Neobanks – The David against banking Goliaths?

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Neobanks – The David against banking Goliaths?

Neobanks – The David against banking Goliaths?
Neobanks - The David against banking Goliaths?

The banking industry has traditionally displayed inertia to major disruption and innovation.

With the rise of neobanks in Europe and the UK, and the arrival of Australia’s first neobanks; Volt, Xinja and 86 400, this may be set to change as the younger generation of customers increasingly adopt more digital and customer-centric banking services.

Key takeaways

  • Neobanks are fully digital, typically mobile-first, branchless banks, that focus on new innovative features, well-designed interfaces and unrivalled customer experiences.
  • Unlike challenger banks more focused on the customer experience, neobanks are building new banking platforms, that allow more integrated and customisable products.
  • Millennials are the target demographic for neobanks and are likely to be the main drivers for neobank expansion and innovation.
  • Neobanks face significant obstacles to growth, including low trust, low industry churn rate, regulation, and the threat of tech giants.
  • However, we expect neobanks to steadily gain market share, forcing the traditional banks to redesign their customer offerings.
  • In time, the biggest threat to neobanks, challengers and traditional banks will come from the tech giants, who have scale and capability to dominate the market in the same way that WeChat and Alipay already lead in China.

Neobanks vs Challenger Banks

Neobanks are fully digital, typically mobile-first, branchless banks that provide a suite of financial products with a customer-focused approach. However, they are not simply digital versions of traditional banks. Neobanks differentiate themselves by using new technology, rather than legacy systems which are usually functionally limited and less adaptable.

Not all branchless digital banks are neobanks. Challengers such as ING, Up and ME are not true neobanks, because they rely on existing banking infrastructure. These challengers usually partner with or are owned by traditional banks. Their main aim is to improve the customer experience of banking.

Neobanks are more ambitious. They still want to improve customer experience through better front-end solutions. But they also want to overhaul the whole structure of a bank, using technology to drive more efficient operations with more open APIs that third-party services can integrate into. As a result, neobanks offer a more streamlined set of products and services with more transparency and flexibility. To date, neobanks have been targeted towards millennials and early technology adopters. These customers are more open to digital-first offerings.

The first neobanks originated in Europe and there are now more than 100 neobanks across the world. In the UK alone, more than 30 neobanks have gained regulatory approval since the licensing regime was changed in 2014. The most well-known neobanks include Revolut, now with 1.5m customers, as well as Atom and Monzo. Market share for neobanks in the UK is now around 3%.[1]

Globally, Brazil has Banco Original and Nubank. Germany is home to SolarisBank and N26; N26 is preparing to launch in the US, where the growth of neobanks has been slower. Asian players include China’s MyBank, backed by Alibaba, and WeBank, launched by Tencent. There is also Digibank of India; Vietnam’s Timo; Japan’s Jibun Bank; and South Korea’s K Bank and Kakao Bank.[2]

Figure 1. Top funding raised by European neobanks

SOURCE: Business Insider, 2018

Neobanks can be backed by independent capital or by smaller financial institutions. In Australia, the independents include Volt and Xinja, each founded by executives from traditional banks. They are joined by the institution-backed start-ups, namely 86 400, which is owned by payments company Cuscal.[3]

Volt is the most advanced of the local players. It obtained a restricted bank licence in May 2018 and it is currently applying for a full licence. Volt intends to develop a full retail offering, including transaction and savings accounts, term loans and credit cards. It has targeted a 1% mortgage market share over 10 years.[4]

Historically, Australian banking licences have been difficult to obtain. A $50m capital threshold is required for an institution to be considered an Authorised Deposit-taking Institution (ADI), which is particularly prohibitive for start-ups. However, in May 2018, APRA announced that Volt bank would become the first recipient of a 2-year restricted licence under its new regime, created after the federal government indicated that it wanted to see more competition in banking.

Under the new regulations, Volt bank will: only be able to accumulate total deposits of $2 million; have a limited aggregate balance of $250,000 for its individual account holders; and have total assets (loans) capped $100 million – just 0.002% of the total banking system. Deposits will also be limited to staff, the family and friends of staff, and some early adopters. The restricted licence also means that their depositors will be protected under the Australian Government deposit guarantee if the neobank fails.[5]

How Neobanks will be integrated into banking ecosystem?

The rise of neobanks is analogous to challenger models in other industries, such as Airbnb for accommodation, and Uber for transportation. They provide similar products and services through different models, often adopting a more customer-focused approach.

Neobanks will most-likely be competitors to major retail banks, attracting younger customers who are more likely to adopt digital and mobile based services. Millennials also have the largest average wallet size compared to other demographic groups and will be the most valuable demographic for banks globally by 2028, remaining so for an estimated 18 years.[6]

Figure 2. Millennial interest for digital only banks in Australia (%)

SOURCE: Global Data, 2017

In addition to becoming competitors to large banks, neobanks also create new links within the banking system.

  • They can partner with third party insurance brokers to offer more tailored products to customers. This may be especially beneficial when acquiring initial customers.
  • They can work with or as roboadvisors. They can utilise their digital platforms and analytics to offer roboadvice enhancing their customised service.
  • They can streamline insurance by offering more customised policies. They can also enhance transparency and deliver faster claims processes. This will inevitably bridge the gap between insurance providers and banks encouraging consolidation between the two industries.

SWOT analysis for Neobanks

Strengths

Currently 80% of banking interactions are carried out through self-serve channels positioning neobanks well.[7] This is aided by the higher dissatisfaction with the established players coming out of the recent Financial Services Royal Commission.

Figure 3. % very or fairly satisfied with their bank, 10 largest consumer retail banks

SOURCE: Roy Morgan, 2018

In addition, neobanks have reduced operating and setup costs compared to traditional banks that support branches and greater personnel. This allows neobanks to scale faster, provided their marketing is done through effective channels. Lower costs also mean neobanks are less reliant on scale for profitability. There are also nimbler where account openings are much faster.

Collectively, a neobank’s versatility allows them to focus on breadth rather than depth of offerings. A variety of new products (e.g., commodities, roboadvice, foreign exchange) can therefore be offered under the one user interface and platform. This is more user friendly than the complex and delayed experience of separate platforms and systems within the one bank.

However, in the current competitive market, such a strategy may be unsuitable. In the UK, differentiation has key to success. As a result, neobanks there have focused on specific banking applications or niches, e.g., payments, cryptocurrency, community based, rather than offering a full suite of services.

Weaknesses

Many traditional banks already have an extensive digital and mobile presence. Their customers rarely enter a bank branch. Neobanks risk offering limited obvious advantages compared to digitally strong traditional banks with therefore lower up-take.

Initial trust from customers will also be challenging for neobanks in driving early uptake. Despite the outcomes of the Royal Commission, customers will remain unwilling to deposit their savings and rely on services from an institution that is at risk of disappearing soon after entering the market.

Large banks have also traditionally experienced low churn from customers. This is especially the case for those with heavy investments or loans. Studies have shown that customers are generally unwilling to switch providers, with only 3% of UK residents switching in 12 months. Further, only 14% of people indicated they would be willing to switch to a neobank as their primary banking provider. [8]

This collectively suggests that the benefits of remaining with a well-established player may outweigh the advertised advantages of the emerging banking model for many customers, affecting neobank growth.[9]

Opportunities

Despite the weaknesses, neobanks create opportunities to more strongly engage their customers on their financial management. Compared to other services, banking is viewed as one where customers have limited control and transparency over the inner workings. A fully digital experience allows users to have more real time input into the management of their financial assets with greater encouragement of everyday habits and behaviours.

As mentioned previously, in addition to providing basic banking, neobanks can also offer new services such as roboadvice, insurance, and cryptocurrency (bitcoins can be bought and stored with Revolut). Revenue growth will be greatest for these non-traditional products. Roboadvice is also becoming preferred among younger generations. Two thirds of millennials prefer to receive financial advice via a digital platform rather than a professional, citing greater independence and faster response times.[10]

Threats

The highly competitive nature of traditional banks, as well as their dominance and resources, is a key threat. Neobanks risk being absorbed or acquired by these larger establishments. Traditional banks will also look to quickly transform their legacy systems and processes and directly compete with neobanks. Going forward, there are various scenarios which may occur:

  • Neobanks gain market share from conventional banks. Millennials especially would be the fastest adopters of neobank services.
  • Neobanks are acquired by large banks, and their technologies integrated. Larger banks will continue to thrive and dominate the landscape, leaving little opportunities for challengers.
  • Larger banks will copy neobanks and drive them out of the market. This is perceived to be less likely given the lack of true innovative drive historically displayed by large banks.
  • Neobanks and traditional banks will coexist. Neobanks will slowly gain share and influence the direction larger banks take. The two types of institutions will serve different customers, and potentially have overlapping ones also.

Looking beyond financial services institutions, tech giants may pose the greatest threat to neobanks (and traditional and challenger banks). This is because they are uniquely placed to leverage their platforms and capabilities, size and existing customer base with detailed personal data on their customers. Facebook, Google, Amazon have been active in Fintech providing financial services such as payments and loans. In China, Alibaba and Tencent are significantly more advanced dominating the payments market and moving into broader banking offerings.

For the US-based, now global tech giants, complex and internationally diverse regulations remain barriers for now. However, according to a survey by Marketforce, 83% of senior bankers expect Amazon to enter mainstream banking within a decade. 66% believe this will happen within the next five years.[11] From the customer side, 77% of respondents in an Accenture survey said they would set up an account with Google or Facebook if they started offering financial services.[12]

Figure 4. Tech giants and the state of their finance/banking products

SOURCE: Venture Insights, Company press releases

Figure 5. Percentage of respondents using third-party payments app, such as WeChat in the past week in Asia (%)

SOURCE: Bain, Research Now 2017

If tech giants decide to become ADIs and provide fully fledged banking and financial services in Australia, how will neobanks compete? Will the market become too crowded with traditional banks, tech banks, and neobanks all fighting for customers? Most people have basic and limited banking needs. They are therefore unlikely to be tied to multiple providers.

Neobanks have the least competitive advantage, with traditional banks and potentially tech banks leveraging their reputation and existing customer dependency. However, neobanks are a hybrid of banking and technology companies. Therefore, with the right guidance and support they can leverage their position to pioneer in a new type of bank, one that is the next step in the evolution of financial institutions.

Neobank strategies

What does a neobank need to do to succeed, and what should its strategies be? To start, neobanks must offer the fundamental customer needs of a bank or financial institution:

  1. An account or system that enables the transfer of payments
  2. Access to lines of credit and loans
  3. Storage of savings and by extension, investment options

To compete with existing banks, neobanks must first determine their point of differentiation, and offer relevant products at competitive prices and a more engaging user experience.

Given the relatively low operating costs of the digital age, neobank accounts should be free, or be close to free with premium services charged extra, if any. There should be also greater front and back end transparency with no hidden fees and charges and more open APIs.

An Australian survey revealed the main reasons for considering a non-traditional banking provider were convenience, customisation of products and lower fees. These are all key for neobanks to establish their customer base.

Figure 6. Reasons for consideration of non-traditional providers (%)

SOURCE: Telstra Research 2016

Proactive customer acquisition will also be critical to sustained growth. In a Bain study, more than one-third of respondents said they moved to a competitor bank because they received a compelling offer or an advertisement.[13] Neobanks should therefore partner with trusted marketing channels to build their initial credibility.

A less obvious strategy is to partner with an existing bank and offer a differentiated and complementary product. However, historically this has been difficult to sustain. Clashes in terms of culture, strategy and focus have led to the demise of the smaller player, as was the case in the acquisition of Simple by BBVA.

Customer retention for neobanks is also different to traditional banks, with more reliance on superior AI, social media and innovative customer engagement initiatives (e.g., referral offers, online prizes).

Conclusion

In summary, Neobanks will play a critical role in defining the pace and direction of innovation across financial services, gaining share over time.

They will, however, struggle to displace the scale advantages of large established financial institutions. This is consistent with the traction of other challenger fintech which shift how financial services are structured and consumed, but which struggle to establish themselves as dominant players.[14]

In saying this, since the Financial Services Royal Commission, customer satisfaction with traditional banks has fallen. This dissatisfaction might push customers to seek out and try new banking options. Should this dissatisfaction remain, Neobanks can capitalise on market conditions by building a differentiated value proposition that engenders trust.[15]

In time, however, the biggest threat may come from the tech giants who have the scale and capability to dominate, should they choose to directly compete in Australia.

[1] NCR survey, 2017

[2] KPMG, 2018 – “The rise of the challenger banks”

[3] AFR 2018, – “Volt bank aims to send bold into digital market”

[4] Digfin, 2018 – “Neo-banks to storm the shores of Oz”

[5] AFR, 2018 – “Three disruptive forces driving Aussie neobanks like volt, as fintech start-ups get serious”

[6] Telstra, 2017 – “Millennials and their mobiles are changing the banking experience”

[7] Forbes, 2014 – “Do Bank Branches Still Matter? Retail Banking and The Customer Experience”

[8] Bank NXT, 2017

[9] Mastercard research, 2017

[10] Telstra research, 2016

[11] Moneylive, 2017

[12] AFR, 2017, – “Bank dominance under threat from technology, trust

[13] Bain, Research now, 2017

[14] World Economic Forum, 2017

[15] Business Insider, 2018 – “Despite the royal commission, people are currently not as unhappy with banks as many think”