes in customer behavior as well as in regulation (cf. PSD2). With such agility, Monzo can serve its users with a customer centric approach, based on a lean model and with more autonomy in terms of infrastructure. In other words, you don’t rely on 3rd party providers (such as Fiserv or FIS), but on your own core banking system, to innovate according to your customers’ needs. To understand these needs, the lean model has become a standard in the tech ecosystem. Monzo’s roadmap is built with the feedback of customers via a public and transparent roadmap published on Trello. Customers are involved, and the virtue of this is reflected by their tremendous engagement on Monzo’s two Crowdcube campaigns. The company has achieved the fastest crowd-equity ever by collecting £1m in only 96 seconds in 2016. In 2017, it registered an astronomic £12m pledge for their latest crowdfunding campaign, which was capped at £2.5m.

A banking model that leverages on unsiloed data

Mastering the infrastructure is mandatory for a platform to leverage on its data. If the core banking system is not efficient enough to process real-time data, then, there’s a huge opportunity loss to quickly turn customer data into actionable insights. That’s why the future market leaders will address these challenges by driving important improvements through data and analytics. Let’s take a simple example: if you’re traveling to a foreign country, your bank in the future might know it via your GPS location and propose you in real-time relevant services such as trip insurance, mobile phone insurance, the best FX or relevant information on the banking prices in this area (fees for withdrawals…). For now, you still need to warn your bank about your trip if you do not want your credit cards to be blocked for security reasons (as your bank might consider that it’s a fraudulent transaction).

There’s another huge friction point for incumbent banks in terms of data processing. Most of their business lines and IT have been launched and maintained in silos, and paper is still king. The verticalization of their model is a major challenge in a data-driven world. For example, credit cards are often separated from personal lending. Above the inefficiency of serving products on individual platforms, it also creates a friction when it comes to processing customer data. These silos are slowing down the potential of innovation or cross-sales and make it almost impossible to have a data-driven approach, adapted to market change, customer behaviors or to any AI (Artificial Intelligence) services, since data is the fuel of this technology. If you don’t break data silos, your banking experience can’t be personalized and won’t be really customer-centric, compared to what companies such as Amazon or Facebook can provide.

By gaining in agility and flexibility, challengers like Monzo can shift the center of gravity from branches to customers in order to bring the banking market into the technological world where it is all about data. The future of retail banking won’t be about fighting on prices or to lock clients through certain products, but about delivering the best customer experience by processing data.

Reshaping the business model of banks: Banking-as-a-Platform

As previously said, disruption is catalyzed by technology, but it is mainly about the business model. Instead of providing each product and service through their balance sheet in a closed network around branches, platforms are willing to create an ecosystem of services around their infrastructure, shifting the banking value from branches to their API layer. This gives many opportunities to build strategic partnerships and opens an unexplored world in terms of product innovation and data monetization.

It’s a radically new way of doing banking since the business model won’t be based on balance sheet but on technological assets, data and customer base. The platform is the engine for growth and there’s no regulation to limit the number of partnerships. That’s why we call this business model an “Asset-light model”: it breaks the limitation imposed by regulation to banks on their balance sheet and it embraces those to come (PSD2, GDPR).

The revenues are not only driven by the balance sheet and the capacity of leveraging it, (minimizing the equity while maximizing debt) which can be risky, as demonstrated by the financial crisis. It is also driven by a marketplace model. The agility given by the platform model allows Monzo to serve its customers with the best providers (Monzo itself or another company). Rather than competing with the impressive amount of Fintech, you can leverage on them and share revenue. From a bank driven by margins, you become a bank driven by your customer needs in favor of a more trustful relationship.

Nonetheless, this disruptive business model has not yet reached the profitability scale of current banks but it’s too early to judge because most of them are focusing on growth rather than profitability. Monzo has enrolled more than 240,000 active users in less than 20 months with an acquisition cost being a small fraction of the one of incumbent banks. Still, one of the main challenges for neobanks will be to maintain their customer cost of acquisition as low as possible and to manage well their profitability/growth dilemma until their business model becomes the new standard of doing banking.

To sum up, we can compare Monzo’s position and the one of incumbent banks using Choudary’s framework. On the one hand, incumbent banks have an outdated infrastructure, their business model and IT is mainly organized around their branches. On the other hand, Monzo built its own infrastructure to leverage on its data and serve its customers mainly via a marketplace.

Retail banking innovation can only come from neobanks

In conclusion, it’s hard to imagine that the bank of the future might come from a current leading bank, regarding the state of the European retail sector. Being a newcomer allows to rethink the banking culture, technology and business model without having to bother about cannibalization or short term goals.

But disrupting retail banking isn’t the easiest task. Barriers to entry remain high, it takes time to build a well-known and trusted brand such as leading banks. Retail banking is a local business, it needs to be adapted to local regulation and culture and the strong competition on pricing does not facilitate the path of profitability. Most of the online banks launched a few years ago are still not profitable but they can rely on the infrastructure of their parent companies to contain their costs and sustain their customer growth.

However, the M&A window that seems to open for neobanks reinforces our idea that newcomer are leading innovation in the market but it also opens the way to an intermediate model such as online banks backed by incumbent. With the support of incumbent banks some neobanks could pursue their innovation efforts in a market in which most of the disruption is still ahead and will come when business models are sustainable, data gold mines will be exploited and third parties services will be eventually massively integrated.

The path is steep and there is a long way to go but the direction is straight, and neobanks have the right hiking shoes to climb.


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This article has been written with Antoine Maurel, investment manager at Orange Digital Ventures. Thanks to him for all the insights he gave me all along the long and numerous discussions we had on this topic since we launched the fund back in early 2015.

About Orange Digital Ventures

We stands as an early-stage corporate fund to support unconventional and driven entrepreneurs from around the world whose ambition is to imagine, design and develop tomorrow’s services and technologies. We engage with compelling technology startups, creative spirits and visionary founders to help them achieve breakthrough innovation in the digital industry, accelerate their growth and successfully bring their products and services to the market.

Since 2015, we already invested in 15 companies.

Find out more at http://digitalventures.orange.com/