Author: Ryo Weng, Graphics: Nina Tagliabue
The BRB Bottomline
Neobanks are firms that employ financial technology to streamline and digitize the traditional banking experience. In the past several years, these neobanks have been boasting high valuations that appear to be an incredibly attractive investment. While these banks may prove to be a profitable investment given its relative nascency, evolving traditional banks are mimicking neobanks by utilizing similar emerging technologies. In this article, investing columnist Ryo Weng analyzes how new neobanks stack up against their older established counterparts: brick and mortar banks.
What are Neobanks?
At their core, neobanks are financial institutions that operate entirely online. From one’s mobile phone or computer, users of neobanks can easily access their checking and savings accounts, transfers, payments, and loans. There are two types of neobanks: full-stack and front-end. Full-stack neobanks are able to function entirely independently with their own banking license, whereas front-end focused neobanks must partner with pre-existing banks to serve their customers.
With major decreases in capital expenditures due to fully digital platforms, and often much more limited services in comparison to traditional brick and mortar banks, neobanks are able to charge lower fees and offer higher interest rates. In general, users who reap the most value from neobanks are those who are technologically savvy and don’t mind the reduced capabilities of a digital financial service. Many customers use neobanks as a complementary or secondary service to their pre-existing accounts with traditional banks.
Technologically speaking, neobanks are faster and more transparent than traditional banks due to their ability to incorporate artificial intelligence (AI). According to Simon Pearson, thought leader in fintech, AI, and blockchain, “AI helps financial institutions to make more effective lending decisions and better risk management.” Neobanks posess software that enables them to collect and analyze data within consumer behaviors to give users personalized recommendations. In terms of blockchain capabilities, “proprietary operating system[’s] and decentralized private blockchain network technology [is used] to create ultra-secure banking ecosystems.” Neobanks also use big data analytics and robotic process automation to provide users with services otherwise unavailable to traditional bank customers.
Industry Context
There is no doubt that we are seeing just the inception of the neobanking industry. In 2020, the global market size valuation of the industry was $34.77 billion and had an estimated annual growth rate (CAGR) of 47.7% over the next seven years. In comparison, the US Commercial Banking Market has an expected 7% CAGR from 2019-2024.
With respect to how the COVID-19 pandemic is changing the landscape for neobanks, banks are being pressured to adapt to developments in the neobanking industry. One example of this is U.S. Bancorp, a bank holding company that permanently closed 400 of their branches to “create a leaner operation.” Additionally, with many jobs offering fully remote work options, changing attitudes about traditional banking have also emerged. According to the Citizens Financial Group, “76% of businesses said the pandemic changed how they interact with their financial institution.” People are beginning to realize how the rise in digital banking can complement their preexisting interactions with traditionally tangible services. Consequently, this indicates a potential increase in the growth of the industry.
Additionally, certain AI tools, which allow near-instant customer concern problem-solving for neobanks, hint at an attractive future for the industry. According to Peggy Mangot, the former senior vice president of innovation at Wells Fargo and a current operating partner of PayPal, “there’s two main advantages that neobanks have…The first is product velocity, and the second is marketing effectiveness.”
Neobanks differentiate themselves from traditional banks in a number of ways. Specifically, they have the ability to use complex databases to ensure a trustworthy network that can “assess risk, document risk mitigation and come to a decision and approve the new product upgrade.” Due to neobanks’ digital infrastructures, there is minimal human interaction necessary for the maintenance of a given neobank. Moreover, a CAGR of 8.9% over the next 7 years for the global industrial automation and control systems market shows that automation will continue to trend upwards. As a result, neobanks’ utilization of emerging technologies is helping them ride the tailwinds of the rapidly growing automation industry.
Through an entrepreneurial lens, neobanks seem like a profitable investment due to their business model. In an interview with UC Berkeley Professor Kurt Beyer, who specializes in entrepreneurship and innovation, he touches on why he thinks neobanks will be successful in the long run. “[Neobanks] are in the innovation phase. They are just finding their first successful blue ocean. In a sense, they’ve proven product market fit in certain segments.” Beyer refers to the relatively new inception of neobanks and how, given their continuous evolutions in innovation, neobanks are now just starting to recognize how they fit into consumer markets. Additionally, he compares neobanks to finding a blue ocean, an untapped new market with many attractive opportunities. However, Charley Ma, a previous growth manager for Plaid and current General Manager of Fintech at Alloy, asserts, “My general framework is that once you get to product-market fit, you have to start asking: how do you continuously add tons of value into your customer relationships?” The answer to this question will likely determine how successful the industry will be in the future, shedding light on how profitable an investment might be.
Opposing Perspectives
Many customers are not yet confident in making the wholesale shift to neobanks as their primary accounts. In terms of customer lifetime value, traditional banks still outperform neobanks. Customers tend to prioritize their higher deposit balances with traditional banks and only use neobanks as a secondary service. According to Business Insider, “this is unfortunate for neobanks, because acting as their customers’ primary bank—and, in turn enjoying higher transaction and deposit volume—is a key way for neobanks to boost profit margins, an almost ubiquitous problem for [them].” In other words, neobanks are not as profitable as traditional banks because they aren’t being used for primary transactions, so they miss out on interchange fees and interest earned on customer deposits.
Another reason why neobanks are not necessarily poised for immediate growth is the competitor reactions from traditional banks. The modernization of traditional banking efforts are proving to yield higher customer acquisition costs. Customers of traditional banks “were happy to try a fresh, new, digital-only product,” because of how easy it is to sign up with a neobank. Nonetheless, competitors in the adjacent traditional banking market have offered their own neobank-esque services to drive customer retention.
An example of a traditional bank evolving their services includes Goldman Sachs launch of Marcus by Goldman Sachs in 2016. Marcus combines the attractiveness of cutting-edge digitization with the sound infrastructure of a profound firm. Specifically, Marcus provides users with competitive rates on all accounts, no hidden fees, and financial tracking to create personalized insights, all with constant online access. Goldman Sachs’ new initiative attracts customers through their “can-do” approach to marketing as represented by their tagline, “You can money.” Similarly, Capital One 360 Banking, which is primarily online, doesn’t require minimums on opening deposits and required balances, allows for mobile check deposits, and boasts a large ATM network which blends the idea of fully online banking services with physical branches. Furthermore, Capital One 360 Banking has diverse service offerings with accounts tailored to children and retirement options. These digitization efforts from traditional banks threaten the scalability and growth of neobanks.
My Take
It can be easy to get drawn into investing in emerging technologies, especially in the financial sector. Often, fintech startups post high valuations that either attract people to invest or make people question their validity and trustworthiness. However, given the current market landscape, neobanks are profitable and act as a sustainable investment in the long run. This is because neobanks niche positioning drives value creation for those welcoming of new technologies. Financial institutions will keep up with technology, and as more services transition to digital, I expect neobanks to become a standard in personal finance. Traditional brick and mortar banks will likely continue to serve the majority of society, but for upcoming generations who are more comfortable with technology, neobanks can serve as a great tool for basic financial needs.
Conclusion
Neobanks have struggled in demonstrating their ability to generate positive free cash flow over a long period of time. However, the combined forces of digitization and the pandemic are making an increasing need for remote access to personal financial information more prevalent, placing neobanks in a position to profit. For an investor, neobanks display signs of high volatility. But in the long term, neobanks may well become a high growth industry to invest in because they revolutionize how the financial industry operates.
Take-Home Points
- Neobanks are an on the rise digital banking platform that utilizes emerging technologies to assist in the financial needs of consumers.
- Neobanks combine artificial intelligence, big data, and blockchain technology to provide personalized insights to users.
- Neobanks are competitors of the traditional banking industry and are looking to attract technology-inclined consumers.
- Given advancements in the financial technology sector, traditional banks are developing new digital services to compete with neobanks.
- The neobanking industry is subject to unpredictability and volatility.