Kerry Grady, Founding Principal
After the financial crisis, unhappy customers were expected to flee the megabanks for small competitors. It didn’t happen. And the big banks became even more entrenched. Now another wave of alternative banks are at it again, and they say they’ve learned from the mistakes of the upstart banks that tried, and failed, before them. Chime, the biggest new name to pop up, has opened two million fee-free online checking accounts and is adding more customers each month than Wells Fargo or Citibank. That has inspired a crop of newer start-ups, like Empower, which started its first fee-free online checking accounts, with lots of digital bells and whistles. Venture capitalists are pouring money into American start-ups that are offering basic banking services – known as neo-banks or challenger banks. American neo-banks have gotten four times as much funding as they did last year, and ten times as much funding as they did in 2015, according to data from CB Insights. Big players from outside the consumer banking industry, like Square and Goldman Sachs, are also moving in.
What is a Neobank?
A neobank (also known as an online bank, internet-only bank, or digital bank) is a type bank that operates exclusively online without traditional physical branch locations. It is the latest technological advancement which places an emphasis on the technology and removal of traditional means. A neobank is what Amazon was to the traditional brick and mortar retail market, and what Uber is to the local taxi business.
Why are They Becoming so Popular?
The banking industry has traditionally been a monopoly with high barriers to market with big names like JP Morgan Chase and HSBC having roots going as far back more than 150 years. However, as a result of a progressive approach to financial regulation, the banking industry has opened up to greater competition. Here are some of the reasons why and how neobanks are making their mark on the banking industry.
Lower Costs: Neobanks allow customers to control their finances via their apps has resulted in lower overheads which allows to provide lower fees. One of the ways neobanks have been able to attract customers is through the promise of lower fees. Because they do not have to pay the costs of running physical branches, they are able to offer services for free that more established institutions charge for, such as withdrawing money in a foreign currency.
Better Customer Service: The reputation of neobanks is based on superior customer experience and reactive support, these two features require extensive investment in human resources. If customer support is an attitude it is nonetheless a major cost center which can’t be supported by the classical Freemium or low-cost business model adopted by most of neobanks. To balance the books, it is mandatory to increase the per-customer revenue by proposing premium services or more profitable products. N26 and Revolut have opted for a broaden offer with metallic bank cards. More than this the support services available through superior online chat systems allows neobanks to effectively resolve customer problems. This superior customer service has been implemented by a mixture of good user interface design and smart artificial engine to power the chatbots.
Better Technology: Although internet banking has been available for the past decade, the apps offered by main stream banks have been hampered by poor functionality and security concerns. Traditional banks have legacy systems weighing them down, they’ve found it tough to develop innovative user experiences. More than this, those at the top of the traditional banking leaders have been reluctant to embrace and leverage new technology.
The big, established banks are acting too slowly in the move to adapt digital services. On the one hand, they can commit to investing a lot of money to FinTech; on the other, conservatism and bureaucracy seriously hamper putting effective FinTech in place. Some banks still can’t believe that the majority of their customers use mobile apps and want to use a tablet or wearable devise for banking. Maybe that’s why not every bank has mobile banking, and those that do, offer only limited functionality. “In consumer banking, you have what is one of the largest industries in the United States in terms of profits, and at the same time one of the least disrupted industries, and the most unpopular with consumer,” said Andrei Cherny, the founder of Aspiration, a neo-bank that has attracted nearly a million customers. “Those three things create a perfect storm for disruption.”
The persistent unpopularity of big banks has been a boon to the newcomers. And they are helped by a new attitude among financial regulators who have grown more comfortable with online banking and young customers who have no hesitation about cashing a check or sending money on a phone. That doesn’t mean that building a profitable business will be easy, as the first neo-banks, like Simple and Moven, discovered. Establishment banks have big budgets to fend off challengers. And the services that many neo-banks are starting with, like checking and savings, are not very profitable. Chime and its ilk all want to eventually move into lending and other business.
There is, however, a growing conviction that banking is set to change. The consulting firm CG42 said in a recent report that it expected the 10 largest banks would lose $159 billion in deposits to smaller competitors over the next year. “Everyone is looking at cards and bank accounts as the next battleground,” said Lindsay Davis, and analyst covering financial technology companies for CB Insights. Neobanks are trying to replace the old, branch-based way of banking with a mobile phone-friendly account that does away with the fees that have made banking giants so unpopular. “If you look ahead five years, there’s no way there will be a financial services industry that is charging consumers $30 billion a year in overdraft fees,” said Chris Britt, the chief executive of the neobank, Chime. “We aim to shake that up, and I think a lot of other consumer companies will be doing the same thing.”
The deposits going to start-ups like Chime and Aspiration are still a drop in the bucket compared with the trillions of dollars in accounts at places like JPMorgan Chase and Wells Fargo. New companies in the United States are also lagging those in places like China and Britain, where a much greater proportion of consumers have already fled to upstarts. But fast-growing online banks in Britain like Monzo and Revolut are providing a template for American start-ups. Bother companies have said they want to move into the United States.
Banking regulators recently signaled that they will give the first banking charter to a neobank – Varo, San Francisco start-up that is offering fee-free checking accounts without any minimum balances. Another national bank regulator, the Office of the Comptroller of the Currency, has said it plans to begin offering special fintech charters to new companies that want to handle money. These charters will allow start-ups like Varo to operate without relying on an established bank to hold their money, which adds significant costs. Most of the new companies have kept their money and run transactions through partner banks, generally smaller regional banks that don’t have the money or the expertise to build out their own digital services.
Traditional banks are recognizing the threat. Wells Fargo is testing an app-based banking product, Greenhouse, that does away with overdraft fees and service fees. JPMorgan Chase already offers a similar app, Finn, aimed at younger customers and announced last month that it was building a new fintech campus in Silicon Valley. The banks are struggling to adapt because they have built an expensive infrastructure of local branches and have become increasingly reliant on revenue from fees. Surveys have shown that a wide array of fees, for everything from A.T.M. use to checking account maintenance, have been steadily rising in recent years. The big banks have also held on to the interest payments they get rather than passing them along to depositors. That has created an opening for online companies. Empower is paying its customers 2 percent for deposits, compared with the 0.01 percent that Wells Fargo is offering.
One of the most unexpected new competitors has been Goldman Sachs. Goldman took its first step with an online lending product called Marcus. It has combined that with an online savings account that is offering customers 2.05 percent for deposits, and executives have signaled that they plan to expand to a full-service online bank. Several other established companies are also moving in. Acorn, which attracted four million customers to its investing app, is about to start offering its customers a debit card to spend their money. And SoFi, originally an online lender, has added a bank account offering this year. Even Amazon is rumored to be working on a checking account for younger customers.
Neobanks are reaching a growing customer base that is underserved and even to the point of unbanked. The banking industry will never be the same. The big banks that are slow to adapt to change will surely pay the price.