Why digital banks thrive in Europe, but struggle in the US

When I started my internship in Berlin, one of my first priorities was setting up a German bank account. I looked up a top German bank, Commerzbank, and went to their website. It was only available in German. Hmm. Duolingo had not prepared me for this.

Google Translate didn’t help. The site’s heading became: “We are test winners: best advice and best branch bank in Germany”. While I understood the gist, ‘test winner’ was awkward, and ‘best branch bank’ was painfully alliterative. Aside from content, their website was a jumble of different font sizes (my #1 pet peeve) and needlessly bolded words (#2).

Luckily, my coworkers saved me from my Type A tendencies and suggested I go with N26, a German banking startup. A digital bank, N26 doesn’t have physical branches and instead offers products via its mobile app and website. You can setup a bank account in 10 minutes online, whereas a traditional German bank usually requires an in-person appointment.

I opened N26’s flawlessly localized English website with relief. In minimalist Sans-Serif text read the following: “The first bank you will love.” I opened an account with them that day.

I was hesitant to use a digital bank or ‘challenger bank’ as they’re often called. In the US, I’ve always worked with a traditional player, Bank of America, and would also recommend an established financial institution to a friend. It wouldn’t cross my mind to suggest a banking startup.

I even had to search ‘US digital banks’ to remember the names of a few competitors — Simple and Moven. Research on both was discouraging. Simple became known after an email leaked their meager customer count of 33,387. Founded in 2011, Moven split into two businesses in 2018. Neither has been able to scale their user base; both have survived by working with the banks that they wanted to disrupt. While Simple was acquired by BBVA in 2014, Moven now licenses its software to TD Ameritrade.

However, in Germany and the UK, digital / challenger banks have quickly acquired users and secured funding.

In March, N26 raised $160 million in a Series C round, which represents the biggest FinTech deal in Germany and one of the largest in Europe to date. It took them just 9 months to double from 500,000 to 1 million users. As a point of comparison, Commerzbank has 11.9 million customers but was founded in 1870.

Outside continental Europe, the UK is also home to a number of challenger banks, such as Revolut and Monzo. Revolut broke even in December 2017 and now has 2 million customers. Monzo is the startup known for the largest equity crowdfunding in history — £1 million in 96 seconds.

Why have challenger banks taken off in parts of Europe, but remained sluggish in the US?

1. Competitive dynamics

While challenger banks have been able to carve a niche in Germany’s fragmented and loss-making banking industry, they have found it harder to find a foothold in America’s relatively concentrated and profitable market.

In Germany, there are three types of retail banks — cooperative, savings, and national. Cooperatives and savings banks control roughly two-thirds of the market. Co-ops are similar to US credit unions in that they are owned by their members, whereas savings banks are owned by local municipalities and exist to serve the local economy. Since neither provider is incentivized by profitability, a large majority of Germany’s banking sector overlooks cash flow and the customers that generate it. For consumers, this is a double edged sword. They typically pay low fees for banking services, but they use outdated digital services.

The remaining ≈32% of the industry consists of national banks, such as Deutsche Bank and Commerzbank. Since their competitors are not profit-driven and charge low prices, national banks find it hard to make money in retail banking; instead, they concentrate on lucrative divisions like corporate lending, ignoring the investments needed to develop digital experiences for their retail clients.

In a market that leaves neglected German customers navigating even more neglected digital channels, banking startups focused on user experience have been able to thrive. N26’s branding as the ‘mobile bank’ and emphasis on simplicity has struck a chord with consumers frustrated by clunky services.

Compared to Germany, the US has a relatively concentrated banking environment — the top five banks control 50% of banking assets. Through M&A and consolidation, leading American banks have been able to achieve returns that many European banks cannot fathom. And they have funneled these profits into digital. This year, Chase is increasing technology spend by $1.4 billion, most of which is dedicated to improving mobile and web banking.

Customers are recognizing their efforts. Recently, J.D. Power and Associates, a market research company, surveyed consumers and awarded Bank of America the first mobile app certification of its kind for an “exceptional mobile app experience”.

How can a US digital bank compete with the digital resources that banks like Bank of America possess? I’m all for parables of David and Goliath, but in this case, I’m betting my money on the giant.

2) Regulation

While proactive regulation in Europe has encouraged the rise of challenger banks and other FinTech companies, DC’s hands-off approach has hindered it.

Earlier this year, the European Commission published the FinTech Action Plan, an initiative to encourage competition in the space. The plan includes PSD2 or Payment Services Directive 2, which gives FinTechs the right to access banks’ customer data through APIs. Moreover, they’ve released pan-EU standards on services like transfers and invoicing, further clarifying the requirements for FinTechs to operate across the continent.

The UK takes a similar approach. In 2014, the British Financial Conduct Authority started Project Innovate, a development program that works with startups to ensure they’re meeting financial requirements as they build their companies. Programs like this and less restrictive capital and liquidity mandates have made it easier for challenger banks to acquire banking licenses.

However, the lack of definitive legislation in the US limits the development of digital banks. While Dodd Frank legislation in 2010 bolstered small financial institutions, there hasn’t been much concrete regulation for consumer finance startups since then. Part of this disconnect could be perception. Fintech areas such as bitcoin and blockchain have received much more buzz and investment dollars than the digital banking sector. Thus, big banks’ lobbying arms are more interested in defining how crypto will play in their fields than worrying about seemingly inconsequential digital banks. Since consumer finance is a highly monitored space, US banking startups are disadvantaged without proactive guidance.

3) Venture Investment

Finally, venture capital has also spurred digital banks in Europe more than in the US. From 2014 to Q1 2018, 57% of challenger bank deals have come from Europe, but only 21.9% from America. This is noteworthy, since FinTech investing as a whole is dominated by US startups, which accounted for 70% of FinTech deal flow in 2017. While American investors are engaged, they are focused on other areas of FinTech, not digital banking.

Looking ahead — N26’s plans to enter the US:

I heard from Maximilian Tayenthal, N26’s Co-Founder, earlier this summer at Berlin’s Factory, a startup co-working space. He spoke about their plans for US expansion. Will N26 survive and possibly thrive in America?

The reasons above — competition, regulation, investment — diagnose why digital banks have failed to gain traction in the US, but they do not prescribe this to always be the case.

As N26 enters the US, all indicators suggest that it will struggle with regulation and competition, but will be supported by deep pockets and a strong value proposition. I suspect that N26 has a ‘secret sauce’ that previous US mobile banks did not. After iterating their service across 17+ European countries, they’ve built a model that reliably attracts customers through intuitive UX and cheap fees. While they’re unlikely to ever directly challenge Chase or Wells Fargo, they don’t need to in order to call US expansion a ‘success’. As in Europe, they must find a niche of sticky customers, and I have no doubt they will.

Although I don’t think I’ll bid ‘tschüss’ or ‘bye’ to my BofA account anytime soon, I have finally found a digital bank in the US that I would recommend.