Pandemic as a turning point for neobanks: will they sink or thrive?
There are polarized opinions on how pandemic will affect the neobanks/challenger banks. Some analysts conclude that pandemic will present a “moment similar to the bursting of the dotcom bubble” for neobanks, while some say neobanks will thrive as customers are rapidly moving online. Which scenario will prevail?
Neobanks key selling points are state-of-art mobile apps with sleek interface design, comprehensive online functionalities including fully digital on-boarding and expense analytics as well as lower payments fees. However, they frequently lack comprehensive product portfolios of banks (most noticeable in lending), offer limited customer service (e.g. chatbots) and sometimes are not covered by deposit guarantee schemes. At the same time, traditional banks lure customers by their complete suite of banking products, centuries-proof solidity and reliability which is frequently de-facto guaranteed by the state. Neobanks operate asset-light low-cost business model. At the end of 2019 UK average cost per customer being £20 to £50 — compared to traditional banks whopping £170. But at the same time income per customer difference is even more drastic — on average £9 for Neobanks compared to £270 for traditional banks — with most of it coming from lending. In total it meant an average loss of £5–15 per customer for UK neobanks.
However, the focus of Neobanks was not on profit, but on getting large, preferable global scale. Profit was supposed to follow the scale automatically at some point in the future, when new services will be added and the marketing budget will be cut. Steady growth in the number of customers was driving new investment rounds over gigantic valuations. Pandemic changes that situation in many dimensions.
1) Investments flow is drying up.
Intense competition and abundant funding forced neobanks to concentrate on growth for too long, overlooking the revenue management and product portfolio expansion. Depressed revenues caused by pandemic magnify this discrepancy. Already in late 2019 some investors started becoming skeptical about the endless loss-making scaling. As pandemic shifted the expectations about the future further down, there will be more investor voices demanding immediate moves towards profitability — in order for neobanks to secure further funding.
Revolut and Starling were lucky to close the funding rounds in February — weeks before the pandemic hit. Revolut tripled its valuation to $5.5bn from $1.7bn in April’18. Monzo’s funding round in May already reflected 40% plunge in valuation — showing a desperate need for cash and unfortunate timing. Looking at Monzo’s round other neobanks’ investors are likely to demand cost-cutting and refocusing from growth to profitability — in an attempt to preserve the peak valuation and delay the next funding round until the business is doing better in terms of profit.
Investment thirst creates favorable grounds for consolidations — neobanks that were rejecting bids from traditional banks (e.g. Monzo- RBS in 2017), now they might give it a second thought. More importantly, times, when there were hundreds of neobanks in Europe and US, are likely to be over. The pandemic becomes a mark after which the frontrunners continue their run into finals, while all the smaller and more local ventures are going to fall victim to either consolidation or bankruptcies.
2) Customer growth and deposits are falling, despite accelerating sign-ups from late adopters and unbanked.
In March 2020 downloads of Neobanks’ apps on average declined 25% compared to February. It is likely that closure of physical branches and low digital readiness of traditional banks will attract some over-65 (Covid-19 risk group) and late technology adopters to neobanks at a later stage of the lockdown.
However, the number of active customers and card spend is much more important for profitability than downloads. Neobanks accounts are frequently used as secondary or even tertiary — after accounts in traditional banks. Ample supply of banking services allows customers to cherry-pick particular services from specific providers: e.g. using a traditional bank for deposits and credit, and a neobank for ATMs, FX or payments abroad. More than half of respondents whose primary account is with a challenger bank still do not trust it with making large transactions or salary deposits.
Already in 2H’19 UK neobanks acquired 6mn customers reaching a total of 20mn, at the same time average deposit per customer slipped down 25% from £350 to £260 per customer, which in general means that lower percentage of customers deposit funds. This behavior will accelerate this trend even more, as formerly active customers may start withdrawing their money from seemingly shaky neobanks, some of which are not even covered by national deposit insurance schemes (e.g. Revolut in UK). The good news is that such bank runs will not cause bankruptcies, as most neobanks do not leverage customer money for lending (or leverage a small portion). Nevertheless, it will send neobanks revenues further down.
Customers at banking startups maintain average deposits of only around 4% of their counterparts at incumbent banks.
The implication is that importance of growth in downloads is misleading and overstated. Increase in ghost customers, that register, use an account for a month and then forget about it, or in customers that use an account for bank transfers and a card for ATM withdrawals actually means multiplying costs for the neobank, not revenues.
As a result, the focus of many neobanks is likely to shift from the insane race for downloads to developing and deepening the relationship with existing customers.
3) Collapse of prominent customers use cases: travel, freelance and start-ups
Many Neobanks built their business model around specific use cases (e.g. servicing SME or travel), and many of those use cases are being severely affected by the Covid-19 crisis. The most prominent example is travel: as people stop traveling and spending abroad, it is useless for them to pay for the Revolut subscription that offers better FX rates and access to the airport lounges. They also stop spending abroad, effectively shutting down interchange revenues for players the likes of Monzo and Monese. Even increased local spend will not build up for this, as cross-regional (1–3%) or commercial (1–2%) card interchange rates are substantially higher than the ones on local private cards (0.2%-0.3% in Europe).
Banks that specialized on serving business customers (e.g. Starling, Qonto, Anytime) built their businesses around SMEs, startups and freelancers -the categories most exposed to the current crisis. Wave on bankruptcies and a decrease in new ventures will hit their customer base. Neobanks that were actively lending to SME (e.g. OakNorth) are cautious about an increase in non-performing loans. A large chunk of unbanked people signing with neobanks were newcomer migrants — now with immigration being put on hold, this stream also dries up. The segments less affected by the economic crisis — large companies, affluent individuals, elderly — are core customers of traditional banks.
Those changing behaviors and needs put additional pressure on neobanks to come up with new services and business models built around new use cases.
4) Traditional banks accelerate digital transformations
Many banks were delaying their digitalization and makeover investments for years. Change in core banking systems (e.g. from stationary to cloud) not only requires investment, but most importantly are very risky to current operations.
Branch closures and the general attitude shift to online brings urgency to this decision. Now banks have an opportunity (and excuse in front of employees) for massive branches shut down. On the other side, the crisis brings urgency to digitalization programs — creating a great opportunity and excuse (in front of shareholders) for banks to take a risk of migration and set off the investment budget. One may argue that banks are generally not capable to do well on the digital front, due to factors like conservative mentality, culture differences and talent gap. However, those on the forefront of banking innovation (ING, Citi, BBVA) proved that competitive and successful digital products can be created by traditional banks. If a critical mass of traditional banks starts digital transformation, neobank valuations are going to fall off the cliff, as their key selling point is going to dissolve. Having a lower scale, fewer resources, lower trust — neobanks will stand little chance against digitalized incumbents.
5) The crisis speeds up Big Tech moving into banking
Actually, the widespread paradigm of “neobanks vs banks” combat doesn’t take into account an elephant in the room — Big Tech. Apple, Facebook, Google and Amazon realize that their scale of global customer relationships is good not only for digital services distribution or e-commerce but also for payment and banking business. The threat is mostly viewed as aimed towards traditional banks, as Big Tech may steal the customer relationships, putting banks in a position of infrastructure providers. However, neobanks might be affected even more. They’ll face a competitor that is digital native, extremely well-funded, has the best talent and most importantly — already has a vast and loyal customer base. While US neobank Chime needs to spend millions of investor’s funds on advertising to raise awareness about its service, Apple card doesn’t need a lot of advertising. Apple products are always hard to beat on functionality and design, as they were made by the brightest engineers, sponsored by one of the richest companies globally. Rapid scaling, low customer acquisition costs, great functionality, high loyalty — all the neobanks can only dream of could be easily achieved by Big Tech’s banking products. Google is launching its card somewhere is 2020. Facebook has an e-Money license and is expected to roll-off transformed Libra currency in 2020–21. Pandemic shifts the world online and brings even more power and loyalty to Big Tech. If their upcoming banking products achieve scaling in Europe and US, neobanks propositions might very quickly become obsolete.
Despite the pandemic-triggered shift to online, neobanks do not appear to be the clear beneficiaries of the crisis. Raising demand for online onboarding, digital account servicing and mobile payments and expense management undoubtedly comes to their advantage. However, drying up investment flow, lack of customer trust and loyalty, badly affected customer segments and arming-up competition puts neobanks on coronavirus victims bench.
What neobanks are definitely great at is adapting to the new conditions. The crisis will clean up and consolidate the market, leaving space for the stronger and more adaptive to lead the industry tomorrow.
My next article looks more specifically into neobanks’ options to reach profitability.
