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    Neobank Business Models: Exploring Solutions for Improved Profitability

    As digitalization continues rocking the finance and banking industry amid the pandemic, customer interactions have largely shifted from brick-and-mortar bank branches to the so-called neobanks or challenger banks. 

    There are over 250 neobanks in the world now, with dozens of apps that are about to be launched. However, it still remains unclear how many of these projects are profitable today, and how many will ever actually return a sustainable profit. Although we know the success stories of such giants like Revolut, Monzo, or Chime that are already valued at billions of dollars, it’s not the same thing with smaller market players. The common challenge for neobanks is that they face increasing costs, while the margins generated per customer remain low thanks to the offering of free services or higher saving account interest rates.

    The Surf team is closely following the fintech industry trends and has developed numerous mobile apps for banks and crypto exchanges. Since neobanks are part of fintech, we are always aware of the recent solutions provided by the top players. In this article, we’ll look more closely at the issues of challenger banks’ profitability, business models of top neobanks, and approaches that will help you to choose the right path for your neobank to become a profitable project. 

    What is a neobank?

    First of all, let’s briefly recall the pillars of the neobank concept and the main features that distinguish it from a traditional brick-and-mortar institution.

    Neobank is a fully digital bank that doesn’t have any physical branches and functions exclusively online. Users can perform their common finance operations from money transfers to asset management via neobank’s mobile app or website. Depending on whether a neobank has a banking license, it provides financial services independently or via a partner bank. 

    Challenger banks boast lower fees (as they do not have to pay the costs of running physical branches), better customer service (users even with poor credit history can open accounts in minutes or deposit paychecks a few days faster compared to traditional banks), and better technology (conservative and bureaucratic physical banks are not as fast in applying the cutting edge technologies). 

    It’s obvious that the neobank niche is becoming more crowded — a trend that will only accelerate with fintech conquering the world enabling any company to include a bank account or other fintech offering as a product extension.

    It’s important to understand that even the biggest neobanks were not created equal with a common business model at the base. Looking into neobank business models reveals remarkable operational differences and highlights specific features that can lead a similar project to success in the long term.

    Neobanks profitability issue

    Following a period of an impressive boost, neobanks are now facing increasing pressure from investors to shift their focus from growth to sustainable unit economics. The thing is that the very idea of a challenger bank involves an asset-light and low-cost business model. After years of huge marketing spending to accelerate the growth of neobanks, they now end up in a situation where their ability to generate a stable income is thoroughly tested. 

    Various figures seem to support this statement. The most illustrative example is from the UK fintech market: according to Accenture’s Digital Banking Tracker, the neobanks’ average cost per customer in the country varies from $26 to $65 — compared to traditional banks whopping $230. However, income per customer is quite drastic: $12 for neobanks and $360 for traditional banks — with most of it coming from lending. Essentially, this means that UK neobanks on average lose $6-20 per customer. 

    How can this be explained? The profitability of even top neobanks is determined by the LTV/CAC ratio — the higher the resulting figure, the more income a neobank is able to generate per new customer. Let’s look deeper into the components of this formula:

    • LTV stands for the customer Life-Time Value. In simple words, it’s an average revenue generated by one customer in a certain period of time (usually several years). It’s logical that to keep the LTV/CAC ratio in a good shape, this figure should be as high as possible. However, this can be challenging for many neobanks now. For example, biggest neobanks like N26 and Monzo seek revenue predominantly from the low debit card interchange fees (earned when customers use their cards to buy goods and services) that leads to a very low LTV. Things for companies with such a business model have got even worse due to lockdowns and their damage to sales within some industries like travel. At the same time, neobanks like SoFi, offering lending services feel better, although at this point they have to compete with traditional banks still taking the majority of high-quality loans.
    • CAC is a Customer Acquisition Cost — the total money spent on customer acquisition divided by the number of new customers. A good LTV/CAC ratio requires CAC to be as low as possible. Most neobanks still achieve better CAC values than traditional banks, with an average CAC of neobanks around $33 versus $225 for incumbent banks, but it’s still too high compared to the average revenue generated per customer. Several years ago, the CAC of neobanks was lower, as they literally disrupted the market and many customers, disappointed with the services of brick-and-mortar banks, were quickly switching to a new, digital-only product. However, traditional banks have been successfully upgrading their own offerings over time and becoming better at attracting new customers in the digital space. This, in turn, results in rising CAC for neobanks – additional efforts should be paid to attract potential customers. 

    Top neobanks are struggling to convince users to switch their primary bank accounts from traditional banks, improving their apps and broadening the list of features. Primary bank accounts are the most profitable for three main reasons:

    • They imply higher payment volumes and a greater number of transactions. 
    • Such accounts usually have a higher amount of funds deposited in them. These are accounts where people receive their salaries and pay scheduled payments from.
    • Becoming a customers’ primary bank account also leads to higher revenues from interchange fees for neobanks. 

    However, the majority of customers tend to preserve their primary accounts in incumbent banks, as neobanks’ offerings are not appealing and comprehensive enough to completely displace reliable brick-and-mortar institutions. 

    All this compelled even the biggest neobanks to seek new income flows from paid subscriptions, handing out loans, earning commissions from referrals, as well as broadening the product range to savings and investment products. In 2020, Monzo launched a premium account, complete with a metal payment card charging its customers £15 per month. Furthermore, both N26 and Revolut have recently announced that they will be introducing low- and mid-tier subscription plans for €4.99 and £2.99 per month, respectively.  

    How do neobanks make money? 

    There are five leading neobank business models known to be effective:

    1. Interchange-led

    Some neobanks get income sourced through interchange as the revenue driver — every time a customer uses the neobank’s card as a payment method a neobank gets paid. The best example of this monetization strategy is the most popular US neobank Chime that is now used by about 12 million people. 

    Chime does not operate any physical branches, but its app comes with a physical Visa debit card. Whenever a user makes a purchase using Chime Visa Debit Card, Visa collects an interchange fee from the merchant for processing the payment, which is about 1.5% percent of the total purchase amount. Chime itself gets a small part of this percentage. 

    Of course, interchange fees are not the only source of income for one of the biggest neobanks, but the fundamental one within its business model. Chime also earns on the interest earned on cash and ATM fees. Certainly, this monetization strategy proved to be beneficial for Chime: in 2020, the US neobank announced that it hit the 8 million account milestone, while just 1 million customers used Chime in 2018. 

    1. Credit-led business model 

    Such neobanks leverage a credit-first model, starting off with a credit card or similar offering, and later offering a bank account. This is another way of how neobanks make money. 

    Nubank, a Brazilian challenger bank with over 40 million users, which considers itself the world’s largest neobank, chose the credit-led business model to gain profit. Its primary revenue streams are built around the company’s credit card business: the neobank gains revenue every time their customers tap their credit cards in-store or make a payment online (interchange fee). Moreover, the bank also gets profit on the carried credit-card balances of its customers based on the interest rates applied to those balances.

    By the way, the Nubank credit card has no annual fees. In Brazil, people are used to paying in installments — something similar to BNPL (Buy Now Pay Later). Thus, Nubank customers pay interest on installments.

    1. Ecosystem-led business model

    While traditional banks were spending a lot of time creating an ecosystem of ancillary services around their core banking proposition, neobanks have a chance to make it faster thanks to the rise of APIs (Application Programming Interfaces). As challenger banks are becoming a one-stop shop for users’ financial needs, it paves the way to make money by integrating all services in one place. Most important and value-added services may be brought in-house with time, increasing profit potential. Many top neobanks — including Monzo, Revolut, and Starling — set up marketplaces giving their customers access to different integrations: investment, insurance, credit brokers, accounting software providers, and so on.

    Building an ecosystem around the core product is the main strategy of Monzo, a UK-based large neobank. This challenger bank partnered in 2018 with TransferWise, an online money transfer service, to give its users the opportunity to make international money transfers right out of the Monzo app. Later that year, Monzo allied with PayPoint to allow customers to deposit cash from any PayPoint locations across the UK. Instead of creating its own saving options, Monzo partnered with other banks and asset management firms such as OakNorth, Shawbrook, ParagonSave to provide savings accounts to Monzo users. Most recently, Monzo talked about plans to add the option for users to view their credit score inside the Monzo app for free, and this is done in collaboration with TransUnion, the US credit consumer agency.

    1. Asset-led business model

    In accordance with this model, neobanks gain money from offering savings accounts and acquiring deposits with competitive rates. 

    Goldman Sachs, one of Wall Street’s best-known names in investment banking, in 2016 expanded its offerings into consumer banking with Marcus by Goldman Sachs. Marcus does not provide consumers with a wide range of services like other neobanks but offers high-yield savings accounts, high-yield certificates of deposit (CDs), and no-fee personal loans. As of October 2020, Marcus had $96 billion in deposits and is recognized as one of the best online savings accounts and as having some of the best CD rates. This online bank doesn’t have physical locations, but it does have a mobile banking app available on the App Store and on Google Play.

    As Surf closely monitors the global fintech market and its fluctuations, we are always aware of the latest trends in the industry. The global trend on users’ higher engagement in investments has recently become quite noticeable, and now we are witnessing the increasing demand for investment apps. Recently, Surf has created a concept of a mobile app for both brokers and investors to help brokers educate and retain their clients while making the overall experience less stressful for investors.

    1. Product extensions

    Another type of a neobank business model is centered around product extensions that remove the barriers between financial domains. According to some forecasts, the biggest drivers here will come from product extensions from larger tech companies. 

    Robinhood, an online discount brokerage that offers a commission-free investing and trading platform, is a good example of such a strategy. In 2016, Robinhood launched an extension of its main product  — Robinhood Gold. This service allows users to get access to deposits, professional research, Nasdaq Level II market data, and invest on margin. The Gold subscription starts at $5 per month and can get as high as $50 per month. The pricing depends on the amount of money that traders borrow on margin. Revenue from Robinhood Gold increased by 396.5% to $39.2 million in Q1 FY 2021, accounting for nearly 8% of companywide revenue.

    How to make a neobank profitable?

    Generally, there are three issues that are faced by neobanks on their path for stable profitability: 

    • The lack of trust from customers. The aforementioned customers’ frequent reluctance to choose a neobank as their primary bank is a clear demonstration of that. This leads to the situation when it’s difficult for neobanks to build long-term relations with customers, raise the volume of customers’ deposits and interaction ratios. 
    • Incumbent banks are catching up with their digitalization strategies. Recently, traditional banks have started heavily investing in improving their IT infrastructure, so sometimes it’s difficult to compete with them, even for the most profitable neobank business models. The pandemic only accelerated banks’ aspirations to win this digital race, as many branches have been closed due to the COVID restrictions. 
    • The threat of Big Tech (Apple, Google, and others) venturing into banking. Companies like Apple offer the same commodity services (like payments, debit cards, credit cards) as the neobanks, and provide the same type of advantages (with regards to a digital, simple, and fluent offering) – this threat might actually be bigger for neobanks than for incumbent banks.

    All these obstacles will potentially impede the neobanks’ profitability in the coming years: some of them might stop functioning, others will get acquired by the major banks. However, there is a way out of this standstill: neobanks should reposition themselves, in other words, find a niche where they can reach stable profitability and stop fighting head to head with the large banks.

    This niche positioning should be performed in two directions: 

    • Diversification of the product range. Now, top neobanks offer quite basic products as primary ones, like foreign currency transactions (Revolut), credit cards (NuBank), debit cards (Chime, N26, or Monzo), or short-term lending (SoFi). However, more innovative, flexible and personalized products could potentially attract more loyal customers. For example, in the credit space, many opportunities exist for more flexible and personalized products.
    • Bringing value for more customer segments. Since biggest neobanks position themselves towards the general retail customers (obviously with a focus on the digital-native millennials) or SMEs, some more specific segments like freelancers and independents, other specific professions (such as lawyers, doctors, content creators), and also the unbanked and underbanked people are not covered by their product range. Neobanks can provide well-adapted services for specific groups of customers to be better equipped for the above described upcoming challenges.

    Bottom line 

    Neobanks are among the most trending fintech apps nowadays. They enable a solid upgrade of the existing user experience when it comes to banking services, and make personal finance management easy and fast. 

    However, despite neobanks’ growing popularity, there is a serious challenge for their owners to make the unit economics metrics remain stable, and keep generating revenue. This doesn’t mean that even the biggest neobanks are doomed to fall in recent years, but pose a kind of threat in case certain repositioning of their offerings is not implemented. 
    We at Surf offer the best solutions to fintech companies and know firsthand how successful fintech apps work and make a profit. You can get acquainted with our fintech cases and fill in the form so we could estimate your project.