Will the neobank business model weather the storm?

24 January 2023 Consultancy.uk 9 min. read

Is the neobank bubble about to burst? Marouane Bakhtar, Managing Director and Head of Banking at financial services consulting firm Synpulse, asks whether neobanks and their business models will be able to weather the storm.

Ongoing economic uncertainty and bloated valuations are having a dramatic impact on fintech funding rounds. Figures from the past year paint a discouraging picture – according to CB Insights, fintech firms raised $75 billion in 2022, a drop of 46% compared to the year previous.

With fintech valuations and start-up funding plummeting in 2022, combined with the threat of a looming recession, this begs the question – are neobanks, which came into their own during the Covid-19 pandemic, facing a watershed moment?

Marouane Bakhtar, Head of Banking, Synpulse

The outbreak of Covid-19 called for immediate changes across the financial services industry, most notably the new and urgent demand for contactless online services. According to Statista, almost one in five (18%) of banks launched contactless payment methods to accommodate digital services.

As remote banking began charting the way forward, a new generation of neobanks – digital-only players – was well-positioned to quickly accelerate the digitalisation of financial services. But with the number of neobanks across the world exploding since 2019, neobank entrants face new challenges to secure their future.

Neobanks face economic pressures

Despite their lofty valuations, only 5% of neobanks today are thought to be breaking even – let alone turning a profit. Neobanks depend on high levels of investment, yet with a recession around the corner, investors are writing fewer and smaller cheques.

With less capital flowing into the sector – and in particular to fintechs that have yet to prove capital efficiency – neobanks are facing a tough road ahead. Meanwhile, the rising cost of living might see people retreating to their ‘first’ bank accounts to ride out the recession.

The pull of convenience means that many people have a ‘secondary’ neobanking account, however some may be willing to give this up in order to play it safe with traditional and fully licensed banks as the recession begins to bite.

These two factors are squeezing financial services companies, with costs going up and profitability going down.

Non-sustainable business models

Neobanks’ underlying business models are being put to the ultimate test. As a cash-intensive business, they rely on high levels of consistent funding – yet their revenue model remains vulnerable, with the cost of customer acquisition and retention also spiralling as competition heats up.

Most neobanks offer two things – a mobile application and a debit card (powered by either Visa or Mastercard). Because they are hyper-focused on growth and staying ahead of their competition, they rely on low card fees and interchange revenue to attract users and thereby miss out on FX fees, monthly fees, transactions and the like.

Instead, their business model is built on nudging customers to upgrade to a premium account which offers additional benefits – and incurs monthly fees. Alternatively, they might upsell customers on services such as insurance, crypto and lending.

The challenge is that only a small subset of customers would upgrade to a premium account, while upselling other services proves difficult when all neobanks are competing on essentially the same premium services. Assuming neobanks rely on these premium services for revenue, the very nature of adding these expensive products and services to their offering represents a compound effect on their cost base and structure, hindering their path to profitability.

Neobanks with their own banking licence will naturally be more sheltered from upcoming contractions. Meanwhile, those which rely on a traditional bank to process transactions are akin to a world-class F1 racing car manufacturer that has to rely on competitors for the tires, driving wheels, and even the driver. Relying on a third party for core components will naturally leave neobanks vulnerable to external factors.

Compliance woes for neobanks

Neobanks today are also facing increased scrutiny over their compliance systems. Against the backdrop of the cost-of-living crisis and rising financial scams, regulators are probing neobanks to ensure they have the appropriate fraud and compliance systems in place.

Many neobanks face an uphill battle to ensure their compliance programs evolve in line with the new products they are offering. Early stage fintechs generally lack the resources of a traditional finance institution to staff and operate internal compliance systems, with the focus of the C-suite typically on driving new products to market, quickly.

Yet as regulation catches up with digital innovation across the industry, neobanks must invest in teams that can manage these processes, create greater confidence in their offering, and foster a better customer journey. If neobanks are to step onto the same footing as their bricks-and-mortar counterparts, they must give due importance to compliance and shore up defences against financial crime.

Goliath’s revenge on the cards?

The competitive threats to neobanks from existing providers are also multiplying, as traditional banks and fintech giants begin stepping on the toes of neobanks.

J.P. Morgan’s own neobank equivalent in the United Kingdom, Chase, attracted more than £8 billion of deposits and reached half a million UK customers in just eight months following its launch. Meanwhile, fintech giants like PayPal have set their sights on becoming a fully fleshed out finance app, offering a range of competitive features for those considering shifting their finances to neobanks.

As competition from established players grows, differentiation will become key for neobanks looking to cement their position. Larger businesses will naturally have access to a larger pool of customers, which means that neobanks would do well to target a specific market niche that is poorly served by mainstream providers. This could mean catering to those who are financially marginalised, gig workers, or young people.

Another option is to set themselves apart through the digital experience. While established banks are wading into the neobanking space by offering features and rewards, neobanks’ USP lies in their ability to deliver an attractive and personalised user interface. The products delivered may be the same, but customers will naturally gravitate towards solutions that can bend to their needs, and are slick and intuitive to use.

Neobanks' advantages are multi-fold. Firstly, they have minimal overheads so can maintain lower pricing than traditional banks. Secondly, tech is in their cultural DNA, which means they can react more quickly to threats or opportunities. It also means they can deliver a more streamlined onboarding and KYC experience, along with innovative features like budget visualisation tools.

And thirdly, they have access to a wider client base, with lower barriers to entry for customers with lower credit scores or those who cannot meet traditional requirements. To survive, neobanks must nurture these advantages outperform their incumbent counterparts.

Yet both sides are now facing threats from embedded finance, which is redefining the banking space. Non-banking brands are increasingly offering their customer financial features, which calls into the questions the relevance of traditional banks, or even neobanks, when customers can access credit and other banking products directly from their favourite brands.

Where does this leave neobanks?

The era of “cheap” funding is gone, and offering services at a price lower than cost is no longer sustainable. The way neobanks are set up fails to offer a rapid enough route to profitability, and the amount of relative capital means that they must think carefully about their next move. Indeed, even the biggest rounds of investment pale in comparison to the financial resources of traditional banks.

Innovation and differentiation are key if neobanks are to survive. Ant Financial is a great example of a neobank that has disrupted the Chinese financial space, now worth 50% more than Goldman Sachs. This has been made possible by the uniqueness of its value proposition: combining social media, ecommerce, and payments. Ant is the largest money market fund in the world, and the cherry on top is that it offers a return on surplus funds, which means consumers are moving money from their current accounts into their Alipay wallets.

More than ever, the survival chances of neobanks will depend on the experience and engagement offered to customers. As “choice architects” of potential changes to our financial services habits, neobanks will still have an opportunity to deliver a real shake-up – or risk other players taking this opportunity.

As neobanks deliberate about the future, expect to see the rise of technology-first companies leveraging embedded finance and offering their sprawling user base a reimagined financial services experience.

Going back to China’s financial services market, we can imagine social media companies making some bold moves and adding to their services the financial services experience layer. Could Twitter be the next big disruptor to the banking industry? Let’s see what the future holds.