Is it too “Gucci” to fail?

Neobanks are revamping the purpose of a bank by incorporating a unique aspect – the intuition factor. These financial platforms strive to be more than mere custodians for money. They see an untapped channel, where they can understand clients better by embedding their tools, products, and services into a customer’s daily financial tasks. The next-gen of financial banks unlocks growth by supporting the customer journey with disruptive operating models.

Coupled with their distinctive outlook, neobanks have the added capability to present simple, innovative, and affordable banking solutions across multiple digital touchpoints. The last five years have been conducive for the segment, as neobanks increased exponentially across Asia Pacific countries. The count went from 10 to 65 neobanks between 2015 and 2020. The customer base at the end of 2020 stood at over 830 million people.

The new brand of banks, however, is unable to bring money home despite enriching customer experiences. They fall short in converting acquisitions and investments into tangible profitability. There is a huge gap between the extrapolated valuations of the neobanks, massive rounds of funding, and the income generated per customer. These liabilities need to be made a top priority, especially at a time when traditional banks are escalating their journeys to be digitally relevant too.

Our research narrows in on six key factors that previously brought about sustainability risks in neobanks. If left unchecked, these risks pose a challenge for upcoming neobanks should they fail to create real value in the market.

1. High growth is achieved at the cost of credit quality

Neobanks take pride in having the fastest approval rates for both secured and unsecured lending. Competition in this area is intense, with various neobanks having an approval time of fewer than five minutes for both personal and SME loans. They can penetrate untapped segments with their flexible loan assessment criteria. This, however, has a shortfall as neobanks are pushed towards a compromise in assessing creditworthiness.

There is also an increased risk in non-performing loans. Credit quality is jeopardised in instances where the borrower is a first-timer, or when the neobank applies its resources in rural areas that lack financial and credit history. Neobanks must improve on their structure – they need to have a solid credit risk assessment while retaining the low-cost vertical, which is still the cheaper lending option compared to conventional banks.

• Is Judo Bank compromising on its credit quality to drive revenues onward?
• Judo Bank of Australia has shown significant success during the pandemic, unlike its contemporaries in the country. The neobank applies a flexible risk assessment approach to lending. Instead of taking the borrower’s assets into account, Judo Bank uses a relationship-based lending model, one which relies on the discretionary judgment of its bankers. The bank was able to find lending opportunities at COVID-19 times, while traditional banks tightened their lines of credit. Judo Bank saw a surge in its lending business by 40%, scaling up to USD 1.94 billion with its focus directed at SME lending. This aggressive business model, however, came with its share of risks. The bank identified that USD 330 million in loans required close monitoring, with 18% expected to become non-performing loans (NPLs).

2. Building a significant scale to achieve profitability

Most digital banks offer a subset of banking services, and this affects their revenue’s true potential. The added-on services do not make them a concrete banking alternative for customers. Neobanks attract a large customer base with its interactive and personalised user experience, but there is an immense share of dormant customers who use digital banks as a secondary account.

• Did N26 shut operations in the UK due to Brexit norms, or a weakened performance?
• The Berlin-based neobank shut down its UK operations in early 2020, citing Brexit as its key factor for pulling out. N26 was, at the same time, unable to achieve the same level of success it had in other parts of the world. The neobank struggled to stay afloat, even with a customer base of five million customers. It could not build a differentiated proposition that could stand tall and contend alongside local players Monzo and Revolut. N26 suffered in a drop in ranking by as far as the 19th place, with dwindling monthly active users.

3. Digital flexibility and its co-relation with security risk

Neobanks are on the rise as they deliver state-of-the-art customer experience (CX). While this is a critical strength, it also results in a multitude of security gaps. The focus of digital flexibility is to bring agility and speed which in turn enhances CX. On the same forefront, a JavaScript attack exposes the entire financial platform to malicious users. It gives them a free pass to analyse the code and decipher its functionalities.

A competitor can gain access to a propriety business model in one instance, while a hacker can obtain confidential personal information by tricking users in another. Neobanks, therefore, need have continued investment in improving CX, and should not lose sight on risk management, a key priority. Technical and security flaws can have a powerful impact on a bank’s credibility.

• Bo, the platformification strategy that was flawed from the start
• Royal Bank of Scotland had to shut down its digital banking arm as it succumbed to technical flaws and stiff competition. The platform had a bumpy start- its tech stack was plagued with problems. The tech team spent the initial three months fixing bugs post-launch. Back in January 2020, RBS had to reissue 6,000 debit cards as it failed to comply with EU rules. Bo did not survive more than 6 months, as it was crippled by the pandemic’s economic effects and its patchy launch.

4. Customer success is limited to less sticky low margin products

While the focus on everyday banking and payments has a high volume of transactions per customer, it operates on an exceptionally low margin. A key success measure can be determined via competitive low-cost pricing and incentivising customers to switch from traditional banks to neobanks under thin margins. Neobanks tend to offer higher deposit rates compared to the industry average, inviting a large customer base. The challenge here is the failure to create revenue-generating products such as credit cards and loans for a more sustainable future.

• Did Xinja’s strategy for mass customer acquisition lead to its downward spiral?
• Xinja was a top contender for Australia’s cutthroat neo banking market. It attracted over USD 78 million in deposits within the first two weeks, most from millennials that wanted better interest for their deposits. Traditional banks offered an interest of less than one percent for savings deposits, but Xinja gave a lucrative rate of 2.25 percent. The neobank was, however, unable to convert these account holders from depositors into revenue-generating loan product holders. This led to Xinja dropping its deposit interest rate and even refusing to accept new deposits in an attempt to reduce its operating losses. The bank received equity financing twice in a year to prevent staff layoffs and was highly dependent on additional capital to stay afloat. Xinja had to close its operations in December 2020 due to these enabling factors.

5. Justifying valuations and raising capital

To survive, neobanks require tremendous amounts of easy money from investors in their initial years. They need funding to acquire customers and scale in operations, while also managing short-term incurred losses. Their focus on positive earnings is usually a lower priority; deposits are not put to optimal use (i.e., by lending) and long-term business models are unclear. Such a scenario makes it more challenging to justify valuations. Low profitability with over-projected market valuations is a further “war chest,” one that makes it difficult to convince investors for subsequent rounds of funding.

• Can delighting customers justify valuations? Monzo’s case of devaluation and fund-raising
• Monzo is one of Europe’s biggest neobank. However, it was forced to raise money at a 40% discount to its valuation in 2020 compared to the previous year. The first warning sign for the bank was when it saw valuations drop from USD 2.6 billion in June 2019 to USD 1.6 billion. The scenario also triggered VC investors to replace their founder with a professional banker as CEO. The bank said that the pandemic was threatening its ability to operate at a sustainable rate; it was increasing its cost margins without a proper revenue pipeline in place.

6. Building a differentiated brand identity

Neobanks primarily became successful because of the convenience and experience they deliver to customers. Traditional banks are failing on this front, as there is a lack of intent in their innovation process. The market share creep-in by neobanks have, however, triggered a fear for competition among legacy banks. The monolithic giants are capitalising on their voluminous customer data and adopting a platform-approach to fight off competition. Traditional banks’ spin-offs are falling short in creating a differentiated proposition for customers, resulting in a shift from the existing brand experience to a mobile version of the bank

• How different is Finn’s platform from JP Morgan’s app?
• JP Morgan launched Finn as its digital-only subsidiary. However, the platform did not provide anything particularly different from the bank’s mobile banking app. Due to their similarities, there was no pull factor to get customers to open an account with Finn. Moreover, while establishing Finn, the bank was also channeling its focus towards expanding the branch network and announced the opening of 400 new branches in the U.S. Finn was eventually shut down as there was a shortfall in differentiated services.

Conclusion

While these platform-based neobank structures bring transformational digital-first customer experiences, they must achieve cost efficiencies and create sustainable revenue streams. A robust profitability plan built on increasing the per capita consumption of products is critical for success. Neobanks that focus on dramatic entries into new markets at the cost of burning funding capital on market strategies for customer acquisitions may not survive in the future.

Endnotes

Gurinayat Brar and Sourav Kumar, Research Interns, contributed to this research.