Neobanks’ path to profitability — exploring potential routes
Following a period of an extraordinary boost, neobanks are facing increasing pressures from investors to switch their focus from growth to profitability. Many smaller neobanks are likely to shut their digital doors in 2020–21, while the frontrunners are entering a period of cost-cutting, converting downloads into revenues and finally finding their path to profitability. Here are a few routes they should consider:
1) Building up a subscription-based financial marketplace. Traditional banks spent decades building an ecosystem of ancillary services around their core banking proposition. Nowadays, with APIs flying around, challengers may replicate those much faster and go beyond, through building a balanced portfolio of in-house and partnership-led capabilities. As they become a one-stop-shop for financial needs, it opens a way to monetizing on integrating all services in one place. Most important and value-added services may be brought in-house with time, increasing profit potential. All of the big UK neobanks — Monzo, Revolut, Starling — built marketplaces giving their customers access a variety of integrations: investment, insurance, credit brokers, accounting software providers, etc.
Until 2019, there was a widespread belief, led by Revolut and Monzo, that the marketplace model is the main bet for neobanks and is enough to reach positive net income territory. However, in late 2019 Monzo changed its rhetoric, acknowledging that lending is a key lever to profitability. In May 2020 Revolut followed by launching an official bank in Lithuania.
2) Boosting lending to consumers and SMEs. Incumbent banks make the most of their money by lending out 80–95% of their deposits, while most neobanks merely use 10% of their deposit base for credit. Theoretically, increasing leverage will increase profitability, however, there are several pitfalls. Lending to micro-companies, start-ups and underbanked individuals could be extensively risky, long-term loans could hurt solvency and liquidity. When it comes to individuals, mortgage or auto lending is not something neobanks will be able to afford given their shaky deposit base (apart from those owned by traditional banks, e.g. Atom). Direct short-term consumer financing may have a flavor of pawnshops — not something digital challengers would like to be associated with. The remaining niches — credit cards, overdrafts, salary-tied liquidity financing and purchase financing could present significant revenue-generating opportunities. However, the biggest sweet spot is SME lending, especially in a higher market end, as established companies’ solvency is easier to evaluate and collateralize. The only profitable UK challenger — OatNorth makes its money from lending to mid-sized companies. Therefore, for the banks that signing up smaller companies today (e.g. Starling, Tide) is of utmost importance to maintain the relationship as their customers develop and grow in size — generating more revenue for their digital banks.
3) Getting into business banking. Businesses have much higher money flows and deposits compared to individuals, a variety of unmet needs, and are more willing to pay for the services that save them time or money. At the same time, small and medium businesses tend to be underserved by banks, highly susceptible to innovations and more flexible with switching their banks. Moreover, looking from the longer-term strategic perspective, the SME banking segment is less likely to threatened by Big Tech (Apple, Google, etc.) venturing into banking. Those factors make SMEs an ideal playground for functionally mature neobanks. However, the client spectrum is quite wide within SME: some Neobanks like UK’s Starling and German Penta focus on micro-enterprises and freelancers, while others like UK’s OakNorth and French Qonto target primarily higher end of small and medium-sized clients. There is also a diverse set of monetization mechanisms: subscription and freemium models, charging for incoming and outgoing bank transfers, FX services, company cards, accounting and other integrations, and of course business lending. Feeling the segment attractiveness, even retail-focused neobanks entered the space — Revolut in 2019 and Monzo in March 2020.
Given the market extensive competition, the upcoming trend is likely to be the emergence of more industry-specific business packages, tailored to the needs of retail, hospitality, travel, e-commerce, etc. The next product frontier is likely to be payment acceptance, which is a high margin business currently overlooked by neobanks. Currently, none of the challengers offers in-house payment acceptance, while a few most advanced went into partnerships with established PSPs (e.g. Penta directs customers to SumUp). Such partnerships are going to spread when neobanks realize that this is a quick way to earn referral commissions, capitalizing on their SME customer base. Furthermore, the upcoming PSD2 Payment Initiation functionality will allow neobanks to break through into online payment acceptance — as many of them already hold PIS licenses.
4) Branching into Banking-as-a-Service (BaaS) offering. Neobanks can sell their payments and accounts back-end platforms for other fintech companies to build their own interface on top of it. This allows for a speedy scale-up of payment volume processed through a neobank platform. Comparing to the client-facing business, the BaaS commission is lower by 80–90%, but the marketing expenses are cut by 100%. Serving as BaaS may also create an economy of scales to payback investment into the platform and cover fixed maintenance costs. US first Neobank Moven shut down all of its unprofitable client-facing business in April, in order to concentrate on profitable and flourishing BaaS part of the business — investor pressure had an impact on this decision. The retail neobank market in Europe is overcrowded and has a small revenue potential due to domestic interchange caps. At the same time, UK, French and German Neobanks are state-of-art platforms that could be exported abroad — into fast-growing and uncapped markets of South-East Asia, Eastern Europe, Latin America and Africa. While expanding client-facing retail operations to those markets is challenging due to tremendous cultural differences, regulations and lack of local expertise, BaaS offering could be easily exported. A great example of a cross-border offer is Railsbank — UK BaaS platform that recently received an investment from Visa, and targeting Singapore, Vietnam, the Philippines, and Thailand.
5) Cutting on marketing expenses. Neobanks used to heavily rely on online advertising, social media marketing, direct sales, and even TV advertising (e.g. Monzo, Starling) — to skyrocket their growth in a highly competitive environment. This practice formed gigantic customer acquisition spends that largely overweighed revenue. At the end of 2019, an average neobank revenue per customer of £5–15 was much lower than the acquisition cost of £20 to £50. By giving up on 3-digit downloads growth and cutting marketing burn some banks already may jump (or at least come close) to positive net income territory. Neobanks’ consolidation also may facilitate rationalizing marketing costs and balancing growth with profitability.
6) Getting into a consolidation game. The two most probable options include getting acquired by a traditional bank and merge or acquire a fellow neobank. The first option allows for quick investment return and potential for a variety of revenue-generating and cost-saving plays: cross-selling services, using neobanks network and interface for credit distribution, exploiting neobank technology, centralizing customer service and overhead functions. We are likely to see acquisitions like this among the second division of neobanks, while the frontrunners are likely to be protected from those deals by their high valuations, risks to the client base, and founders’ resistance. Therefore, the second option is more feasible: neobanks mergers allow for saving on marketing and overhead budgets, product cross-selling, and potentially geographic synergies. Imagine an N26-Monzo merger — the resulting neobank will create a pan-European customer base, huge potential for cost-cutting, and rationalizing IT costs, create weight for partner negotiations, and a strong base for US expansion, where both neobanks are intensely trying to build a presence. The cost-saving and growth generating potential of such a deal would be enormous.
7) Looking for new emerging niches. What made neobanks get to the market is high sensitivity to changes in customer needs and technology. To advance to profitability they need to keep adjusting to emerging customer needs — and doing it fast. A great example is Starling’s launch of a card allowing delegated shopping on behalf of self-isolating people — only 3 weeks after the pandemic started in Europe. The speed of action and resulting first-mover advantage remains a key differentiator for the overcrowded and commoditized digital banks market. For challenger banks being ahead of the curve is key to pave the way to profitability. There are still plenty of not covered and potentially monetizable use-cases: managing subscriptions for customers, bill payments, payment initiation, SCA white-listing, money pots, etc.
As the neobank market develops and hype slowly fades away, it becomes clear that the path to profitability — and survival — will be tough. For some it may go through business model diversification and incorporating several options mentioned above, for some it may involve piloting some of them and settling down with two or three, some may find luck through going deeply into one specific business model. Anyway, the market is undergoing tectonic shifts and the challenger bank landscape in 2025 is likely to have very little resemblance with this in 2020.
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